DERIVATIVES ANALYSIS

DERIVATIVES ANALYSIS
K 1ST
A
S E

C.I.F.A
N
D
E ADVANCED LEVEL I
T
B
2024 I
O
N

Kimanzi Williams is a Public Accountant with over ten years’ experience in teaching and
publishing.
©
CENTER FOR CIFA STUDIES – 0727871093 - REVISION KIT Page 1
DERIVATIVES ANALYSIS

ISBN: 978-9914-40-549-1
All rights reserved. No part of this publication may be reproduced in any form without prior
permission from the author.
First published 2024

Published by:
FATIMA TRAINING INSTITUTE
THIKA - KENYA
0727-871-093
Email: [email protected].
Website: Fatima institute. Co.ke.
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INTRODUCTION
We are cheerful to present our First Edition of Derivatives Analysis Revision Kit which is
in line with the July 2021 Revised Syllabus. This Revision kit is ideal for the students
appearing for the C.I.F.A ADVANCED LEVEL.

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DERIVATIVES ANALYSIS

We have covered past papers from 2015 – 2023.

The suggested solutions to these past papers do not reflect the position of the examination
body (KASNEB) but that of the author.
This book among many others under the K.A.S.N.E.B Examinations can be obtained from
our You-Tube channel – @ Fatima Institute. We encourage the students to subscribe to our
You Tube channel so as to obtain as much information as possible from our lectures.

Note: Whereas we have summarized all the questions from 2015 – 2023, we have not
provided answers for those questions whereby the topic(s) were moved from the current
syllabus or purposely to test for your understanding in line with the CBC (Competency –
Based Curriculum) Where you find a question without a solution in this text, we have given
two reasons namely:

 Solution omitted deliberately – It means that the question/chapter is part of the syllabus but
we have not provided the solution deliberately so as to enable the student test his/her
understanding of the chapter independently.
 Not part of the syllabus – It means that the question is not part of this current syllabus. So no
solution is provided.

DISCLAIMER:
The solutions to these questions do not portray the position of KASNEB but that of the
author and as in such, these solutions may slightly differ from those provided for by
KASNEB.
Whereas every care has been taken for the sake of accuracy, the book may contain few
typing errors which we regret in advance if that is the case but we take no responsibility
since our focus is aimed at helping the students (not accuracy) understand some of the key
concepts for the purpose of the exam.
The purpose of this book is NOT to help the student to answer all the questions (2015 –
2023) but to offer a guidance on how to answer few of these questions then leave the
student alone to answer the rest of the questions. This we have done deliberately so as to
make the student competent and independent whenever not only when answering
examination questions but also when making financial and investment decisions in real life
situations.

PAPER NO. 16
DERIVATIVES ANALYSIS

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UNIT DESCRIPTION:
This paper is intended to equip the candidate with the knowledge and skills that will enable
him/her to analyze and trade in the various types of derivative investments.
LEARNING OUTCOMES
 Demonstrate an understanding of the features, structure and operations of derivatives
markets.
 Develop a framework for pricing various types of derivatives.
 Value derivative instruments using discrete time and continuous time valuation principles.
 Price and hedge interest rate swaps.
 Use financial derivative instruments for managing and hedging portfolio risk.
 Apply the framework for risk management so as to enable identification, assessment and
control of numerous sources of risk.

CONTENT

INTRODUCTION TO DERIVATIVE MARKETS AND INSTRUMENTS

1.1 Introduction to Derivatives.
1.2 Derivative specific definitions and terminologies.
1.3 Types of Derivatives: forward commitments, contingent claims, financial futures, forward
contracts, options, swaps, Exotic Derivatives, Forwards: Range forward contract, break
forward contract; Options: Asian or average-rate options, Look back options, Barrier options,
Rainbow options, Compound options, Chooser options; Swaps: Interest rate swap variants,
Currency swap variants, Equity swap variants.
1.4 Overview of derivative markets; regulation, players, Trading of financial derivatives,
Trading of commodities derivatives, Buying and shorting financial assets.
1.5 The Structure and purpose of derivative markets.
1.6 Users and uses of financial derivatives.
1.7 Criticisms of derivative markets.
1.8 Elementary principles of derivative pricing.
1.9 Size and Scope of derivatives markets; Global and regional derivatives markets.

FORWARD MARKETS AND CONTRACTS

2.1Introduction to forward markets and contracts
2.2 The structure and role of forward markets
2.3 Types of forward contracts: equity forwards contracts; bond and interest rate forward
contracts; currency forward contracts; other types of forward contracts.
2.4 Mechanics of Forward Markets and Contracts; Delivery and settlement of a forward
contract; default risk and forward contracts; termination of a forward contract; cost of carry
and transaction costs.
2.5 Pricing and valuation of forward contracts: generic pricing and valuation of forward
contracts; pricing and valuation of equity forward contracts; pricing and valuation of fixed-
income and interest rate forward contracts; pricing and valuation of currency forward
contracts
2.6 Credit risk and forward contracts.

FUTURES MARKETS AND CONTRACTS

3.1 Introduction: Definition of Futures, Brief history of futures markets;
3.2 Types of futures contracts: short-term interest rate futures contracts; intermediate- and
long-term interest rate futures contracts; Bond futures contracts; stock index futures

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contracts; currency futures contracts; Commodities futures contracts – Agricultural, Energy,

Precious and Industrial metal futures.
3.3 Characteristics of Futures markets: Public standardized transactions; homogenization and
liquidity; the clearinghouse; daily settlement; and performance guarantee; regulation
3.4 Futures trading: the clearinghouse, margins, and price limits; delivery and cash
settlement; futures exchanges. Mechanics of trading in futures markets; Long and short
positions, Profit and loss at expiration, Closing of positions, Delivery procedures, marking to
market of futures contracts, leverage effect, futures quotes.
3.5 Pricing and valuation of futures contracts: generic pricing and valuation of a futures
contract; pricing interest rate futures, stock index futures, and currency futures; Factors
determining contract price - CAPM, hedging pressure theory and cost of carry model;
Theoretical and Reality price of futures; Comparing the calculated value of the future vs the
market.
3.6 Uses of financial and non-financial futures.
3.7 The role of futures markets and exchanges.

RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES

STRATEGIES.
4.1 Introduction to risk exposures managed by Forwards and Futures.
4.2 Strategies and applications for managing interest rate risk: managing the interest rate risk
of a loan using a forward contract; strategies and applications for managing bond portfolio
risk.
4.3 Strategies and applications for managing equity market risk: measuring and managing the
risk of equities; managing the risk of an equity portfolio; creating equity out of cash; creating
cash out of equity.
4.4 Asset allocation with futures: adjusting the allocation among asset classes; pre-investing
in an asset class.
4.5 Strategies and applications for managing foreign currency risk: managing the risk of a
foreign currency receipt; managing the risk of a foreign currency payment; managing the risk
of a foreign-market asset portfolio
4.6 Hedging strategies using futures: hedge ratio, perfect hedge, basis risk and correlation
risk, minimum variance hedge ratio and hedging with several futures contracts.

SWAP MARKETS AND CONTRACTS

5.1 Introduction: Definition of Swap contracts, Types of swaps: currency swaps; interest rate
swaps; equity swaps; commodity and other types of swaps
5.2 Characteristics of swap contracts.
5.3 The structure of global swap markets.
5.4 Pricing and valuation of swaps; pricing and valuation of swaps.
5.5 Swaptions: basic characteristics of swaptions; uses of swaptions; swaption payoffs;
pricing and valuation of swaptions.
5.6 Termination of a swap.
5.7 Forward swaps.
5.8 The role of swap markets.
5.9 Uses of Swap Contracts: Credit risks and swaps.
RISK MANAGEMENT APPLICATION OF SWAP STRATEGIES
6.1 Introduction to risk exposures managed by Swaps.
6.2 Strategies and applications for managing interest rate risk: using interest rate swaps to
convert a floating-rate loan to a fixed-rate loan (and vice versa); using swaps to adjust the

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duration of a fixed-income portfolio; using swaps to create and manage the risk of structured
notes, reducing the cost of debt.
6.3 Strategies and applications for managing exchange rate risk: converting a loan in one
currency into a loan in another currency; converting foreign cash receipts into domestic
currency; using currency swaps to create and manage the risk of a dual-currency bond
6.4 Strategies and applications for managing equity market risk; diversifying a concentrated
portfolio; achieving international diversification; changing an asset allocation between stocks
and bonds; reducing insider exposure.
6.5 Strategies and applications using swaptions; using an interest rate swaption in anticipation
of a future borrowing; using an interest rate swaption to terminate a swap

OPTION MARKETS AND CONTRACTS

7.1 Introduction: Basic definitions and illustrations of options contracts:
7.2 Types of options: Financial options; options on futures; commodity options; other types
of options.
7.3 Characteristics of Options Contracts: some examples of options;
7.4 The concept of moneyness of an option.
7.5 The structure of global options markets: over-the-counter options markets; exchange-
listed option markets.
7.6 Options Valuation: Determinants of option price, Option pricing models, sensitivity
analysis options premiums.
7.7 Principles of option pricing; payoff values: Boundary conditions; the effect of a
difference in exercise price; the effect of a difference in time to expiration; put-call parity;
American options, lower bounds, and early exercise; the effect of cash flows on the
underlying asset; the effect of interest rates and volatility; option price sensitivities.
7.6 Discrete-time option pricing: The binomial model; the one-period binomial model; the
two-period binomial model; binomial put option pricing; binomial interest rate option
pricing; American options: extending the binomial model.
7.7 Continuous-time option pricing: The Black-Scholes-Merton model; assumptions of the
model; the black-Scholes-Merton formula; inputs to the black-Scholes-Merton model; the
effect of cash flows on the underlying; the critical role of volatility.
7.8 Pricing options on forward and futures contracts and an application to interest rate option
pricing: Put-call parity for options on forwards; early exercise of American options on
forward and futures contracts; the black model; application of the black model to interest rate
options
7.9 The role of options markets;
7.10 Uses of Options.

RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES

8.1 Introduction to risk exposures managed by options
8.2 Option strategies for equity portfolios: standard long and short positions; risk
management strategies with options and the underlying; money spreads; combinations of
calls and puts Interest rate option strategies using: interest rate calls with borrowing; interest
rate puts with lending; an interest rate cap with a floating-rate loan; an interest rate floor with
a floating-rate loan; an interest rate collar with a floating-rate loan
8.4 Option portfolio risk management strategies: delta hedging an option over time; gamma
and the risk of delta; Vega and volatility risk; the Greeks.

CONTEMPORARY ISSUES AND EMERGING TRENDS IN DERIVATIVES

CONTRACTS

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9.1 Numerical methods of Pricing Options: binomial model, finite difference method and
Monte Carlo method.
9.2 Credit derivatives: Credit default swaps (CDS), Credit linked notes (CLN), role of credit
derivatives, market participants, Valuation of credit derivatives, credit derivatives
institutional framework, spread volatility of credit default swaps.
9.3 Financial Engineering; Construction, Uses and Abuses of Derivatives.
9.4 Applications of Artificial intelligence and financial technology in derivatives markets.
9.5 Benefits and Indispensability of derivatives.
9.6 Trends and future of derivatives market globally.
9.7 Effects of Crises and Pandemic on global derivatives market.

TOPICS PAGE
1 INTRODUCTION TO DERIVATIVE MARKETS AND INSTRUMENTS........................ 9

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2 FORWARD MARKETS AND CONTRACTS…………………………………………….. 42

3 FUTURES MARKETS AND CONTRACTS……………………………………………… 81
4 RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES STRATEGIES…….. 124
5 SWAP MARKETS AND CONTRACTS…………………………………………………… 153
6 RISK MANAGEMENT APPLICATION OF SWAP STRATEGIES……………………… 174
7 OPTION MARKETS AND CONTRACTS………………………………………………… 189
8 RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES…………………. 311
9 CONTEMPORARY ISSUES AND EMERGING TRENDS IN DERIVATIVES CONTRACTS….

CHAPTER ONE
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INTRODUCTION TO DERIVATIVE MARKETS AND INSTRUMENTS

PAGE
 Introduction to Derivatives……………………………………………
 Derivative - Specific definitions and terminologies…………………..
 Types of Derivatives…………………………………………………..
Forward commitments, contingent claims, financial futures, forward contracts, options,
swaps, Exotic Derivatives, Forwards: Range forward contract, break forward contract;
Options: Asian or average-rate options, Look back options, Barrier options, Rainbow
options, Compound options, Chooser options; Swaps: Interest rate swap variants,
Currency swap variants, Equity swap variants.
 Overview of derivative markets………………………………………..
Regulation, players, Trading of financial derivatives, Trading of commodities derivatives,
Buying and shorting financial assets.
 The Structure and purpose of derivative markets………………………
 Users and uses of financial derivatives…………………………………
 Criticisms of derivative markets……………………………………….
 Elementary principles of derivative pricing……………………………
 Size and Scope of derivatives markets; Global and regional derivatives markets…..

KEY TOPIC ISSUES

What are derivatives?
Derivatives are financial contracts, set between two or more parties that derive their value
from an underlying asset, group of assets, or benchmark. A derivative can trade on an
exchange or over-the-counter. Prices for derivatives are derived from fluctuations in the
underlying asset.
Derivatives are products whose value is derived from one or more basic variables called
underlying assets or base. In simpler form, derivatives are financial security such as an option
or future whose value is derived in part from the value and characteristics of another
underlying asset. The primary objectives of any investor are to bring an element of certainty
to returns and minimize risks. Derivatives are contracts that originated from the need to limit
risk.
Derivative contracts can be standardized and traded on the stock exchange. Such derivatives
are called exchange-traded derivatives. Or they can be customized as per the needs of the user
by negotiating with the other party involved. Such derivatives are called over-the-counter
(OTC) derivatives.
What is a derivative market?
A derivative market is a platform where financial securities that fall under the category of
derivative contracts are traded. A derivative market is specially designed to facilitate the
trading of all derivatives. Derivative markets include both exchange-traded derivatives and
Over-the-Counter (OTC) derivatives. A derivative is a type of financial instrument based on
the value of an underlying asset, including stocks, commodities, and currencies. Derivatives
take the form of a financial contract between two or more parties. The four main types of
derivative contracts include forwards, futures, options, and swaps. Derivatives are traded
only on the derivative market, and investors use derivatives to hedge their risk.
Derivative Markets function through contracts formed between parties by betting on the
forthcoming value of an underlying asset or group of assets. A derivative contract is
purchased based on the price predictions of the underlying asset. In order to undertake

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derivatives trading, a derivative account, a trading account, and a margin maintenance

amount are essential. Using these three requisites, participants purchase in derivatives
contracts. Derivatives trading in a derivatives market occurs through exchange or over-the-
counter trading. Derivative trading through an exchange is governed by a regulatory body,
whereas over-the-counter trading is not regulated by any authority. The derivative market
participants enter into financial contracts with other participants by placing bets on the
predicted prices of the underlying assets. In a derivative market, there are four participants,
namely speculators ,arbitrageurs, hedgers, and margin traders. These four participants in
the derivatives market are classified according to their trading motives.
A derivative market is a financial platform that facilitates trading all financial instruments
that fall within the derivatives category and whose values are derived from underlying assets.
The derivatives market includes both exchange-traded derivatives and over-the-counter
derivatives. Derivative markets handle the trading of all four types of derivatives, including
futures, swaps, options, and forward contracts. All derivative markets comprise four main
participants, including hedgers, speculators, arbitrageurs, and margin traders. Participants
turn to the derivatives market mainly to hedge against risks and to take advantage of
arbitrage.
For instance, a farmer who produces cotton enters into a derivative contract with a textile
miller. The farmer’s objective in entering the contract is to mitigate the risk of a fall in the
price of cotton. The contract ensures that he is paid a reasonable predetermined amount on a
fixed future date, irrespective of price fluctuations. For the textile miller, the contract serves
as a hedge against the impact of a rise in the price of cotton. The contract locks the price at an
amount that is agreeable to both parties. The fear of the seller is when the price goes down,
he/she will be losing while the fear of the buyer is that if the price goes up he/she will be
buying at a higher price. Not unless there is no change in price, one party will gain while the
other will lose depending with the direction of the future price.

Importance of Derivative markets

1) It increases the volume of transactions.
2) In derivative markets, the transaction costs are lower
3) The risk of holding underlying assets is lower
4) It gives increased liquidity for investors
5) It leads to faster execution of transactions
6) It enhances the price discovery process
7) It facilitates the transfer of risk from risk averse investors to risk takers.
8) It increases the savings and investments in the economy.

How do Derivative Markets work?

The derivatives market works as a financial contract between two or more parties. The
derivatives market functions based on the bets placed on the future prices of the underlying
assets. Derivative contracts can be purchased on the derivatives market, which is either
through exchanges or over-the-counter transactions.
There are two main classes of derivative contracts, namely, “lock” and “option.” A lock binds
the parties entering the contract to terms that are decided upon by the involved parties. An
option gives the holders the right to purchase or sell the predetermined security at a set price
on or before a fixed date. Options, however, are not obligatory like locks. Market
participants, including hedgers, speculators, arbitrageurs, and margin traders, enter into
derivative contracts with other market participants depending on their investment objectives.
For example, a carrot farmer enters into a “lock” contract with a vegetable seller. The
farmer’s objective is to hedge against a drop in the prices of carrots. By entering into a “lock”

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contract, the vegetable seller agrees to purchase a fixed quantity of carrots for a fixed price on
a set date. The vegetable seller’s objective in entering the contract is to hedge against the
possibility of an increase in the price of carrots. In this manner, each participant enters into a
derivative contract depending on their needs and investment objectives.
Market participants can buy or sell derivative instruments through an exchange or over-the-
counter transactions. Exchange-based transactions in the derivatives market are regulated by
authorized bodies, whereas contracts made through over-the-counter transactions are not
regulated by any authority. Over-the-counter transactions in the derivatives market, thus, pose
more risk.
The underlying assets in a derivative market include stocks, bonds, currencies, commodities,
etc. Predicted price fluctuations in the underlying asset determine the prices of the
derivatives.
The four main steps in trading in a derivatives market are listed below.
1. Conducting market research
The first step to trading in a derivatives market is conducting proper market research.
Derivatives contracts are bets placed on the predicted value of underlying assets. Therefore,
the strategies applied to the derivatives market differ from that applied to stock markets, as
derivative contracts are based on the expected change in the asset prices and not their current
market price.
2. Opening a demat and trading account
The second step in trading in the derivatives market is opening a demat and trading account.
These two are requisites to undertaking trades in the derivatives market. The accounts can be
created online in any brokerage of the investor’s choice. Once the two accounts are set up, the
participants can enter into derivative contracts, either through an exchange or through over-
the-counter transactions.
3. Maintaining a margin balance
The third step to keep in mind while trading in the derivatives market is maintaining a margin
amount. A margin amount is essential in derivatives trading and cannot be withdrawn from
the account until the derivative contract’s expiry date.
4. Undertaking desired trades
The fourth and final step in trading in the derivatives market is undertaking the desired trades.
The participants can opt for lock or options contracts depending on the investment goals.
They can also choose from various derivatives available, including forwards, options, swaps,
and futures.

Futures Contract
A futures contract is an agreement between two parties that gives the holder the right to
purchase or sell the underlying asset for a specified price on a specific date. Futures contracts
are obligatory, and therefore binding on the two parties. Futures contracts are standardized
derivative contracts that trade on exchanges. Traders use futures contracts to hedge against
risks due to price fluctuations in the underlying assets. Futures contracts promise the holder a
predetermined buying or selling price, which remains unaltered irrespective of the market
volatility, and therefore shields them from risk.
Futures contracts are based on any type of asset or commodity, including agricultural goods,
energy-based commodities, stocks, bonds, etc. For example, an agricultural future contract is
based on an agricultural commodity such as wheat or cotton. A bakery owner buys a futures
contract for wheat, for 100 kg at Kes. 40,000, with an expiry date of December 23, 2022. The
bakery owner makes this purchase because he fears the wheat price will increase. By
purchasing this futures contract, he is assured 100 kg at Kes. 40,000 irrespective of the price
change.

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Swaps Contract
Swaps are derivative contracts with two holders who exchange the obligatory financial terms
of the contract. Swaps are not sold through exchanges as they are tailor-made to suit the
requirements of the two participating parties. Commonly used swap contracts include interest
rate swaps, currency exchange rate swaps, mortgage bond swaps, etc. Swap contracts help
investors and traders to exchange one type of cash flow with another.
For example, let us assume that a company, A borrows a loan of Rs 20 lakhs at a variable
interest of 5% now. Since the loan is of variable interest, A worries about the increasing
interest rates and thus wishes to switch to a fixed interest rate. In such a situation, A can
approach another company B, which has a fixed-interest loan at 6%. B is willing to exchange
the payments from the fixed rate loan of 6% for the payments from the variable interest loan
of 5%. A will have to pay B the percentage difference of 2% on the principal amount of 20
lakhs if the variable interest rate drops to 4%. However, B will have to pay A the percentage
difference of 1% if the variable interest rate increases from 5% to 7%. In this manner, A can
switch from a variable-interest loan to a fixed-interest one.
Traders enter into swap contracts to shift from variable interest rates to fixed interest rates. It
can also be used to switch from fixed interest rates to variable interest rates. Swap contracts
come in handy, mainly when lenders are reluctant to lend more credit to companies.

Options Contract
Options contracts are derivative contracts that give buyers the right to buy or sell the
underlying asset on or before a specified date. Options contracts, however, are not obligatory
wherein the buyer is bound to fulfill the terms of the contract. Like futures contracts, options
contracts also form an agreement between two parties. The only difference between a futures
contract and an options contract is that the holders of options contracts are not under any
obligation to buy or sell the asset as deemed by the contract. Options contracts only provide
their holders with the opportunity to buy or sell an asset at a specific price, should they so
desire. Option contracts protect traders from risks while allowing them to avoid falling
through with the contract if the contract terms do not seem attractive later. Options help
traders to hedge against market price fluctuations.
For example, an investor, X, owns 100 shares in a company, AB. Let us assume that the price
of each share is Kes. 100. X is worried about price fluctuations that can cause a decline in his
stock price, so he decides to buy an options contract. Through an exchange, X buys an option
that allows him to sell the 100 shares for Kes.100 each on or before a specified date. Let us
assume that the stock price falls to Kes 80 per share before the contract’s expiry date. Using
the option, the option holder gets to sell his shares at the predetermined price of Kes 100 per
share. Assuming that the options contract costs the buyer Kes 1000, this is the only cost
incurred by the option holder. Without the options contract, he would have had to sell his
shares for Kes 80 each, incurring a loss of Kes 2000.
Options also help speculators in speculating the forthcoming market prices.

Forward Contract
Forward contracts are derivatives that are similar to future contracts but are sold over the
counter rather than through an exchange. Forward contracts are customized agreements
whose terms are made to cater to the needs of the buyers and sellers. Since they are sold over
the counter, they encompass more risk to both the involved parties. Forward contracts do not
fall under the jurisdiction of regulatory authorities such as the SEBI in India and the SEC in
the United States, thereby making them riskier than futures contracts. Forwards contracts

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involve counterparty risks when one party cannot fulfill their obligations as deemed by the
contract.
Forward contracts, like futures contracts, help hedge as well as speculate. Forward contracts
shield holders from incurring huge losses apart from offering the two parties the means to
customize the contract according to their specific needs. Since futures contracts are exchange
based, they cannot be altered to suit the needs of the two parties. In situations where there’s a
need to customize the derivatives contract, the forward contract works better. For example, a
company can purchase a forward contract for oil for Kes 3800 a barrel with an expiry date of
November 23, 2024, from an oil seller. This contract ensures that regardless of the price
fluctuations, the company can buy oil for Kes 3800 a barrel on the set date. However, since
the contract is not exchange-based, there is a slight chance that the seller will not stick to the
terms of the contract.

What are the advantages of the Derivative Market?

The five main advantages of the derivatives market are listed below.
1. To hedge securities against risk.
One of the key advantages of the derivatives market is that it allows traders to hedge their
securities. By hedging, traders can protect themselves from huge losses from market
volatility.
2. To transfer risk to other market participants.
The transference of risks onto the risk seekers is another critical advantage of the derivatives
market. The derivatives market comprises risk-averse and risk-seeking traders as participants,
making it possible for the risk-averse traders to pass on the risk to the risk seekers, mainly
through speculations.
3. To lock prices from fluctuations.
Another main advantage of the derivatives market is that it allows the holders to lock the
prices of the underlying assets. Once the contract is bought, the asset’s price cannot be
altered, irrespective of the price changes in the market. The feature is handy to traders,
including producers and farmers, who face huge losses when commodity prices fall.
4. To make profits through arbitrage.
Making profits through arbitrage is another advantageous feature of the derivatives market.
Apart from offering profits to the traders, arbitrage also helps to fix market pricing
inefficiencies in the market, wherein securities are priced lower or higher than they should
be.
5. To mitigate risks cost-effectively.
The derivatives market gives traders and investors a cost-effective way of hedging, as
derivatives contracts can be purchased using the margin balance in the account. The margin
balance is only a tiny percentage of the total cost of the derivatives contract.

What are the disadvantages of the Derivative Market?

The four commonly pointed-out disadvantages of the derivatives market are listed below.
1. The risk involved.
The derivatives market is not entirely risk-free. Over-the-counter contracts are considered
even riskier than exchange-based derivatives, primarily because no authority regulates them.
2. The effect of market volatility
The derivatives market is volatile. For example, derivative contracts are sensitive to changes
in interest rates or the expiry periods of the contracts, making the derivatives market volatile.
3. The complex functioning of the derivatives market

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The functioning of the derivatives market can seem complex to many traders and investors
because derivatives are contracts based on the value of an underlying asset. However, trading
in the derivatives market is not done directly through the underlying asset.
4. The counterparty risks associated with derivatives
Derivatives are associated with a greater risk of counterparty risks. Counterparty risk refers
to the risk of the other party in the contract not fulfilling their obligations concerning the deal.
Since OTC derivatives do not come under the jurisdiction of securities regulatory bodies, the
counterparty risk is more significant for OTC derivatives.

What is arbitrage?
Arbitrage is an investment strategy in which an investor simultaneously buys and sells an
asset in different markets to take advantage of a price difference and generate a profit. While
price differences are typically small and short-lived, the returns can be impressive when
multiplied by a large volume. Arbitrage is commonly leveraged by hedge funds and other
sophisticated investors.

REVISION QUESTIONS

DECEMBER 2023
Q.1.A – Explain the following terms as used in derivatives markets:
i. Forward commitments. (2 mks)
ii. Contingent claims. (2 mks)
iii. Exotic derivatives. (2 mks)

Forward commitments are contracts in which the parties promise to execute the
transaction at a specific later date at a price agreed upon in the beginning.
They are legally binding promises to perform some actions in the future. They include
forward contracts, futures contracts and swaps. Forward commitments are contracts in
which the two parties enter into an agreement to engage in a transaction at a later date at a
price established at the start. Within the category of forward commitments, two major
classifications exist: exchanged-traded contracts, specifically futures, and over-the-counter
contracts, which consist of forward contracts and swaps.

Contingent claims are contracts in which the payoff depends on the occurrence of a certain
event. Unlike forward commitments where the contract is bound to be settled on or before
the termination date, contingent claims are legally obliged to settle the contract only when a
specific event occurs. Contingent claims are also categorized into OTC and exchange-traded
contracts, depending on the type of contract.
Options are contingent claims that depend on the stock price at some future date.
Forwards, futures and swaps have payments that are made based on a price or rate of
outcome whether the movement is up or down. Contingent claims only require a payment if
a certain threshold price is broken.
For instance, a product is currently trading at sh. 55. Rebecca may promise Naomi that she
will buy this product in the future if the price falls below sh. 50. Sincerely it can be
observed that for Rebecca to buy this product the product must be trading at less than sh.
50. For the product to trade at less than sh. 50 is an uncertain / contingent event.
Any derivative instrument that is not a contingent claim is called a forward commitment.
Contingent claims are derivatives in which the payoffs occur if a specific event happens.
We generally refer to these types of derivatives as options. Specifically, an option is a
financial instrument that gives one party the right, but not the obligation, to buy or sell an

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underlying asset from or to another party at a fixed price over a specific period of time. An
option that gives the right to buy is referred to as a call; an option that gives the right to sell is
referred to as a put. The fixed price at which the underlying can be bought or sold is called
the exercise price, strike price, striking price, or strike, and is determined at the outset of the
transaction. In this book, we refer to it as the exercise price, and the action of buying or
selling the underlying at the exercise price is called exercising the option. The holder of the
option has the right to exercise it and will do so if conditions are advantageous; otherwise, the
option will expire unexercised. Thus, the payoff of the option is contingent on an event taking
place, so options are sometimes referred to as contingent claims.
In contrast to participating in a forward or futures contract, which represents a commitment
to buy or sell, owning an option represents the right to buy or sell. To acquire this right, the
buyer of the option must pay a price at the start to the option seller. This price is called the
option premium or sometimes just the option price. In this book, we usually refer to it as the
option price. Because the option buyer has the right to buy or sell an asset, the seller of the
option has the potential commitment to sell or buy this asset. If the option buyer has the right
to buy, the option seller may be obligated to sell. If the option buyer has the right to sell, the
option seller may be obligated to buy. As noted above, the option seller receives the amount
of the option price from the option buyer for his willingness to bear this risk.

Exotic derivatives
Exotic derivatives are financial products with complicated underlying contracts. Derivatives
are based on the value of underlying assets and can vary in complexity, allowing people to
control risk by buying, selling, and trading derivative contracts. In the case of exotic
derivatives, the structure of the contract is not straightforward, and may be customized for a
specific investor or market. This contrasts with vanilla derivatives, which have
straightforward terms.
An exotic derivative, in finance, is a derivative which is more complex than commonly traded
"vanilla" products. This complexity usually relates to determination of payoff. The category
may also include derivatives with a non-standard subject matter - i.e., underlying - developed
for a particular client or a particular market. The term "exotic derivative" has no precisely
defined meaning, being a colloquialism that reflects how common a particular derivative is in
the marketplace. As such, certain derivative instruments have been considered exotic when
conceived of and sold, but lost this status when they were traded with significant enough
volume. Examples of this phenomenon include interest rate- and currency-swaps. As regards
valuation, given their complexity, exotic derivatives are usually modeled using specialized
simulation- or lattice-based techniques. Often, it is possible, to "manufacture" the exotic
derivative out of standard derivatives. For example, a knockout call can be "manufactured"
out of standard options.

Q.1.B – Describe three market participants in derivatives markets. (6 mks)

The participants in the derivative markets can be broadly classified into three depending upon
their motives. These are:
1) Hedgers
2) Speculators
3) Arbitrageurs

Hedgers
Hedgers are those who enter into a derivative contract with the objective of covering risk. A
farmer growing wheat faces uncertainty about the price of his produce at the time of the
harvest. Similarly, a flour mill needing wheat also faces uncertainty of price of input.

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Both the farmer and the flour mill can enter into a forward contract, where the farmer agrees
to sell his produce when harvested at predetermined price to the flour mill. The farmer
apprehends price fall while the flour mill fears price rise. Both the parties face price risk. A
forward contract would eliminate price risk for both the parties. A forward contract is entered
into with the objective of hedging against the price risk being faced by the farmer as well as
the flour mill. Such participants in the derivatives markets are called hedgers. The hedgers
would like to conclude the contract with the delivery of the underlying asset. In the example
the contract would be settled by the farmer delivering the wheat to the flour mill on the
agreed date at an agreed price.

Speculators
Speculators are those who enter into a derivative contract to make profit by assuming risk.
They have an independent view of future price behavior of the underlying asset and take
appropriate position in derivatives with the intention of making profit later.
For example, the forward price in US dollar for a contract maturing in three months is
$ 48.00. If one believes that three months later the price of US dollar would be $50, one
would buy forward today and sell later. On the contrary, if one believes US dollar would
depreciate to ` $46.00 in 1 month one would sell now and buy later. Note that the intention is
not to take delivery of underlying, but instead gain from the differential in price.

Arbitrageurs
I first define the term arbitrage from where this name is derived from.
Arbitrage – The act of buying a product from markets with low prices and selling in the
markets with high prices so as to make a profit.
An arbitrageur takes risk neutral position and makes profits because markets are imperfect.
Naturally, such imperfections cannot exist for long. These imperfections are extremely short-
lived. The arbitrageur cashes upon these short-lived opportunities. Such actions restore the
balance in prices and remove distortions in the pricing of assets.
Fundamentally the speculators and arbitrageurs fall in the same category in as much as that
both are not looking at owning or disowning the underlying asset by delivery like hedgers.
Both speculators and arbitrageurs are also trying to render competitiveness to the market,
thereby helping the price discovery process. Difference between the two lies in the amount of
risk they assume.
While speculators have their opinions about the future price of the underlying asset by
making investment, the arbitrageur is concentrating on the mispricing in different markets by
taking riskless position with no investment of his own. By his actions an arbitrageur is
restoring the balance and consistency among different markets, while speculators only hope
for the desirable movement in prices. Arbitrageurs are the ones who prohibit speculators to
overbid or underbid the prices in the derivatives as compared to the physical markets.

Q.4.A – Highlight four common characteristics among all forward commitments. (4 mks)
Forward commitments are: forward contracts, futures contracts and swaps.
1)There is an agreement to buy or sell an asset at a future date at a pre-determined price.
2)There must be an underlying asset upon which the price depends on.
3)The contracts do not depend on the occurrence of uncertain future events as it is the case
with contingent claims.
4)The major motive is hedging/risk mitigation.
5)There is no delivery of goods/services at the initiation of the agreement.
6)They can be tailored to meet the needs of both parties.
7)There can be a counterparty default risk.

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AUGUST 2023
Q.1.A – Discuss three criticisms of derivatives markets. (6 mks)
1)Speculation and gambling.
2)Destabilization and systematic risk.
3)Complexity.

Speculation and Gambling

For hedging to work, there must be speculators on the other side of the trade. The more
speculators the market attracts, the cheaper it becomes to hedge. Unfortunately, the
perception of speculators is not a good one. They are thought to be short-term traders who
seek to make a short-term profit and engage in price manipulation and trade at extreme
prices. The profit from short-term trading is taxed more heavily than profit from long-term
trading – a way of “punishing” these activities.

Destabilization and Systemic Risk

Opponents of the derivatives market claim the operational benefits result in an excessive
amount of speculative trading, bringing instability to the financial markets. They argue that as
speculators use large amounts of leverage, they are subjecting themselves and their creditors
to high risk if the market moves against them. Defaults by speculators can lead to defaults by
their creditors, and these chain-reaction events can be systemic. Instability can, therefore, be
spread through the market.

Complexity
Another criticism of derivatives is their complexity. Although it is unclear why complex
mathematics should create criticism, when the models on which derivative pricing is based
break down due to sometimes irrational actions by financial market participants, the model
builders are often blamed for failing to capture financial market reality accurately.

APRIL 2023
Q.1.A – Outline three distinctions between “contingent claims” and “forward commitments”
as used in derivatives. (6 mks)
Forward Commitments
Forward commitments are contracts entered into between two parties that require both parties
to transact in the future at a pre-specified price known as the forward price. The parties and
the identity and quantity of the underlying are specified. Also specified are the date of the
future transaction (expiration) and the nature of the settlement. The parties have to transact;
they are obligated to do so. In the event of non-performance, because of the obligation of the
forward contract, a legal remedy is possible to enforce the obligation. The payoff profiles of
forward commitments are linear in nature and move upwards or downwards in direct relation
to the price of the underlying asset. Forward commitments include futures contracts and
forwards contracts.

Contingent Claims
A contingent claim is a type of option where the payoff profile is dependent on the outcome
of the underlying asset. This is not dissimilar to a forward commitment, however with a
contingent claim, there is the right to transact but not the obligation. Given that the holder of
the contingent claim has the option as to whether to transact or not, contingent claims have
become synonymous with the term “option.” Due to this choice, the payoff profile of an

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option contract is not linear. Instead, options limit losses in one direction and therefore
transform the payoff profile of the underlying asset.

Contingent claims Forward commitments

The payout is dependent on the realization This is an agreement to buy or sell an asset
of some uncertain future events. at a future date at a pre-determined price.
The primary type is options. Primary types are forwards, futures and
swaps.

DECEMBER 2022
Q.1.A – Outline four differences between a cash market and a derivative market. (4 mks)
A cash market is a marketplace in which the commodities or securities purchased are paid for
and received at the point of sale. For example, a stock exchange is a cash market because
investors receive shares immediately in exchange for cash. A cash market is referred to as a
marketplace in which financial tools like commodities and securities are purchased and
received in exchange for cash. Cash markets are also known as spot markets as the
transaction is settled on spot. Cash market transactions can be conducted either in a regulated
environment such as a stock exchange or on some over the counter transactions that are
deemed as unregulated.
A derivatives market is a financial marketplace for financial instruments like future contracts
or options which are borrowed from other asset forms. Trading motives obviously differ
within the derivatives market but there are four groups of participants, Hedgers, Speculators,
Margin Traders and Arbitrageurs.
The derivatives market has come under attack in recent years with the accusation that they
played a role in the financial crisis of 2007-2008, with specificity placed on the Credit
Default Swaps (CDS). CDS are instruments which are traded within the over the counter
derivatives market. Their leveraging options make them appealing in terms of risk taking, and
the lack of clearing obligations became very damaging for the balance with the markets. The
G20 proposed a financial markets reform with emphasis on, amongst other things, stronger
risk management and an international surveillance of financial firms’ operations.

Differences between cash market and derivatives market

1) Ownership
When you buy shares in the cash market and take delivery, you are the owner of these shares
or you are a shareholder, until you sell the shares. You can never be a shareholder when you
trade in the derivatives segment of the capital market. This is because you just hold positional
stocks, which you have to square-off at the end of the settlement.
2) Holding period
When you buy shares in the cash segment, you can hold the shares for life. This is not true in
the case of the futures market, where you have to settle the contract within three months at
the very maximum. In fact, when you buy shares in the cash segment they can also be trans-
generational, that is they can be transferred from one generation to the other.
3) Dividends
When you buy shares in the cash segment, you normally take delivery and you are the
owner. Hence, you are entitled to dividends that companies pay. No such luck when you buy
any derivatives contract. This is not only true in the case of dividends, but, also other
corporate benefits like rights shares, bonus shares etc.
4) Risk
Both, cash and futures markets pose risk, but the risk in the case of futures can be higher,
because you have to settle the contract within a specified period and book losses. In the case

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of shares bought in the cash market, you can hold onto them for an indefinite period and can
hence sell when prices are higher.
5) Investment objective differs-You buy a contract in the derivatives market to hedge risk or
to speculate. Individuals buying shares in the cash market are investors.
6) Lots vs shares - In the derivatives segment you buy a lot, while in the cash segment you
buy shares.
7) Margin money - In the derivatives segment you pay only margin money for example, if
you buy 1 lot of Kenya National Bank (4000 shares) you just pay 15 to 20 per cent of the
cost of the 4,000 shares and not the entire amount. That is not true in the case of cash
segment, where you have to pay the entire amount and not only margin.

Cash markets Derivatives markets

In a cash (spot) market, purchasers take Investors purchase the right to take possession
immediate possession of goods at the point of at some future date.
sale.
Cash market trades assets such as equities. Derivative markets trade contracts e.g. futures
Cash markets create ownership because the and options.
transfers take place with immediate effect. Derivatives do not create ownership but they
are a contract between two traders having
different views about the possible price
movement of the underlying asset.
Cash market has timeless assets. Derivatives markets have expiries.
Equity has really no time limit. You can hold it Since derivative market trades are contracts,
as long as the company is in existence and the they necessarily have an expiry. For instance, a
equity shares exist. How long you want to hold typical derivatives contract can either have a 1-
is your choice but the asset per se is perpetual. month expiry, 2-month expiry or a 3-month
expiry. But you cannot hold your futures
position for ever. You have to close the
position on or before the expiry, otherwise the
exchange will automatically close the position
and debit or credit the losses or profits on your
position.
There is no speculation, hedging and arbitrage. There is a lot of speculation, hedging and
arbitrage.
There are IPOs in the cash market. There is only secondary trading.
Equities are originated through the IPO market There is no concept of IPO in derivatives
where companies come to raise fresh funds. market. Here standardized contracts are
Eventually, they become secondary market introduced by the exchange on a periodic basis
traded stocks once they are listed. in a pre-accepted format and logic. Once the
contracts are introduced, traders can trade in
these futures and options contracts.
Cash markets are more expensive because of Derivative markets are cheaper because they
brokerage fees and statutory fees. are leveraged products
In the case of options, the STT is charged on
the premium value rather than on the notional
value which makes these derivative products a
lot more cost effective.
These are less risky. These are more risky.
Prima facie, if you compare trading in equities
and speculating in futures and options, equities

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are less risky than futures and options. For

instance, it has been empirical observed that
equities have typically created wealth in the
long run if you create a diversified quality
portfolio. That is not true of futures and
options. The cost and risk calculations are lot
more complicated. However, it must be said
that derivatives used as a hedge actually reduce
the risk in equities.

Q.1.B - Explain three types of forward commitment contracts. (6 mks)

Forward commitments are contracts in which the parties promise to execute the transaction
at a specific later date at a price agreed upon in the beginning.
There are three main types of derivatives with forward commitments: forward contracts,
futures contracts and swaps.
Forward commitments include forwards, futures, and swaps. A forward contract is a promise
to buy or sell an asset at a future date at a price agreed to at the contract's initiation . The
forward contract has a linear payoff function, with both upside and downside risk.
Forward contracts
A forward contract is a customized contract between two parties to buy or sell an asset at a
specified price on a future date. A forward contract can be used for hedging or speculation,
although its non-standardized nature makes it particularly suitable for hedging.
Suppose you are a farmer and you want to sell corn at the current rate of sh. 1,000, but you
know that corn prices will fall in the coming months ahead. In this case, you enter a contract
with a grocery for selling them a particular amount of corn at sh. 1,000 in three months.
Futures contracts
A futures contract is a legal agreement to buy or sell a standardized asset on a specific date or
during a specific month that is facilitated through a futures exchange. It is a legal agreement
to buy or sell a particular commodity asset, or security at a predetermined price at a specified
time in the future.
For example, if someone wants to buy a February crude oil futures contract. So they make a
futures contract that they will buy 300 barrels of oil from the agreed price as of February
expiration whatever the market price at that time. The seller also agrees to sell those 300
barrels of oil at the agreed price.
Forward contracts and futures contracts may look similar but we should note the following
difference:
A forward contract is a private and customizable agreement that settles at the end of the
agreement and is traded over the counter (OTC). A futures contract has standardized terms
and is traded on an exchange, where prices are settled on a daily basis until the end of the
contract.
Swaps
A swap is a derivative contract through which two parties exchange the cash flows or
liabilities from two different financial instruments. Most swaps involve cash flows based on a
notional principal amount such as a loan or bond, although the instrument can be almost
anything.
It is a derivative contract between two parties that involves the exchange of pre-agreed cash
flows of two financial instruments.
A swap is a derivative contract where one party exchanges or "swaps" the cash flows or value
of one asset for another. For example, a company paying a variable rate of interest may swap
its interest payments with another company that will then pay the first company a fixed rate.

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Note:
A derivative is a contract between two parties which derives its value/price from an
underlying asset. The most common types of derivatives are: futures, options, forwards and
swaps.
It is a financial instrument which derives its value/price from the underlying assets.
Originally, underlying corpus is first created which can consist of one security or a
combination of different securities. The value of the underlying asset is bound to change as
the value of the underlying assets keep changing continuously.
Underlying assets are the financial assets upon which a derivative's price is based. Options
are an example of a derivative. A derivative is a financial instrument with a price that is based
on a different asset. Generally stocks, bonds, currency, commodities and interest rates form
the underlying asset.

AUGUST 2022
Q.1.A – Discuss three features of derivatives. (6 mks)
1) Initially, there is no profit or loss for both the counterparties in a derivative contract.
2) Fair value of the derivative contract changes with changes in the underlying asset over time.
3) It requires either no initial investment or requires a small initial investment compared to the
actual outright buying/selling of the underlying asset.
4) They are always traded with future maturity and settled in the future.

Q.1.B – Cite four reasons why exotic derivative products have become popular in the recent
past. (4 mks)
To answer this question, the student needs to know the benefits of Exotic derivatives over
the plain vanilla.
Exotic derivatives are financial products with complicated underlying contracts. Derivatives
are based on the value of underlying assets and can vary in complexity, allowing people to
control risk by buying, selling, and trading derivative contracts. In the case of exotic
derivatives, the structure of the contract is not straightforward, and may be customized for a
specific investor or market. This contrasts with vanilla derivatives, which have
straightforward terms.
An exotic derivative, in finance, is a derivative which is more complex than commonly traded
"vanilla" products. This complexity usually relates to determination of payoff. The category
may also include derivatives with a non-standard subject matter - i.e., underlying - developed
for a particular client or a particular market. The term "exotic derivative" has no precisely
defined meaning, being a colloquialism that reflects how common a particular derivative is in
the marketplace. As such, certain derivative instruments have been considered exotic when
conceived of and sold, but lost this status when they were traded with significant enough
volume. Examples of this phenomenon include interest rate- and currency-swaps. As regards
valuation, given their complexity, exotic derivatives are usually modeled using specialized
simulation- or lattice-based techniques. Often, it is possible, to "manufacture" the exotic
derivative out of standard derivatives. For example, a knockout call can be "manufactured"
out of standard options.
An exotic derivative is a more complex derivative than those normally transacted, or relative
to plain vanillas. This complexity is usually how the return and the characteristics of the
contract are defined. Exotic derivatives include, for example, derivatives whose contract is
not standardized in the sense that the underlying asset is not common and can be made for a
particular customer or market. In addition to that, the advanced structure presented by exotic
derivatives allows holders to have significant returns that they wouldn’t have with the hold of
plain vanilla derivatives. These types of derivatives are associated with a high risk.

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Why Exotic derivatives are popular

For investors, exotic derivatives create more options. People concerned with controlling and
managing risk may find vanilla derivatives poorly suited or inadequate for their needs,
depending on the type of risk involved.
Exotic Options belong to that category of Options Trading or Options Contracts, which
are a bit different from the traditional Vanilla Options. These differences are with regard
to the payment structures, expiration dates and strike prices. Also, Exotic Options
provide various investment alternatives. This leads to a broader portfolio for the
investors.
There are some features that explain Exotic Options very well, and these are:
 An Exotic Option has a “payoff” structure which is unlike the traditional Option’s payoff
structure. Option payoff is nothing but the net profit/loss made by the buyers and sellers
of options.
In case of Exotic Options, the payoff at the maturity is based on not only the value the
underlying index holds at maturity but also on its value several times during the course
of the contract's life.
1) Also, another interesting feature of Exotic Options is that they may also include a non-
standard underlying asset/instrument specifically developed for a client in particular or a
specific market.
2) The value of an underlying asset or instrument can be based on more than one index.
3) They are generally traded Over-The-Counter (OTC). Generally, investors choose Exotic
Options for getting a diversified portfolio which is quite broad.
4) There could be call-ability and put-ability rights.
5) Also, it could involve foreign exchange rates in various ways. As they are advanced,
they surely also have some uncommon advantages. Exotic Options have gained an upper
hand over the traditional Vanilla options by:
1) Customizing risk-management needs of the investors.
2) Providing investors with a broad portfolio to meet their portfolio needs.
3) Offering lower premiums as compared to the Traditional Options.

VANILLA DERIVATIVES
Like in ice cream, vanilla derivatives, or plain vanilla, are the simplest and most common
version of an asset or financial instrument. There are no embellishments, no extras, and no
complex features. These are usually applied to options, bonds, futures and swaps and are
generally associated with lower risk levels.
A plain vanilla swap is simply an interest rate swap in which one party pays a fixed rate and
the other pays a pouting rate, with both sets of payments in the same currency. In fact, the
plain vanilla swap is probably the most common derivative transaction in the global financial
system.

APRIL 2022
Q.1.B – Describe the role of each of the four participants in the derivative markets. (4 mks)
Participants in the derivatives market:
1) Hedgers.
2) Speculators.
3) Arbitrageurs.
4) Margin traders.

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A derivative market is a financial platform that facilitates trading all financial instruments
that fall within the derivatives category and whose values are derived from underlying assets.
The derivatives market includes both exchange-traded derivatives and over-the-counter
(OTC) derivatives. Derivative markets handle the trading of all four types of derivatives,
including futures, swaps, options, and forward contracts. All derivative markets comprise
four main participants, including hedgers, speculators, arbitrageurs, and margin traders.
Participants turn to the derivatives market mainly to hedge against risks and to take advantage
of arbitrage.
The four participants in the derivatives markets and their respective roles are described
below:
Speculators
Speculators are traders who take huge risks by making predictions about value of assets.
Speculators make speculations about market price movements and enter into derivatives
contracts based on these speculations. Speculators have a high-risk appetite and are driven by
the desire to make higher returns. They believe that the higher the risk involved, the greater
the chances of making high returns. Speculators are key in providing liquidity to the market
as they are high-risk takers. Examples of speculators include day traders and position
traders. As the name suggests, day traders make returns through price fluctuations with the
trading hours in a day. Position traders, on the other hand, make long-term speculations that
take place over weeks or even months.

Arbitrageurs
Arbitrageurs are traders who purchase securities from one market and sell them in another so
as to make a profit. Arbitrageurs are traders with low-risk appetite. Arbitrageurs make use of
securities that are simultaneously being sold in more than one market at different prices.
Arbitrageurs take advantage of the pricing inefficiencies that are present in one market,
wherein an asset is priced either higher or lower than it should be. When such a price
difference exists, arbitrageurs purchase them from the market where they are priced lower
and sell them in the market where the asset is priced higher. In this manner, arbitrageurs help
to limit such inefficiencies. Arbitrageurs are commonly experienced investors with
experience and know-how about various assets and markets.

Hedgers
Hedgers are traders who invest in the derivatives market to mitigate risk. Hedgers are risk-
averse investors who use derivative instruments to reduce the losses that market volatility
entails. Hedging helps to counterbalance the risks involved in investing in assets such as
stocks, bonds, commodities, or currencies. Through hedging, the investors protect their assets
by entering into an exact opposite trade in the derivative market. In this manner, the hedger
transfers the risk to other market participants who are risk-seekers and hedge against losses.
The risk-seekers, in turn, are those investors and traders willing to take on the risk. Hedgers
commonly include producers, farmers, and wholesalers who face losses if their commodities’
prices fall.

Margin Traders
Margin traders are speculators who aim to make quick profits through the derivatives market.
Margin traders use leveraging to make purchases that are beyond the means of their current
financial status. Their trading technique is known as margin trading. Margin trading refers to
the trading technique where the investors only pay a fraction of the total amount payable
initially. A small fraction of the total amount payable is as a deposit, known as the margin
balance. Using margin trading, investors can make more significant trades than what their

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financial capacity can afford. Margin trading is a technique that is distinctive to the
derivatives market. Examples of margin traders include day traders and position traders.

Q.2.A – Evaluate four roles of derivative markets in the finance industry. (4 mks)
Role of derivatives markets
1) Risk Management
2) Price discovery
3) Operational advantages
4) Market efficiency
5) Hedging and risk mitigation.
6) Speculation and profit making.
7) To provide leverage.
8) To obtain exposure to the underlying.
9) To create option stability.
We pick and explain some of these roles briefly:

Price Discovery
Futures market prices depend on a continuous flow of information from around the world
and require a high degree of transparency. A broad range of factors (climatic conditions,
political situations, debt default, refugee displacement, land reclamation and environmental
health, for example) impact supply and demand of assets (commodities in particular) - and
thus the current and future prices of the underlying asset on which the derivative contract is
based. This kind of information and the way people absorb it constantly changes the price of
a commodity. This process is known as price discovery.

Risk Management
This could be the most important purpose of the derivatives market. Risk management is the
process of identifying the desired level of risk, identifying the actual level of risk and altering
the latter to equal the former. This process can fall into the categories of hedging and
speculation. Hedging has traditionally been defined as a strategy for reducing the risk in
holding a market position while speculation referred to taking a position in the way the
markets will move. Today, hedging and speculation strategies, along with derivatives, are
useful tools or techniques that enable companies to more effectively manage risk.

They Improve Market Efficiency for the Underlying Asset

For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index
fund or replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either
of these methods will give them exposure to the index without the expense of purchasing all
the underlying assets in the S&P 500. If the cost of implementing these two strategies is the
same, investors will be neutral as to which they choose. If there is a discrepancy between the
prices, investors will sell the richer asset and buy the cheaper one until prices reach
equilibrium. In this context, derivatives create market efficiency.

Derivatives Also Help Reduce Market Transaction Costs

Because derivatives are a form of insurance or risk management, the cost of trading in them
has to be low or investors will not find it economically sound to purchase such "insurance"
for their positions.

Advantages of Derivatives:
1) They help in transferring risks from risk averse people to risk oriented people.

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2) They help in the discovery of future as well as current prices.

3) They catalyze entrepreneurial activity.
4) They increase the volume traded in markets because of participation of risk averse people
in greater numbers.
5) They increase savings and investment in the long run.

DECEMBER 2021
Q.1.A – Argue three cases against the existence of derivatives markets in your country. (6 mks)
The risk involved.
The derivatives market is not entirely risk-free. Over-the-counter contracts are considered
even riskier than exchange- traded derivatives, primarily because no authority regulates them.
The effect of market volatility
The derivatives market is volatile. For example, derivative contracts are sensitive to changes
in interest rates or the expiry periods of the contracts, making the derivatives market volatile.
The complex functioning of the derivatives market
The functioning of the derivatives market can seem complex to many traders and investors
because derivatives are contracts based on the value of an underlying asset. However, trading
in the derivatives market is not done directly through the underlying asset.
The counterparty risks associated with derivatives
Derivatives are associated with a greater risk of counterparty risks. Counterparty risk refers
to the risk of the other party in the contract not fulfilling their obligations concerning the deal.
Since OTC derivatives do not come under the jurisdiction of securities regulatory bodies, the
counterparty risk is more significant for OTC derivatives.

Q.1.B – Explain the following terms used in derivatives market and contracts:
i. Exchange traded derivative. (2 mks)
ii. Over the counter contract. (2 mks)
iii. Contingent claims. (2 mks)

Exchange traded derivatives (ETD)

Exchange - Traded Derivatives (ETDs) – These are standardized contracts traded on a
recognized exchange, with the counterparties being the holder and the exchange. The
contract terms are non-negotiable and their prices are publicly available.
Exchange Traded Derivatives (ETD) are standardized contracts that trade on the stock
exchange in a regulated conduct. The exchange determines the expiration date, settlement
process, and lot size and explicitly states the underlying instrument of the contract.
Also, SEBI formulates the rules and regulations for trading in Exchange Traded Derivatives.
The exchange traded derivatives majorly comprise futures and options. Unlike over the
counter derivatives, these contracts promote transparency by providing market-based pricing
information. Furthermore, it increases liquidity and reduces flexibility and chances of
negotiation.
There are two groups of derivative contracts: privately traded over the counter (OTC)
derivatives such as swaps that do not go through an exchange or other intermediary and
exchange traded derivative contracts (ETD) that are traded through specialized derivatives
exchanges or other exchanges.
The following are the features and advantages of ETDs
 Standardization: This is a differentiation feature of this contract where every contract has an
expiration date, lot size, settlement process and other rules and regulations specified by the
stock exchange. This uniformity eliminates the difficulty of buyers and sellers wanting
specialized contracts and also makes it easy for the exchange.

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 Presence of Intermediary: The parties are not dealing with each other but rather through an
intermediary, which eliminates the counterparty risk. This is because the stock exchange
contractually binds the parties and acts as an intermediary to eliminate any risk of default.
 Easy Offsetting: ETDs provide convenience to traders, which give them the option to offset
any previous contracts easily. The ETD can be offset without any hassle in two ways – where
a trader can sell the current position in the market, and traders can purchase the offset
position at a revised price.
 Rules and Regulations: This market is subject to the rules and regulations of market
regulators. It is responsible for publishing daily information about major trades in the market.
This regulation makes it difficult for the big players to break the rules through unfair trade
practices.
 Market Depth: The ETDs have considerable market depth as they have high liquidity. This
enables the traders for easy reversal positions as it does not take much time to connect with
the counterparty to make an opposite bet against or sell their stake. Due to this high liquidity
in the market, parties are found easily. Also, they execute the trades quickly without any
significant loss.

Over the counter contract (OTC)

Over-the-Counter Contracts (OTCs) – These are bespoke contracts traded off - exchange with
specific terms and conditions determined and agreed by the buyer and the seller
(counterparties). As a result, OTC derivatives are more illiquid, e.g. forward contracts and
swaps.
An over-the-counter (OTC) contract is a financial contract that does not trade on an asset
exchange, and which can be tailored to each party's needs. A derivative is a security with a
price that is dependent upon or derived from one or more underlying assets.
Over-the-Counter (OTC) derivative contracts are not traded on an exchange (for example the
Nairobi Stock Exchange) but instead privately negotiated between two counterparties (for
example a bank and a manufacturer). The definition of OTC derivatives refers to all
derivatives contracts which are not "executed on a regulated market". As a result all
derivatives contracts executed on a venue of execution which is not a regulated market (e.g. a
Multilateral trading facility), is considered as an OTC derivative contract.

Contingent claims
A contingent claim is another term for a derivative with a payout that is dependent on the
realization of some uncertain future event.
A contingent claim is a type of option where the payoff profile is dependent on the outcome
of the underlying asset. This is not dissimilar to a forward commitment, however with a
contingent claim, there is the right to transact but not the obligation. Given that the holder of
the contingent claim has the option as to whether to transact or not, contingent claims have
become synonymous with the term “option.”
Due to this choice, the payoff profile of an option contract is not linear. Instead, options limit
losses in one direction and therefore transform the payoff profile of the underlying asset.
For example, suppose a stock is trading at Kes.25. Two traders, John and Smith, agree to a
contract whereby John sells a contingent claim that stipulates he will pay Smith if, after one
year, the stock is trading at Kes.35 or above. If the stock is trading at less than Kes.35, Smith
receives nothing.
Clearly; it can be observed that in a contingent claim, for the contract to be completed, there
must be an occurrence of an uncertain future event known as a “contingent event.” In the
above example, the uncertain event is for the price to trade at sh. 35 and above.

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Forward Commitments
Forward commitments are contracts entered into between two parties that require both
parties to transact in the future at a pre-specified price known as the forward price. The
parties and the identity and quantity of the underlying are specified. Also specified are the
date of the future transaction (expiration) and the nature of the settlement. The parties have
to transact; they are obligated to do so. In the event of non-performance, because of the
obligation of the forward contract, a legal remedy is possible to enforce the obligation.
The payoff profiles of forward commitments are linear in nature and move upwards or
downwards in direct relation to the price of the underlying asset. Forward commitments
include futures contracts and forwards contracts.

SEPTEMBER 2021
Q.1.B – Distinguish between “hedgers” and “arbitrageurs” as used in derivatives markets. (4 mks)

Arbitrageurs
Arbitrageurs are traders who purchase securities from one market and sell them in another.
Arbitrageurs are traders with low-risk appetite. Arbitrageurs make use of securities that are
simultaneously being sold in more than one market at different prices. Arbitrageurs take
advantage of the pricing inefficiencies that are present in one market, wherein an asset is
priced either higher or lower than it should be. When such a price difference exists,
arbitrageurs purchase them from the market where they are priced lower and sell them in the
market where the asset is priced higher. In this manner, arbitrageurs help to limit such
inefficiencies. Arbitrageurs are commonly experienced investors with experience and know-
how about various assets and markets.

Hedgers
Hedgers are traders who invest in the derivatives market to mitigate risk. Hedgers are risk-
averse investors who use derivative instruments to reduce the losses that market volatility
entails. Hedging helps to counterbalance the risks involved in investing in assets such as
stocks, bonds, commodities, or currencies. Through hedging, the investors protect their assets
by entering into an exact opposite trade in the derivative market. In this manner, the hedger
transfers the risk to other market participants who are risk-seekers and hedge against losses.
The risk-seekers, in turn, are those investors and traders willing to take on the risk. Hedgers
commonly include producers, farmers, and wholesalers who face losses if their commodities’
prices fall.

MAY 2021
Q.1.B – Examine five types of risks associated with trading derivatives. (5 mks)
In general, the risks associated with derivatives can be classified as credit risk, market risk,
price risk, liquidity risk, operations risk, legal or compliance risk, foreign exchange rate
risk, interest rate risk, and transaction risk. These categories are not mutually exclusive.

Credit Risk
Derivatives are subject to credit risk or the risk to earnings or capital due to obligor’s failure
to meet the terms of a contract. Credit risk arises from all activities that can only be
accomplished on counterparty, issuer, or borrower’s performance. Credit risk in derivative
products comes in the form of pre-settlement risk and settlement risk.
 Derivatives are exposed to pre-settlement credit risk or loss due to failure to pay on a
contract during the life of a transaction by the counterparty. This credit risk exposure
consists of both the replacement cost of the derivative transaction or its market value and an

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estimate of the future replacement cost of the derivative. Even out-of-the-money derivative
contracts have potential pre-settlement credit risk.
 Derivatives are also subject to settlement risk or loss exposure arising when an organization
meets its obligation under a contract before the counterparty meets its obligation.

Market Risk
Derivatives are also subject to market risk or risk due to unfavorable movements in the level
or volatility of market prices. Market risk results from exposures to changes in the price of
the underlying cash instrument and to changes in interest rates. Though market risk can be
created or hedged by derivatives such as future or swap in a clear-cut manner, it is not so
simple in the case of options. This is because the value of an option is also affected by other
factors, including the volatility of the price of the underlying instrument and the passage of
time. In addition, all trading activities are affected by market liquidity and by local or world
political and economic events.

Price Risk
Price risk is an extension of the market risk. Price risk is the risk to earnings or capital arising
from changes in the value of portfolios of financial instruments. The degree of price risk of
derivatives depends on the price sensitivity of the derivative instrument and the time it takes
to liquidate or offset the position. Price sensitivity is generally greater for instruments with
leverage, longer maturities, or option features.
Price Risk can result from adverse change in equity prices or commodity prices or basis risk.
The exposure from an adverse change in equity prices can be either systematic or
unsystematic risk. As equity markets can be more volatile than other financial markets equity
derivatives can experience larger price fluctuations than other derivatives. Commodity
derivatives usually expose an institution to higher levels of price risk because of the price
volatility associated with uncertainties about supply and demand and the concentration of
market participants in the underlying cash markets. Price risk may take the form of basis risk
or the risk that the correlation between two prices may change.

Liquidity Risk
All organizations involved in derivatives face liquidity risks. Liquidity risk is the risk to
earnings or capital from an organization’s inability to meet its obligations when they are due,
without incurring unacceptable losses. This risk includes the inability to manage unplanned
decreases or changes in funding sources. An organization involved in derivatives faces two
types of liquidity risk in its derivatives activities: one related to specific products or markets
or market liquidity risk and the other related to the general funding of the institution’s
derivatives activities or funding risk.
Market Liquidity Risk: Market liquidity risk is the risk that an organization may not be able
to exit or offset positions easily at a reasonable price at or near the previous market price
because of inadequate market depth or because of disruptions in the marketplace. In dealer
markets, market depth is indicated by the size of the bid/ask spread that the financial
instrument provides. Similarly, market disruptions may be created by a sudden and extreme
imbalance in the supply and demand for products. Market liquidity risk may also result from
the difficulties faced by the organization in accessing markets because of its own or
counterparty’s real or perceived credit or reputation problems. In addition, this risk also
involves the odds that large derivative transactions may have a significant effect on the
transaction price.

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Funding Liquidity Risk: Funding liquidity risk is the possibility that the organization may
be unable to meet funding requirements at a reasonable cost. Such funding requirements arise
each day from cash flow mismatches in swap books, the exercise of options, and the
implementation of dynamic hedging strategies. The rapid growth of derivatives in recent
years has focused increasing attention on the cash flow impact of such instruments.

Operations Risk
Like other financial instruments, derivatives are also subject to operations risk or risks due to
deficiencies in information systems or internal controls. The risk is associated with human
error, system failures and inadequate procedures and controls. In the case of certain
derivatives, operations risk may get aggravated due to complexity of derivative transactions,
payment structures and calculation of their values.

Legal or Compliance Risk

Derivative transactions face risk to earnings or capital due to violations, or non-conformance
with laws, rules, regulations, prescribed practices, or ethical standards.
The risk also arises when the laws or rules governing certain derivative instruments may be
ambiguous. Compliance risk exposes an organization involved in derivatives to fines, civil
money penalties, payment of damages, and the voiding of contracts. Besides, legal and
compliance risk may adversely affect reputation, business opportunities and expansion
potential of the organization.

Foreign Exchange Rates Risk

Derivatives traded in the international markets are also exposed to risk of adverse changes in
foreign exchange rates. Foreign exchange rates are very volatile. Foreign exchange risk is
also known as translation risk. Foreign exchange rates risk in derivatives is the risk to
earnings arising from movement of foreign exchange rates. This risk is a function of spot
foreign exchange rates and domestic and foreign interest rates. It arises from holding foreign-
currency-denominated derivatives such as structured notes, synthetic investments, structured
deposits, and off-balance-sheet derivatives used to hedge accrual exposures.

Interest Rate Risk

Interest rate risk is the risk to earnings or capital arising from movements in interest rates.
The magnitude of interest rate risk faced by derivatives from an adverse change in interest
rates depends on the sensitivity of the derivative to changes in interest rates as well as the
absolute change in interest rates. The evaluation of interest rate risk must consider the impact
of complex illiquid hedging strategies or products, and also the potential impact on fee
income that is sensitive to changes in interest rates. When trading is separately managed, this
impact is on structural positions rather than trading portfolios.
Financial organizations are exposed to interest rate risk through their structural balance sheet
positions.

Transaction Risk
Another risk associated with derivatives is transaction risk. In fact transaction risk exists in
all products and services. Transaction risk is the risk to earnings or capital arising from
problems with service or product delivery. This risk is a function of internal controls,
information systems, employee integrity, and operating processes. Derivative activities can
pose challenging operational risks because of their complexity and continual evolution.
Thus, derivatives are subject to various technical risks. The problems surrounding the use of
derivatives in recent years have primarily been due to difficulty in understanding these risks

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and thus using appropriate derivatives for risk management purposes. Derivative use is
sometimes misunderstood because, depending on the terms of derivative it may be used to
increase, modify, or decrease risk. In addition to the technical risks highlighted herein, there
may also be a fundamental risk that the use of these products may be inconsistent with entity-
wide objectives.

Q.3.A – Distinguish between “over the counter” (OTC) and “Exchange market” as used in
derivatives trading. (4 mks)
Over the counter (OTC) Exchange market
Over the Counter or OTC is a decentralized Exchange market is an organized and
dealer market wherein brokers and dealers regulated market, wherein trading of stocks
transact directly via computer networks and takes place between buyers and sellers in a
phone. safe, transparent and systematic manner.
Contracts are customized. Contracts are standardized.
It is for unlisted stocks. It is for listed stocks.
It has no physical location. It has a physical location.
It is used by small companies. It is used by well established companies.

Q.5.A – Derivative contracts are largely classified into either forward commitments or
contingent claims. Citing relevant examples, distinguish between “forward commitments”
and “contingent claims.” (6 mks)

CONTINGENT CLAIMS
A contingent claim is another term for a derivative with a payout that is dependent on the
realization of some uncertain future event.
A contingent claim is a type of option where the payoff profile is dependent on the outcome
of the underlying asset. This is not dissimilar to a forward commitment, however with a
contingent claim, there is the right to transact but not the obligation. Given that the holder of
the contingent claim has the option as to whether to transact or not, contingent claims have
become synonymous with the term “option.”
Due to this choice, the payoff profile of an option contract is not linear. Instead, options limit
losses in one direction and therefore transform the payoff profile of the underlying asset.
For example, suppose a stock is trading at Kes.25. Two traders, John and Smith, agree to a
contract whereby John sells a contingent claim that stipulates he will pay Smith if, after one
year, the stock is trading at Kes.35 or above. If the stock is trading at less than Kes.35, Smith
receives nothing.
A contingent claim is a claim that depends on a specific event that occurs in the future. An
option is an example of a contingent claim which depends on the price of an underlying asset
– say a share – at a specific time in the future.

OPTION
There are two basic types of options:
1. call options and
2. Put options.
Each option gives its owner (the buyer) a right, but not an obligation, to buy (in the case of a
call option) or to sell (in the case of a put option) a specified quantity of an underlying asset
at a specified price on a specified date in the future. The buyer can decide whether to exercise
the option or not. If the buyer decides to exercise the option, the writer of the option (i.e. the
seller) has a legal obligation to perform.

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Suppose you bought a call option on a share with an exercise price of USD 50. The option
gives you a right, but not an obligation, to buy the share in the future at the price of USD 50.

Forward Commitments
Forward commitments are contracts entered into between two parties that require both
parties to transact in the future at a pre-specified price known as the forward price. The
parties and the identity and quantity of the underlying are specified. Also specified are the
date of the future transaction (expiration) and the nature of the settlement. The parties have to
transact; they are obligated to do so. In the event of non-performance, because of the
obligation of the forward contract, a legal remedy is possible to enforce the obligation.
The payoff profiles of forward commitments are linear in nature and move upwards or
downwards in direct relation to the price of the underlying asset. Forward commitments
include futures contracts and forwards contracts.
Forward commitments enable two parties to reduce the risks and uncertainties around a
planned transaction in the future. For example, a producer of a commodity like wheat knows
he must sell his crop at some point after the harvest.
A forward commitment is a legally binding agreement between two parties to perform certain
actions in the future. The buyer of the contract agrees to purchase and the seller of the
contract – to sell an underlying asset at a specific time in the future at a price specified in the
contract. In other words, this is a kind of a bet on what the value of the underlying asset (e.g.
share, bond, index, interest rate, etc.) will be at the expiration date specified in the contract.
If in the future the price of the underlying asset is above the price specified in the contract,
the buyer will make a profit, and if the price of the underlying asset is lower than the price
given in the contract, the seller will make a profit. Forward contracts, futures and swaps are
all examples of forward commitments.
Forward Contract
A forward contract is an agreement under which one party agrees to buy and the other party
agrees to sell certain assets (e.g. stocks, commodities, currency, etc.) at a specific time in the
future at a specified price. Both parties agree on terms and conditions of the transaction
(including the type of the underlying asset, the price, the expiration date, etc.). This is why
we call such instruments “tailor-made” or customized. Both parties to the contract are
exposed to the risk that the other party may default on the contract.(counterparty risk)

Futures Contract
A futures contract is, what might be called, a variation of a forward contract as it works the
same way. However, it has certain features that distinguish it from popular forwards. Futures
contracts are actively traded on the secondary market where they are strictly regulated and
supervised by a clearinghouse. Futures contracts are standardized and, as opposed to
forwards, there is no risk of a party’s default (contracts are guaranteed by a clearinghouse).

NOVEMBER 2020
Q.1.B – Explain four main purposes of derivatives market in your country. (4 mks)
To hedge securities against risk
One of the key advantages/purposes of the derivatives market is that it allows traders to
hedge their securities. By hedging, traders can protect themselves from huge losses from
market volatility.
To transfer risk to other market participants
The transference of risks onto the risk seekers is another critical advantage/purpose of the
derivatives market. The derivatives market comprises risk-averse and risk-seeking traders as

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participants, making it possible for the risk-averse traders to pass on the risk to the risk
seekers, mainly through speculations.
To lock prices from fluctuations
Another main advantage/purpose of the derivatives market is that it allows the holders to lock
the prices of the underlying assets. Once the contract is bought, the asset’s price cannot be
altered, irrespective of the price changes in the market. The feature is handy to traders,
including producers and farmers, who face huge losses when commodity prices fall.
To make profits through arbitrage
Making profits through arbitrage is another advantageous feature of the derivatives market.
Apart from offering profits to the traders, arbitrage also helps to fix market pricing
inefficiencies in the market, wherein securities are priced lower or higher than they should
be.
To mitigate risks cost-effectively.
The derivatives market gives traders and investors a cost-effective way of hedging, as
derivatives contracts can be purchased using the margin balance in the account. The margin
balance is only a tiny percentage of the total cost of the derivatives contract.

MAY 2019
Q.1.A – Highlight five differences between “currency exchange futures” and “forward
contracts.” (5 mks)
A forward contract is a private and customizable agreement that settles at the end of the
agreement and is traded over the counter (OTC). A futures contract has standardized terms
and is traded on an exchange, where prices are settled on a daily basis until the end of the
contract.

DIFFERENCES BETWEEN FUTURES AND FORWARDS

The fundamental difference between futures and forwards is that futures are traded on
exchanges and forwards trade OTC. The difference in trading venues gives rise to notable
differences in the two instruments:
1) Futures are standardized instruments transacted through brokerage firms that hold a "seat"
on the exchange that trades that particular contract. The terms of a futures contract -
including delivery places and dates, volume, technical specifications, and trading and
credit procedures - are standardized for each type of contract. Like an ordinary stock trade,
two parties will work through their respective brokers, to transact a futures trade. An
investor can only trade in the futures contracts that are supported by each exchange. In
contrast, forwards are entirely customized and all the terms of the contract are privately
negotiated between parties. They can be keyed to almost any conceivable underlying asset
or measure. The settlement date, notional amount of the contract and settlement form (cash
or physical) are entirely up to the parties to the contract.
2) Forwards entail both market risk and credit risk. Those who engage in futures transactions
assume exposure to default by the exchange's clearing house. For OTC derivatives, the
exposure is to default by the counterparty who may fail to perform on a forward. The
profit or loss on a forward contract is only realized at the time of settlement, so the credit
exposure can keep increasing.
3) With futures, credit risk mitigation measures, such as regular mark-to-market and
margining, are automatically required. The exchanges employ a system whereby
counterparties exchange daily payments of profits or losses on the days they occur.
Through these margin payments, a futures contract's market value is effectively reset to
zero at the end of each trading day. This all but eliminates credit risk.

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4) The daily cash flows associated with margining can skew futures prices, causing them to
diverge from corresponding forward prices.
5) Futures are settled at the settlement price fixed on the last trading date of the contract (i.e.
at the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the
start).
6) Futures are generally subject to a single regulatory regime in one jurisdiction, while
forwards - although usually transacted by regulated firms - are transacted across
jurisdictional boundaries and are primarily governed by the contractual relations between
the parties.
7) In case of physical delivery, the forward contract specifies to whom the delivery should be
made. The counterparty on a futures contract is chosen randomly by the exchange.
8) In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.
The fundamental difference between futures and forwards is that futures are traded on
exchanges and forwards trade on the OTC. The difference in trading venues gives rise to
notable differences in the two instruments:
Futures are standardized instruments transacted through brokerage firms that hold a "seat" on
the exchange that trades that particular contract. The terms of a futures contract - including
delivery places and dates, volume, technical specifications, and trading and credit procedures
- are standardized for each type of contract. Like an ordinary stock trade, two parties will
work through their respective brokers, to transact a futures trade. An investor can only trade
in the futures contracts that are supported by each exchange. In contrast, forwards are entirely
customized and all the terms of the contract are privately negotiated between parties. They
can be keyed to almost any conceivable underlying asset or measure. The settlement date,
notional amount of the contract and settlement form (cash or physical) are entirely up to the
parties to the contract. Forwards entail both market risk and credit risk. Those who engage in
futures transactions assume exposure to default by the exchange's clearing house. For OTC
derivatives, the exposure is to default by the counterparty who may fail to perform on a
forward. The profit or loss on a forward contract is only realized at the time of settlement, so
the credit exposure can keep increasing. With futures, credit risk mitigation measures, such as
regular mark-to-market and margining, are automatically required. The exchanges employ a
system whereby counterparties exchange daily payments of profits or losses on the days they
occur. Through these margin payments, a futures contract's market value is effectively reset
to zero at the end of each trading day. This all but eliminates credit risk. The daily cash flows
associated with margining can skew futures prices, causing them to diverge from
corresponding forward prices.
1) Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at
the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the start).
2) Futures are generally subject to a single regulatory regime in one jurisdiction, while forwards
- although usually transacted by regulated firms - are transacted across jurisdictional
boundaries and are primarily governed by the contractual relations between the parties.
3) In case of physical delivery, the forward contract specifies to whom the delivery should be
made. The counterparty on a futures contract is chosen randomly by the exchange.
4) In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.
NOVEMBER 2019
Q.3.A – Your country’s Securities Exchange recently introduced derivatives trading as a
new strategy of expanding its product offerings:
In light of the above statement:
i. Describe three types of traders common in the derivatives market. (3 mks)

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 Speculators
 Arbitrageurs
 Hedgers
 Margin traders
Note – Refer to April 2022 Q.1.B. For detailed explanations of these traders.
ii. Propose three factors that could have hindered the growth of derivatives markets in
developing countries. (3 mks)
1) Leverage is a double edged sword and therefore if you do not get it right chances are; you
wound end up losing huge amount of money because these contracts have specific
maturities and on that date they get expired unlike cash market where you can hold on to
stocks for long period of time.
2) Since its inception many critics have been blaming derivatives for huge fall which keeps
happening frequently after the introduction of derivatives and many people say that it
increases unnecessary speculation in the market which is not good for the small retail
investors who are the backbone of stock market.
3) It is quite complex and various strategies of derivatives can be implemented only by an
expert and therefore for a layman it is difficult to use this and therefore it limits its
usefulness.

MAY 2018
Q.5.A – Highlight three similarities between swap contracts and forward contracts. (3 mks)
1) Both are derivative contracts.
2) In both cases the motive is risk mitigation/hedging motive.
3) Both are forward commitments.
4) Presence of underlying asset.
5) The outcome does not depend on the occurrence of uncertain future event.

NOVEMBER 2018
Q.1.A – In relation to derivatives trading, distinguish between “forward commitments” and
“contingent claims.” (2 mks)
This question has become lackluster (tested many times) – The probability of it being tested
is almost 99%.

Forward commitments are contracts entered into between two parties that require both
parties to transact in the future at a pre-specified price known as the forward price. The
parties and the identity and quantity of the underlying are specified. Also specified are the
date of the future transaction (expiration) and the nature of the settlement. The parties have
to transact; they are obligated to do so. In the event of non-performance, because of the
obligation of the forward contract, a legal remedy is possible to enforce the obligation.
The payoff profiles of forward commitments are linear in nature and move upwards or
downwards in direct relation to the price of the underlying asset. Forward commitments
include futures contracts and forwards contracts.

A contingent claim is a type of option where the payoff profile is dependent on the outcome
of the underlying asset. This is not dissimilar to a forward commitment, however with a
contingent claim, there is the right to transact but not the obligation. Given that the holder of
the contingent claim has the option as to whether to transact or not, contingent claims have
become synonymous with the term “option.”
Due to this choice, the payoff profile of an option contract is not linear. Instead, options limit
losses in one direction and therefore transform the payoff profile of the underlying asset.

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Q.3.A – Assess four objectives of global regulation of derivatives market. (8 mks)

1) Improving efficiency of marketing through on-line trading in dematerialization form.
2) Minimization of settlement risks.
3) Improving efficiency of operations by providing best infrastructure and latest technology.
4) Rationalizing the transaction fees to optimum level.
5) Implementing best quality standards of warehousing, grading and testing in tune with trade
practices.
6) Improving facilities for structured finance.
7) Improving quality of services rendered by suppliers.
8) Promoting awareness about on-line features trading services across the length and breadth of
the world.

Q.4.A – Highlight three similarities between “forward contracts” and “futures contracts.” (3 mks)
a) In both cases there is an agreement to buy/sell a commodity at a certain price in the
future.
b) There is price speculation at the start of the contract period.
c) Pre-set price – Price is set at the start of the contract as well as the delivery date.
d) The underlying asset is delivered at the expiration date. Thus no commodity is delivered
at the start of the contract. There is no initial delivery hence delivery occurs in the future.
1) Both futures and forwards are firm and binding agreements to act at a later date. In most
cases this means exchanging an asset at a specific price sometime in the future.
2) Both types of derivatives obligate the parties to make a contract to complete the transaction
or offset the transaction by engaging in another transaction that settles each party's obligation
to the other. Physical settlement occurs when the actual underlying asset is delivered in
exchange for the agreed-upon price. In cases where the contracts are entered into for purely
financial reasons (i.e. the engaged parties have no interest in taking possession of the
underlying asset), the derivative may be cash settled with a single payment equal to the
market value of the derivative at its maturity or expiration.
3) Both types of derivatives are considered leveraged instruments because for little or no cash
outlay, an investor can profit from price movements in the underlying asset without having
to immediately pay for, hold or warehouse that asset.
4) They offer a convenient means of hedging or speculating. For example, a rancher can
conveniently hedge his grain costs by purchasing corn several months forward. The hedge
eliminates price exposure, and it doesn't require an initial outlay of funds to purchase the
grain. The rancher is hedged without having to take delivery of or store the grain until it is
needed. The rancher doesn't even have to enter into the forward with the ultimate supplier of
the grain and there is little or no initial cash outlay.
5) Both physical settlement and cash settlement options can be keyed to a wide variety of
underlying assets including commodities, short-term debt, Eurodollar deposits, gold, foreign
exchange, the S&P 500 stock index, etc.

MAY 2017
Q.1.A – Argue three cases for the existence of derivatives markets in your country. (6 mks)
1) Risk Management
2) Price discovery
3) Operational advantages
4) Market efficiency

BENEFITS OF FORWARD AND FUTURES MARKETS

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Forward and futures markets protect against price fluctuations:

Any expectation in the price increase or any decline in the same can be protected by entering
into forward contracts to buy or sell at a particular price.
Forward and futures markets provide the option of buying and selling:
The buyer or seller can exercise their option and if they are not keen to execute the contract
they can opt out by paying a nominal amount.
They enable the buyer or seller to make proper arrangements for finance:
Since the transactions are for future buying or selling, suitable financial arrangements could
be done by proper planning.
Investors can plan their future investments:
Based on the forward or future market, investors can plan their investments either by shifting
it from the existing investment or by borrowing and going in for new investments.
Cash crunch does not arise owing to these markets:
As the transactions do not involve payments in bulk and with buying and selling of securities
or currencies, only marginal amount is involved.
Forward and futures markets help in large transactions:
With more people entering the market, volume of transactions increases along with frequent
turnover of transactions.
Flexibility in forward and futures markets:
They are very flexible contracts enabling the buyer or seller to opt out by paying a small
margin amount. The market provides flexibility, as simultaneously a person can buy and sell
in different markets due to the development of Information Technology.
Forward and Futures markets reduce risks for financial companies:
The forward and futures market has improved financial services and financial companies are
able to reduce their risks. With various credit instruments available and resources made
available from various sources, the financial companies are in a position to earn good profits
even with a very low margin in their price. This is due to the higher volume of trade. The
market is also attracting funds from foreign countries. So, the financial companies with
various financial products are able to have better returns for their investment.
Portfolio investment:
Mutual fund companies are able to have better portfolio investment due to forward contracts
and hedging against price fluctuations
A forward contract is a customized contractual agreement where two private parties agree
to trade a particular asset with each other at an agreed specific price and time in the future.
Forward contracts are traded privately over-the-counter, not on an exchange.
A futures contract — often referred to as futures — is a standardized version of a forward
contract that is publicly traded on a futures exchange. Like a forward contract, a futures
contract includes an agreed upon price and time in the future to buy or sell an asset — usually
stocks, bonds, or commodities, like gold.
The main differentiating feature between futures and forward contracts — that futures are
publicly traded on an exchange while forwards are privately traded — results in several
operational differences between them. This comparison examines differences like
counterparty risk, daily centralized clearing and mark-to-market, price transparency, and
efficiency.

DECEMBER 2017
Q.1.A – Highlight three advantages of exchange traded options compared to options traded
in the over the counter (OTC) market. (3 mks)

EXCHANGE TRADED CONTRACT

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Exchange traded contracts trade on a derivatives facility that is organized and referred to as
an exchange. These contracts have standard features and terms, with no customization
allowed and are backed by a clearinghouse.
1) They have standard terms and features.
2) They are backed by clearing house.
3) They trade on a derivatives facility that is organized.
4) They are regulated.
5) They have minimal chances of default risk.

OVER THE COUNTER CONTRACT

Over the counter (OTC) contracts are those transactions that are created by both buyers and
sellers anywhere else. Such contracts are unregulated and may carry the default risk for the
contract owner.
Q.2.A – Summarize four similarities common to both options and forward contracts. (4 mks)
Solution omitted deliberately.
MAY 2016
Q.2.A – Describe five ways that could be used to manage credit risk in derivatives markets. (5 mks)
Credit risk in a forward contract arises when the counterparty that owes the greater amount is
unable to pay at expiration or declares bankruptcy prior to expiration. The market value of a
forward contract is a measure of the net amount one party owes the other. Only one party, the
one owing the lesser amount, faces credit risk at any given time. Because the market value
can change from positive to negative, however, the other party has the potential for facing
credit risk at a later date. Counterparties occasionally mark forward contracts to market, with
one party paying the other the current market value; they then re-price the contract to the
current market price or rate.
The common tools for hedging interest rate risk are:
1) Forward rate agreements (FRA)
2) Interest rate futures.
3) Interest rate swaps.
4) Interest rate options.
Credit risk is most simply defined as the potential that a bank borrower or counterparty will
fail to meet its obligations in accordance with agreed terms.
To manage credit risk:
1) Establish an appropriate credit risk environment
2) Operating under a sound credit granting process;
3) Maintaining an appropriate credit administration, measurement and monitoring process;
and;
4) Ensuring adequate controls over credit risk.
The growing complexity of the derivatives business, coupled with greater market volatility,
weak economic and credit cycles, and a higher incidence of derivative-related losses, has led
financial and corporate institutions and regulators to adopt a stricter posture regarding
derivative risk management controls. This focus has been constructive. Specific
enhancements that financial and regulatory professionals have emphasized over the past few
years include:
1) Implementing independent internal risk management controls.
2) Enhancing client sales disclosures .
3) Employing comprehensive risk-mitigation techniques
4) Managing exposures accurately and actively.

NOVEMBER 2016

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Q.1.A – Derivatives trade in markets around the world, which include organized exchanges
where highly standardized and regulated versions exist, and over the counter(OTC) markets,
where customized and more highly regulated versions trade.
In relation to the above statement, discuss the following types of derivatives contracts:
i. Forward contract. (2 mks)
ii. Futures contract. (2 mks)
iii. Swap contract. (2 mks)
iv. Option. (2 mks)

Forward Contract
A forward contract is an agreement under which one party agrees to buy and the other party
agrees to sell certain assets (e.g. stocks, commodities, currency, etc.) at a specific time in the
future at a specified price. Both parties agree on terms and conditions of the transaction
(including the type of the underlying asset, the price, the expiration date, etc.). This is why
we call such instruments “tailor-made” or customized. Both parties to the contract are
exposed to the risk that the other party may default on the contract.(counterparty risk)
Futures Contract
A futures contract is, what might be called, a variation of a forward contract as it works the
same way. However, it has certain features that distinguish it from popular forwards. Futures
contracts are actively traded on the secondary market where they are strictly regulated and
supervised by a clearinghouse. Futures contracts are standardized and, as opposed to
forwards, there is no risk of a party’s default (contracts are guaranteed by a clearinghouse).

Swap contracts
A swap Derivative is a contract wherein two parties decide to exchange liabilities or cash
flows from separate financial instruments. Often, swap trading is based on loans or bonds,
otherwise known as a notional principal amount. However, the underlying instrument used in
Swaps can be anything as long as it has a legal, financial value. Mostly, in a swap contract,
the principal amount does not change hands and stays with the original owner. While one
cash flow may be fixed, the other remains variable and is based on a floating currency
exchange rate, benchmark interest rate, or index rate.
Typically, at the time someone initiates the contract, at least one of these cash flows is
determined through an uncertain or random variable, like foreign exchange rate, interest rate,
equity price, or a commodity price.
Essentially, Swap Trading works when two parties agree to swap their cash flows or
liabilities based on two separate financial instruments. Although there are many types, the
most common kind of swap is known as an interest rate swap. A swap is not standardized
and does not trade on public stock exchanges, and it is not common for retail investors to
engage in a swap.
Instead, swaps are contracts that are traded over-the-counter primarily between financial
institutions or businesses. Since they are traded over-the-counter, the terms of the swap
contract are negotiated and customized to the needs of both parties. Financial institutions and
firms dominate the swap derivatives market, with almost no individuals ever participating. As
a result of swaps occurring on the over-the-counter market, the swap contracts are considered
risky because of the counterparty risk where one party can default on the payment.
Option
An option is a derivative, a contract that gives the buyer the right, but not the obligation, to
buy or sell the underlying asset by a certain date (expiration date) at a specified price ( strike
price). There are two types of options: calls and puts. American-style options can be

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exercised at any time prior to their expiration. European-style options can only be exercised
on the expiration date.

Call options
Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike
price specified in the option contract. Investors buy calls when they believe the price of the
underlying asset will increase and sell calls if they believe it will decrease.

Put options
Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike
price specified in the contract. The writer (seller) of the put option is obligated to buy the
asset if the put buyer exercises their option. Investors buy puts when they believe the price of
the underlying asset will decrease and sell puts if they believe it will increase.

Futures: standard exchange contracts that enable participants to buy or sell an underlying
asset at a predetermined forward price.
Forwards: customized off-exchange contracts that permit participants to buy or sell an
underlying asset at a predetermined forward price.
Swaps: customized off-exchange contracts that enable participants to exchange periodic
flows based on an underlying reference.
Options: standard exchange or customized off-exchange contracts that grant the buyer the
right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price.
Structured products: financing/capital market instruments that contain embedded derivatives
that alter risk and return characteristics.

NOVEMBER 2015
Q.1.C – Explain the following terms with respect to derivatives instruments:
i. Fiduciary call. (1 mk)
ii. Protective put. (1 mk)
Fiduciary call is an option strategy that replaces what is known as protective put
options (also known as married put options) that are more costly and require large upfront
investment, with low cost and low capital input call options.
A fiduciary call is a modified long position utilizing call options and a riskless position in an
interest-bearing instrument. A fiduciary call can be used to lower the costs inherent in
exercising a call option. A fiduciary call is similar to a protective put in terms of its profit/loss
profile.
A “protective put” implies that stock was purchased previously and that puts are being
purchased against an existing stock position, and protective puts can affect the holding period
of the stock for tax purposes.
Protective puts are commonly utilized when an investor is long or purchases shares of stock
or other assets that they intend to hold in their portfolio. Typically, an investor who owns
stock has the risk of taking a loss on the investment if the stock price declines below the
purchase price. By purchasing a put option, any losses on the stock are limited or capped.
Let us understand how fiduciary call is preferable with an example:
Shares of Abcd Bank are trading at Rs 300 per share and the call and put options are each
trading at Rs 50.
Strategy 1: Protective put
Rohini buys 100 shares of Abcd bank and also a put options contract of Abcd Bank for Rs 50.
So she spends:
Rs 300 x 100 shares = 30,000

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Rs 50 x 100 shares = 5,000

Rohini is putting down a total of Rs 35,000
When the expiration date arrives, Rohini observes the stock price.
If it has increased beyond the strike price, she will not exercise her option.
If it is below the strike price she exercises the put option and her earnings are the difference
between the current share price and the strike price, minus the premium she paid for the put.
Strategy 2: Fiduciary call
Mohini instead buys the call options contract for Rs 50.
She spends Rs 5,000.
She invests the other Rs 30,000 in some risk-free, guaranteed interest investment like fixed
deposit or insurance. They may alternatively choose a very low-risk investment vehicle like
government bonds.
Upon contract expiry, if the price of Abcd Bank’s shares has risen above the strike price,
Mohini will redeem her risk-free investment and exercise her option. Her earnings are the
difference between the strike price and the market value of the shares, minus the premium she
paid for the call.

SEPTEMBER 2015
Q.2.B – Explain the following terms:
i. Vocational arbitrage. (2 mks)
ii. Triangular arbitrage. (2 mks)
Vocational arbitrage
Arbitrage is the strategy of taking advantage of price differences in different markets for the
same asset. For it to take place, there must be a situation of at least two equivalent assets with
differing prices. In essence, arbitrage is a situation where a trader can profit from the
imbalance of asset prices in different markets. The simplest form of arbitrage is purchasing
an asset in the market where the price is lower and simultaneously selling the asset in the
market where the asset’s price is higher.
Arbitrage is a process of simultaneously buying and selling an asset and generating a profit
due to imbalances in prices. The main objective of all the different types of arbitrage
strategies is to exploit the inefficiencies in the market. If the markets were perfectly efficient,
there would be no arbitrage opportunities.
Triangular arbitrage
Triangular arbitrage is a trading strategy which takes advantage of the price differences
between three currencies in the forex market. It is also known as three-point arbitrage or cross
currency arbitrage. The price discrepancies arise in situations where one market is
undervalued and another is overvalued.
Triangular arbitrage trading strategy is executed by converting first currency into second,
then second currency into third and finally converting the third currency back to first. All
these transactions are done by trading algorithms in a matter of seconds.
Triangular arbitrage opportunities are very rare in real world as foreign exchange markets are
highly sophisticated and competitive with large number of players. These transactions require
large trading amounts as the price difference between currencies is limited to few cents.
Due to this, such opportunities can only be exploited by high frequency traders with low
transaction costs. Using high speed algorithms these traders can easily find the mispricing
and immediately execute the necessary trades.
Traders notice a difference in the exchange rate of currencies in three foreign countries. They
convert a sum of money into the currency of one country, convert it again to another
currency, then convert back to its original currency, gaining the profit. For example, the
trader would convert USD to Euros, Euros to JPY, then JPY back to USD.

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Example
A trader has 1 million Canadian dollars (CAD), and there are three different currency
exchange rates at three different banks. The first bank converts CAD to Euros at a rate of
0.67. The second bank converts Euros to USD at a rate of 1.20. The third bank converts USD
to CAD at a rate of 1.25.
The trader converts the 1 million at the lowest rate from the first bank, which results in
665,245 Euros. Next, they convert the Euros into USD, resulting in $800,813. Finally, the
trader visits the third bank and converts the USD back to its original currency, giving them
1,000,896.13 CAD. They earned a profit of $896.13.

NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this
by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

CHAPTER TWO
FORWARD MARKETS AND CONTRACTS

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PAGE
2.1Introduction to forward markets and contracts ………………………………….
2.2 The structure and role of forward markets …………………………………….
2.3 Types of forward contracts…………………………………………………….
Equity forwards contracts; bond and interest rate forward contracts; currency forward
contracts; other types of forward contracts.
2.4 Mechanics of Forward Markets and Contracts………………………………….
Delivery and settlement of a forward contract; default risk and forward contracts;
termination of a forward contract; cost of carry and transaction costs.
2.5 Pricing and valuation of forward contracts………………………………………
generic pricing and valuation of forward contracts; pricing and valuation of equity
forward contracts; pricing and valuation of fixed-income and interest rate forward
contracts; pricing and valuation of currency forward contracts
2.6 Credit risk and forward contracts…………………………………………………

KEY TOPIC ISSUES

FORWARDS
“I will buy your product at sh. 100 per unit one year from today regardless of the then
prevailing market price! Thus after one year, deliver the product to me at sh. 100 per
unit.”
From the above statement it can be noted that forward contracts have these characteristics:
1) The parties agree on the future prices.
2) There is no delivery currently but such a delivery will take place in the future agreed time.
3) Delivery will take place on the agreed time at the agreed price at the inception date
regardless of the prevailing market price.
4) On the expiry date, the price can either remain constant, go up or go down. Thus one party
will be losing while the other party will be gaining. If on the contract date for instance the
price was sh. 100, on expiration date, the price may either remain at sh. 100, go up to sh.
150 or fall to sh. 90.

Note – Forward contracts are traded over the counter (OTC)

Sh. 150

Price today Sh. 100

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Sh. 90
DERIVATIVES ANALYSIS

Price as at the contract date Possible future prices on expiration date

The price today is simply the agreed price between the parties.
The possible future prices on expiration date are the prevailing market prices by then.
If the prices are at sh. 150 on expiration date, the long position (buyer) will buy at sh. 100
instead of sh. 150 hence he will be gaining. The short position (Seller) will be losing because
he will sale at sh. 100 instead of sh. 150. The long positioning holder on the contract agrees
to buy the underlying asset on the future date because they are betting on the price to go up.
If prices fall to sh. 90 on the expiration date, the buyer (long position ) will pay the agreed
price of sh. 100 instead of sh. 90 hence he will be losing. The short position (seller will be
gaining because he will receive sh. 100 instead of sh. 90 which is prevailing in the market.
The most basic forward contract is a forward delivery contract. A forward delivery contract
is a contract negotiated between two parties for the delivery of a physical asset (e.g., oil or
gold) at a certain time in the future for a certain price fixed at the inception of the contract.
The parties that agree to the forward delivery contract are known as counterparties. No actual
transfer of ownership occurs in the underlying asset when the contract is initiated. Instead,
there is simply an agreement to transfer ownership of the underlying asset at some future
delivery date. A forward transaction from the perspective of the buyer establishes a long
position in the underlying commodity. A forward transaction from the perspective of the
seller establishes
a short position in the underlying commodity.
A simple forward delivery contract might specify the exchange of 100 troy ounces of gold
one year in the future for a price agreed on today, say $400/oz. If the discounted expected
future price of gold in the future is equal to $400/oz. today, the forward contract has no value
to either party ex ante and thus involves no cash payments at inception. If the spot price of
gold (i.e., the price for immediate delivery) rises to $450/oz. one year from now, the
purchaser of this contract makes a profit equal to $5,000 ($450 minus $400, times 100
ounces), due entirely to the increase in the price of gold above its initial expected present
value. Suppose instead the spot price of gold in a year happened to be $350/oz. Then the
purchaser of the forward contract loses $5,000 ($350 minus $400, times 100 ounces), and she
would prefer to have bought the gold at the lower spot price at the maturity date.
For the short, every dollar increase in the spot price of gold above the price at which the
contract is negotiated causes a $1 per ounce loss on the contract at maturity. Every dollar
decline in the spot price of gold yields a $1 per ounce increase in the contract’s value at
maturity. If the spot price of gold at maturity is exactly $400/oz., the forward seller is no
better or worse off than if she had not entered into the contract.
A forward contract is a simple customized contract between two parties to buy or sell an
asset at a certain time in the future for a certain price. Unlike future contracts, they are not
traded on an exchange, rather traded in the over-the-counter market, usually between two
financial institutions or between a financial institution and its client.
In brief, a forward contract is an agreement between the counter parties to buy or sell a
specified quantity of an asset at a specified price, with delivery at a specified time (future) and
place. These contracts are not standardized; each one is usually being customized to its
owner’s specifications.

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The basic features of a forward contract are given in brief here as under:
1) Forward contracts are bilateral contracts, and hence, they are exposed to counter-party risk.
There is risk of non-performance of obligation either of the parties, so these are riskier than
futures contracts.
2) Each contract is custom designed, and hence, is unique in terms of contract size, expiration
date, the asset type, quality, etc.
3) In forward contract, one of the parties takes a long position by agreeing to buy the asset at a
certain specified future date. The other party assumes a short position by agreeing to sell the
same asset at the same date for the same specified price. A party with no obligation
offsetting the forward contract is said to have an open position. A party with a closed
position is, sometimes, called a hedger.
4) The specified price in a forward contract is referred to as the delivery price. The forward
price for a particular forward contract at a particular time is the delivery price that would
apply if the contract were entered into at that time. It is important to differentiate between
the forward price and the delivery price. Both are equal at the time the contract is entered
into. However, as time passes, the forward price is likely to change whereas the delivery
price remains the same.
5) In the forward contract, derivative assets can often be contracted from the combination of
underlying assets, such assets are often known as synthetic assets in the forward market.
6) In the forward market, the contract has to be settled by delivery of the asset on expiration
date. In case the party wishes to reverse the contract, he has to compulsorily go to the same
counter party, which may dominate and command the price it wants as being in a
monopoly situation.
7) In the forward contract, covered parity or cost-of-carry relations are relations between the
prices of forward and underlying assets. Such relations further assist in determining the
arbitrage-based forward asset prices.
8) Forward contracts are very popular in foreign exchange market as well as interest rate bearing
instruments. Most of the large and international banks quote the forward rate through their
‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange
quotes by these banks are displayed with the spot rates.
9) As per the Indian Forward Contract Act- 1952, different kinds of forward contracts can be
done like hedge contracts, transferable specific delivery (TSD) contracts and non-
transferable specific delivery (NTSD) contracts. Hedge contracts are freely transferable and
do not specify, any particular lot, consignment or variety for delivery. Transferable specific
delivery contracts are though freely transferable from one party to another, but are
concerned with a specific and predetermined consignment. Delivery is mandatory. Non-
transferable specific delivery contracts, as the name indicates, are not transferable at all, and
as such, they are highly specific.
A forward contract on a security (or commodity) is a contract agreed upon at date t = 0 to
purchase or sell the security at date T for a price, F , that is specified at t = 0.
When the forward contract is established at date t = 0, the forward price, F , is set in such a
way that the initial value of the forward contract, f0, satisfies f0 = 0. At the maturity date, T ,
the value of the contract is given by FT = ± (ST − F ) where ST is the time T value of the
underlying security (or commodity). It is very important to realize that there are two “prices”
or “values” associated with a forward contract at time t: ft and F . When we use the term
“contract value” or “forward value” we will always be referring to ft, where as when we use
the term “contract price” or “forward price” we will always be referring to F . That said, there
should never be any ambiguity since ft is fixed (equal to zero) at t = 0, and F is fixed for all t
> 0 so the particular quantity in question should be clear from the context. Note that ft need
not be (and generally is not) equal to zero for t > 0.

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Examples of forward contracts include:

• A forward contract for delivery (i.e. purchase) of a non-dividend paying stock with maturity
6 months.
• A forward contract for delivery of a 9-month T-Bill with maturity 3 months. (This means
that upon delivery, the T-Bill has 9 months to maturity.)
• A forward contract for the sale of gold with maturity 1 year.
• A forward contract for delivery of 10m Euro (in exchange for dollars) with maturity 6
months.

Features of Forward Contract

1) It is an agreement between the two counter parties in which one is the buyer and the other
is the seller. All the terms are mutually agreed upon by the counterparties at the time of the
formation of the forward contract.
2) It specifies a quantity and type of the asset (commodity or security) to be sold and
purchased.
3) It specifies the future date at which the delivery and payment are to be made.
4) It specifies a price at which the payment is to be made by the seller to the buyer. The price
is determined presently to be paid in future.
5) It obligates the seller to deliver the asset and also obligates the buyer to buy the asset.
6) No money changes hands until the delivery date reaches, except for a small service fee, if
there is.

Terms used
Long Position - The party who agrees to buy in the future is said to hold long position. For
example, the bank can take a long position agreeing to buy 3-month dollar in future.
Short Position- The party who agrees to sell in the future holds a short position in the
contract. For example, ABC LTD can take a short position by selling the dollar to the bank
for a 3-month future.
The Underlying Asset - It means any asset in the form of commodity, security or currency
that will be bought and sold when the contract expires, e.g., US dollar can be-the underlying
asset which is sold and purchased in future.
Spot-Price - This refers to the purchase of the underlying asset for immediate delivery. In
other words, it is the quoted price for buying and selling of an asset at the spot or immediate
delivery.
Delivery Price - The specified price in a forward contract will be referred to as the delivery
price. This is decided or chosen at the time of entering into forward contract so that the value
of the contract to both parties is zero. It means that it costs nothing to take a long or a short
position. In other words, at the day on writing of a forward contract, the price which is
determined to be paid or received at the maturity or delivery period of the forward contract is
called delivery price. On the first day of the forward contract, the forward price may be same
as to delivery price. This is determined by considering each aspect of forward trading
including demand and supply position of the underlying asset.
The Forward Price - It refers to the agreed upon price at which both the counter parties will
transact when the contract expires. In other words, the forward price for a particular forward
contract at a particular time is the delivery price that would apply if the contract were entered
into at that time.
The party to the forward contract that agrees to buy the financial or physical asset has a long
forward position and is called the long. The party to the forward contract that agrees to
sell/deliver the asset has a short forward position and is called the short.

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We will illustrate the basic forward contract mechanics through an example based on the
purchase and sale of a Treasury bill. Note that while forward contracts on T-bills are usually
quoted in terms of a discount percentage from face value, we use dollar prices here to make
the example easy to follow.
Consider a contract under which Party A agrees to buy a $ 1, 000 face value 90-day Treasury
bill from Party B 30 days from now at a price of $990. Party A is the long and Party B is the
short. Both parties have removed uncertainty about the price they will pay or receive for the
T-hill at the future date. If 30 days from now T-bills are trading at $992, the short must
deliver the T-hill to the long in exchange for a $990 payment. If T-bills are trading at $988 on
the future date, the long must purchase the T-hill from the short for $990, the contract price.
Each party to a forward contract is exposed to default risk, the probability that the other party
(the counterparty) will not perform as promised. Typically, no money changes hands at the
inception of the contract, unlike futures contracts in which each party posts an initial deposit
called the margin as a guarantee of performance.
At any point in time, including the settlement date, the party to the forward contract with the
negative value will owe money to the other side. The other side of the contract will have a
positive value of equal amount. Following this example, if the T-bill price is $992 at the
(future) settlement date, and the short does not deliver the T-bill for $990 as promised, the
short has defaulted.

A Simple Version of the Cost-of-Carry Model

In order to explain the no-arbitrage condition as it applies to the determination of forward
prices, we will first consider a forward contract on an asset that costs nothing to store and
makes no payments to its owner over the life of the forward contract. A zero-coupon (pure
discount) bond meets these criteria. Unlike gold or wheat, it has no storage costs; unlike
stocks, there are no dividend payments to consider; and unlike coupon bonds, it makes no
periodic interest payments.
The general form for the calculation of the forward contract price can be stated as follows:
FP = So x (1 + RF)T
FP = forward price
SO = Spot price at the inception of the contract (t = 0)
Rf = Annual risk free rate.
T = Forward contract term in years.

Example
Calculating the no-arbitrage forward price
Consider a 3-month forward contract on a zero-coupon bond with a face value of $1,000 that
is currently quoted at $500, and assume a risk-free annual interest rate of 6%. Determine the
price of the forward contract under the no-arbitrage principle.
FP = So x (1 + RF)T
T = 3/12 = 0.25
FP = 500 x 1.060.25
FP = $507.3

Cash and Carry Arbitrage When the Forward Contract is Overpriced

Suppose the forward contract is actually trading at $510 rather than the no-arbitrage price of
$507.34. A short position in the forward contract requires the delivery of this bond three
months from now. The arbitrage that we examine in this case amounts to borrowing $500 at
the risk-free rate of 6%, buying the bond for $500, and simultaneously taking the short

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DERIVATIVES ANALYSIS

position in the forward contract on the zero-coupon bond so that we are obligated to deliver
the bond at the expiration of the contract for the forward price and receive $510.
At the settlement date, we can satisfy our obligation under the terms of the forward contract
by delivering the zero-coupon bond for a payment of $510, regardless of its market value at
that time. We will use the $510 payment we receive at settlement from the forward contract
(the forward contract price) to repay the $500 loan. The total amount to repay the loan, since
the term of the loan is three months, is:
FP = 500 x 1.060.25
FP = $507.34
The payment of $510 we receive when we deliver the bond at the forward price is greater
than our loan payoff of $507.34, and we will have earned an arbitrage profit of$510 –
$507.34 = $2.66. Notice that this is equal to the difference between the actual forward price
and the no-arbitrage forward price.
Suppose the forward contract is actually trading at $502 instead of the no-arbitrage price of
$507.34. We reverse the arbitrage trades from the previous case and generate an arbitrage
profit as follows. We sell the bond short today for $500 and simultaneously take the long
position in the forward contract, which obligates us to purchase the bond in 90 days at the
forward price of $502. We invest the $500 proceeds from the short sale at the 6% annual rate
for three months.
In this case, at the settlement date, we receive the investment proceeds of $507.34,accept
delivery of the bond in return for a payment of $502, and close out our short position by
delivering the bond we just purchased at the forward price.
The payment of $502 we make as the long position in the contract is less than investment
proceeds of $507.34, and we have earned an arbitrage profit of $507.34 – $502 = $5.34.
If we denote the value of the long position in a forward contract at time t as Vt, the value of
the long position at contract initiation, t = 0, is:

V0 (of long position at initiation) = S0 - FP

(1 + Rf)T

Note that the no-arbitrage relation we derived in the prior section ensures that the value of the
long position (and of the short position) at contract initiation is zero.
If S0= FP
(1 + Rf)T

Then V0 = 0
The value of the long position in the forward contract during the life of the contract after t
years (t < T) have passed (since the initiation of the contract) is:

Vt (of long position during life of contract) = St - FP

(1 + Rf)T-t

This is the same equation as above, but the spot price, St, will have changed, and the period
for discounting is now the number of years remaining until contract expiration (T – t). This is
a zero-sum game, so the value of the contract to the short position is the negative of the long
position value:

Vt (of short positioning during life of contract) = FP - st

T-t
(1 + RF)

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DERIVATIVES ANALYSIS

= -vt (of long position during life of contract)

Notice that the forward price, FP, is the forward price agreed to at the initiation of the
contract, not the current market forward price. In other words, as the spot and forward market
prices change over the life of the contract, one side (i.e., short or long position)wins and the
other side loses. For example, if the market spot and forward prices increase after the contract
is initiated, the long position makes money, the value of the long position is positive, and the
value of the short position is negative. If the spot and forward prices decrease, the short
position makes money.

Example:

Determining value of a forward contract prior to expiration:

In our 3-month zero-coupon bond contract example, we determined that the no arbitrage
forward price was $507.34. Suppose that after two months the spot price on the zero-coupon
bond is $515, and the risk-free rate is still 6%. Calculate the value of the long and short
positions in the forward contract.
V2 (of long position after two months) = 515 – (507.34 /1.061/12)
= 10.12
V2(of short position after two months) = − $10.12
Another way to see this is to note that because the spot price has increased to $515,the current
no-arbitrage forward price is:
FP = $515×1.061/12= $517.51
The long position has made money (and the short position has lost money) because the
forward price has increased by $10.17 from $507.34 to $517.51 since the contract was
initiated. The value of the long position today is the present value of $10.17 for one month at
6%:
V2 long (position after two months) = 10.17/1.061/12 = 10.12
At contract expiration, we do not need to discount the forward price because the time left on
the contract is zero. Since the long can buy the asset for FP and sell it for the market price
ST, the value of the long position is the amount the long position will receive if the contract is
settled in cash:
VT (of long position at maturity) = ST – FP
VT (of short position at maturity) = FP – ST = - VT (of long position to maturity)

EQUITY FORWARD CONTRACTS WITH DISCRETE DIVIDENDS

Recall that the no-arbitrage forward price in our earlier example was calculated for an asset
with no periodic payments. A stock, a stock portfolio, or an equity index may have expected
dividend payments over the life of the contract. In order to price such a contract, we must
either adjust the spot price for the present value of the expected dividends (PVD) over the life
of the contract or adjust the forward price for the future value of the dividends (FVD) over
the life of the contract. The no-arbitrage price of an equity forward contract in either case is:
FP (on an equity security) = (S0 – PVD) x (1 + RF)T
FP (on an equity security) = S0 x (1 + RF)T – FVD
For equity contracts, use a 365-day basis for calculating T if the maturity of the contract is
given in days. For example, if it is a 60-day contract, T = 60 / 365. If the maturity is given in
months (e.g., two months) calculate T using maturity divided by number of months (e.g., T.=
2 / 12).

Example:

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Calculating the price of a forward contract on a stock

Calculate the no-arbitrage forward price for a 100-day forward on a stock that is currently
priced at $30.00 and is expected to pay a dividend of $0.40 in 15 days,$0.40 in 85 days, and
$0.50 in 175 days. The annual risk-free rate is 5%, and the yield curve is flat.

Solution
Ignore the dividend in 175 days because it occurs after the maturity of the forward contract.

PVD = 0.40 + 0.40

1.0515/365 1.0585/365

= 0.7946

FP = (30 – 0.7946) x 1.05100/365

= 29.60
To calculate the value of the long position in a forward contract on a dividend-paying stock,
we make the adjustment for the present value of the remaining expected discrete dividends at
time t (PVD t) to get:
Vt (Long positioning) = (St – PVDt) – (FP)
(1 + RF)T-t
Example:
Calculating the value of an equity forward contract on a stock
After 60 days, the value of the stock in the previous example is $36.00. Calculate the value of
the equity forward contract on the stock to the long position, assuming the risk-free rate is
still 5% and the yield curve is flat.
Solution
There’s only one dividend remaining (in 25 days) before the contract matures (in 40days) as
shown below, so:
V60 (long positioning) = 36 – 0.3987 – (29.60)
1.05 40/365

= 6.16
Equity Forward Contracts With Continuous Dividends
To calculate the price of an equity index forward contract, rather than take the present value
of each dividend on (possibly) hundreds of stocks, we can make the calculations if the
dividends are paid continuously (rather than at discrete times) at the dividend yield rate on
the index. Using continuous time discounting, we can calculate the no arbitrage forward price
as:

FP (on an equity index) = S0 x e(Rfc – dc) x T

=(S0 x e-dcxT) x eRfc x T

RFc = continuously compounded risk free rate.

dc = continuously compounded dividend yield.

Example:
Calculating the price of a forward contract on an equity index

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The value of the S&P 500 index is 1,140. The continuously compounded risk-free rate is
4.6% and the continuous dividend yield is 2.1%. Calculate the no-arbitrage price of a 140-day
forward contract on the index.

Solution
FP = 1140 x e (0.046 – 0.021) x (140/365) = 1151
For the continuous time case, the value of the forward contract on an equity index is
calculated as follows:
Vt (of the long positioning) = St FP
edc x (T –t) - eRfc x (T – t)

Example:
Calculating the value of a forward contract on an equity index
After 95 days, the value of the index in the previous example is 1,025. Calculate the value to
the long position of the forward contract on the index, assuming the continuously
compounded risk-free rate is 4.6% and the continuous dividend yield is2.1%.

Solution
After 95 days there are 45 days remaining on the original forward contract:

V95 (of the long positioning) = 1025 - 1151

0.021x (45/365) 0.046 x (45/365)
e e

= - 122.14
In order to calculate the no-arbitrage forward price on a coupon-paying bond, we can use the
same formula as we used for a dividend-paying stock or portfolio, simply substituting the
present value of the expected coupon payments (PVC )over the life of the contract for PVD,
or the future value of the coupon payments (FVC ) for FVD, to get the following formulas:
FP (on a fixed income security) = (S0 – PVC) x (1 + RF)T
Alternatively:
S0 x (1 + RF)T – FVC
The value of the forward contract prior to expiration is as follows:
Vt (long positioning) = (St - PVCt) – (FP
(1 + RF)T-t

In our examples, we assume that the spot price on the underlying coupon-paying bond
includes accrued interest. For fixed income contracts, use a 365-day basis to calculate T if the
contract maturity is given in days.

Example:
Calculating the price of a forward on a fixed income security
Calculate the price of a 250-day forward contract on a 7% U.S. Treasury bond with a spot
price of $1,050 (including accrued interest) that has just paid a coupon and will make another
coupon payment in 182 days. The annual risk-free rate is 6%.

Answer:
Remember that U.S. Treasury bonds make semi-annual coupon payments, so:
C = 1000 x 0.07
2
= 35

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PVC = 35 / 1.06 185/365

= 34
The forward price of the contract is therefore:
FP (on a fixed income security) = (1050 – 34) x 1.06 250/365
= 1057.37
Example:
Calculating the value of a forward on a fixed income security
After 100 days, the value of the bond in the previous example is $1,090. Calculate the value
of the forward contract on the bond to the long position, assuming the risk-free rate is 6.0%.
Answer:
There is only one coupon remaining (in 82 days) before the contract matures (in 150days), so:
PVC = 35 / 1.06 82/365 = 34.54
V100 (long position) = 1090 – 34.54 – (1057 / 1.06 150/365 = 23.11

LIBOR -Based Loans and Forward Rate Agreements

Eurodollar deposit is the term for deposits in large banks outside the United States
denominated in U.S. dollars. The lending rate on dollar-denominated loans between banks is
called the London Interbank Offered Rate (LIBOR). It is quoted as an annualized rate based
on a 360-day year. In contrast to T-bill discount yields, LIBOR is an add-on rate, like a yield
quote on a short-term certificate of deposit. LIBOR is used as a reference rate for floating rate
U.S. dollar-denominated loans worldwide.

Example: LIBOR-based loans

Compute the amount that must be repaid on a $1 million loan for 30 days if 30-day LIBOR is
quoted at 6%.
Answer:
The add-on interest is calculated as $1 million × 0.06 × (30 / 360) = $5,000. The borrower
would repay $1,000,000 + $5,000 = $1,005,000 at the end of 30 days.
LIBOR is published daily by the British Banker’s Association and is compiled from quotes
from a number of large banks; some are large multinational banks based in other countries
that have London offices. There is also an equivalent euro lending rate called Euribor, or
Europe Interbank Offered Rate. Euribor, established in Frankfurt, is published by the
European Central Bank.
The long position in a forward rate agreement (FRA) is the party that would borrow the
money (long the loan with the contract price being the interest rate on the loan). If the
floating rate at contract expiration (LIBOR for U.S. dollar deposits and Euribor for euro
deposits) is above the rate specified in the forward agreement, the long position in the
contract can be viewed as the right to borrow at below market rates and the long will receive
a payment. If the floating rate at the expiration date is below the rate specified in the forward
agreement, the short will receive a cash payment from the long. (The right to lend at above
market rates would have a positive value.)
The notation for FRAs is unique. There are two numbers associated with an FRA: the number
of months until the contract expires and the number of months until the underlying loan is
settled. The difference between these two is the maturity of the underlying loan. For example,
a 2 × 3 FRA is a contract that expires in two months (60days), and the underlying loan is
settled in three months (90 days). The underlying rate is 1-month (30-day) LIBOR on a 30-
day loan in 60 days.

Pricing FRAs

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There are three important things to remember about FRAs when we’re pricing and valuing
them:
1. LIBOR rates in the Eurodollar market are add-on rates and are always quoted on a30/360
day basis in annual terms. For example, if the LIBOR quote on a 30-day loan is 6%, the
actual annualized monthly rate is 6% × (30/360) = 0.5%
2. The long position in an FRA, in effect, is long the rate and wins when the rate increases.
3.Although the interest on the underlying loan won’t be paid until the end of the loan(e.g., in
three months), the payoff on the FRA occurs at the expiration of the FRA (e.g., in two
months). Therefore, the payoff on the FRA is the present value of the interest savings on the
loan.

Example: Calculating the price of an FRA

Calculate the price of a 1 × 4 FRA (i.e., a 90-day loan, 30 days from now). The current 30-
day LIBOR is 4% and the 120-day LIBOR is 5%.

Answer:
The actual (annualized) rate on the 30-day loan is:
R30 = 0.04 x 30/360 = 0.0033
The actual (annualized) rate on the 120-day loan is:
R120 = 0.05 x 120/360 = 0.01667
We wish to calculate the actual rate on a 90-day loan from day 30 to day 120:
Price of 1 x 4 FRA = 1 + R120- 1
1 + R30
= 1.01667 - 1
1.00333

= 0.01333
We can annualize this rate as:
0.0133 x 360/90 = 0.0532 = 5.32%
This is the no-arbitrage forward rate—the forward rate that will make the values of the long
and the short positions in the FRA both zero at the initiation of the contract.

Valuing an FRA at Maturity

To understand the calculation of the value of the FRA after the initiation of the contract,
recall that in the previous example the long in the FRA has the “right” to borrow money 30
days from inception for a period of 90 days at the forward rate. If interest rates increase
(specifically the 90-day forward contract rate), the long will profit as the contract has fixed a
borrowing rate below the now-current market rate. These “savings” will come at the end of
the loan term, so to value the FRA we need to take the present value of these savings. An
example incorporating this fact will illustrate the cash settlement value of an FRA at
expiration.

Example: Calculating value of an FRA at maturity (i.e., cash payment at settlement)

Continuing the prior example for a 1 × 4 FRA, assume a notional principal of$1 million and
that, at contract expiration, the 90-day rate has increased to 6%,which is above the contract
rate of 5.32%. Calculate the value of the FRA at maturity, which is equal to the cash payment
at settlement.

Answer:
The interest savings at the end of the loan term (compared to the market rate of 6%) will be:

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DERIVATIVES ANALYSIS

(0.0600 x 90/360) – (0.0532 x 90/360) = 1 million = 1,700

The present value of this amount at the FRA settlement date (90 days prior to the end of the
loan term) discounted at the current rate of 6% is:

1700
1 + (0.06 x 90/360)

= 1674.88
This will be the cash settlement payment from the short to the long at the expiration of the
contract. Note that we have discounted the savings in interest at the end of the loan term by
the market rate of 6% that prevails at the contract settlement date for a90-day term.

Valuing an FRA Prior to Maturity

To value an FRA prior to the settlement date, we need to know the number of days that have
passed since the initiation of the contract. For example, let’s suppose we want to value the
same 1 × 4 FRA ten days after initiation. Originally it was a 1 × 4 FRA, which means the
FRA now expires in 20 days. The calculation of the “savings” on the loan will be the same as
in our previous example, except that we need to use the “new” FRA price that would be
quoted on a contract covering the same period as the original “loan.”
In this case the “new” FRA price is the now-current market forward rate for a 90-dayloan
made at the settlement date (20 days in the future). Also, we need to discount the interest
savings implicit in the FRA back an extra 20 days, or 110 days, instead of 90days as we did
for the value at the settlement date.

Example: Calculating value of an FRA prior to settlement

Value a 5.32% 1 × 4 FRA with a principal amount of $1 million 10 days after initiation if
110-day LIBOR is 5.9% and 20-day LIBOR is 5.7%.

Answer:
Step 1: Find the “new” FRA price on a 90-day loan 20 days from today. This is the current
90-day forward rate at the settlement date, 20 days from now.

1 + (0.059 x 110/360) - 1 x 360/90 = 0.05925

1 + (0.057 x 20/360)

Step 2: Calculate the interest difference on a $1 million, 90-day loan made 20 days from now
at the forward rate calculated previously compared to the FRA rate of 5.32%.
(0.05925 x 90/360) – (0.0532 x 90/360) x 1 m = 1514
Step 3: Discount this amount at the current 110-day rate.

1514
1 + (0.059 x 110/360)

= 1487

Example: Calculating the price of a currency forward contract

The risk-free rates are 6% in the United States and 8% in Mexico. The current spot exchange
rate is $0.0845 per Mexican peso (MXN). Calculate the forward exchange rate for a 180-day
forward contract.
Solution

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FT (Currency forward contract) = 0.0845 x 1.06 180/365

1.08 180/365
= 0.0837

FT (Currency forward contract) S0 x(1 + RDC)T

(1 + RFC)T
F and S are quoted in domestic currency per unit of FC.
RDC = Domestic currency interest rate.
RFC = Foreign currency interest rate.
For foreign currency contracts use a 365-day basis to calculate T if the maturity is given in
days.
Valuing Currency Forward Contracts
At any time prior to maturity, the value of a currency forward contract to the long will depend
on the spot rate at time t, St, and can be calculated as:

Vt (currency forward contract) = St FT

(1 + RFC) T –t -
(1 + RDC) (T-t)

Example: Calculating the value of a currency forward contract

Calculate the value of the forward contract in the previous example if, after 15 days, the spot
rate is $0.0980 per MXN.
Answer:

V15 (Currency forward contract) = (0.0980 - 0.0837

(1.08 165/365) 1.06 165/365

= 0.0131
The continuous time price and value formulas for currency forward contracts are:
FT (Currency forward contract) = S0 x e (RCDC – RCFC) x T

Vt (currency forward contract) = st - FT

rcfc RCDC
e x (T – t) e x (T –t)

Vt in both cases is the value in domestic currency units for a contract covering one unit of the
foreign currency. For the settlement payment in the home currency on a contract, simply
multiply this amount by the notional amount of the foreign currency covered in the contract.
At any date after initiation of a forward contract, it is likely to have positive value to either
the long or the short. Recall that this value is the amount that would be paid to settle the
contract in cash at that point in time. The party with the position that has positive value has
credit risk in this amount because the other party would owe them that amount if the contract
were terminated. The contract value and, therefore, the credit risk, may increase, decrease, or
even change sign over the remaining term of the contract. However, at any point in time, the
market values of forward contracts, as we have calculated them, are a measure of the credit
risk currently borne by the party to which a cash payment would be made to settle the
contract at that point. One way to reduce the credit risk in a forward contract is to mark-to-
market partway through.

REVISION QUESTIONS

DECEMBER 2023

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DERIVATIVES ANALYSIS

This chapter was not tested.

AUGUST 2023
Q.2.B – Lesley Gikenye is an investment practitioner with Wanda Capital and is evaluating
the following forward contract positions that affect the company:
1. A 180 – day forward contract involving the Mexican Peso (MXN) and the United
States Dollar (USD). The risk free rates are 6% in the United States and 8% in
Mexico. The current spot exchange rate is $0.0845.
2. The company entered into a four- month forward contract to buy 10 million Euro (€)
at a price of USD ($) 1.112 per Euro. A month later, the three month forward price is
$ 1.109 per Euro. The USD interest rate is 0.30% and the Euro interest rate is 0.40%.
Required:
i. Calculate the forward exchange rate for a 180 – day forward contract that Wanda
Capital should engage in.
(3 mks)
ii. Calculate the value of Wanda Capital’s forward position in the four-month forward
contract. (3 mks)
Solution omitted deliberately.

APRIL 2023
Q.4.C – Jackline Mutua, an investment analyst with cooperative capital is analyzing the
company’s forward rate agreement (FRA) the company is exposed to and has gathered the
following information:
1. The contract is 5.32%, 1 x 4FRA with a principal amount of sh. 1 million.
2. 10 days have lapsed from initiation of the contract and the 110 days London
Interbank Offered Rate (LIBOR) is 5.9% with 20 day LIBOR quoted at 5.7%.
Assume a 360 day year.
Required:
i. Price of the FRA 10 days into the contract. (3 mks)
ii. The present value of the FRA discounted at the 110 day rate. (4 mks)
Solution
Step 1: Find the “new” FRA price on a 90-day loan 20 days from today. This is the current
90-day forward rate at the settlement date, 20 days from now.

1 + (0.059 x 110/360) - 1 x 360/90 = 0.05925

1 + (0.057 x 20/360)

Step 2: Calculate the interest difference on a $1 million, 90-day loan made 20 days from now
at the forward rate calculated previously compared to the FRA rate of 5.32%.
(0.05925 x 90/360) – (0.0532 x 90/360) x 1 m = 1514
Step 3: Discount this amount at the current 110-day rate.
1514
1 + (0.059 x 110/360)

= 1487
DECEMBER 2022
Q.2.A – Describe three types of risks involved in forward contracts. (6 mks)
 Default risk
 Credit risk

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Price Risk
Price risk is an extension of the market risk. Price risk is the risk to earnings or capital
arising from changes in the value of portfolios of financial instruments. The degree of price
risk of derivatives depends on the price sensitivity of the derivative instrument and the time
it takes to liquidate or offset the position. Price sensitivity is generally greater for instruments
with leverage, longer maturities, or option features.
Price Risk can result from adverse change in equity prices or commodity prices or basis risk.
The exposure from an adverse change in equity prices can be either systematic or
unsystematic risk. As equity markets can be more volatile than other financial markets equity
derivatives can experience larger price fluctuations than other derivatives. Commodity
derivatives usually expose an institution to higher levels of price risk because of the price
volatility associated with uncertainties about supply and demand and the concentration of
market participants in the underlying cash markets. Price risk may take the form of basis risk
or the risk that the correlation between two prices may change.

Liquidity Risk
All organizations involved in derivatives face liquidity risks. Liquidity risk is the risk to
earnings or capital from an organization’s inability to meet its obligations when they are due,
without incurring unacceptable losses. This risk includes the inability to manage unplanned
decreases or changes in funding sources. An organization involved in derivatives faces two
types of liquidity risk in its derivatives activities: one related to specific products or markets
or market liquidity risk and the other related to the general funding of the institution’s
derivatives activities or funding risk.

Market Liquidity Risk: Market liquidity risk is the risk that an organization may not be able
to exit or offset positions easily at a reasonable price at or near the previous market price
because of inadequate market depth or because of disruptions in the marketplace. In dealer
markets, market depth is indicated by the size of the bid/ask spread that the financial
instrument provides. Similarly, market disruptions may be created by a sudden and extreme
imbalance in the supply and demand for products. Market liquidity risk may also result from
the difficulties faced by the organization in accessing markets because of its own or
counterparty’s real or perceived credit or reputation problems. In addition, this risk also
involves the odds that large derivative transactions may have a significant effect on the
transaction price.

Funding Liquidity Risk: Funding liquidity risk is the possibility that the organization may
be unable to meet funding requirements at a reasonable cost. Such funding requirements arise
each day from cash flow mismatches in swap books, the exercise of options, and the
implementation of dynamic hedging strategies. The rapid growth of derivatives in recent
years has focused increasing attention on the cash flow impact of such instruments.

Operations Risk
Like other financial instruments, derivatives are also subject to operations risk or risks due to
deficiencies in information systems or internal controls. The risk is associated with human
error, system failures and inadequate procedures and controls. In the case of certain
derivatives, operations risk may get aggravated due to complexity of derivative transactions,
payment structures and calculation of their values.

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Legal or Compliance Risk

Derivative transactions face risk to earnings or capital due to violations, or non-conformance
with laws, rules, regulations, prescribed practices, or ethical standards.
The risk also arises when the laws or rules governing certain derivative instruments may be
ambiguous. Compliance risk exposes an organization involved in derivatives to fines, civil
money penalties, payment of damages, and the voiding of contracts. Besides, legal and
compliance risk may adversely affect reputation, business opportunities and expansion
potential of the organization.

Foreign Exchange Rates Risk

Derivatives traded in the international markets are also exposed to risk of adverse changes in
foreign exchange rates. Foreign exchange rates are very volatile. Foreign exchange risk is
also known as translation risk. Foreign exchange rates risk in derivatives is the risk to
earnings arising from movement of foreign exchange rates. This risk is a function of spot
foreign exchange rates and domestic and foreign interest rates. It arises from holding foreign-
currency-denominated derivatives such as structured notes, synthetic investments, structured
deposits, and off-balance-sheet derivatives used to hedge accrual exposures.
Other types of risks
1) Interest rate risk.
2) Foreign exchange risk.
3) Political risk
4) .Regulatory risk.
5) Fiscal risk.
6) Operational risk.
7) Forex risks (transaction risk, economic risk and transaction risk)

Q.4.A – Describe two ways of settling a forward contract. (4 mks)

There are two ways for a settlement to occur in a forward contract: delivery or cash basis. If
the contract is on a delivery basis, the seller must transfer the underlying asset or assets to the
buyer. The buyer then pays the seller the agreed-upon price in cash.

AUGUST 2022
Q.4.A – Kennedy Mwangi owns a dividend paying stock currently worth sh. 150. He plans
to sell the stock in 250 days. In order to hedge against a possible price decline, he takes a
short position in a forward contract that expired in 250 days. The risk free rate is 5.25%.
Over the next 250 days, the stock will pay dividends according to the following schedule:
Days to next dividend Dividend per share (sh)
30 1.25
120 1.25
210 1.25
Additional information:
1. 100 days after the forward contract is entered, the stock price declines to sh. 115.
2. At expiration, the stock price is at sh. 130.
There are 365 days in a year.
Required:
i. The forward price of a contract established today and expiring in 250 days. (3 mks)
ii. The value of a forward contract after 100 days of entering the forward contract (3
mks)
iii. The value of the forward contract at its expiration. (2 mks)
Solution

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The forward price of a contract established today which expires in 250 days
So = sh.150
T = 250/365
r = 0.0525
PV(D,O,T) = sh.l.25/(1. 0525)30/365 + sh. l.25/(1 .0525)120/365 + 210/(l. 052)210/365
= sh.3.69
F(0,T) = (sh.150.00 – sh.3.69)(1.0525)250/365
= sh. 151.53

The value of the forward contract after 100 days assuming that the stock price is sh. 115 on
that day.
St = sh.115
F(0,T) = sh.151.53
t = 100/365
T = 250/365
T - t = 150/365
r = 0.0525
After 100 days, two dividends remain: the first one in 20 days, and the second one in 110
days.
PV(D,t,T) = sh.1.25/(1.052)20/365 + sh. 1.25/(1.0525)110/365 = sh. 2.48
V,(O,T) = sh.115.00 – sh.2.48 – sh.151.53/(1.0525)150/365 = - 35.86
A negative value is a gain to the short.

The value of the contract at expiration assuming that the stock price is sh. 130 at expiration
ST = sh.130
F(0,T) = sh.151.53
VT(0,T) = sh.130.00 – sh.151.53 = - sh. 21.53
The contract expires with a value of negative sh.21.53, a gain to the short.

Refer to December 2023 Q.1.C – Chapter four in this book

Refer to November 2019. Q.1.B – This chapter

APRIL 2022
Q.3.B – Describe five differences between “futures contracts” and “forward contracts.”(5 mks)
Futures are standardized instruments transacted through brokerage firms that hold a "seat" on
the exchange that trades that particular contract. The terms of a futures contract - including
delivery places and dates, volume, technical specifications, and trading and credit procedures
- are standardized for each type of contract. Like an ordinary stock trade, two parties will
work through their respective brokers, to transact a futures trade. An investor can only trade
in the futures contracts that are supported by each exchange. In contrast, forwards are entirely
customized and all the terms of the contract are privately negotiated between parties. They
can be keyed to almost any conceivable underlying asset or measure. The settlement date,
notional amount of the contract and settlement form (cash or physical) are entirely up to the
parties to the contract. Forwards entail both market risk and credit risk. Those who engage in
futures transactions assume exposure to default by the exchange's clearing house. For OTC
derivatives, the exposure is to default by the counterparty who may fail to perform on a
forward. The profit or loss on a forward contract is only realized at the time of settlement, so
the credit exposure can keep increasing. With futures, credit risk mitigation measures, such as
regular mark-to-market and margining, are automatically required. The exchanges employ a
system whereby counterparties exchange daily payments of profits or losses on the days they

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occur. Through these margin payments, a futures contract's market value is effectively reset
to zero at the end of each trading day. This all but eliminates credit risk. The daily cash flows
associated with margining can skew futures prices, causing them to diverge from
corresponding forward prices.
1) Futures are settled at the settlement price fixed on the last trading date of the contract (i.e.
at the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the
start).
2) Futures are generally subject to a single regulatory regime in one jurisdiction, while
forwards - although usually transacted by regulated firms - are transacted across
jurisdictional boundaries and are primarily governed by the contractual relations between
the parties.
3) In case of physical delivery, the forward contract specifies to whom the delivery should
be made. The counterparty on a futures contract is chosen randomly by the exchange.
4) In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.

DECEMBER 2021
Q.2.B – An investor would like to hedge himself against stock market index volatility. He
enters into a forward contract on the NSE share index currently valued at 1140. The
continuously compounded risk-free rate is 4.6% and the continuous dividend yield is 2.1%.
The forward contract is for 140 days.
Assume a year has 365 days.
Required:
i. The forward price. (2 mks)
ii. The value of the forward contract after 95 days assuming the value of the NSE index is at 1025.
(3 mks)
Solution
FP = 1140 x e (0.046 – 0.021) x (140/365) = 1151
For the continuous time case, the value of the forward contract on an equity index is
calculated as follows:
Vt (of the long positioning) = St FP
edc x (T –t) - eRfc x (T – t)

After 95 days, the value of the index is 1,025. Calculate the value to the long position of the
forward contract on the index, assuming the continuously compounded risk-free rate is 4.6%
and the continuous dividend yield is2.1%.
Solution
After 95 days there are 45 days remaining on the original forward contract:

V95 (of the long positioning) = 1025 - 1151

e0.021x (45/365) e0.046 x (45/365)

= - 122.14
SEPTEMBER 2021
Q.3.B – The following information relates to the shares of XYZ Ltd:
1. The current price of each share is sh. 35.
2. The expected continuously compounded rate of return is 8%.
3. XYX Ltd pays semi-annual dividends of sh. 0.32 per share with the next dividend
expected to be paid two months from now.
4. The continuously compounded risk free interest rate is 4%.

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Required:
The current one year forward price of XYZ Ltd’s share. (4 mks)
Solution omitted deliberately.

MAY 2021
Q.2.A – Highlight four features of a forward contract. (4 nks)
1) It is an agreement between the two counter parties in which one is the buyer and the other
is the seller. All the terms are mutually agreed upon by the counterparties at the time of the
formation of the forward contract.
2) It specifies a quantity and type of the asset (commodity or security) to be sold and
purchased.
3) It specifies the future date at which the delivery and payment are to be made.
4) It specifies the price at which the payment is to be made by the seller to the buyer. The
price is determined presently to be paid in future.
5) It obligates the seller to deliver the asset and also obligates the buyer to buy the asset.
6) No money changes hands until the delivery date reaches, except for a small service fee, if
there is.

Q.3.B – WazemboLimited’s share is trading for sh. 70 and pays a sh. 2.20 dividend in one
month. The one month risk free rate is 10% quoted on an annual compounding basis. The
share trades ex-dividend the same day the single share forward contract expires.
Required:
The one month forward price for Wazembo’s limited ordinary share. (3 mks)
Solution omitted deliberately.
NOVEMBER 2020
Q.3.D – The following information relates to a long forward contract on a non-dividend
paying stock entered into a few months ago:
1. The forward contract expires in six months.
2. The risk free rate is 10% per annum that is compounded continuously.
3. The stock has a price of sh. 25 per share.
4. The delivery price is sh. 24.
Required:
The value of the forward contract (4 mks)
Solution omitted deliberately.
Q.4.A – Assess four salient differences between a futures contract and a forward contract. (4
mks)

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1) Futures are standardized instruments transacted through brokerage firms that hold a "seat" on
the exchange that trades that particular contract. The terms of a futures contract - including
delivery places and dates, volume, technical specifications, and trading and credit procedures
- are standardized for each type of contract. Like an ordinary stock trade, two parties will
work through their respective brokers, to transact a futures trade. An investor can only trade
in the futures contracts that are supported by each exchange. In contrast, forwards are entirely
customized and all the terms of the contract are privately negotiated between parties. They
can be keyed to almost any conceivable underlying asset or measure. The settlement date,
notional amount of the contract and settlement form (cash or physical) are entirely up to the
parties to the contract. Forwards entail both market risk and credit risk. Those who engage in
futures transactions assume exposure to default by the exchange's clearing house. For OTC
derivatives, the exposure is to default by the counterparty who may fail to perform on a
forward. The profit or loss on a forward contract is only realized at the time of settlement, so
the credit exposure can keep increasing. With futures, credit risk mitigation measures, such as
regular mark-to-market and margining, are automatically required. The exchanges employ a
system whereby counterparties exchange daily payments of profits or losses on the days they
occur. Through these margin payments, a futures contract's market value is effectively reset
to zero at the end of each trading day. This all but eliminates credit risk. The daily cash flows
associated with margining can skew futures prices, causing them to diverge from
corresponding forward prices.
2) Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at
the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the start).
3) Futures are generally subject to a single regulatory regime in one jurisdiction, while forwards
- although usually transacted by regulated firms - are transacted across jurisdictional
boundaries and are primarily governed by the contractual relations between the parties.
4) In case of physical delivery, the forward contract specifies to whom the delivery should be
made. The counterparty on a futures contract is chosen randomly by the exchange.
5) In a forward there are no cash flows until delivery, whereas in futures there are margin
requirements and periodic margin calls.

FORWARDS FUTURES
Private contracts between the two parties; Traded on organized exchanges.
bilateral contracts.
Not standardized/ (customized) Standardized contract.
Normally one specified delivery date. Range of delivery dates.
Settled at the end of maturity. No cash Daily settled. Profit/Loss are paid in cash.
exchange prior to delivery date.
More than 90 percent of all forward contracts Not more than 5 percent of the futures
are settled by actual delivery of assets. contracts are settled by delivery.
Delivery or final cash settlement usually Contracts normally closed out prior to the
takes place. delivery.
Usually no margin money required. Margins are required of all the participants.
Cost of forward contracts based on bid-ask Entail brokerage fee for buy and sell orders.
spread.
There is credit risk for each party. Hence, The exchange’s clearing house becomes the
credit limits must be set for each customer. opposite side to each futures contract,
thereby reducing credit risk substantially.
MAY 2019
This chapter was not tested.
NOVEMBER 2019

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Q.1.B – HezbonOtieno owns a dividend paying stock which is currently worth sh.150. He
plans to sell the stock in 250 days. In order to hedge against possible price decline, Hezbon
decides to take a short position in a forward contract that expires in 250 days.
Additional information:
1. The risk-free rate is 5.25%.
2. Over the next 250 days the stock will pay dividends as follows:
Days to next dividend Dividends per share (DPS) SH.
30 1.25
120 1.25
210 1.25
3. Assume a 365- day year.
Required:
i. The forward price of a contract established today which expires in 250 days. (4 mks)
ii. The value of the forward contract after 100 days assuming that the stock price is sh.
115 on that day. (4 mks)
iii. The value of the contract at expiration assuming that the stock price is sh. 130 at
expiration. (2 mks)
Solution
The forward price of a contract established today which expires in 250 days
So = sh.150
T = 250/365
r = 0.0525
PV(D,O,T) = sh.l.25/(1. 0525)30/365 + sh. l.25/(1 .0525)120/365 + 210/(l. 052)210/365
= sh.3.69
F(0,T) = (sh.150.00 – sh.3.69)(1.0525)250/365
= sh. 151.53

The value of the forward contract after 100 days assuming that the stock price is sh. 115 on
that day.
St = sh.115
F(0,T) = sh.151.53
t = 100/365
T = 250/365
T - t = 150/365
r = 0.0525
After 100 days, two dividends remain: the first one in 20 days, and the second one in 110
days.
PV(D,t,T) = sh.1.25/(1.052)20/365 + sh. 1.25/(1.0525)110/365 = sh. 2.48
V,(O,T) = sh.115.00 – sh.2.48 – sh.151.53/(1.0525)150/365 = - 35.86
A negative value is a gain to the short.
The value of the contract at expiration assuming that the stock price is sh. 130 at expiration
ST = sh.130
F(0,T) = sh.151.53
VT(0,T) = sh.130.00 – sh.151.53 = - sh. 21.53
The contract expires with a value of negative sh.21.53. This is a gain to the short.

MAY 2018
Q.1.A – Describe two possible arrangements that could be used to settle forward contract
obligations upon expiration. (4 mks)
 Delivery

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 Cash basis
Q.1.B – Onyango Omamo holds an asset worth sh. 125.72 million. He wishes to raise funds
and intends to sell the asset in nine months time. Onyango is concerned about the uncertainty
in the price of the asset at that time. As an investment analyst specializing in derivatives, you
advise Onyango to take advantage of using a forward contract by entering into such a
contract to sell the asset in nine months time which he accepts. The risk free rate is 5.625
percent.
Required:
i. The appropriate price that Onyango Omamo could receive in nine months’ time using
forward contract. (2 mks)
ii. Suppose that the counterparty to the forward contract in (1) above is willing to engage in such
a contract at a forward price of sh. 140 million, illustrate the type of transaction that the
investor could execute to take advantage of this situation. (2 mks)
iii. Calculate the rate of annualized return using the information given in (ii) above and
explain why the transaction is attractive. (3 mks)
iv. Assume that the forward contract is entered into at the price computed in (i) above
and two months later, the price of the asset is sh. 118.875 million. Onyango would
like to evaluate his position with respect to any gain or loss accrued on the forward
contract. Determine the market value of the forward contract at this point in time from
the perspective of the investor in (i) above. (3 mks)
v. Determine the value of the forward contract at expiration assuming the contract is
entered into at the price computed in (i) above and the price of the property is sh.
123.50 million at expiration.
Comment on how the investor performed on the overall position of both the asset and
the forward contract in terms of the rate of return. (3 mks)
Solution
The appropriate price that Onyango Omamo could receive in nine months’ time using
forward contract:
T = 9/12 = 0.75
S0 = 125.72
r = 0.05625
F(0T) = 125.72(1.05625)0.75 = sh. 130.99m

Suppose that the counterparty to the forward contract in (1) above is willing to engage in such
a contract at a forward price of sh. 140 million, illustrate the type of transaction that the
investor could execute to take advantage of this situation.
Solution
As found in Part 1 above, the forward contract should be selling at sh.130.99 million, but it is
selling for sh.140 million. Consequently, it is overpriced and an overpriced contract should
be sold. Because the investor holds the asset, he will be hedged by selling the forward
contract. Consequently, his asset, worth sh. 125.72 when the forward contract is sold, will be
delivered in nine months and he will receive sh.140 million for it. The rate of return will be:
(140/125.72) – 1 = 0.1136 = 11.36%

Calculate the rate of annualized return using the information given in (ii) above and explain
why the transaction is attractive.
Solution
This risk-free return of 11.36% for nine months is clearly in excess of the 5.625% annual
rate. In fact, a rate of 11.36% for nine months annualizes to: (1.1136)12/9 – 1 = 0.1543 =
15.43%

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An annual risk-free rate of 15.43% is clearly preferred over the actual risk free rate of
5.625%. The position is not only hedged but also earns an arbitrage profit.

Assume that the forward contract is entered into at the price computed in (i) above and two
months later, the price of the asset is sh. 118.875 million. Onyango would like to evaluate his
position with respect to any gain or loss accrued on the forward contract. Determine the
market value of the forward contract at this point in time from the perspective of the investor
in (i) above.
Solution
T = 2/12, T-t = 9/12 – 2/12 = 7/12
St = 118.875
F(0T) = 130.99
Vf(0,T) = V2/12 (9/12) = 118.875 – 130.99/(1.05625)7/12 = -8.0
The contract has a negative value. Note, however, that in this form, the answer applies to the
holder of the long position. This investor is short. Thus, the value to the investor in this
problem is positive 8.0.

Determine the value of the forward contract at expiration assuming the contract is entered
into at the price computed in (i) above and the price of the property is sh. 123.50 million at
expiration.
Comment on how the investor performed on the overall position of both the asset and the
forward contract in terms of the rate of return.
Solution
ST = 123.50 m
123.50 – 130.99 = -7.49
This amount is the value to the long. This investor is short, so the value is a positive 7.49.
The investor incurred a loss on the asset of 125.72 - 123.50 = 2.22.
Combined with the gain on the forward contract, the net gain is 7.49 - 2.22 = 5.27. A gain of
5.27 on an asset worth 125.72 when the transaction was initiated represents a return of
5.27/125.72 = 4.19%. When annualized, the rate of return equals: (1.0419)12/9 - 1 = 0.05625
It should come as no surprise that this number is the annual risk-free rate. The transaction
was executed at the no-arbitrage forward price of sh.130.99. Thus, it would be impossible to
earn a return higher or lower than the risk-free rate.

NOVEMBER 2018
Q.3.B – John Njoroge is a derivative consultant in New York and is working on four
assignments relating to different clients.
Client 1:
The client manages equity portfolio for a pension fund. One month (30 days) ago, the pension
fund expected a large inflow of cash in 60 days. In order to hedge against a potential rise in
equity value, Njoroge advised the client to enter into a long forward contract on the S & P
500 index expiring in 60 days. The information relating to the transaction is provided below:
Price of a 60 – day S & P forward contract 30 days ago 1,403.22
S & P 500 index level today 1,450.82
Annualized continuously compounded risk free rate 3.92%
Annualized continuously compounded dividend yield for S & P 500 2.50%

Client 2
Thee months ago (90 days), the client purchased a bond with a 5% annual coupon rate and a
maturity of 7 years from the date of purchase. The bond has a face value of sh. 1,000 and

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pays interest every 180 days from the date of issue. As the client is concerned about the
potential increase in the interest rate, Njoroge advised the client to enter into a short forward
contract expiring in 360 days. The annualized risk free rate now is 4%per year and price of
the bond with accrued interest is sh. 1,071.33.
Client 3
A corporate treasurer has gathered the following information:
Annualized 90 day LIBOR rate 3.2%
Annualized 450 day LIBOR rate 4.5%
Annualized risk free rate in the United States 4.0%
Annualized risk free rate in the Euro zone 6.0%
Spot exchange rate, USD per EUR 1.39

Three months (90 days) from now, the treasurer expects to borrow USD 5 million at LIBOR
for a period of twelve months (360 days). He is concerned that interest rates may rise
significantly over the next few months and wishes to hedge this risk. Njoroge advises him to
enter into a forward rate agreement (FRA) expiring in 90 days on a 360 day LIBOR.
Client 4
The client expects an inflow of EUR 3,000,000 that needs to be converted to United States
Dollars (USD) in 270 days and is concerned that the Euro will decline in value over this
period. Njoroge advises the client to enter into an agreement to sell the Euro forward in 270
days.
Required:
i. The value of the equity forward contract. (3 mks)
ii. The price of the forward contract on the bond purchased. (3 mks)
iii. The rate on the forward rate agreement (FRA) expiring in 90 days on 360 day LIBOR.
(3 mks)
iv. The forward price that the client should sell the Euros. (3 mks)
Solution omitted deliberately.

MAY 2017
Q.4.A – Although there is a clear similarity between forward contracts and futures contracts,
critical distinctions nonetheless exist between the two.
Required:
In relation to the above statement, explain five differences between forward contracts and
futures contracts. (5 mks)
Apparently, forwards contracts and futures contracts seem to be similar, both relate to a
contract to be fulfilled on a future date at the Pre specified rate for a specific quantity.
However, there are a number of differences between the forwards and the futures. The
forwards contracts are private bilateral contracts. These are traded off-exchanges and are
exposed to default risk by either party. Each forward contract is unique in terms of size, time
and types of assets, etc. The price fixation may not be transparent and is not publicly
disclosed. A forward contract is to be settled by delivery of the asset on the specified date.
On the other hand, futures contract is a contract to buy or sell a specified quantity of a
commodity or a specified security at a future date at a price agreed to between the parties.
Since these contracts are traded only at organized exchanges, these have built-in safeguard
against default risk, in the form of stock brokers or a clearing house guarantee. The idea
behind futures contracts is to transfer future changes in the prices of commodities from one
party to another. These are trade able and standardized contracts in terms of size, time and
other features. These contracts are transparent, liquid and trade able at specified exchanges.
Futures also differ from forwards in that former are subject to daily margins and fixed

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settlement period. Both forwards and futures contracts are useful in cases where the future
price of the commodity is volatile. For example, in case of agricultural products, say
sugarcane, the peasant’s revenue is subject to the price prevailing at the time of harvesting.
Similarly, the sugar-mill is not sure whether it will be able or not to procure required quantity
of sugarcane at the reasonable price. Both parties can reduce risk by entering into a forward
or futures contract requiring one party to deliver and other party to buy the settled quantity at
the agreed price regardless of the actual price prevailing at the time of delivery. Both result in
a deferred delivery sale. However, it can be offset by a counter contract. Futures market is a
formalized and Futures market is a formalized and standardized forward market. Players and
sellers do not meet by chance but trade in the centralized market. No doubt, the
standardization process eliminates the flexibility available in the informal contacts (i.e.,
forwards).Futures have four specific characteristics as against the forwards: 1.Liquidity, as
futures are transferable. 2.Standard volume. 3.Counter-party guarantee provided by the
Exchange. 4.Intermediate cash flows.
Refer to November 2020 Q.4.A

Q.4.B – A long forward contract on a non- dividend paying stock was entered some time ago.
It has 6 months to maturity. The risk free rate of interest with continuous compounding is
10% per annum. The stock price is sh. 25 and the delivery price is sh. 24.
Required:
The value of the forward contract (3 mks)
Solution omitted deliberately.
DECEMBER 2017
Q.3.B – A US based company that exports goods to Switzerland expects to receive payment
on shipment of goods in three months time. Since the payment will be in Swiss Francs, the
US company intends to hedge against a decline in the value of the Swiss Francs over the next
three months.
The US risk free rate is 2% and the Swiss risk free rate is 5%. Assume that interest rates are
expected to remain fixed over the next six months. The current spot rate is 0.5974.
Assume a 365 – day year.
Required:
i. Advise the US company whether it should use a long forward contract or a short forward
contract to hedge against the currency risk. (2 mks)
Solution
The risk to the U.S. company is that the value of the Swiss franc will decline and it will
receive fewer U.S. dollars on conversion. To hedge this risk, the company should enter into
a contract to sell Swiss francs forward.

ii. Calculate the no-arbitrage price at which the US Company could enter into a forward that
expires in three months. (2 mks)
Solution
3 months = 90 days
So = 0.5974
T = 90/365
r = 0.02
rf = 0.05
F(0,T) = 0.5974 x (1.02)90/365
(90/365)
1.05

= $0.5931

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iii. It is now 30 days since the US company entered into a forward contract. The spot rate is 0.55.
interest rates are the same as before. Calculate the value of the US company forward
position. (3 mks)
Solution
ST = $0.55
T = 90/365
t = 30/365
T – t = 60/365
r = 0.02
rf = 0.05
0.55/(1.05)60/365 – 0.5931/(1.02)60/365 = 0.0456

MAY 2016
Q.4.B – Jonathan Atwori is doing some scenario analysis on forward contracts. The process
involves pricing the forward contracts and then estimating their values based on likely
scenarios provided by the firm’s forecasting and strategy department. The forward contracts
with which Jonathan is most concerned are those on fixed income securities, interest rates
and currencies.

Fixed income securities forward contract:

The first contract he needs to price is a 270 day forward on a sh. 1 million Treasury bond
with 10 years to maturity. The bond has a 5% coupon rate, has just made a coupon payment
and will make its next two coupon payments in 182 days and 365 days respectively. It is
currently selling for sh. 98.25. The effective annual risk free rate is 4%.
Interest rates forward contract:
Jonathan analysis forward rate agreements (FRA) using LIBOR spot rate curve as follows:
30 day: 3.12% 60 day : 3.32% 90 day: 3.52%
120 day: 3.72% 150 day: 3.92% 180 day: 4.12%
After 30 days, Jonathan wants to value a sh. 10 million short position in the FRA. The 90 day
forward rate in 30 days is now 4.14% and the original price of the FRA which was 4.30% for
120 day LIBOR has changed to 3.92%.
Currency forward contract:
Jonathan also wants to price and value a currency forward on euros. The spot rate is 1.1854
USD. The dollar risk free rate is 3% and the euro risk free rate is 4%.
Required:
i. Determine the no arbitrage price for the forward contract on the Treasury bond. (2 mks)
ii. Assume that the Treasury bond price decreases to sh. 98.11 (including accrued
interest) over the next 60 days. Calculate the value of the short position in the 270 day
forward on a sh. 10 million bond. (2 mks)
iii. Calculate the price of a 2 x 5 forward rate agreement (FRA). (2 mks)
iv. Determine the current value of the sh. 10 million FRA to the short position under the
second scenario mentioned above. (2 mks)
v. Calculate the no arbitrage price for a 1 year forward contract on the euros. (2 mks)

Solution omitted deliberately.

NOVEMBER 2016
Q.3.D – The following information relates to a currency forward contract involving two
currencies, Kenya shilling (KES) and the United States Dollar (USD):

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Forward price (KES/USD) 0.01

Risk free rate (Kenya) 6%
Risk free rate (United States) 8%
Current spot rate (KES/USD) 0.009
Time to expiration 165 days
Required:
The value of the currency forward contract (2 mks)
Solution omitted deliberately.
Q.3.E – A portfolio manager expects to purchase a portfolio of stocks in 90 days from the
Nairobi Securities Exchange (NSE). The manager decides to take a long position on a 90 day
forward contract on the NSE 20 share index. The index is currently at 4580. The continuously
compounded dividend yield is 1.75% while the discrete risk free rate is 4.25%.
Required:
The value of the forward contract 28 days into the life of the forward contract if the NSE
share index is at 4,900. Assume a 365 day year.
(3 mks)
Solution omitted deliberately.

NOVEMBER 2015
Q.5.A – In derivatives market, numerous opportunities and strategies exist for managing risk
using futures and forwards. Some types of hedges are almost always executed using futures
while others are almost always executed using forwards. The choice or preference for one of
the above derivative instruments over the other to hedge risk is prompted by their distinct
characteristics.
Required:
Evaluate five primary differences between forward contracts and futures contracts that would
make a derivatives analyst to prefer one of these derivatives over the other when managing
risk. (5 mks)
Refer to November 2020 Q.4.A

SEPTEMBER 2015
Q.5.A – Consider a stock price at sh. 60 which pays dividend of sh. 5 per share in one month.
The risk free rate is 10%. A forward contract expiring in a month was priced at sh. 59.37.
One month later, the spot price is sh. 62.
Required:
The forward price and the value of the contract at this stage (6 mks)

Solution
Forward price is the predetermined delivery price for an underlying commodity, currency, or
financial asset as decided by the buyer and the seller of the forward contract, to be paid at a
predetermined date in the future. At the inception of a forward contract, the forward price
makes the value of the contract zero, but changes in the price of the underlying will cause the
forward to take on a positive or negative value. When the underlying asset in the forward
contract does not pay any dividends, the forward price can be calculated using the following
formula:
F = S x e(r x t)
Where;
F=the contract’s forward price
S=the underlying asset’s current spot price

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e=the mathematical irrational constant approximated by 2.7183

r=the risk-free rate that applies to the life of theforward contract
t=the delivery date in years

For example, assume a security is currently trading at sh.100 per unit. An investor wants to
enter into a forward contract that expires in one year. The current annual risk-free interest rate
is 6%. Using the above formula, the forward price is calculated as:
F = S x e(r x t)
F = 100 x 2.7183 (0.06 x 1)
F = sh. 106.18
If there are carrying costs that is added into the formula:
F=S×e(r+q)×t
Q represents the carrying cost.
If the underlying asset pays dividends over the life of the contract, the formula for the
forward price is:
F=(S−D)×e(r×t)
Here, D equals the sum of each dividend's present value, given as:
D= PV(d(1))+PV(d(2))+⋯+PV(d(x))
d(1)×e−(r×t(1))+d(2)×e−(r×t(2))+⋯+
d(x)×e−(r×t(x))
Using the example above, assume that the security pays a 50-cent dividend every three
months. First, the present value of each dividend is calculated as:
PV(d(1))=sh.0.5×e−(0.06×3/12)=sh.0.493
PV(d(2))=sh.0.5×e−(0.06×6/12)=sh.0.485
PV(d(3))=sh.0.5×e−(0.06×9/12)=sh.0.478
PV(d(4))=sh.0.5×e−(0.06×12/12)=sh.0.471
The sum of these is ksh.1.927. This amount is then plugged into the dividend-adjusted
forward price formula:
F= (sh.100−sh.1.927)×e(0.06×1)=sh.104.14

FATIMA TRAINING INSTITUTE – MOCKS

QUESTION 1
An investor holds title to an asset worth €125.72. To raise money for an unrelated purpose,
the investor plans to sell the asset in nine months. The investor is concerned about uncertainty
in the price of the asset at that time. The investor learns about the advantages of using
forward contracts to manage this risk and enters into such a contract to sell the asset in nine
months. The risk-free interest rate is 5.625 percent.
Required:
i. Determine the appropriate price the investor could receive in nine months by means
of the forward contract.
ii. Suppose the counterparty to the forward contract is willing to engage in such a
contract at a forward price of € 140. Explain what type of transaction the investor
could execute to take advantage of the situation. Calculate the rate of return
(annualized), and explain why the transaction is attractive.
iii. Suppose the forward contract is entered into at the price you computed in Part 1.
Two months later, the price of the asset is € 118.875. The investor would like to
evaluate her position with respect to any gain or loss accrued on the forward contract.

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Determine the market value of the forward contract at this point in time from the
perspective of the investor in Part 1.
iv. Determine the value of the forward contract at expiration assuming the contract is
entered into at the price you computed in Part 1 and the price of the underlying asset
is €123.50 at expiration. Explain how the investor did on the overall position of both
the asset and the forward contract in terms of the rate of return.

Solution
Part 1
T = 9/12 = 0.75
S0 = 125.72
r = 0.05625
F(0,T) = 125.72(1.05625)0.75 = €130.99

Part 2
As found in Part 1, the forward contract should be selling at €130.99, but it is selling for
€140. Consequently, it is overpriced-and an overpriced contract should be sold. Because the
investor holds the asset, she will be hedged by selling the forward contract. Consequently, her
asset, worth € 125.72 when the forward contract is sold, will be delivered in nine months and
she will receive €140 for it. The rate of return will be:
(140/125.72) – 1 = 0.1136

This risk-free return of 11.36 percent for nine months is clearly in excess of the 5.625 percent
annual rate. In fact, a rate of 11.36 percent for nine months annualizes to:
(1.1136)12/9 – 1= 0.1543
An annual risk-free rate of 15.43 percent is clearly preferred over the actual risk free rate of
5.625 percent. The position is not only hedged but also earns an arbitrage profit.

Part 3
t = 2/12
T – t = 9/12 – 2/12 = 7/12
St = 118.875
F(O,T) = 130.99
Vt (0,T) = V2/12 (0.9/12) = 118.875 – 130.99/(1.05625)7/12 = - 0.8
The contract has a negative value. Note, however, that in this form, the answer applies to the
holder of the long position. This investor is short. Thus, the value to the investor in this
problem is positive 8.0.

Part 4
ST = 123.50
VT = (0,T) = V9/12 (0.9/12) = 123.50 – 130.99 = -7.49
This amount is the value to the long. This investor is short, so the value is a positive 7.49.
The investor incurred a loss on the asset of 125.72 - 123.50 = 2.22.
Combined with the gain on the forward contract, the net gain is 7.49 - 2.22 = 5.27. A gain of
5.27 on an asset worth 125.72 when the transaction was initiated represents a return of
5.27/125.72 = 4.19 percent. When annualized, the rate of return equals:
(1.0419)12/9 – 1 = 0.05625
It should come as no surprise that this number is the annual risk-free rate. The transaction
was executed at the no-arbitrage forward price of €130.99. Thus, it would be impossible to
earn a return higher or lower than the risk-free rate.

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QUESTION 2
An asset manager anticipates the receipt of funds in 200 days, which he will use to purchase a
particular stock. The stock he has in mind is currently selling for $62.50 and will pay a $0.75
dividend in 50 days and another $0.75 dividend in 140 days. The risk-free rate is 4.2 percent.
The manager decides to commit to a future purchase of the stock by going long a forward
contract on the stock.
Required:
i. At what price would the manager commit to purchase the stock in 200 days through a
forward contract?
ii. Suppose the manager enters into the contract at the price you found in Part 1. Now,
75 days later, the stock price is $55.75. Determine the value of the forward contract
at this point.
iii. It is now the expiration day, and the stock price is $58.50. Determine the value of the
forward contract at this time.
Solution
So = $62.50
T = 200/365
D1 = $0.75 , t = 50/365
D2 = $0.75. t2 = 140/365
r = 0.042
Part 1
$0.75/(1.042)50/365 + $0.75/(1.042)140/365 = $1.48
Then find the forward price:
F(0,T) = F(0,200/365) = $62.50 - $1.48)(1.042)200/365 = $62.41

Part 2
We must now find the present value of the dividends 75 days after the contract begins. The first dividend
has already been paid, so it is not relevant. Because only one remains, the second dividend is now the
"first" dividend. It will be paid in 65 days. Thus, t1 - t = 65/365. The present value of this dividend
is $0.75/(1.042)65/365 = $0.74 . The other information is:
t = 75/365
T – t = (200 – 75) / 365 = 125 / 365
St = $55.75
The value of the contract is, therefore:
Vt (O,T) = V75/365 (0,200/365) = ($55.75 - $0.75) - $62.41/(1.042)125/365
= -$6.53
Thus, the contract has a negative value.
Part 3
ST = $58.50
V200/365(0,200/365) = VT(0,T) = $58.50 - $62.41 = -$3.91
Thus, the contract expires with a value of negative $3.91.

QUESTION 3
An investor purchased a bond when it was originally issued with a maturity of five years. The
bond pays semiannual coupons of $50. It is now 150 days into the life of the bond. The
investor wants to sell the bond the day after its fourth coupon. The first coupon occurs 181
days after issue, the second 365 days, the third 547 days, and the fourth 730 days. At this
point (150 days into the life of the bond), the price is $1,010.25. The bond prices quoted here
include accrued interest.
Required

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i. At what price could the owner enter into a forward contract to sell the bond on the
day after its fourth coupon? Note that the owner would receive that fourth coupon.
The risk-free rate is currently 8 percent.
ii. Now move forward 365 days. The new risk-free interest rate is 7 percent and the new
price of the bond is $1,025.375. The counterparty to the forward contract believes
that it has received a gain on the position. Determine the value of the forward
contract and the gain or loss to the counterparty at this time. Note that we have now
introduced a new risk-free rate, because interest rates can obviously change over the
life of the bond and any calculations of the forward contract value must reflect this
fact. The new risk-free rate is used instead of the old rate in the valuation formula.
Solution

Part 1
First we must find the present value of the four coupons over the life of the forward contract.
At the 150th day of the life of the bond, the coupons occur 31 days from now, 215 days from
now, 397 days from now, and 580 days from now. Keep in mind that we need consider only
the first four coupons because the owner will sell the bond on the day after the fourth coupon.
The present value of the coupons is:
50/(1.08)31/365 + 50/(1.08)215/365 + 50/(1.08)397/365 + 50/(1.08)397/365 + 50/(1.08)580/365
= $187.69
Because we want the forward contract to expire one day after the fourth coupon, it expires in
731 - 150 = 581 days. Thus, T = 581/365.
F(0,T) = F(0,581/365) = ($1010.25 - $187.69)(1.08)581/365 = $929.76

Part 2
It is now 365 days later-the 515th day of the bond's life. There are two coupons to go, one
occurring in 547 - 5 15 = 32 days and the other in 730 - 5 15 = 215 days. The present value of
the coupons is now:
$50/(1.07)32/365 + $50/(1.07)215/365 = $97.75.
To address the value of the forward contract and the gain or loss to the counterparty, note that
731 - 515 = 216 days now remain until the contract's expiration. Because the bondholder
would sell the forward contract to hedge the future sale price of the bond, the bondholder's
counterparty to the forward contract would hold a long position. The value of the forward
contract is the current spot price minus the present value of the coupons minus the present
value of the forward price:
$1025.375 - $97.75 - $929.76/(1.07)216/365 = $34.36
Because the contract was initiated with a zero value at the start and the counterparty is long
the contract, the value of $34.36 represents a gain to the counterparty.

QUESTION 4
A corporate treasurer needs to hedge the risk of the interest rate on a future transaction.
The risk is associated with the rate on 180-day Euribor in 30 days. The relevant term
structure of Euribor is given as follows:
30-day Euribor 5.75%
210-day Euribor 6.15%
Required:

i. State the terminology used to identify the FRA in which the manager is interested.
ii. Determine the rate that the company would get on an FRA expiring in 30 days on
180-day Euribor.

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iii. Suppose the manager went long this FRA. Now, 20 days later, interest rates have
moved significantly downward to the following:
10-day Euribor 5.45%
190-day Euribor 5.95%
The manager would like to know where the company stands on this FRA transaction.
Determine the market value of the FRA for a €20 million notional principal.

iv. On the expiration day, 180-day Euribor is 5.72 percent. Determine the payment made
to or by the company to settle the FRA contract.

Solution
Part 1
This transaction would be identified as a 1 X 7 FRA.
Part 2
Here the notation would be h = 30, m = 180, h + m = 210. Then:

FRA(0,h,m) = FRA(0,30,180) = 1 + 0.0615(210/360) - 1 (360/180)

1+0.0575 (30/360)

= 0.0619
Part 3
Here g = 20, h - g = 30 - 20 = 10, h + m - g = 30 + 180 - 20 = 190.
The value of the FRA for a €1 notional principal would be:
Vg(o,h,m) = V20(0,30,180) = 1/1 + 0.0545(10/360) – 1 + 0.0619(180/360) / 1 +
0.0595(190/360)
= -0.0011
Thus, for a notional principal of €20 million, the value would be €20,000,000(-0.0011)
= -€22,000.

Part 4
At expiration, the payoff is:
L,h(m) – FRA(0,h,m) (m/360)
1 + l,h(m)(m/360)
= (0.0572 – 0.0619) (180/360)
1 + 0.0572(180/360)
= - 0.0023
For a notional principal of €20 million, the payoff would then be €20,000,000(-0.0023)
= -€46,000. Thus, €46,000 would be paid by the company, because it is long and the final
rate was lower than the FRA rate.

QUESTION 5
The spot rate for British pounds is $1.76. The U.S. risk-free rate is 5.1 percent, and the U.K.
risk-free rate is 6.2 percent; both are compounded annually. One-year forward contracts are
currently quoted at a rate of $1.75.
Required:
i. Identify a strategy with which a trader can earn a profit at no risk by engaging in a
forward contract, regardless of her view of the pound's likely movements. Carefully
describe the transactions the trader would make. Show the rate of return that would

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be earned from this transaction. Assume the trader's domestic currency is U.S.
dollars.
ii. Suppose the trader simply shorts the forward contract. It is now one month later.
Assume interest rates are the same, but the spot rate is now $1.72. What is the gain or
loss to the counterparty on the trade?
iii. At expiration, the pound is at $1.69. What is the value of the forward contract to the
short at expiration?
Solution
Part 1
The following information is given:
S0 = $1.76
r = 0.051
rf = 0.062
T = 1.0
The forward price should be:
F(O,T) = ($1.76/1.062) (1.051) = $ 1.7418.

With the forward contract selling at $1.75, it is slightly overpriced. Thus, the trader should be
able to buy the currency and sell a forward contract to earn a return in excess of the risk-free
rate at no risk. The specific transactions are as follows:

1) Take $1.76/(1.062) = $1.6573. Use it to buy 1/1.062 = £0.9416,

2) Sell a forward contract to deliver £1.00 in one year at the price of $1.75.
3) Hold the position for one year, collecting interest at the U.K. risk-free rate of 6.2
percent. The £0.9416 will grow to (0.9416)(1.062) = £ 1.00.
4) At expiration, deliver the pound and receive $1.75. This is a return of:
(1.75/1.6573) – 1 = 0.0559
A risk-free return of 5.59 percent is better than the U.S. risk-free rate of 5.1 percent, a result
of the fact that the forward contract is overpriced.

Part 2
We now need the value of the forward contract to the counterparty, who went long at $1.75.
The inputs are:
t = 1/12
St = $1.72
T – t = 11/12
F(0,T) = $1.75
Vt(0,T) = 1.72 /(1.062)11/12 – 1.75/(1.051)11/12 = - 0.0443 which is a loss of $0.0443 to the long
and a gain of $0.0443 to the short.

Part 3
The pound is worth $1.69 at expiration. Thus, the value to the long is:
VT (O,T) = 1.69 – 1.75 = - 0.06 and the value to the short is +$0.06. Note the minus sign in
the equation VT(O,T) = -0.06. The value to the long is always the spot value at expiration
minus the original forward price. The short will be required to deliver the foreign currency
and receive $1.75, which is $0.06 more than market value of the pound.
The contract's value to the short is thus $0.06, which is the negative of its value to the long.

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QUESTION 6
 Calculate the price for a T-bill with a face value of $10,000, 153 days to maturity, and
a discount yield of 1.74 percent.
 Calculate the asked discount yield for a T-bill that has 69 days to maturity, a face
value of $10,000, and a price of $9,950.
Solution
Discount yield = 0.0174 = (10,000 – price) x (360/153)
10,000
Price = $ 9,926.05

Discount yield = (10,000 – 9,950 / 10,000) x (360/69)

Discount yield = 0.0261

QUESTION 7
Assume that 60-day LIBOR is 4.35 percent. You are based in London and need to borrow
$20,000,000 for 60 days. What is the total amount you will owe in 60 days?
Solution
$20,000,000(1 + 0.0435)(60/360) = $20,145,000

QUESTION 8
The treasurer of Company A expects to receive a cash inflow of $15,000,000 in 90 days. The
treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge
against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on
90-day LIBOR. The FRA is quoted at 5 percent. At expiration, LIBOR is 4.5 percent.
Assume that the notional principal on the contract is $l5,000,000.
Required:
1) Indicate whether the treasurer should take a long or short position to hedge interest
rate risk.
2) Using the appropriate terminology, identify the type of FRA used here.
3) Calculate the gain or loss to Company A as a consequence of entering the FRA.
Solution
Part one
Taking a short position will hedge the interest rate risk for Company A. The gain on the
contract will offset the reduced interest rate that can be earned when rates fall.
Part two
This is a 3 x 6 FRA.
Part three
$15,000,000 (0.045 – 0.05) (90/360)
1 + 0.045(90/360)

= - $18,541.41
The negative sign indicates a gain to the short position, which Company A holds

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QUESTION 9
Suppose that a party wanted to enter into a FRA that expires in 42 days and is based on 137-
day LIBOR. The dealer quotes a rate of 4.75 percent on this FRA. Assume that at expiration,
the 137-day LIBOR is 4 percent and the notional principal is $20,000,000.
Required:
1) What is the term used to describe such nonstandard instruments?
2) Calculate the FRA payoff on a long position.
Solution
Part one
These instruments are called off-the-run FRAs.
Part two
$20,000,000 0.04 – 0.0475) (137/360)
1 + 0.04(137/360)
= - $56,227
Because the party is long, this amount represents a loss.

QUESTION 10
A corporate treasurer wishes to hedge against an increase in future borrowing costs due to a
possible rise in short-term interest rates. She proposes to hedge against this risk by entering
into a long 6 x 12 FRA. The current term structure for LIBOR is as follows:

Term Interest rate

30 day 5.10%
90 day 5.25%
180 day 5.70%
360 day 5.95%

Required:
1) Indicate when this 6 x 12 FRA expires and identify which term of the LIBOR this
FRA is based on.
2) Calculate the rate the treasurer would receive on a 6 x 12 FRA.

Suppose the treasurer went long this FRA. Now, 45 days later, interest rates have risen and
the LIBOR term structure is as follows:

Term Interest rate

135 day 5.90%
315 day 6.15%

3) Calculate the market value of this FRA based on a notional principal of $10,000,000.
4) At expiration, the 180-day LIBOR is 6.25 percent. Calculate the payoff on the FRA.
Does the treasurer receive a payment or make a payment to the dealer?
Solution:
Part one
A 6 x 12 FRA expires in 180 days and is based on 180-day LIBOR.
Part two
h = 180
m = 180
h + m = 360

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LO(h + m) = 0.0595
L0(h) = 0.057
FRA(o,h,m) = 1 + 0.0595 (360/360) - 1 ( 360/360)
1 + 0.0570 (180/360)
= 0.0603
Part three
h = 180
m = 180
g = 45
h – m = 135
h + m – g = 315
L45(h – g) = 0.0590
L45(h + m – g) = 0.0615
Vt (o,h,m) = 1 / 1 + 0.0590 (135/360) – 1 + 0.063 (180/360) / 1 + 0.0615 (315/360)
= 0.0081
For $10,000,000 notional principal, the value of the FRA would be = 0.0081 x 10,000,000
= $8,100.

Part four
h= 180
m = 180
L180(h + m) = 0.0625
At expiration, the pay off is:
(0.0625 – 0.0603) (180/360)
1 + 0.0625 (180/360)
= 0.001067
Based on a notional principal of $10,000,000, the corporation, which is long, will receive
$10,000,000 x 0.001067 = $10,670 from the dealer.

QUESTION 11
Assume that a security is currently priced at $200. The risk-free rate is 5 percent.
Required:
1) A dealer offers you a contract in which the forward price of the security with delivery
in three months is $205. Explain the transactions you would undertake to take
advantage of the situation.
2) Suppose the dealer were to offer you a contract in which the forward price of the
security with delivery in three months is $198. How would you take advantage of the
situation?
Solution
Part one
The no-arbitrage forward price is F(0,T) = $200(1.05)3/12 = $202.45.
Because the forward contract offered by the dealer is overpriced, sell the forward contract
and buy the security now. Doing so will yield an arbitrage profit of $2.55.
Borrow $200 and buy security. At the end of three months, repay $202.45
At the end of three months, deliver the security for $205.00
Arbitrage profit $2.55.

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Part two
At a price of $198.00, the contract offered by the dealer is underpriced relative to the no-
arbitrage forward price of $202.45. Enter into a forward contract to buy in three months at
$198.00. Short the stock now, and invest the proceeds. Doing so will yield an arbitrage profit
of $4.45.
Short security for $200 and invest proceeds for three months $202.45
At the end of three months, buy the security for $198.00
Arbitrage profit $4.45

QUESTION 12
The euro currently trades at $1.0231. The dollar risk-free rate is 4 percent and the euro risk-
free rate is 5 percent. Six-month forward contracts are quoted at a rate of $1.0225. Indicate
how you might earn a risk-free profit by engaging in a forward contract.
Clearly outline the steps you undertake to earn this risk-free profit.

Solution
Part one
First calculate the fair value or arbitrage-free price of the forward contract:
So = $1.023
T = 180/365
r = 0.04
rf = 0.05
F(0,T) = 1.0231 (1.04) 180/365
180/365
(1.05)

= $ 1.0183
The dealer quote for the forward contract is $1.0225; thus, the forward contract is overpriced.
To earn a risk-free profit, you should enter into a forward contract to sell euros forward in six
months at $1.0225. At the same time, buy euros now.

Part two
Step 1
Take 1.0231/(1.05)180/365 = $0.9988. Use it to buy 1/(1.05)180/365 = 0.9762 Euros.
Step two
Enter a forward contract to deliver €1.00 at $1.0225 in six months.
Step three
Invest €0.9762 for six months at 4.5 percent per year and receive €0.9762 x (1.05)180/365
= 1.00 Euro at the end of six months.
Part four
At expiration, deliver the euro and receive $1.0225. Return over six months is
$1.0225/$0.9988 – 1 = 0.0237, or 4.74 percent a year.

QUESTION 13
Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect
the value of the pound to increase against the U.S. dollar over the next 30 days.
You will be making payment on a shipment of imported goods in 30 days and want to hedge
your currency exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is
4.5 percent. These rates are expected to remain unchanged over the next month. The current
spot rate is $1.50.
Required

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1) Indicate whether you should use a long or short forward contract to hedge the
currency risk.
2) Calculate the no-arbitrage price at which you could enter into a forward contract that
expires in 30 days.
3) Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate
the value of your forward position.
Solution
Part one
The risk to you is that the value of the British pound will rise over the next 30 days and it will
require more U.S. dollars to buy the necessary pounds to make payment. To hedge this risk
you should enter a forward contract to buy British pounds.
Part two
So = $1.50
T = 30/365
r = 0.055
rf = 0.045
F(O,T) = $1.50 / (1.04)30/365 (1.055)30/365
= $1.5018
Part three
St = $1.53
T =30/365
t = 10/365
T – t = 20/365
r = 0.055
rf = 0.045
Vt(0,T) = $1.53 / (1.045)20/365 - $1.5012 / (1.055)20/365
= $ 0.0295
Because you are long, this is a gain of $0.0295 per British pound.

QUESTION 14
The Japanese yen currently trades at $0.00812. The U.S. risk-free rate is 4.5 percent, and the
Japanese risk-free rate is 2.0 percent. Three-month forward contracts on the yen are quoted at
$0.00813.
Required:
1) Indicate how you might earn a risk-free profit by engaging in a forward contract.
2) Outline your transactions.
Solution
Part one
First, calculate the fair value or arbitrage free price of the forward contract:
So = $0.00812 per yen
T = 90/365
r = 0.045
rf = 0.02
F(O,T) = $0.00812 / (1.02)90/365 (1.045)90/365
= $0.00817
Part two

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The dealer quote for the forward contract is $0.008 13. Therefore, the forward contract is
underpriced. To earn a risk-free profit, you should enter into a forward contract to buy yen in
three months at $0.00813. At the same time, sell yen now.
The spot rate of $0.00812 per yen is equivalent to¥123.15 per U.S. dollar.

1) Take ¥123.15 / (1.045)90/365 = ¥121.82. Use it to buy 1/(1.045)90/365 = $0.9892

2) Enter a forward contract to buy yen at $0.00813 in three months. One U.S. dollar will buy
1/$0.00813 = ¥ 123.00.
3) Invest $0.9892 for three months at 4.5 percent a year and receive $0.9892 x
(1.045)90/365 = $1.00 at the end of three months.
4) At expiration, deliver the dollar and receive ¥ 123. The return over three months is:
(¥123 / ¥121.82) – 1 = 0.00969, or 3.88 percent a year.
Because we began our transactions in yen, the relevant comparison for the return from our
transactions is the Japanese risk-free rate. The 3.88 percent return above exceeds the Japanese
risk-free rate of 2 percent. Therefore, we could borrow yen at 2 percent and engage in the
above transactions to earn a risk-free return of 3.88 percent that exceeds the rate of
borrowing.

NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this
by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

CHAPTER THREE
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FUTURES MARKETS AND CONTRACTS

PAGE
Introduction: Definition of Futures, Brief history of futures markets……………..
Types of futures contracts………………………………………………………….
short-term interest rate futures contracts; intermediate- and long-term interest rate
futures contracts; Bond futures contracts; stock index futures contracts; currency
futures contracts; Commodities futures contracts – Agricultural, Energy, Precious and
Industrial metal futures.
Characteristics of Futures markets……………………………………………
Public standardized transactions; homogenization and liquidity; the clearinghouse;
daily settlement; and performance guarantee; regulation
Futures trading………………………………………………………………
The clearinghouse, margins, and price limits; delivery and cash settlement; futures
exchanges. Mechanics of trading in futures markets; Long and short positions, Profit
and loss at expiration, Closing of positions, Delivery procedures, marking to market of
futures contracts, leverage effect, futures quotes.
Pricing and valuation of futures contracts……………………………………
generic pricing and valuation of a futures contract; pricing interest rate futures, stock
index futures, and currency futures; Factors determining contract price - CAPM,
hedging pressure theory and cost of carry model; Theoretical and Reality price of
futures; Comparing the calculated value of the future vs the market.
Uses of financial and non-financial futures………………………………………..
The role of futures markets and exchanges………………………………………..
Revision questions – 2015 – 2023…………………………………………………

KEY TOPIC ISSUES

A futures contract is essentially a forward contract that is traded on an organized financial
exchange such as the Chicago Mercantile Exchange (CME). Organized futures markets as we
know them arose in the mid-1800s in Chicago. Futures markets began with grains, such as
corn, oats, and wheat, as the underlying asset. Financial futures are futures contracts based on
a financial instrument or financial index.
A futures contract, or simply called futures, is a contract to buy or sell a stated quantity of a
commodity or a financial claim at a specified price at a future specified date.
The parties to the futures have to buy or sell the asset regardless of what happens to its value
during the intervening period or what happens to be the price on the date when the contract is
implemented. Both the parties to the futures have a right to transfer the contract by entering
into an offsetting futures contract. If not transferred until the settlement/specified date, then
they have obligations to fulfill the terms and conditions of the contract. Futures are traded on
the exchanges and the terms of the futures contracts are standardized by the exchange with
reference to quantity, date, units of price quotation, minimum change in price (tick), etc.
Futures can be in respect of commodities such as agricultural products, oil, gas, gold, silver,
etc., or of financial claims such as shares, debentures, treasury bonds, share index, foreign
exchanges, etc. In a futures contract, the parties fix the terms of the transaction and lock in
the price at which the transaction will take place between them at future date. The futures
contract, as they appear to be, providing for the physical delivery of the asset, however, in
practice most of the futures are settled by and offsetting futures contract. If a particular

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futures is not settled by the party himself then it will be settled by the exchange at a specified
price and the difference is payable by or to the party. The basic motive for a future is not the
actual delivery but the hedging for future risk or speculation. Further, in certain cases, the
physical asset does not exist at all. For example, in case of Stock Index Futures, the Index is
the weighted average price and cannot be delivered. So, such futures must be cash settled
only.
Futures are traded at the organized exchanges only. Some of the centers where futures are
traded are Chicago Board of Trade, Tokyo Stock Exchange, London International Financial
Futures Exchange (LIFFE), etc. The exchange provides the counter-party guarantee through
its clearing house and different types of margins system. Futures contracts are marked to
market at the end of each trading day. Consequently, these are subject to interim cash flows
for adverse or favourable price movement. With reference to trading in Stock Index Futures,
SEBI has provided that the participating parties have to deposit an initial cash margin as well
as that difference in traded price and actual price on daily basis. At the end of the settlement
period or at the time of squirring off a transaction, the difference between the traded price and
settlement price is settled by cash payment. No carry forward of a futures contract is allowed
beyond the settlement period.

Futures contracts are very much like the forward contracts. They are similar in that:
1) Deliverable contracts obligate the long to buy and the short to sell • a certain quantity of
an asset for a certain price on a specified future date.
2) Cash settlement contracts are settled by paying the contract value in cash on the expiration
date.
3) Both forwards and futures are priced to have zero value at the time the investor enters into
the contract.
There are important differences between forwards and futures, including:
1) Futures are marked to market at the end of every trading day. Forward contracts are not
marked to market.
2) Forwards are private contracts and do not trade on organized exchanges. Futures contracts
trade on organized exchanges.
3) Forwards are customized contracts satisfying the needs of the parties involved.
4) Futures contracts are highly standardized.
5) Forwards are contracts with the originating counterparty; a specialized entity called
clearinghouse is the counterparty to all futures contracts.
6) Forward contracts are usually not regulated. The government having legal jurisdiction
regulates futures markets.

HOW FUTURES CONTRACTS ARE TERMINATED/SETTLED

A trader who has a long or short position in a futures contract can terminate the contract
in four ways:
1) Close out
2) Delivery
3) Cash settlement.
4) Exchange for physical.

Closeout
This is the case where the futures trader closes out the futures contract even before the
expiry. A trader who has a long position can take an equivalent short position in the same
contract, and both the positions will be offset against each other. Similarly, a trader with a
short position can take a long position in the same contract to close out the position.

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Delivery
On the settlement date, the short can settle the contract by delivering the underlying asset
to the long. The contract is settled by delivery. This method is hardly used and constitutes
not more than 1% of contract settlements. In case of the physical delivery, the
clearinghouse will select a counterparty for physical settlement (accept delivery) of the
futures contract. Typically the counterparty selected will be the one with the oldest long
position.
Cash Settlement
Cash settlement can be done only if the contract specifies so. The trader just leaves his
position open and when the contract expires, his margin account will be marked-to market
for P&L on the final day of the contract. This is the most commonly used method as the
trader saves on the transaction costs of closing out the position.
Exchange for Physicals
A contract can also be terminated through an exchange of physicals. In this case, a trader
finds another trader who has an opposite position in the same futures contract and delivers
the underlying assets to him. This happens outside the exchange floor, and is called an ex-
pit transaction. The traders will then inform the clearinghouse about the transaction.

FUNCTIONS OF FUTURES MARKET

HEDGING
The primary function of the futures market is the hedging function which is also known as
price insurance, risk shifting or risk transference function.

PRICE DISCOVERY
Another important use of futures market is the price discovery which is the revealing of
information about futures cash market prices through the futures Market.

FINANCING FUNCTION
Another important function of a futures market is to raise finance against the stock of assets
or commodities. Since futures contracts are standardized contracts, so they make it easier for
the lenders about the assurance of quantity, quality and liquidity of the underlying asset.

LIQUIDITY FUNCTION
They are operated on the basis of margins which are determined on the basis of rides
involved in the contract. Under this the buyer and the seller have to deposit only a fraction of
the contract value, say 5 percent or 10 percent, known as margins. It means that the traders in
the futures market can do the business a much larger volume of contracts than in a spot
market, and thus, makes the market more liquid.

PRICE STABILIZATION FUNCTION

Another important function of a futures market is to keep a stabilizing influence on spot
prices by reducing the amplitude of short term fluctuations. In other words, Futures market
reduces both the heights of the peaks and the depth of the troughs.

DISSEMINATING INFORMATION
Apart from the aforementioned functions of the futures markets like risk transference
(hedging), price discovery, price stabilization, liquidity, and financing, this market is very
much useful to the economy too, Futures markets disseminate information quickly,

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effectively and inexpensively, and, as a result reducing the monopolistic tendency in the
market.

CONVERGENCE PROPERTY
As futures contracts mature and are compulsorily settled on the specified maturity date, the
futures price and the spot price of the underlying asset on that date must coverage.
This may be called the convergence property. If the two prices are not equal then every
investor would like to make profit by capitalizing the opportunity. But then, who will lose?
On the date of the settlement, the two prices would almost be the same.
For example, an investor takes a long position in Nifty Futures (1 month) and holds that
position till maturity. The sum of daily statements (mark to marker) would be equal to F T. FD
where F0 is initial futures price at contract time and FT is futures price on maturity.

Day Future Price Profit /loss Cumulative Profit

0 1650 - -
1 1680 30 30
2 1685 5 35
3 1695 10 45
4 1685 -10 35
5 1690 5 40
6 1692 2 42

As explained above, FT will be equal to ST due to convergence property, Where ST is spot

price of asset on maturity. So, the profit on maturity is S - F0 and it tracks changes in the price
of the underlying asset. In the above Table, the convergence property and its effect on
profit/loss on NIFTY futures have been shown.
Due to the convergence property, the spot price of NIFTY on Day 6 could be 3692 und profit
at settlement is (3692-3650) i.e., sh. 42 per unit. The same profit is also shown by column 3
and 4. The net receipts in mark to market are also sh. 42. So, the convergence property states
that the futures prices and spot prices are equal on the maturity date. However, before
maturity, the futures prices may differ substantially from current spot prices, So, from the
point of view of the investor, if the futures contact and the asset are held until maturity, he
bears no risk because on the maturity date, the asset value equal to the current price. Risk is
eliminated because on that day, the futures prices and spot prices are equal. However, if the
futures contract and assets are to be liquidated earlier, the investor in this case bears ‘basis
risk’. The reason being that future price and spot price are not in perfect lock up position at
all times before maturity, and the profit / loss on one may not perfectly offset the loss/profit
on the other.

THE OPERATION OF MARGINS

If two investors get in touch with each other directly and agree to trade an asset in the future
for a certain price, there are obvious risks. One of the investors may regret the deal and try to
back out. Alternatively, the investor simply may not have the financial resources to honor the
agreement. One of the key roles of the exchange is to organize trading so that contract
defaults are avoided. This is where margins come in.

The Maintenance Margin

The maintenance margin is the minimum amount which must be remained (kept) in a margin
account. In other words, so much minimum, balance in the margin account must be
maintained by the investor. This is normally about 75 percent of the initial margin. If the

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futures prices move against the investor resulting in falling the margin account below the
maintenance margin, the broker will make a call, i.e., asking the client to replenish the margin
account by paying the
variation. Hence, the demand for additional fund known as a margin call.
For example, assume that the initial margin on 2 futures contract is sh. 5,000 and the
maintenance margin sh. 3,750 (75% of the initial margin). The next day assume that the party
has sustained a loss of sh.1,000, reducing the balance in Margin to sh. 4,000. Further assume
that on the next day the price decreased and sustained loss is sh. 500. Thus, the balance
remained in the margin account to sh. 3,500.

The Variation Margin

It refers to that additional amount which has to be deposited by the trader with the broker so
as to bring the balance of the margin account to the initial margin level.
For instance, in the above-mentioned example, the variation margin would be sh. 1500
(sh. 5000 – sh. 3500) i.e. the difference of initial margin and the balance in the margin
account. If the investor does not pay the initial margin immediately, the broker may proceed
to unilaterally close out the account by entering into an offsetting futures position.

Daily Settlement
To illustrate how margins work, we consider an investor who contacts his or her broker to
buy two December gold futures contracts on the COMEX division of the New York
Mercantile Exchange (NYMEX), which is part of the CME Group. We suppose that the
current futures price is $1,250 per ounce. Because the contract size is 100 ounces, the
investor has contracted to buy a total of 200 ounces at this price. The broker will require the
investor to deposit funds in a margin account. The amount that must be deposited at the time
the contract is entered into is known as the initial margin. We suppose this is $6,000 per
contract, or $12,000 in total. At the end of each trading day, the margin account is adjusted to
reflect the investor’s gain or loss. This practice is referred to as daily settlement or marking
to market.
Suppose, for example, that by the end of the first day the futures price has dropped by $9
from $1,250 to $1,241. The investor has a loss of $1,800 (200 x $9), because the 200 ounces
of December gold, which the investor contracted to buy at $1,250, can now be sold for only
$1,241. The balance in the margin account would therefore be reduced by $1,800 to $10,200.
Similarly, if the price of December gold rose to $1,259 by the end of the first day, the balance
in the margin account would be increased by $1,800 to $13,800.
A trade is first settled at the close of the day on which it takes place. It is then settled at the
close of trading on each subsequent day.
Note that daily settlement is not merely an arrangement between broker and client.
When there is a decrease in the futures price so that the margin account of an investor with a
long position is reduced by $1,800, the investor’s broker has to pay the exchange $1,800 and
the exchange passes the money on to the broker of an investor with a short position.
Similarly, when there is an increase in the futures price, brokers for parties with short
positions pay money to the exchange and brokers for parties with long positions receive
money from the exchange.
The investor is entitled to withdraw any balance in the margin account in excess of the initial
margin. To ensure that the balance in the margin account never becomes negative a
maintenance margin, which is somewhat lower than the initial margin, is set. If the balance
in the margin account falls below the maintenance margin, the investor receives a margin
call and is expected to top up the margin account to the initial margin level by the end of the
next day. The extra funds deposited are known as a variation margin. If the investor does not

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provide the variation margin, the broker closes out the position. In the case of the investor
considered earlier, closing out the position would involve neutralizing the existing contract
by selling 200 ounces of gold for delivery in December.

The table below illustrates the operation of the margin account for one possible sequence of
futures prices in the case of the investor considered earlier. The maintenance margin is
assumed to be $4,500 per contract, or $9,000 in total. On Day 7, the balance in the margin
account falls $1,020 below the maintenance margin level. This drop triggers a margin call
from the broker for an additional $4,020 to bring the account balance up to the initial margin
level of $12,000. It is assumed that the investor provides this margin by the close of trading
on Day 8. On Day 11, the balance in the margin account again falls below the maintenance
margin level, and a margin call for $3,780 is sent out. The investor provides this margin by
the close of trading on Day 12. On Day 16, the investor decides to close out the position by
selling two contracts. The futures price on that day is $1,226.90, and the investor has a
cumulative loss of $4,620. Note that the investor has excess margin on Days 8, 13, 14, and
15. It is assumed that the excess is not withdrawn.

Illustration
Operation of margins for a long position in two gold futures contracts
The initial margin is $6,000 per contract, or $12,000 in total; the maintenance margin is
$4,500 per contract, or $9,000 in total. The contract is entered into on Day 1 at $1,250 and
closed out on Day 16 at $1226.90.
Day Settlement price Daily Cumulative Margin Margin call
gain/loss gain/loss account
balance
0 1250.00 - - 12000
1 1241.00 -1800 -1800 10200
2 1238.30 -540 -2340 9660
3 1244.60 +1260 -1080 10920
4 1241.30 -660 -1740 10260
5 1240.10 -240 -1980 10020
6 1236.20 -780 -2760 9240
7 1229.90 -1260 -4020 7980 4020
8 1230.80 +180 -3840 12180
9 1225.40 -1080 -4920 11100
10 1228.10 +540 -4380 11640
11 1211.00 -3420 -7800 8220 3780
12 1211.00 0 -7800 12000
13 1214.30 +660 -7140 12660
14 1216.10 +360 -6780 13020
15 1223.00 +1380 -5400 14400
16 1226.90 +780 -4620 15180

1250 – 1241 = 9 x 200 = 1800

1238.30 – 1241 = 2.7 x 200 = 540
1244.60 – 1238.30 = 6.3 x 200 = 1260……………

12000 – 1800 = 10200

10200 – 540 = 9660
9660 + 1260 = 10920……………………..

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REVISION QUESTIONS

DECEMBER 2023
Q.2.A – Assess three ways of terminating a futures contract. (6 mks)
1) Physical delivery
2) Cash settlement
3) Offsetting / close out
4) Exchange of future for physical

Physical Delivery
One way of liquidating of futures position is by making or taking physical delivery of the
goods/asset. The exchange has provided alternatives as to when, where and what will be
delivered. It is the choice of the party with a short position. When the party is ready to
deliver, it will send a notice of intention to deliver to the exchange. The price is settled with
normally most recent with a possible adjustment for the quality of the asset and chosen
delivery location. After that, the exchange selects a party with an outstanding long position to
accept delivery. Let us see how physical delivery works.
Let us take an example of particular futures contract: Silver traded on COMEX where a
short-trader is required to make delivery of 5000 troy ounce (6 percent more or less) of
refined silver bar cost in heights of 1000 to 1100 ounces each and at 0.999 fineness. Which
should bear the serial number and identifying stamp of a refiner approved by the COMEX
exchange. At the beginning of the delivery month on the exchange-designated notice days,
say, December 2023 contract, exchange rules requires that all traders having open positions
in
December 2023 contract notify their member brokers to take or make delivery for this. In
turn, the brokers will inform to the clearing house of their customer’s intention. After this
notification, the clearing house matches longs and shorts usually by matching the oldest short
to the oldest long position, until all short quantities are matched. Delivery notices are then
served to all the traders through their brokers indicating to whom their delivery obligations
runs and when, where and in what quantities is to be made. Some exchanges impose heavy
penalty in case of default by any party. When delivery is satisfactory made then the clearing
house notify and accord the same. In case of financial futures, delivery is usually made by
wire transfer.

Cash Settlement/Delivery
This is relatively new procedure followed for settling futures obligations through cash
delivery. This procedure is a substitute of physical delivery and hence, do not require
physical delivery. The exchange notifies about this where cash delivery is the settlement
procedure. There are certain financial futures like stock indices futures, certain treasury
securities, euro-dollar, time deposits, municipal bonds, etc. When a cash settlement contract
expires, the exchange sets its final settlement price equal to the spot price of the underlying
asset on that day. In other words, it is simply marked-to-market at the end of the last trading
day to handover the underlying assets. Since cash settlement contracts are settled at the spot
price, their futures prices are converged to the underlying spot prices. Therefore, the prices of
cash settlement contracts behave just like the prices of delivery contracts at their expiration
period.

Offsetting

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The most common and popular method of liquidating the open futures position is to effect an
offsetting futures transaction or via a reversing trade which reverses the existing open
position. For example, the initial buyer (long) liquidates his position by selling (going short)
an identical futures contract (which means same delivery month and same underlying asset).
Similarly, the initial seller (short) goes for buying (long) an identical futures contract. After
executing these trades, these are reported to the clearing house then both trade obligations are
extinguished on the books of the brokers and the clearing house.
No doubt, the clearing house plays a significant role in facilitating settlement by offset. In
comparison to the physical delivery, this method is relatively simple which requires good
liquidity in the market, and entails only, the usual brokerage costs.
For example, there are two parties X and Y. X has an obligation to the clearing house to
accept 10,000 bushels of cotton in September and to pay ` 180 per bushels. For them at that
time. X does not wish to actually receive the oats and want to exit the futures market earlier.
Similarly, Y has an obligation to the clearing house to deliver 10,000 bushels of cotton in
September and to receive ` 180 per bushels. Both parties can reverse or offset their position in
that way whereby buyer becomes seller and seller becomes the buyer. Before the due date
i.e., September, X will sell September contract for cotton at ` 190 per bushels Y will buy at
190 per bushels.

Exchange of Futures for Physicals (EFP)

This is another method of liquidating the futures contract in form of physical delivery, called
exchange of futures for physicals. In this method, a party who holds a futures contract may
like to liquidate his position that is different from those the exchange offers.
For example, a party may like to deliver the assets before the specified futures period, or may
deliver the asset at different place, or deliver outside the normal trading hours, etc.
In simple terms, the contracts fulfilled by the parties on non-contract terms under this
technique. For example, a party with a long gold futures position may wish to take delivery in
Los Angels rather than in New York, as the contract specifies. Further, the EFP system
permits to exchange a futures position for a cash position that meets both the parties’
preferences, of course, for EFP, the party must find another party willing to make the trade.

Q.3.C – John Okenangwa manages an investment portfolio consisting of a futures contract on

a Treasury bill that expires in 50 days. The treasury bill matures in 140 days. The discount
rates on Treasury bill are as follows:
 50 day treasury bill 5.0%
 140 day treasury bill 4.6%
Required:
i. The appropriate futures price by using the prices of the 50 day and 140 day Treasury
bill. (1 mk)
ii. Determine the futures price in terms of the underlying spot price compounded at the
appropriate risk free rate. (2 mks)
iii. Convert the futures price to the implied discount rate on the futures. (2 mks)

Solution
We give a detailed similar question here first then take the above question as an assignment.
Understand the below given question first, attempt the above question, then check our
solutions.
QUESTION
A futures contract on a T-bill expires in 30 days. The T-bill matures in 120 days. The
discount rates on T-bills are as follows:

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 30-day bill: 5.4 percent

 120-day bill: 5.0 percent
Required:
1) Find the appropriate futures price by using the prices of the 30- and 120-day T-bills.
2) Find the futures price in terms of the underlying spot price compounded at the
appropriate risk-free rate.
3) Convert the futures price to the implied discount rate on the futures.
4) Now assume that the futures is trading in the market at an implied discount rate 20 basis
points lower than is appropriate, given the pricing model and the rule of no arbitrage.
Demonstrate how an arbitrage transaction could be executed.
5) Now assume that the futures is trading in the market at an implied discount rate 20 basis
points higher than is appropriate, given the pricing model and the rule of no arbitrage.
Demonstrate how an arbitrage transaction could be executed.
Solution
Find the appropriate futures price by using the prices of the 30- and 120-day T-bills
First, find the prices of 30- and 120-day bills:
Bo (30) = 1 – 0.054(30/360) = 0.9955
Bo (120) = 1 – 0.050(120/360) = 0.9833
0.9833/0.9955 = 0.9877
Find the futures price in terms of the underlying spot price compounded at the appropriate
risk-free rate.
We must find the rate at which to compound the spot price of the 120-day T-bill.
The spot rate, obtained from the 30-day T-bill, is:
1/0.9955 = 1.0045
Based on the rate ro(h), every dollar invested should grow to a value of 1.0045.
Thus, the futures price should be the spot price (price of the 120-day T-bill) compounded by
the factor 1 .0045:
0.9833/1.0045 = 0.9877

Convert the futures price to the implied discount rate on the futures.
Given the futures price of 0.9877, the implied rate is:
1 – 0.9877(360/90) = 0.0492
Now assume that the futures is trading in the market at an implied discount rate 20 basis
points lower than is appropriate, given the pricing model and the rule of no arbitrage.
Demonstrate how an arbitrage transaction could be executed.
If the futures contract is trading for 20 basis points lower, it is trading at a rate of 4.72
percent. So the futures price would be:
1 – 0.0472(90/360) = 0.9882
Do the following:
Buy the 120-day bill at 0.9833.
Sell the futures at 0.9882.
This transaction produces a return per dollar invested of: 0.9882/0.9833 = 1.0050 which is a
risk-free return and compares favorably with a return per dollar invested of 1.0045 (computed
in Part B above) for a 30-day T-bill.

Now assume that the futures is trading in the market at an implied discount rate 20 basis
points higher than is appropriate, given the pricing model and the rule of no arbitrage.
Demonstrate how an arbitrage transaction could be executed.
If the futures contract is trading for 20 basis points higher than is appropriate, it trades at a
rate of 5.12 percent. So the futures price would be: 1 – 0.0512(90/360) = 0.9872.

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Do the following:
Sell the 120-day bill at 0.9833.
Go long a 30-day futures contract at 0.9872.
Thus, at the beginning, you received 0.9833. At expiration 30 days later, the 120- day bill you
sold short at the beginning is a 90-day bill. You would take care of this by paying 0.9872 and
taking the delivery of a 90-day T-bill (because you had bought a 30-day futures contract at
the beginning). Effectively, what you have done is you have borrowed at a rate of:
0.9872/0.9833 = 1.0040 which compares favorably with the risk-free rate of 1.0045
computed in Part B above. You could also look at the above as follows. You go long a 30-day
futures contract at 0.9872. You sell the 120-day bill at 0.9833. Invest this amount in a 30- day
T-bill. At maturity, you will have 0.9833(1.0045), or 0.9877. This return compares favorably
with the 0.9872 that you owe at expiration.
Assignment – December 2023 question 3.c.
Solution for December 2023 question 3.c.
Answer for part 1
First, find the prices of the 50- and 140-day bonds:
B0(50) = 1 – 0.05(50/360) = 0.9931
B0(140) = 1 – 0.046(140/360) = 0.9821
The futures price is, therefore, F0(50) = 0.9821/0.9931 = 0.9889
Answer for part 2
First, find the rate at which to compound the spot price of the 140-day T-bill. This rate is
obtained from the 50-day T-bill:
1/0.9931 = 1.0069
We actually do not need to solve for ro(h). The above says that based on the rate ro(h), every
dollar invested should grow to a value of 1.0069. Thus, the futures price should be the spot
price (the price of the 140-day T-bill) compounded by the factor 1.0069:
F0(50) = 0.9821(1.0069) = 0.9889
Annualized, this rate would equal (1.0069)365/50 -1= 0.0515.
Answer for part 3
Given the futures price of 0.9889, the implied discount rate is:
r0(50) = 1 – 0.9889)(360/90) = 0.0444

Assignment
Now assume that the futures contract is trading in the market at an implied discount rate 10
basis points lower than is appropriate, given the pricing model and the rule of no arbitrage.
Demonstrate how an arbitrage transaction could be executed and show the outcome.
Calculate the implied repo rate and discuss how it would be used to determine the
profitability of the arbitrage. (This assignment relates to the above question but was not part
of the questions in the original paper)

AUGUST 2023
Q.1.C – A 250 – day futures contract is entered into using a 7% semi-annual pay coupon
bond with a spot price of sh. 1,050 (accrued interest inclusive) and will make a coupon
payment 182 days later. The annual risk free rate is 6%. Assume a year has 365 days.
Required:
Calculate the price of the 250 – day futures contract. (4 mks)
Solution
Calculate the price of a 250-day forward contract on a 7% U.S. Treasury bond with a spot
price of sh.1,050 (including accrued interest) that has just paid a coupon and will make
another coupon payment in 182 days. The annual risk-free rate is 6%.

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Remember that U.S. Treasury bonds make semi-annual coupon payments, so:
C = 1000 x 0.07
2
= 35

PVC = 35 / 1.06 182/365

= 34
The forward price of the contract is therefore:
FP (on a fixed income security) = (1050 – 34) x 1.06 250/365
= 1057.37
Q.3.A – Describe three types of margin used in the futures market. (6 mks)
1) Initial margin
2) Maintenance margin
3) Variation margin
Types of Margin
There are three types of margin such as initial margin, maintenance margin and variation
margin. The initial margin is the original amount that must be deposited into account to
establish futures position. It varies from stock to stock. To determine the initial margin, the
exchange usually considers the degree of volatility of price movements in the past of the
underlying the asset. After that, the exchange sets the initial margin so that the clearing house
covers losses on the position even in most adverse situation. The initial margin approximately
equals the maximum daily price fluctuation permitted by the exchange for that underlying
asset.
The exchange has the right to increase or decrease the quantum of initial marginal depending
upon the likely anticipated changes in the futures price. For most of the futures contracts, the
initial margin may be 5 percent or less of the underlying asset’s value. After proper
completion of all the obligations associated with investor’s futures position, the initial
margin is returned to the trader.
The Maintenance Margin
The maintenance margin is the minimum amount which must be retained (kept) in a margin
account. In other words, so much minimum, balance in the margin account must be
maintained by the investor. This is normally about 75 percent of the initial margin. If the
futures prices move against the investor resulting in falling the margin account below the
maintenance margin, the broker will make a call, i.e., asking the client to replenish the margin
account by paying the variation. Hence, the demand for additional fund is known as a margin
call.
For example, assume that the initial margin on a futures contract is sh. 5,000 and the
maintenance margin sh.3,750 (75% of the initial margin). The next day assume that the party
has sustained a loss of sh. 1,000, reducing the balance in margin to sh. 4,000. Further assume
that on the next day the price decreased and sustained loss is sh.500. Thus, the balance
remained in the margin account to `sh.3,500, below the maintenance margin. In this situation,
the broker will make a call (margin call) to replenish the margin account to sh.5,000, the
level of initial margin.

The Variation Margin

It refers to that additional amount which has to be deposited by the trader with the broker to
bring the balance of the margin account to the initial margin level. For instance, in the above

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mentioned example, the variation margin would be sh. 1500 ( sh.5000— sh.3500), i.e., the
difference of initial margin and the balance in the margin account, the same has been shown
in the below diagram. If the investor does not pay the initial margin immediately, the broker
may proceed to unilaterally close out the account by entering into an offsetting futures
position.

Initial margin
As the parties are betting on the future spot price of the asset, their expectations may not
come true and they may suffer loss. In view of this position, the buyer as well as the seller,
both have to deposit an initial margin with the stock exchange broker on the date of the
transaction. If the initial value of the futures contract is sh. 150,000 and the initial margin is
10%, then the buyer and the seller both have to deposit sh.15,000 each with their respective
brokers. From the date of the transaction till the squarring off date or maturity date, the
futures price may rise or fall, as a result of which a partly may incur loss. The futures
contracts are to be marked to market on daily basis i.e., additional margin money is to be
deposited with the broker in view of the loss occurring till a particular date. For example, in
the above case, the value of contract falls to sh.145,000 next day, and then marked to
market margin of sh. 5,000 is to be deposited.
So, instead of waiting until the maturity date for the parties to book losses, all positions
should recognize losses on daily basis as these accrue. This daily setting is called mark to
market, where the maturity date does not govern the accrual of losses. Margin system is one
basic difference between the forwards and futures. The forwards are simply kept till the
maturity date without any intervening cash flows whereas the futures follow pay-as-you-go
system.

APRIL 2023
Q.1.B – On April 15, the spot price of a bushel of corn is sh. 366, the annual storage cost is
sh. 35 per bushel, the risk free rate is 3% and the cost of transportation of corn from the

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destination point specified on the futures contract to a local grain elevator or vice versa is sh.
3.5 per bushel.
Required:
i. Explain the steps to earn a riskless return on futures contract on the July corn given a
futures price of sh. 385 per bushel. (4 mks)
ii. Calculate the riskless return. (1 mk)
Solution omitted deliberately.
Q.1.C – A share index is at 1,521.75 currently and is the underlying of a futures contract
expiring in 73 days. The risk free rate is 6.1%. The value of the dividends reinvested over the
life of the future is sh. 5.26.
Assume a 365 – day year.
Required:
i. Calculate the present value of the dividends. (2 mks)
ii. Determine the appropriate futures price. (2 mks)
iii. Assuming a continuously compounded yield of 1.75%, determine the futures price. (5 mks)
Solution omitted deliberately
Q.5.A – Outline six functions of the financial futures market. (6 mks)
1) Hedging
2) Price discovery
3) Financing functions
4) Liquidity functions
5) Price stabilization price
6) Disseminating information

Hedging
The primary function of the futures market is the hedging function which is also known as
price insurance, risk shifting or risk transference function. Futures markets provide a vehicle
through which the traders or participants can hedge their risks or protect themselves from the
adverse price movements in the underlying assets in which they deal.
For example, a farmer bears the risk at the planting time associated with the uncertain harvest
price his wheat will command. He may use the futures market to hedge this risk by selling a
futures contract. For instance, if he is expected to produce 1000 tons of wheat in next six
months, he could establish a price for that quantity (harvest) by selling 10 wheat futures
contracts, each being of 100 tons. In this way, by selling these futures contracts, the farmer
intends to establish a price today that will be harvested in the futures. Further, the futures
transactions will protect the farmer from the fluctuations of the wheat price, which might
occur between present and futures period.

Price Discovery
Another important use of futures market is the price discovery which is the revealing of
information about futures cash market prices through the futures market. As we know that in
futures market contract, a trader agrees to receive or deliver a given commodity or asset at a
certain futures time for a price which is determined now. It means that the futures market
creates a relationship between the futures price and the price that people expect to prevail at
the delivery date. In the words of M.J. Powers and D. Vogel, as stated in their book entitled,
“Inside the Financial Futures Market”, futures markets provide a mechanism by which
diverse and scattered opinions of the futures are coalesced into one readily discernible
number which provides a consensus of knowledgeable thinking. It is evident from this
statement that futures prices provide an expression consensus of the today’s expectations
about a specified future time. If these expectations are properly published then they also

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perform an information or publicity function for the users and the society. By using the
information about the futures prices today, the different traders/observers in the market can
estimate the expected spot price in the future time of a given asset. In this way, a user of the
futures prices can make consumption or investment decisions more wisely.

Financing Function
Another important function of a futures market is to raise finance against the stock of assets
or commodities. Since futures contracts are standardized contracts, so, they make it easier for
the lenders about the assurance of quantity, quality and liquidity of the underlying asset.
Though this function is very much familiar in the spot market, but it is also unique to futures
markets. The reason being the lenders are often more interested to finance hedged asset stock
rather than un-hedged stock because the hedged asset stock are protected against the risk of
loss of value.

Liquidity Function
As we see that the main function of the futures market deals with such transactions which are
matured in the future period. They are operated on the basis of margins which are
determined on the basis of rides involved in the contract. Under this the buyer and the seller
have to deposit only a fraction of the contract value, say 5 percent or 10 percent, known as
margins. It means that the traders in the futures market can do the business a much larger
volume of contracts than in a spot market, and thus, makes market more liquid. That is why
the volume of the futures markets is much larger in comparison to the spot markets. This is
also known as gearing or leverage factor. It means that a trader in the futures markets can
gear up his capital 10 times and 20 times if the margin/deposit is 10 percent and 5 percent
respectively, resulting in his profit or loss, as a proportion of his capital is 10 times or 20
times magnified. Gearing is the British term and in American parlance it is known as
leverage.

Price Stabilization Function

Another important function of a futures market is to keep a stabilizing influence on spot
prices by reducing the amplitude of short term of fluctuations. In other words, futures market
reduces both the heights of the peaks and the depth of the troughs. The major causative
factors responsible for such price stabilizing influence are such as, speculation, price
discovery, tendency to panic, etc.

Disseminating Information
Apart from the aforementioned functions of the futures markets like risk transference
(hedging), price discovery, price stabilization, liquidity, and financing, this market is very
much useful to the economy too. Futures markets disseminate information quickly,
effectively and inexpensively, and, as a result, reducing the monopolistic tendency in the
market.
Further, such information disseminating service enables the society to discover or form
suitable true/correct/equilibrium prices. They serve as barometers of futures in price resulting
in the determination of correct prices on spot markets now and in futures. They provide for
centralized trading where information about fundamental supply and demand conditions are
efficiently assimilated-and acted on.

DECEMBER 2022
Q.3.A – Assess three functions of a clearing house in relation to a contract. (6 mks)
1) To guarantee the transactions.

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2) To ensure that parties respect the systems and follow the right procedures.
3) To provide a level playing ground for all the parties.
4) To ensure that the right goods in terms of quality and quantity are supplied.

Clearing House - In the futures contract, the exchange clearing house is an adjunct of the
exchange and acts as an intermediary or middleman in futures. It gives the guarantee for the
performance of the parties to each transaction. The clearing house has a number of members
all of which have offices near to the clearing house. Thus, the clearing house is the counter
party to every contract.
Futures are traded at computerized on-line stock exchanges and there is no one-to-one contact
between the buyers and sellers of futures. In case of default by either party, the counter-
guarantee is provided by the exchange. In this scenario, the role of the stock exchange
clearing house becomes imperative. Unlike shares trading, where position of the defaulting
party is auctioned and the loss is recovered through the broker of the party, the situation in
futures trading is different. When a deal by a seller or buyer of a particular contract is
finalized, on the basis of quotes, etc., the clearing house emerges but invisibly. Impliedly, the
clearing house becomes the seller to a long offer and buyer to a short offer. The clearing
house is required to perform the contract to both the parties i.e., to deliver the underlying
asset to the long positions holder and to pay to the short position holder, The net position of
the clearing house always remains zero because it does not trade on its own but only on
behalf of other parties. So, the clearing house becomes a party to two contracts at a time and
is bound to perform its obligation under both the contracts.
The position of the clearing house is only neutral and provides a link between the buyers and
sellers. Clearing house makes it possible for buyers and sellers to easily square off their
positions and to make the net position zero. The zero net position of a party means that
neither the original position nor the squaring off is to be fulfilled. As the clearing house is
obligated to perform to both parties, it protects its interest by imposing margins on the
parties.

The above figure shows that the position of the clearing house is only neutral and provides a
link between the buyers and sellers. Clearing house makes it possible for buyers and sellers to
easily square off their positions and to make the net position zero. The zero net position of a
party means that neither the original position nor the squaring off is to be fulfilled.
As the clearing house is obligated to perform to both parties, it protects its interest by
imposing margins on the parties.
Futures are traded at computerized on-line stock exchanges and there is no one to- one
contact between the buyers and sellers of futures. In case of default by either party, the
counter-guarantee is provided by the exchange. In this scenario, the role of the stock
exchange clearing house becomes imperative. Unlike shares trading, where position of the

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defaulting party is actioned and the loss is recovered through the broker of the party, the
situation in futures trading is different. When a deal by a seller or buyer of a particular
contract is finalized, on the basis of quotes, etc., the clearing house emerges but invisibly.
Impliedly, the clearing house becomes the seller to a long offer and buyer to a short offer.
The clearing house is required to perform the contract to both the parties i.e., to deliver the
underlying asset to the long positions holder and to pay to the short position holder, The net
position of the clearing house always remains zero because it does not trade on its own but
only on behalf of other parties. So, the clearing house becomes a party to two contracts at a
time and is bound to perform its obligation under both the contracts.

FUNCTIONS OF A CLEARING HOUSE

As mentioned, a clearing house is basically the mediator between two transacting parties.
However, there is also more to what clearing houses do. Let’s take a look at some of their
functions in more detail.
1) The clearing house guarantees that the transactions will occur smoothly and that both
parties will receive what is due to them. This is done by checking the financial capabilities
of both parties to enter into a legal transaction, regardless of whether they are an
individual or an organization.
2) The clearing firm makes sure that the parties involved respect the system and follow the
proper procedures for a successful transaction. The facilitation of smooth transactions
leads to a more liquid market.
3) It is the clearing house firm that provides a level playing field for both parties, where they
can agree on the terms of their negotiation. This includes having the responsibility for
setting the price, quality, quantity, and maturity of the contract.
4) The clearing house makes sure that the right goods are delivered to the buyer, in terms of
both quantity and quality, so that at the end of the transaction there are no complaints nor
arbitration necessary.

AUGUST 2022
Q.2.A – Explain the following terms as used in futures exchange:
i. Floor trader (1 mk)
ii. Scalper (1 mk)
iii. Day trader (1 mk)
iv. Position trader (1 mk)

Solution
A futures exchange is a legal corporate entity whose shareholders are its members. The
members own memberships, more commonly called seats. Exchange members have the
privilege of executing transactions on the exchange. Each member acts as either a floor
trader or a broker. Floor traders are typically called locals; brokers are typically called
futures commission merchants (FCMs). Locals are market makers, standing ready to buy and
sell by quoting a bid and an ask price. They are the primary providers of liquidity to the
market. FCMs execute transactions for other parties off the exchange. The locals on the
exchange floor typically trade according to one of several distinct styles. The most common
is called scalping. A scalper offers to buy or sell futures contracts, holding the position for
only a brief period of time, perhaps just seconds. Scalpers attempt to profit by buying at the
bid price and selling at the higher ask price. A day trader holds a position open somewhat
longer but closes all positions at the end of the day.'" Position trader holds positions open
overnight. Day traders and position traders are quite distinct from scalpers in that they

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attempt to profit from the anticipated direction of the market; scalpers are trying simply to
buy at the bid and sell at the ask.
Speculators can be classified into different categories. For example, a speculator who uses
fundamental analysis of economic conditions of the market is known as fundamental analyst
whereas the one who uses to predict futures prices on the basis of past movements in the
prices of the asset is known as technical analyst. A speculator who owns a seat on a particular
exchange and trades in his own name is called a local speculator. These, local speculators can
further be classified into three categories, namely, scalpers, pit traders and floor traders.
Scalpers usually try to make profits from holding positions for short period of time. They
bridge the gap between outside orders by filling orders that come into the brokers in return
for slight price concessions. Pit speculators like scalpers take bigger positions and hold them
longer. They usually do not move quickly by changing positions overnights. They most likely
use outside news. Floor traders usually consider inter commodity price relationship. They
are full members and often watch outside news carefully and can hold positions both short
and long.
Position traders vs scalpers
Speculators can be classified as scalpers, day traders, or position traders. Scalpers watch
the market for very short-term trends and attempt to profit from small changes in the contract
price. They usually hold their positions for only a few minutes. Day traders hold their
positions for less than one trading day. They are unwilling to take the risk that adverse news
will occur overnight. Position traders hold their positions for much longer periods of time.
They hope to make significant profits from major movements in the markets.
As it can be observed from the above explanation, the major difference between a scalper and
a position trader is that a scalper holds his position for a very short period of time usually
seconds while a position trader holds his position for a very long period of time usually
several days, weeks or months.

Q.3.A – With reference to risk management using forward contracts and future contracts,
examine three instances where a short hedge and a long hedge are appropriate. (3 mks)
“Where as the seller is apprehensive about the fall in the future price, the buyer is
apprehensive about the rise in prices.”
If the prices go down in the future, the seller will lose. If prices go up in the future, the buyer
will buy at a higher price. The concept of short and long hedging is applied to mitigate this
situation.
Hedging, in its broadest sense, is the act of protecting oneself against futures loss.
More specifically in the context of futures trading, hedging is regarded as the use of futures
transactions to avoid or reduce price risk in the spot market. In other words, a hedge is a
position that is taken as a temporary substitute for a later position in another asset (or
liability) or to protect the value of an existing position in an asset (or liability) until the
position is liquidated. According to this concept, the firm seeks hedging whether it is on the
asset side or on the liability side of the balance sheet.
Futures hedges can be characterized in several ways depending on the risk being hedged and
the construction of the hedge. A firm that knows it will sell an asset in the future can hedge
the price of this asset by taking a short futures position. This is known as a short hedge. A
firm that knows it will buy an asset in the future can hedge by taking a long position. This is
known as a long hedge.

Short Hedge
A short hedge (or a selling hedge) is a hedge that involves short position in futures contract.
In other words, it occurs when a firm/trader plans to purchase or produce a cash commodity

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sells futures to hedge the cash position, in general sense, it means being short’ having a net
sold position, or a commitment to deliver’, etc. Thus, here the main objective is to protect the
value of the cash position against a decline in cash prices. A short hedge is appropriate when
the hedger already owns all and expects to sell it at sometime in the futures. Once the short
futures position is established, it is expected that a decrease (increase) in the value of the cash
position will be fully or partially compensated by a gain (loss) on the short futures position.

Short hedge: Having a short position (selling a futures) in futures is known as a short hedge.
It happens when an investor plans to buy or produce a cash commodity sells futures to hedge
the cash position. It is appropriate when hedger owns an asset and expects to sell in future on
a particular date. Thus selling some asset without having the same is known as short-selling.
For example suppose a US exporter expects to receive euros in three months. He will gain if
the euro increases in value relative to the US dollar and will sustain loss if the euro decreases
in value relative to US dollar. Another illustration can be understood with the help of the
following example:
Supposing an oil producer made a contract on 10 Oct, 2016 to sell 1 million barrel crude oil
on a market price as on 10 Jan 2017. The oil producer supposing that spot price on 10 Oct,
2016 is $ 50 per barrel and Jan crude future price on NYMEX is $ 48.50 per barrel. Each
future contract on NYMEX is for delivery of 1,000 barrels. The company can hedge its
position by short selling October futures. If the oil borrower closed his position on 10 Jan
2017 the effect of the strategy should be to lock in a price close to $ 48.50 per barrel.
Suppose the spot price on 10 Jan 2017 be $ 47.50 per barrel. The company realizes the gain:
$ 48.50 – $ 47.50 = $ 1.00 or $ 1 million in total from the short future position.
Suppose the oil prices go up by $ 50.50 per barrel. The company realizes $ 0.50 per barrel.
i.e. $ 50.50 – $ 50.0 = $ 0.50

Long Vs Short Hedging

The terms ‘long’ and ‘short’ apply to both spot and futures market and are widely used in the
futures trading. A person who holds stocks of an asset is obviously regarded as ‘being long’
in the spot market but it is not necessary to actually hold stock. Similarly, it is in the case of
‘short’, where one who has made a forward sale, regarded as ‘being short’ on the spot market.
In brief, the position of long and short hedges is shown in the below Table.
Short hedger Long hedger
Position in spot market Long Short
Protection need against Price fall Price rise
Position in futures market Short Long

Example
A farmer anticipates a bumper crop amounting to 150 quintals, which he expects to harvest in
the month of January. It is October and current price of crop is sh. 10,000 per quintal. This
price is acceptable to the farmer and give him a sufficient return. But he is apprehensive of
fall in price by the time crop will be ready. He, therefore, sells 150 quintals on the commodity
futures market at its current price of sh. 9500 per quintal. In the month of January, the price
of crop have in fact risen. Current spot price is sh.11,000 per quintal. Now, the farmer has
two alternatives:
1) He can buy back 200 quintals of January crop on the futures market at a present futures
price of sh.10,500. He can then deliver his actual crop of pepper in spot market at the
ruling rate of sh. 11,000 per quintal. As a result the farmer will have the following
profit/loss: January contract sale @ sh.9500 per quintal. January contract buys @ 10,500.
So, there is a net loss of ` 1000 per quintal. Further he sells his output @ 11,000 in the spot

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market and by deducting the loss on futures market position of sh. 1,000, net price
obtained by the farmer is sh. 10,000 per quintal.
2) He can deliver in the futures market @ `sh.9500 per quintal. This situations; where sale of
futures by those hedging against price fall is called short hedge and is taken to guard
against downward price movements.

Illustration on futures
Suppose a farmer produces rice and he expects to have an excellent yield on rice; but he is
worried about the future price fall of that commodity. How can he protect himself from
falling price of rice in future? He may enter into a contract on today with some party who
wants to buy rice at a specified future date on a price determined today itself. In the whole
process the farmer will deliver rice to the party and receive the agreed price and the other
party will take delivery of rice and pay to the farmer. In this illustration, there is no exchange
of money and the contract is binding on both the parties. Hence future contracts are forward
contracts traded only on organized exchanges and are in standardized contract-size. The
farmer has protected himself against the risk by selling rice futures and this action is called
short hedge while on the other hand, the other party also protects against-risk by buying rice
futures is called long hedge.

Long hedge:
A long hedge is taking long position in futures contract. A long hedge is done in anticipation
of future price increases and when the company knows that it will have to buy a certain asset
in the future at anticipated higher price and wants to lock in a price now. The objective of a
long hedge is to protect the company against a price increase in the underlying asset prior to
buy the same either in spot or future market. A net bought position is actually holding an
asset which is known as inventory hedge.
Suppose an investment banker anticipates to receive Rs. 1 million on June 20 and intends to
buy a portfolio of Indian equities. Assuming that he has a risk factor of increase in the sensex
before money is received. He can go in futures and buy today futures contract at 11000
(today’s sensex 11000). He can close his position by selling 10 August stock futures.

Q.4.B – A future contract on a Treasury bill expires in 50 days. The Treasury bill matures in
140 days. The discount rates on the treasury bills are as follows:
50 day Treasury bill 5.0%
140 day Treasury bill 4.6%
Required:
i. Determine the appropriate futures price by using the prices of the 50 and 140 day
Treasury bill. (3 mks)
ii. Find the futures price in terms of the underlying spot price compounded at the
appropriate risk free rate. (3 mks)
iii. Convert the futures price to the implied discount rate on the futures. (2 mks)
Answer for part 1
First, find the prices of the 50- and 140-day bonds:
B0(50) = 1 – 0.05(50/360) = 0.9931
B0(140) = 1 – 0.046(140/360) = 0.9821
The futures price is, therefore, F0(50) = 0.9821/0.9931 = 0.9889
Answer for part 2
First, find the rate at which to compound the spot price of the 140-day T-bill. This rate is
obtained from the 50-day T-bill:
1/0.9931 = 1.0069

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We actually do not need to solve for ro(h). The above says that based on the rate ro(h), every
dollar invested should grow to a value of 1.0069. Thus, the futures price should be the spot
price (the price of the 140-day T-bill) compounded by the factor 1.0069:
F0(50) = 0.9821(1.0069) = 0.9889
Annualized, this rate would equal (1.0069)365/50 -1= 0.0515.
Answer for part 3
Given the futures price of 0.9889, the implied discount rate is:
r0(50) = 1 – 0.9889)(360/90) = 0.0444

APRIL 2022
Q.1.C – John Mutwiri owns a sh. 100 face value bond that pays 8% semi-annual coupon.
The bond has 10 years to maturity and has a 6% as its yield. John is considering entering into
a futures contract and calls for the delivery of this bond whose current price is sh. 114.88.
The futures contract is for 1½ years.
Required:
The price of the futures contract assuming a risk free rate of 5% (4 mks)
Solution omitted deliberately.
Q.2.B – An equity portfolio manager currently has sh.95 million equity position in the
financial sector. He wants to convert this equity position to cash for a period of six months
without liquidating his holdings.
Additional information:
1. An equity futures contract that expires in six months is priced at sh. 1,564 and has a
multiplier of 100.
2. The dividend yield on the underlying index is 0.45%.
3. The risk free rate is 5.75%.
Required:
i. The number of futures contract required to create synthetic cash. (2 mks)
ii. The effective amount of money committed to the risk free asset and the effective
number of units of the stock index that are converted to cash.
(4 mks)
iii. Describe how this strategy produces an outcome equivalent to investing in cash at the
beginning of the six month period given that the stock index is at 1,735 when the
futures contract expires.
(2 mks)
Solution
In order to create synthetic cash, the number of futures contracts to be sold is:
950m (1.0575)6/12 = 6,246.36
100(1564)
Rounded off, this is 6,246 future contracts short.

The effective amount of stock committed to this transaction is actually:

6246(100)(1564) = sh. 949,945,174
(1.0575)6/12
Invested at the risk-free rate, this amount should grow to sh.949,945,174(1.0575)6/12
= sh.976,874,400, resulting in the following number of shares:
6246(100)/(1.0045)6/12 = 623,199.38.
With reinvestment of dividends, the number of shares will grow to 623,199.38(1.0045)6/12
= 624,600.

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In six months when the futures contract expires, the stock index is at 1735. The payoff of the
futures contract is -6,246(sh.100)(1735 - 1564) = -sh.624,600(1735) + sh.976,874,400 =
sh.106,806,600.
Netting the futures payoft' against the stock position produces sh.976,874,400, equivalent to
investing sh.949,945,174 at 5.75% for six months. The short futures position has thus
effectively converted equity to cash.
Q.3.A – Differentiate between the following types of margins as used in the futures markets:
i. Initial margin (1 mk)
ii. Maintenance margin (1 mk)
iii. Variation margin (1 mk)

Initial margin – This is the amount that must be deposited in the margin account at the time a
futures contract is first entered into.
Maintenance margin - This is set aside so as to ensure that the balance in the margin
account never falls to a negative.
The solution to the above question is in the August 2023 question 3.A above.

Q.5.C- Country A has a risk free rate of 6% while country B has a risk free rate of 4% and the
spot exchange rate (direct quote) between country A and country B is sh. 0.6667.
Required:
i. The continuously compounded country A and country B risk free rates. (1 mk)
ii. The price at which an investor could enter into a forward contract that expires in 90
days. (2 mks)
iii. The value of the forward position 25 days into the contract assuming that the spot rate
is sh. 0.65. (3 mks)
Solution
Part 1
Rfc = In (1.04) = 0.0392
Rc = In (1.06) = 0.0583

Part 2
S0 = sh. 0.6667
T = 90/365
Rfc = 0.0392
Rc = 0.0583
F(0,T) = sh. 0.6667 x e-0.0392(90/365) (e0.0583(90/365)
= sh. 0.6698

Part 3
St = 0.65
T = 90/365
t = 25/365
T – t = 65/365
Rfc = 0.0392
Rc = 0.0583
V,(O,T) = (sh.0.65 x e-0.0392(65/365) ) - (sh.0.6698 x e-0.0583)65/365) = -sh.0.0174

DECEMBER 2021

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Q.1.C – An investor anticipates that in the next month, interest rates are likely to decline
significantly and he would like to increase the bond portfolio’s duration to take advantage of
interest rates decline.
The investor would like to raise the duration on sh. 75 million of bonds from its current level
of 6.22 to 7.5 (These are the modified durations). The investor has identified appropriate
Treasury bond futures contract currently priced at sh. 82,500 with an implied modified
duration of 8.12.
The yield on the bond portfolio is 5% more volatile than implied yield on futures. (Beta is
1.05)
Required:
i. State whether the investor should buy or sell futures contract. (1 mk)
To increase the duration, the investor will need to buy futures contracts.
ii. Calculate the number of futures contract involved in raising bond portfolio’s duration.
(3 mks)

NF = MDURT - MDURP B/F By

MDURF
(7.50 – 6.22)/8.12 (75m/82500)1.05
= 150.47
Because fractional contracts cannot be traded, the investor will buy 150 contracts.
iii. Calculate the profit on futures contract if one month later the future’s price moves to sh.
85,000 (2 mks)
The implied yield on the futures has decreased by 35 basis points, and the futures price has
now moved to sh.85,000.The yield on the bond portfolio has decreased by 40 basis points,
and the portfolio has increased in value by sh.1,933,500.
The profit on the futures transaction is found by multiplying the number of futures
contracts by the difference between the new price and the old price:
In this case, the profit on the futures contract is 150(85,000 - 82,500) = sh.375,000. Thus, the
overall gain is 1,933,500 + 375,000 = sh.2,308,500.
How effective was the transaction? To answer this question, we compare the ex post duration
to the planned duration. The purpose was to increase the duration from 6.22 to a planned
7.50. The return on the portfolio was: 1933500/75m = 0.0258 or 2308500/75m = 0.0308
or 2.58 percent without the futures transaction, and 0.0308.
or 3.08 percent with the futures transaction. What does this set of calculations imply about
the portfolio's ex post duration? Recall that duration is a measure of the percentage change in
portfolio value with respect to a basis point change in yield. The ex post duration of the
portfolio
can be measured by dividing the percentage change in portfolio value by the 40 basis point
change in the portfolio yield:
0.0258/0.0040 = 6.45without the futures transaction and 0.0308/0.0040 = 7.70 with the
futures transaction. The investor came fairly close to achieving its desired increase in
duration using futures.
iv. Assuming the investor wanted to reduce the duration to zero, explain whether he should buy
or sell futures contract. (1 mk)
In the example here, the fund increased its modified duration during a time when interest
rates fell and the bond portfolio value increased. It leveraged itself to take advantage of a
favorable outlook. Not all such decisions work out so well. Suppose in this example the
economist had a different forecast, and as a result, the investor wanted to eliminate all
interest rate risk. So let us rework the problem under the assumption that the fund put on a
full hedge, thereby reducing the modified duration to zero.

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With MDUR, = 0, the number of futures contracts would be:

(0 – 6.22/8.12) (75m/82500) 1.05 = -731.19
Thus, the fund would sell 731 contracts. The profit from the futures transaction would be -
731(85,000 - 82,500) = -1,827,500. The overall transaction earned a profit of 1,933,500 -
1,827,500 = 106,000, a gain of 106000/75m = 0.0014. or 0.14 percent. Thus, shorting the
futures contracts virtually wiped out all of the gain from the decrease in interest rates. Our ex
ante objective was to reduce the modified duration to zero. The ex post modified duration,
however, turned out to be 0.0014/0.0040 = 0.35
Thus the modified duration was reduced almost to zero.

v. Determine the number of futures contract required to achieve the investor’s objective
in (iv) above (1 mk)
731 contracts.
Q.2.A – A futures contract is mostly constructed with the idea that the participants will hold
their positions until the contract expires. However, there may be need to terminate a futures
contract before maturity.
In relation to the above statement, discuss three ways in which derivatives market participant
could terminate a futures contract. (6 mks)
1) Physical delivery.
2) Cash settlement.
3) Offsetting.
4) Exchange of future for physical.
Refer to December 2023 Q.2.A Solutions.

SEPTEMBER 2021
Q.2.C – The gold futures contract on the Globex Trading system covers 100 ounces of gold.
An investor decides to enter into two contracts. The initial futures price per ounce is sh.
1,000. The initial margin requirement is sh. 6,000 per contract and the maintenance margin is
sh. 4,000. The price of the gold in the following 6 days is as follows:
Day Price per ounce of gold (sh)
1 990
2 980
3 970
4 960
5 970
6 980
Required:
The margin account balance at the end of day 6. (6 mks)
Day Futures price Daily loss/gain Cumulative gain/loss Margin account balance
0 1000 - - 12000
1 990 -1000 -1000 11000
2 980 -1000 -2000 10000
3 970 -1000 -3000 9000
4 960 -1000 -4000 8000
5 970 +1000 -3000 9000
6 980 +1000 -2000 10000

MAY 2021
Q.1.C – Describe two uses of index futures. (4 mks)
1) To hedge against unanticipated inflation which cannot be avoided.

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2) Speculation.
3) To protect investors from adverse changes in portfolio value.
Q.1.D – The current price of a futures contract is sh. 212. The initial margin requirement is
sh. 10 and the maintenance margin required is sh. 8. An investor can go long 20 contracts,
meet all margin calls but does not withdraw any excess margin. The contract is purchased at
the settlement price of that day, so there is no mark to market profit or loss on the day of
purchase.
The investor has provided the table below:
Day Beginning Funds Futures Price Gain/loss Ending
balance (sh) deposited price (sh) change (sh) (sh) balance
(sh) (sh)
0 212
1 211
2 214
3 209
4 210
5 204
6 202

Required:
i. Complete the table above. (6 mks)
ii. Determine the total gains or losses by the end of day 6. (1 mk)
Solution

Day Beginning Funds Futures Price Gain/loss Ending

balance (sh) deposited (sh) price (sh) change (sh) (sh) balance
(sh)
0 0 200 212 0 - 200
1 200 0 211 -1 -20 180
2 180 0 214 +3 +60 240
3 240 0 209 -5 -100 140
4 140 60 210 +1 +20 220
5 220 0 204 -6 -120 100
6 100 100 202 -2 -40 160

On day 0, you deposit $200 because the initial margin requirement is $10 per contract and
you go long 20 contracts ($10 per contract times 20 contracts equals $200). At the end of day
3, the balance is down to $140, $20 below the $160 maintenance margin requirement ($8 per
contract times 20 contracts). You must deposit enough money to bring the balance up to the
initial margin requirement of $200. So, the next day (day 4), you deposit $60. The price
change on day 5 causes a gain/loss of -$120, leaving you with a balance of $100 at the end of
day 5. Again, this amount is less than the $160 maintenance margin requirement. You must
deposit enough money to bring the balance up to the initial margin requirement of $200. So
on day 6, you deposit $100

Q.2.D – A spot price of an asset is sh. 50, the interest rate is 6.25%, the futures value of the
storage cost is sh. 1.35 and the futures expires in 15 months.
Required:
Determine the futures price. (2 mks)
Solution

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15/12 = 1.25
F0(T) = S0 (1 + r)T + FV(S0,O.T)
F0(1.25) = 50(1.0625)1.25 + 1.35
= sh. 55.29

NOVEMBER 2020
Q.1.D – The value of a stock index is 3000. The value of an investor’s portfolio is sh.
608,000. The risk free interest rate is 10%per annum, the dividend yield on index is 6% per
annum. The beta of the portfolio is 1.5. A futures contract on the stock index with four
months to maturity is used to hedge the value of the portfolio over the next three months. The
futures contract is for delivery of 50 times the index. The index changes to 2700 at the end of
three months.
Required:
Calculate the gain on short futures position. (4 mks)
Solution omitted deliberately
Q.4.C – The Treasury bond futures price is sh. 101.375. An investor is considering the
following four bonds:
Bond Price (sh) Conversion factor
1 125.15625 1.2131
2 142.46875 1.3792
3 115.96875 1.1149
4 144.06250 1.4026
Required:
Determine the cheapest to deliver bond. (4 mks)
Solution omitted deliberately
MAY 2019
Q.1.D – A derivatives trader has a holding period of 2 months. The standard deviation of spot
prices over the two months period is 0.18 and the volatility of the futures contract over the
same period is 0.29. The correlation of the two changes in price is 0.85.
Required:
The optimal hedge ratio (2 mks)
Solution omitted deliberately.
Q.1.B – Crypto Investments limited is an oil producing company that has just negotiated a
contract to sell 1 million barrels of crude oil on 15 August 2019 (Assuming today is 15 May
2019)
The company is concerned about price fluctuations and is contemplating locking a favorable
price by using futures contract as a hedging strategy.
The spot price on 15 May 2019 is sh. 19 per barrel and the 15 August 2019 oil futures price is
expected to be sh. 18.75 per barrel. Each futures contract consists of 1,000 barrels.
Required:
i. The monetary value of loss to be suffered by Crypto Investments Limited assuming prices on
15 August 2019 fall by sh. 0.01 and assuming that there is no hedging strategy. (1 mk)
ii. State whether the oil producer will short or long the futures so as to hedge its position. (1 mk)
iii. Determine the number of crude oil futures contract that Crypto Investments Limited
would require to engage in so as to hedge its position. (2 mks)
iv. Compute the total amount to be realized by Crypto Investments Limited on 15 August
2019 assuming a spot price of sh. 17.50 and assuming that the company shorts the
futures position. (2 mks)

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v. Determine the total amount that the oil producer will realize assuming that the company
decides to sell the futures contract and the spot price of crude oil turns out to be sh. 19.50 on
15 August 2019. (2 mks)
vi. Comment on the results obtained (iv) and (v) above. (2 mks)
Solution omitted deliberately.
Q.5.A – Discuss three users of futures contracts. (3 mks)
1) Hedgers
2) Speculators
3) Arbitrageurs

NOVEMBER 2019
Q.2.A – Suggest four reasons why futures options are popular in the derivatives market. (4
mks)
Like a forward contract, a futures contract is an agreement between two parties to buy or sell
a specified quantity of an asset at a specified price and at a specified time and place. Futures
contracts are normally traded on an exchange which sets the certain standardized norms for
trading in the futures contracts.
They serve the following purposes:
1) Hedging
2) Price discovery
3) Financing function
4) Liquidity function

Hedging
The primary function of the futures market is the hedging function which is also known as
price insurance, risk shifting or risk transference function. Futures markets provide a vehicle
through which the traders or participants can hedge their risks or protect themselves from the
adverse price movements in the underlying assets in which they deal.

Price Discovery
Another important use of futures market is the price discovery which is the revealing of
information about futures cash market prices through the futures market. As we know that in
futures market contract, a trader agrees to receive or deliver a given commodity or asset at a
certain futures time for a price which is determined now. It means that the futures market
creates a relationship between the futures price and the price that people expect to prevail at
the delivery date.

Financing Function
Another important function of a futures market is to raise finance against the stock of assets
or commodities. Since futures contracts are standardized contracts, so, they make it easier for
the lenders about the assurance of quantity, quality and liquidity of the underlying asset.

Liquidity Function
As we see that the main function of the futures market deals with such transactions which are
matured in the future period. They are operated on the basis of margins which are
determined on the basis of rides involved in the contract. Under this the buyer and the seller
have to deposit only a fraction of the contract value, say 5 percent or 10 percent, known as
margins. It means that the traders in the futures market can do the business a much larger
volume of contracts than in a spot market, and thus, makes the market more liquid.

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Q.2.B – Mercury Investments Limited holds an asset worth sh. 500,000. The firm intends to
enter into a futures contract to sell the asset in 45 days.
Additional information:
1. The risk-free interest rate is 8%.
2. Storage cost is sh. 22,500.
3. The future value of positive cash flow is sh. 7,500.
4. A year has 365 days.
Required:
The appropriate futures price of the asset:
i. Assuming there is neither storage cost nor cash flows. (2 mks)
ii. Considering storage cost only. (2 mks)
iii. Considering the cash flows only. (2 mks)
iv. The future price of the asset is currently trading at sh. 600,000. Show how Mercury
Investments Limited could execute an arbitrage transaction assuming that the cost of
carry is sh. 35,500.
Solution omitted deliberately.
Q.4.B – The discount rates on a 60 – day Treasury bill and a 150 – day Treasury bill are 6%
and 6.25% respectively. Assume that the Treasury bill has a sh. 1 par value and that a year
has 360 days.
Required:
i. The price of a 60 – day futures contract. (4 mks)
Solution
First compute the prices of the 60-day and 150-day T-bills. With h = 60 and h + m = 150,
R0(h) = r0(60) = 0.060
R0(h) = r0(150) = 0.0625
Bo(h) = 1 – r0(h)(h/360)
B0(60) = 1 – 0.006(60/360) = 0.99
Bo (h + m) = 1 – r0(h + m)(h +m/360)
B0(150) = 1 – 0.0625(150/360) = 0.0974
F0(h) = B0(h + m)/B0(h)
= B0(150)/B0(60) = 0.974/0.990 = 0.9838
ii. Using suitable computations, outline the transaction that could be used to take
advantage of any arbitrage opportunity assuming that the actual price of a 60 – day
futures contract is 0.9853. (2 mks)

As the actual futures price of 0.9853 is more than the implied futures price computed
above, you should sell the futures contract. So, do the following. Buy the 150-day T-
bill at 0.974. Sell the 60-day futures contract at 0.9853. The return per dollar would
be:
0.9853/0.9740 = 1.0116. Note that this return is risk free. It compares favorably with
return per dollar on purchasing a 60-day T-bill and holding it to maturity, which is:
1/0.99 = 1.0101
iii. Determine the repo price. (2 mks)
The repo rate is the annualization of the return per dollar because of the arbitrage
transactions outlined above:
1.0116365/60 – 1 = 0.0727
Thus, the rate of return from a cash-and-carry transaction implied by the futures price
relative to the spot price is 7.27%. If the financing rate available in the repo market is less
than this rate, the arbitrage strategy outlined in Part 2 above is worthwhile, because the cost
of funds is less than the return on the funds.

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Q.4.C – Sarah Kizito is a portfolio manager at True Colours Asset Management firm. One of
Sarah’s clients has a portfolio valued at sh. 150 million that is allowed 75% to equities and
25% to bonds. Sarah wants to reduce the portfolios equity allocation to 50% and raise its
bond allocation to 50%. She intends to simultaneously lower the modified duration of the
bond portfolio from 6.05 to 5.50 but leave the beta of the equity portfolio unchanged at 1.08.
She will use equity index and bond futures to achieve these objectives.
Information on the relevant futures contract is as follows:
Beta of equity index futures contract 0.95
Price of equity index futures contract Sh. 125,000
Modified duration of bond futures contract 7.50
Price of bond futures contract Sh. 105,000
The yield beta of the bond futures contract 1.00
The risk free rate is 2.15%
Required:
To achieve Sarah’s portfolio objective, determine:
i. The number of equity index futures contract that she should sell. (3 mks)
ii. The number of bond futures contract that she should buy. (5 mks)
Solution omitted deliberately.
MAY 2018
Q.3.A – Highlight four factors that could affect the price of a futures contract. (4 mks)
1) Supply and demand.
2) Geopolitical events.
3) Interest rates.
4) Seasonal factors.

Q.3.B – Peter Oteba intends to purchase a futures contract whose underlying asset is gold.
The following information is proved to him:
1. The current price of gold is sh. 30,000.
2. The net cost of carry for gold is zero.
3. The risk free rate is 6%.
4. One year has 365 days.
Required:
i. The price of a 90 – day futures contract. (2mks)
ii. Illustrate how an arbitrage transaction could be executed if the futures contract is
priced at sh. 30,600. (4 mks)
iii. Illustrate how an arbitrage transaction could be executed if the futures contract is
priced at sh. 30,300. (4 mks)
Solution omitted deliberately.
NOVEMBER 2018
Q.4.B – Explain the term “marking to market” as used in futures market. (2 mks)
In the futures market, at the end of each trading day, the margin account is adjusted to reflect
the investor’s gain or loss depending on the futures closing price. This is called the marking
to market.
Q.4.C – Agva Asset Management Group (AAMG) is a pension fund management firm. One
of its funds consists of sh. 300 million allocated 80% to equities and 20% to bonds. The
equity portion has a beta of 1.10 and the bond portion has a duration of 6.5. AAMG would
like to temporarily adjust the asset allocation to 50% equities and 50% bonds. The firm will
use stock index futures and bond futures to achieve this objective. The stock index futures
contract has a price of sh. 200,000 and a beta of 0.96. The bond futures contract has an
implied modified duration of 7.2 and a price of sh. 105,250. The yield beta is 1.0. The

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transaction will be put in place on 15 November 2018, and the horizon date for termination is
10 January 2019.
Required:
i. The number of stock index futures contracts that AAMG should sell to achieve the set
objective. (3 mks)
Solution
The market value of the stock is 0.80(sh.300,000,000) = sh.240,000,000. The market value of
the bonds is 0.20(sh.300,000,000) = sh.60,000,000. Because it wants the portfolio to be
temporarily reallocated to half stock and half bonds, AAMG needs to change the allocation to
Sh.1 50 million of each. Thus, AAMG effectively needs to sell sh.90 million of stock by
converting it to cash using stock index futures and buy sh.90 million of bonds by using bond
futures. This would effectively convert the stock into cash and then convert that cash into
bonds. Of course, this entire series of transactions will be synthetic; the actual stock and
bonds in the portfolio will stay in place.
NF = (Bt – Bs)/Br (S/T)
Where Bt is the target beta of zero, p, is the stock beta of 1.10, pf is the futures beta of 0.96, S
is the market value of the stock involved in the transaction of sh.90 million, and f, is the price
of the stock index futures, sh.200,000. We obtain:
(0 – 1.10) / 0.96 x 90m/0.2m = -515.63
By rounding off we get 516 contracts.
AAMG buys 516 contracts
ii. The number of bond futures contracts that AAMG should buy to achieve the set
objective. (3 mks)
Solution
Three-month risk-free bonds with a duration of about 0.25.
The existing bonds are considered cash because we are first going to convert sh.90 million of
stock to synthetic cash. Then we convert that synthetic cash into bonds using bond futures.
(6.5 – 0.25) / 7.2 (90m/105,250) = 742.28
So AAMG buys 742 contracts.

Q.4.E – Evans Nyongesa has recently opened a margin account in which he trades wheat
futures. In July 2018, Ngongesa entered a long position of five wheat contracts, each of
which covered 5,000 bushel.
The contract price was sh. 2 and each contract required an initial margin deposit of sh. 150
and maintenance of sh. 100.
On day 1, the price of wheat declined by sh. 0.02.
On day 2, the price of wheat increased by sh. 0.01.
On day 3, the price of wheat declined by sh. 0.03
Required:
Determine the margin balance for this position at the end of day 3. (5 mks)
Solution omitted deliberately.
MAY 2017
Q.3.D – Kemeloi Capital is a money management firm that specializes in turning the idle
cash of its clients into equity index positions at very low cost. The firm has a new client with
sh. 500 million of cash that it would like to invest in the small cap equity sector. Kemeloi
Capital would like to construct the position using a futures contract on a small cap index.
Additional information:
1. The futures price is sh. 1,500.
2. The multiplier is 100.
3. The contract expires in six months.

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4. The underlying small cap index has a dividend yield of 1%.

5. The risk free rate is 3% per annum.
Required:
Determine how the cash could be equitized using a futures contract. (3 mks)
Solution omitted deliberately.

DECEMBER 2017
Q.1.B.i – Define the term “future option.” (2 mks)
This is simply a stock option. It gives the buyer the right but not the obligation to buy or sell
the underlying asset.
Q.1.B.ii – Argue three cases why futures options have replaced options on fixed income
securities as the options vehicles of choice for institutional investors who want to use
exchange – traded options.
(6 mks)
1) The pricing is straight forward.
2) Liquidity.
3) No time decay.
Q.1.C – A four month put futures position has a strike price of sh. 50. The risk free rate of
interest is 10% per annum. The current futures price is sh. 47.
Required:
The lower bound for the value of the futures option if it is:
i. European futures option. (2 mks)
ii. American futures option. (1 mk)
Solution omitted deliberately.
Q.5.C – The value of a portfolio is sh. 608,000. The risk free interest rate is 10% per annum.
The value of BSE index is 3000. The beta of the portfolio is 1.5 and the dividend yield on the
index is 6% per annum. A futures contract on the BSE index with four months to maturity is
used to hedge the value of the portfolio over the next three months. The futures contract is for
delivery of 50 times the index. After three months, the value of the index is 2700.
Required:
i. The minimum- variance hedge ratio. (5 mks)
ii. The gain on short futures position at the end of three months. (3 mks)
MAY 2016
Q.2.D – A futures contract has a current price of sh. 212. The initial margin requirement is
sh. 10 and the maintenance requirement is sh. 8. An investor goes long 20 contracts and
meets all the margin calls and does not withdraw any excess margin.
The futures price in the days following are shown below:
Day Futures price (sh)
0 212
1 211
2 214
3 209
4 210
5 204
6 202
Required:
The investor’s total gain or loss by the end of day 6 (4 mks)

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Days Future price Daily gain/loss Cumulative gain/loss Margin account balance
0 212 - - 200
1 211 -20 -20 180
2 214 +60 +40 240
3 209 -100 -60 140
4 210 +20 -40 160
5 204 -120 -160 40
6 202 -140 -200 0

By the end of day 6, the investor’s total loss will be sh. 140.
Workings:
The initial margin account = sh. 10 x 20 contracts = sh. 200.
211 – 212 = -1x20 = -20
214 – 211 = 3 x 20 = 60
209 – 214 = -5x20 = -100…………………
200 – 20 = 180
180 + 60 = 240
240 – 100 = 140…………………..

Day Beginning Funds deposited Futures Price change Gain/loss Ending

balance price balance
0 0 200 212 0 0 200
1 200 0 211 -1 -20 180
2 180 0 214 3 60 240
3 240 0 209 -5 -100 140
4 140 60 210 1 20 220
5 220 0 204 -6 -120 100
6 100 100 202 -2 -40 160

On day 0, you deposit $200 because the initial margin requirement is $10 per contract and
you go long 20 contracts ($10 per contract times 20 contracts equals $200). At the end of day
3, the balance is down to $140, $20 below the $160 maintenance margin requirement ($8 per
contract times 20 contracts). You must deposit enough money to bring the balance up to the
initial margin requirement of $200. So, the next day (day 4), you deposit $60. The price
change on day 5 causes a gain/loss of -$120, leaving you with a balance of $100 at the end of
day 5. Again, this amount is less than the $160 maintenance margin requirement. You must
deposit enough money to bring the balance up to the initial margin requirement of $200. So
on day 6, you deposit $100.
By the end of day 6, the price is $202, a decrease of $10 from your purchase price of $212.
Your loss so far is $10 per contract times 20 contracts, or $200. You could also look at your
loss so far as follows. You initially deposited $200, followed by margin calls of $60 and
$100. Thus, you have deposited a total of $360 so far and have not withdrawn any excess
margin. The ending balance, however, is only $160. Thus, the total loss incurred by you so
far is $360 - $160, or $200.

Q.4.C – A stock index is at 755.42. A futures contract on the index expires in 57 days. The
risk free rate is 6.25%. At expiration, the value of the dividends on the index is 3.94.
Assume one year has 365 days.
Required:

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i. The appropriate futures price, using both the futures value of the dividends and the
present value of the dividends. (3 mks)
T = 57/365 = 0.1562
F0 = (0.1562) = 755.42(1.0625)0.1562 – 3.94 = 758.67
Alternatively, we can find the present value of the dividends:
PV(D,0,0 1562) = 3.94/(1.0625)0.1562 = 3.90
Then we can find the futures price as f0(0.1562) = (755.42 - 3.90)(1.0625)0.1562 = 758.67
ii. The appropriate futures price in terms of the two specifications of the dividend yield. (3 mks)
Solution
Under one specification of the yield, we have:
3.94/755.42(1.0625)0.1562 = 0.9948
We need the inverse of this amount, which is 1/0.9948 = 1.0052. Then the futures price is:
(755.42/1.0052) (1.0625)0.1562 = 758.66
Under the other specification of the dividend yield, we have:
3.90/755.42 = 0.0052
The futures price is fo(0.1562) = 755.42(1 - 0.0052)(1.0625)0.1562 = 758.64 with the difference
caused by rounding.

iii. The futures price under the assumption of continuous compounding of interest and
dividends based on the solution obtained in (ii) above. (2 mks)

The continuously compounded risk-free rate is Rc = In(1.0625) = 0.0606. The continuously

compounded dividend yield is:
(1/0.1562) In(1.0052) = 0.0332
fo(0. 1562) = 755.42e(0.0606 - 0.0332)(0.1562)

Q.5.A – Evaluate two applications of index futures. (2 mks)

NOVEMBER 2016
Q.2.B – Citing three reasons, justify why futures options are increasingly becoming popular
in the derivatives market. (6 mks)
1) Additional opportunities to manage risk.
2) They diversify the portfolio.
3) Flexibility.
4) No time decay.
5) Liquidity.
Q.2.C – The following information relates to a European put futures option on crude oil:
1. The time to the option’s expiration is 4 months.
2. The current futures price is sh. 20.
3. The futures exercise price is sh. 20.
4. The risk free interest rate is 9% per annum.
5. The volatility on the futures price is 25% per annum.
Required:
The put price on a European put futures option. (3 mks)
Q.4.C – In a Treasury bond futures contract, it is known that the cheapest bond to deliver will
be a 12% coupon bond with a conversion factor of 1.6000. it is also known that the delivery
will take place in 270 days. Coupons are payable semi-annually on the bond. The last coupon
date was 60 days ago. The next coupon date is in 122 days and the coupon thereafter is in 305
days. The term structure is flat and the rate of interest with continuous compounding is 10%
per annum. The current quoted bond price is sh. 115.
Required:

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The quoted futures price (5 mks)

Q.5.C – John Mukungi is a portfolio manager with Raimulo Financial services. He manages a
portfolio consisting 65% allocation to equities and 35% allocation to bonds. The portfolio has
a market value of sh. 200 million. The beta of the equity position is 1.15 and the modified
duration of the bond position is 6.75. The portfolio wishes to increase the equity allocation to
85% and reduce the bond allocation to 15% for a period of 6 months.
In addition to altering asset allocations, John Mukungi would also like to increase the beta on
the equity position to 1.20 and increase the modified duration of the bonds to 8.25.
A stock index futures contract that expires in six months is priced at sh. 157,500 and has a
beta of 0.95. A bond futures contract that expires in six months is priced at sh. 109,000 and
has implied modified duration of 5.25. The stock futures contract has a multiplier of 1.
Required:
i. Demonstrate how John Mukungi could achieve his goals by using stock index and
bond futures. (5 mks)
ii. The number of futures contracts. (4 mks)
iii. Indicate whether the portfolio manager should go long or short. (1 mk)
NOVEMBER 2015
Q.3.A – Kimanzi Mutua is the chief trader at the Federal Futures Exchange (FFE), the only
futures exchange in his country. One of his duties is to determine the prices of different types
of futures contracts traded at FFE.
Required:
Assess how Kimanzi Mutua could determine the price of the following types of futures
contracts traded at FFE:
i. Treasury bond futures contracts. (2 mks)
ii. Stock index futures contract. (2 mks)
iii. Currency futures contracts. (2 mks)
Q.3.B – A futures contract on a treasury bill expires in 91 days. The treasury bill matures in
182 days. The interest rate on treasury bills are as follows:
91 – Day Treasury bill: 22.13%
182 – Day Treasury bill: 21.84%
Assume a year has 360 days.
Required:
i. The appropriate futures price using the price of the 91 – day treasury bill and 182 –
day treasury bill. (4 mks)
ii. The futures price in terms of the underlying asset spot price compounded at the
appropriate risk free rate. (3 mks)
iii. Convert the futures price computed (i) above to the implied discount rate on the
futures. (3 mks)
iv. Assume that the futures contract is trading in the market at an implied discount rate of
20 basis points lower than is appropriate, given the pricing model and the rule of no
arbitrage. Illustrate how an arbitrage transaction could be executed. Show the
outcome. (4 mks)
SEPTEMBER 2015
Q.1.A – Consider a bond portfolio value of sh. 1,036,300 (duration 1.793), a futures value of
sh. 102,510 (duration 1.62) and a yield beta of 1.2.
Required:
i. Calculate the required number of contracts to reduce the portfolio duration to zero. (2 mks)
ii. Calculate the required number of contracts to achieve a target duration of 1.0. (2 mks)

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FATIMA TRAINING INSTITUTE – MOCKS

QUESTION 1
Consider a futures contract in which the current futures price is $82. The initial margin
requirement is $5, and the maintenance margin requirement is $2. You go long 20 contracts
and meet all margin calls but do not withdraw any excess margin.
Assume that on the first day, the contract is established at the settlement price, so there is no
mark-to-market gain or loss on that day.
Required:
1) Complete the table below and provide an explanation of any funds deposited.
Day Beginning Funds Futures price Price change Gain/loss Ending
balance deposited balance
0 82
1 84
2 78
3 73
4 79
5 82
6 84

2) Determine the price level that would trigger a margin call.

Solution

Day Beginning Funds Futures price Price change Gain/loss Ending

balance deposited balance
0 0 100 82 - - 100
1 100 0 84 2 40 140
2 140 0 78 -6 -120 20
3 20 80 73 -5 -100 0
4 0 100 79 6 120 220
5 220 0 82 3 60 280
6 280 0 84 2 40 320

On Day 0, you deposit $100 because the initial margin requirement is $5 per contract and you
go long 20 contracts. At the end of Day 2, the balance is down to $20, which is $20 below the
$40 maintenance margin requirement ($2 per contract times 20 contracts). You must deposit
enough money to bring the balance up to the initial margin requirement of $100 ($5 per
contract times 20 contracts). So on Day 3, you deposit $80. The price change on Day 3 causes
a gain/loss of -$100, leaving you with a balance of $0 at the end of Day 3. On Day 4, you
must deposit $100 to return the balance to the initial margin level.

Part two
A price decrease to $79 would trigger a margin call. This calculation is based on the fact that
the difference between the initial margin requirement and the maintenance margin
requirement is $3. If the futures price starts at $82, it can fall by $3 to $79 before it triggers a
margin call.

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QUESTION 2
Consider an asset priced at $50. The risk-free interest rate is 8 percent, and a futures contract
on the asset expires in 45 days. Answer the following, with questions A, B, C, and D
independent of the others.
A. Find the appropriate futures price if the underlying asset has no storage costs, cash flows,
or convenience yield.
B. Find the appropriate futures price if the future value of storage costs on the underlying
asset at the futures expiration equals $2.25.
C. Find the appropriate futures price if the future value of positive cash flows on the
underlying asset equals $0.75.
D. Find the appropriate futures price if the future value of the net overall cost of carry on the
underlying asset equals $3.55.
E. Using Part D above, illustrate how an arbitrage transaction could be executed if the futures
contract is trading at $60.
F. Using Part A above, determine the value of a long futures contract an instant before
marking to market if the previous settlement price was $49.
Solution
A. First determine that T = 45/365 = 0.1233. Then the futures price is: fo(0.1233) =
$50(1.08)0.1233 = $50.48
B. Storage costs must be covered in the futures price, so we add them:
fo(0.1233) = $50(1.08)0.1233 +$2.25 = $52.73
C. A positive cash flow, such as interest or dividends on the underlying, reduces the futures
price: fo(0.1233) = $50(1.08)0.1233 - $0.75 = $49.73

D. The net overall cost of carry must be covered in the futures price, so we add it:
fo(0.1233) = $50(1.08)0.1233 + $3.55 = $54.03.

E. Follow these steps:

1) Sell the futures at $60.
2) Buy the asset at $50.
3) Because the asset price compounded at the interest rate is $50.48, the interest forgone is
$0.48. So the asset price is effectively $50.48 by the time of the futures expiration.
4) Incur costs of $3.55.
5) At expiration, deliver the asset and receive $60. The net investment in the asset is $50.48 +
$3.55 = $54.03. If the asset is sold for $60, the net gain is $5.97.

F. If the last settlement price was $49.00 and the price is now $50.48 (our answer in Part A),
the value of a long futures contract equals the difference between these prices:
$50.48 - $49.00 = $1.48.

QUESTION 3
Consider a three-year $1 par Treasury bond with a 7.5 percent annual yield and 8 percent
semiannual coupon. Its price is $1.0132. A futures contract calling for delivery of this bond
only expires in one year. The one-year risk-free rate is 7 percent.
Required:
1) Find the future value in one year of the coupons on this bond. Assume a reinvestment
rate of 3.75 percent per six-month period.
2) Find the appropriate futures price.
3) Now suppose the bond is one of many deliverable bonds. The contract specification
calls for the use of a conversion factor to determine the price paid for a given

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deliverable bond. Suppose the bond described here has a conversion factor of 1.0372.
Now determine the appropriate futures price.
Solution
Part one
One coupon of 0.04 will be invested for half a year at 3.75 percent (half of the rate of 7.5
percent). The other coupon is not reinvested but is still counted. Thus,
FV(CI,0,l) = 0.04(1.0375) + 0.04 = 0.0815.

Part two
fo(l) = 1.0132(1.07) - 0.0815 = 1.0026

Part three
F0(1) = 1.0132(1.07) – 0.0815
1.0372
= 0.9667

QUESTION 4
A stock index is at 755.42. A futures contract on the index expires in 57 days. The risk-free
interest rate is 6.25 percent. At expiration, the value of the dividends on the index is 3.94.
Required:
1) Find the appropriate futures price, using both the future value of the dividends and
the present value of the dividends.
2) Find the appropriate futures price in terms of the two specifications of the dividend
yield.
3) Using your answer in Part 2, find the futures price under the assumption of
continuous compounding of interest and dividends.
Solution
Part one
T = 57/365 = 0.1562
Fo(0.1562) = 755.42(1.0625)0.1562 – 3.94 = 758.67.
Alternatively, we can find the present value of the dividends:
Pv(D,0, 0.1562) = 3.94 / (1.0625)0.1562 = 3.90

Then we can find the futures price as f0(0.1562) = (755.42 – 3.90) (1.0625)0.1562 = 758.67

Part two
Under one specification of the yield, we have:
1/(1+d)T = 1 – (3.94/755.42(1.0625)0.1562
= 0.9948
We need the inverse of this amount, which is 110.9948 = 1.0052. Then the futures price is:
Fo(0.1562) = 755.42/1.0052) (1.0625)0.1562 = 758.66.
Under the other specification of the dividend yield, we have:
d = 3.90/755.42 = 0.0052
The futures price is fo(0.1562) = 755.42(1 – 0.0052)0.1562 = 758.64.
Part three
The continuously compounded risk-free rate is rc = In(1.0625) = 0.0606. The continuously
compounded dividend yield is:

(1/0.1562) In(1.0052) = 0.0332

The futures price would then be:

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fo( 0.1562) = 755.42e(0.0606 - 0.0332)(0.1562)

= 758.66
QUESTION 5
The spot exchange rate for the Swiss franc is $0.60. The U.S. interest rate is 6 percent, and
the Swiss interest rate is 5 percent. A futures contract expires in 78 days.
Required:
A. Find the appropriate futures price.
B. Find the appropriate futures price under the assumption of continuous compounding.
C. Using Part A, execute an arbitrage resulting from a futures price of $0.62.
Solution
Part one
T = 78/365 = 0.2137
Fo(0.2137) = $0.60/(1.05)0.2137 (1.06)0.2137 = $0.6012
Part two
The continuously compounded equivalent rates are:
rfc = ln(1.05) = 0.0488
rc = ln(1.06) = 0.0583
The futures price is:
f0(0.2137) = ($0.60e-0.0488(0.2137) e 0 0583(0.2137)
= $0.6012
Part three
At $0.62, the futures price is too high, so we will need to sell the futures. First, however, we
must determine how many units of the currency to buy. It should be:

1/(1.05)0.2137 = 0.9896
So we buy this many units, which costs 0.9896($0.60) = $0.5938. We sell the futures at
$0.62. We hold the position until expiration. During that time the accumulation of interest
will make the 0.9896 units of the currency grow to 1.0000 unit. We convert the Swiss franc to
dollars at the futures rate of $0.62. The return per dollar invested is:
0.62/0.5938 = 1.0441
This is a return of 1.0441 per dollar invested over 78 days. At the risk-free rate of 6 percent,
the return over 78 days should be (1.06)0.2137 = 1.0125. Obviously, the arbitrage transaction is
much better.

QUESTION 6
1) In February, Donald Trump purchased a June futures contract on the Nasdaq 100 Index.
He decides to close out his position in April. Describe how he would do so.
2) Patricia is a futures trader. In early August, she took a short position in an S&P 500
Index futures contract expiring in September. After a week, she decides to close out her
position. Describe how she would do so.
Solution
Part one
Donald would close out his position in April by offsetting his long position with a short
position. To do so, he would re-enter the market and offer for sale a June futures contract on
the Nasdaq 100 index. When he has a buyer, he has both a long and a short position in the
June futures contract on the Nasdaq 100 index. From the point of view of the clearinghouse,
he no longer has a position in the contract.

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Part two
Patricia would close out her position in August by offsetting her short position with a long
position. To do so, she would re-enter the market and purchase a September futures contract
on the S&P 500. She then has both a short and a long position in the September futures
contract on the S&P 500. From the point of view of the clearinghouse, she no longer has a
position in the contract.

QUESTION 7
A gold futures contract requires the long trader to buy 100 troy ounces of gold. The initial
margin requirement is $2,000, and the maintenance margin requirement is $1,500.
Required:
1) Mark goes long one June gold futures contract at the futures price of $320 per troy
ounce. When could Mark receive a maintenance margin call?
2) Samuel sells one August gold futures contract at a futures price of $323 per ounce.
When could Tosca receive a maintenance margin call?
Solution
Part one
The difference between initial and maintenance margin requirements for one gold futures
contract is $2,000 - $1,500 = $500. Because one gold futures contract is for 100 troy ounces,
the difference between initial and maintenance margin requirements per troy ounce is
$500/100, or $5.
Because Mark has a long position, he would receive a maintenance margin call if the price
were to fall below $320 - $5, or $315 per troy ounce.

Part two
Because Samuel has a short position, he would receive a maintenance margin call if the price
were to rise above $323 + $5, or $328 per troy ounce.

QUESTION 8
A copper futures contract requires the long trader to buy 25,000 lbs of copper. A trader buys
one November copper futures contract at a price of $0.75/lb. Theoretically, what is the
maximum loss this trader could have? Another trader sells one November copper futures
contract. Theoretically, what is the maximum loss this trader with a short position could
have?
Solution
Trader with a long position - This trader loses if the price falls. The maximum loss would be
incurred if the futures price falls to zero, and this loss would be $0.75/lb x 25,000 lbs, or
$18,750. Of course, this scenario is only theoretical, not realistic.
Trader with a short position - This trader loses if the price increases. Because there is no
limit on the price increase, there is no theoretical upper limit on the loss that the trader with a
short position could incur.

QUESTION 9
Sarah Moore has taken a short position in one Chicago Board of Trade Treasury bond futures
contract with a face value of $100,000 at the price of 966/32. The initial margin requirement
is $2,700, and the maintenance margin requirement is $2,000. Moore would meet all margin
calls but would not withdraw any excess margin.
Required

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1) Complete the table below and provide an explanation of any funds deposited. Assume
that the contract is purchased at the settlement price of that day, so there is no mark-
to-market profit or loss on the day of purchase.
2) How much are Moore's total gains or losses by the end of day 6?

Day Beginning Funds Futures price Price change Gain/loss Ending

balance deposited balance
0 96 – 06
1 96 – 31
2 97 – 22
3 97 – 18
4 97 – 24
5 98 – 04
6 97 - 31

Solution
Part one

Day Beginning Funds Futures price Price change Gain/loss Ending

balance deposited balance
0 0 2700.00 96 – 06 0 0 2700.00
1 2700.00 0 96 – 31 25/32 -781.25 1918.75
2 1918.75 781.25 97 – 22 23/32 -718.75 1981.25
3 1981.25 718.75 97 – 18 -4/32 125.00 2825.00
4 2825.00 0 97 – 24 6/32 -187.50 2637.50
5 2637.50 0 98 – 04 12/32 -375.00 2262.50
6 2262.50 0 97 - 31 -5/32 156.25 2418.75

On day 0, Moore deposits $2,700 because the initial margin requirement is $2,700 per
contract and she has gone short one contract. At the end of day 1, the price has increased
from 96-06 to 96-31-that is, the price has increased from $96,187.50 to $96,968.75. Because
Moore has taken a short position, this increase of $781.25 is an adverse price movement for
her, and the balance is down by $781.25 to $1,918.75. Because this amount is less than the
$2,000 maintenance margin requirement, she must deposit additional funds to bring her
account back to the initial margin requirement of $2,700. So, the next day (day 2), she
deposits $781.25. Another adverse price movement takes place on day 2 as the price further
increases by $718.75 to $97,687.50. Her ending balance is again below the maintenance
margin requirement of $2,000, and she must deposit enough money to bring her account back
to the initial margin requirement of $2,700. So, the next day (day 3), she deposits $718.75.
Subsequently, even though her balance falls below the initial margin requirement, it does not
go below the maintenance margin requirement, and she does not need to deposit any more
funds.

Part two
Moore bought the contract at a futures price of 96-06. By the end of day 6, the price is 97-3
1, an increase of 125/32. Therefore, her loss so far is 1.78125 percent of $100,000, which is
$1,781 .25. You could also look at her loss so far as follows: She initially deposited
$2,700, followed by margin calls of $781 .25 and $718.75. Thus, she has deposited a total of
$4,200 so far, and has not withdrawn any excess margin. Her ending balance is $2,418.75.
Thus, the total loss so far is $4,200 - $2,418.75, or $1,781.25.

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QUESTION 10
Mary is expecting large-capitalization stocks to rally close to the end of the year.
She is pessimistic, however, about the performance of small-capitalization stocks. She
decides to go long one December futures contract on the Dow Jones Industrial Average at a
price of 9,020 and short one December futures contract on the S&P Midcap 400 Index at a
price of 369.40. The multiplier for a futures contract on the Dow is $10, and the multiplier for
a futures contract on the S&P Midcap 400 is $500. When Mary closes her position towards
the end of the year, the Dow and S&P Midcap 400 futures prices are 9,086 and 370.20,
respectively.
Required
How much is the net gain or loss to Mary?
Solution
Her gain caused by the increase in the price of Dow Jones Industrial Average futures is
$10(9,086 - 9,020) = $660. Because Mary had a short position in S&P Midcap 400 futures,
her loss caused by the increase in the price of S&P Midcap 400 futures is:
$500(370.20 - 369.40) = $400. Mary’s net gain is $660 - $400 = $260.

QUESTION 11
A. The current price of gold is $300 per ounce. Consider the net cost of carry for gold to be
zero. The risk-free interest rate is 6 percent. What should be the price of a gold futures
contract that expires in 90 days?
B. Using Part A above, illustrate how an arbitrage transaction could be executed if the futures
contract is priced at $306 per ounce.
C. Using Part A above, illustrate how an arbitrage transaction could be executed if the futures
contract is priced at $303 per ounce.
Solution
Part one
T = 90/365 = 0.2466. The futures price is:
f0(T) = So(l + r)T
fo(0.2466) = 300(1.06)0.2466 = $304.34 per ounce.

Part two
Do the following:
1) Enter a short futures position-that is, sell the futures at $306.
2) Buy gold at $300.
3) At expiration, deliver an ounce of gold and receive $306.
4) This amount is $1.66 more than $304.34, which is the sum of the cost of the asset ($300)
and the loss of interest on this amount at the rate of 6 percent a year ($4.34). Thus, the
overall strategy results in a riskless arbitrage profit of $1.66 per futures contract. You can
also look at this scenario in terms of returns: Investing $300 and receiving $306 - 90 days
later is an annual return of 8.36 percent, because 300(1.0836)90/365 = 306. This return is
clearly greater than the risk-free return of 6 percent.

Part three
The steps in this case would be the reverse of the steps in Part B above. So, do the following:
1) Enter a long futures position; that is, buy the futures at $303.
2) Sell short the gold at $300.
3) At expiration, take the delivery of an ounce of gold and pay $303.
This amount paid is $1.34 less than $304.34, which is the sum of the funds received from the
short sale of the asset ($300) and the interest earned on this at the rate of 6 percent per year

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($4.34). Thus, the overall strategy results in a riskless arbitrage profit of $1.34 per futures
contract. In terms of rates, receiving $300 up front and paying $303 - 90 days later represents
an annual rate of 4.12 percent, because 300(1.0412)90/365 = 303. This rate is clearly less than
the risk-free rate of 6 percent. Thus, the overall transaction is equivalent to borrowing at a
rate less than the risk-free rate.

QUESTION 12
Consider an asset priced at $90. A futures contract on the asset expires in 75 days. The risk-
free interest rate is 7 percent. Answer the following questions, each of which is independent
of the others, unless indicated otherwise.
A. Find the appropriate futures price if the underlying asset has no storage costs, cash flows,
or convenience yield.
B. Find the appropriate futures price if the underlying asset's storage costs at the futures
expiration equal $3.
C. Find the appropriate futures price if the underlying asset has positive cash flows.
The future value of these cash flows is $0.50 at the time of futures expiration.
D. Find the appropriate futures price if the underlying asset's storage costs at the futures
expiration equal $3.00 and the compound value at the time of the futures expiration of the
positive cash flow from the underlying asset is $0.50.
E. Using Part D above, illustrate how an arbitrage transaction could be executed if the futures
contract is trading at $95.
F. Using Part A above, determine the value of a long futures contract an instant before
marking to market if the previous settlement price was $89.50.
G. What happens to the value of the futures contract in Part F above as soon as it is marked to
market?
Solution
Part one
A. T = 75/365 = 0.2055. The futures price is f0(0.2055) = 90(1.07)0.2055 = 91.26
B. Storage costs must be covered in the futures price, so we add them:
F0(0.2055) = 91.26 + 3 = 94.26
C. A positive cash flow, such as interest or dividends on the underlying, reduces the futures
price:
F0(0.2055) = 91.26 – 0.50 = 90.76
D. We add the storage costs and subtract the positive cash flow:
F0(0.2055) = 91.26 + 3 – 0.50 = 93.76.

E. We would do the following:

1) Sell the futures at $95.
2) Buy the asset at $90.
3) Because the asset price compounded at the interest rate is $91.26, the interest forgone
is 1.26. So the asset price is effectively $91.26 by the time of the futures expiration.
We have incurred storage costs of $3 on the asset. We have received $0.50 from the asset. At
expiration, we deliver the asset and receive $95. The net investment in the asset is:
$91.26 + $3.00 - $0.50 = $93.76. If we sell it for $95, we make a net gain of $1.24. Thus, the
overall strategy results in a riskless arbitrage profit of $1.24 per futures contract. One can also
look at this profit in terms of returns.
Investing $90 and receiving a net of $95.00 - $3.00 + $0.50 = $92.50 75 days later is an
annual return of 14.26 percent, because $90(1.14264)75/365 = $92.50. This return is clearly
greater than the risk-free return of 7 percent.

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F. The last settlement price was $89.50, and the price in our answer in Part A is $91.26. The
value of a long futures contract is the difference between these prices, or $1.76.
G. When the futures contact is marked to market, the holder of the futures contract receives a
gain of $1.76, and the value of the futures contract goes back to a value of zero.

QUESTION 12
A 45-day T-bill has a discount rate of 5.50 percent. A 135-day T-bill has a discount rate of
5.95 percent.
Required:
1) What should be the price of a futures contract that expires in 45 days? Assume $1 par
value.
2) Show that the purchase of a 135-day T-bill, with its price in 45 days hedged by the
sale of a 45-day futures contract that calls for the delivery of a 90-day T-bill, is
equivalent to purchasing a 45-day T-bill and holding it to maturity.
Solution
Part one
h=45 and h+m= 135
ro(h) = rod(45) = 0.055
ro(h + m) = ro(135) = 0.0595
The prices of these T-bills will, therefore, be:
Bo(h) = 1- r0(h)(h/360)
B0(45) = 1 – 0.055 (45/360) = 0.9931
Bo(h+m) = 1 – r0(h + m) (h + m / 360)
B0(135) = 1 – 0.0595(135/360) = 0.9777

So the price of a futures contract expiring in 45 days is:

F0(h) = b0( h + m) / bo(h)
Fo(45) = b0(135) / bo(45) = 0.9777 / 0.9931 = 0.9845
The discount rate implied in the futures would be:
Ro(h) = 1 – fo(h) (360/m)
R0(45) = 1 – 0.9845(360/90) = 0.0620

Part two
Suppose one purchases the 135-day T-bill for 0.9777 and sells the 45-day futures contract at a
price of 0.9845. Then, 45 days later, the T-bill would be a 90-day T-bill and would be
delivered to settle the futures contract. Thus, at that time, one would receive the original
futures price of 0.9845. One initially paid 0.9777 and 45 days later received 0.9845. The
return per dollar invested is:
0.9845/0.9777 = 1.00696
If instead one purchases a 45-day T-bill at the price of 0.9931 and holds it for 45 days, the
return per dollar invested is: 1/0.9931 = 1.00695.
Thus, the return per dollar invested is the same in both transactions (with a slight difference
caused by rounding), and both transactions are free of risk.

QUESTION 13
The discount rate on a 60-day T-bill is 6.0 percent, and the discount rate on a 150-day T-bill
is 6.25 percent.
Required:
A. Based on the 60-day and 150-day T-bill discount rates, what should be the price of a 60-
day futures contract? Assume $1 par value.

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B. If the actual price of a 60-day futures contract is 0.9853, outline the transactions necessary
to take advantage of the arbitrage opportunity, and show the outcome.
C. Calculate the implied repo rate and discuss how you interpret it to determine the
profitability of the arbitrage strategy outlined in Part B.

Solution
Part one
First compute the prices of the 60-day and 150-day T-bills. With h = 60 and h + m = 150.
R0(h) = r0(60) = 0.060
R0(h + m) = r0(150) = 0.0625
The prices of these T-bills will, therefore, be:
Bo(h) = 1 – r0(h) (h/360)
Bo(60) = 1 – 0.06(60/360) = 0.99
Bo(h + m) = 1 – ro(h + m) (h + m / 360)
Bo(150) = 1 – 0.0625(150/360) = 0.974
So the price of a futures expiring in 60 days is:
F0(h) = b0( h + m) / bo(h)
F0(45) = b0(150) / b0(60) = 0.974 / 0.990 = 0.9838

Part two
As the actual futures price of 0.9853 is more than the implied futures price computed in Part
A, you should sell the futures contract. So, do the following. Buy the 150-day T-bill at 0.974.
Sell the 60-day futures contract at 0.9853. The return per dollar would be:
0.9853 / 0.9740 = 1.0116
Note that this return is risk free. It compares favorably with return per dollar on purchasing a
60-day T-bill and holding it to maturity, which is 1/0.99 = 1.0101.

Part three
The repo rate is the annualization of the return per dollar because of the arbitrage transactions
outlined in Part B:
(1.0116)365/60 – 1= 0.0727
Thus, the rate of return from a cash-and-carry transaction implied by the futures price relative
to the spot price is 7.27 percent. If the financing rate available in the repo market is less than
this rate, the arbitrage strategy outlined in Part B is worthwhile, because the cost of funds is
less than the return on the funds.

NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this
by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

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CHAPTER FOUR
RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES
STRATEGIES.

PAGE
4.1 Introduction to risk exposures managed by Forwards and Futures……………..
4.2 Strategies and applications for managing interest rate risk: …………………….
Managing the interest rate risk of a loan using a forward contract; strategies and
applications for managing bond portfolio risk.
4.3 Strategies and applications for managing equity market risk……………………..
Measuring and managing the risk of equities; managing the risk of an equity
portfolio; creating equity out of cash; creating cash out of equity.
4.4 Asset allocation with futures: …………………………………………………
Adjusting the allocation among asset classes; pre-investing in an asset class.
4.5 Strategies and applications for managing foreign currency risk: ………………..
managing the risk of a foreign currency receipt; managing the risk of a foreign
currency payment; managing the risk of a foreign-market asset portfolio
4.6 Hedging strategies using futures………………………………………………..
Hedge ratio, perfect hedge, basis risk and correlation risk, minimum variance hedge
ratio and hedging with several futures contracts.
Revision questions – 2015 – 2023…………………………………………………

KEY TOPIC POINTS

Notations
T: time until delivery date (years)
S0: spot price of the underlying asset today
F0: forward price today = delivery price K if the contract were negotiated today
r: zero coupon risk-free interest rate with continuous compounding for T years to maturity.

Arbitrage means making of a guaranteed risk free profit with a trade or a series of trades in
the market.

FORWARD PRICE FOR AN INVESTMENT ASSET THAT PROVIDES NO INCOME

Consider a forward contract negotiated today.
T = 3 months = ¼ year, S0 = $40, r = 5%, F0 = ?
General solution:
F0 = S0 erT
So, F0 = $40.50
If the above equation does not hold, an arbitrage opportunity exists.
For example, if F0 = 43 > 40.50, an arbitrage profit = 43 - 40.50 = $2.50
Strategy: (Forward price is too high relative to spot price)
Today:
(1) Borrow $40.00 at 5% for 3 months and buy one unit of the asset.
(2) Sell a 3-month forward contract for one unit of the asset at $43.
After 3 months:
(1) Make the delivery and collect $43.

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(2) Repay the loan of $40.50 = 40e0.05*3/12

(3) Count for profit = 43.00 - 40.50 = $2.50
If F0 = 39 < 40.50, an arbitrage profit = 40.50 - 39 = $1.50.
Show the proof by yourself as an exercise.

One says that has/takes a long position on an asset if one owns/is going to own a positive
amount of that asset. One says that has/takes a short position on an asset if one has/is going to
have a negative amount of that asset. Being short on money means borrowing. You can take a
short position on many financial assets by short selling.

SHORT SELLING
To implement some trading strategy you need to sell some amount of shares (to get money
and invest in other assets). The problem is that you do not have any shares right now.
You can borrow the shares from another investor for a time period (paying interest) and sell
the borrowed shares in the market. At the end of the borrowing period you must buy again the
shares in the market and give them back to the lender.
The party selling the asset is said to be taking a short forward position and the party buying
the asset is said to be taking a long forward position. Both parties are obliged to fulfill the
terms of the contract. The main reason to enter into a forward contract agreement is to
become independent of the unknown future price of a risky asset.
Assume that the contract is entered at time t = 0, the delivery time is t = T and denoted by F
(0,T) the forward price. The time t price of the underlying asset is denoted S (t) . Due to the
symmetry of the contract, no payment is made by either party at the beginning of the contract,
t = 0.
At delivery, the party with the long position makes a profit if:
F (0, T) < S (T), while the party with the short position will make a loss (exactly of the same
magnitude as the profit of the other party). If, F (0, T) > S (T), the situation is reversed.
The payoff at delivery for a long forward position is:

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The payoff at delivery for a short forward position is:

FORWARD PRICE
If the contract is initiated at t < T, we will write F (t, T) for the forward price and the payoffs
will be S (T) − F(t, T) (long position) and F (t, T) − S (T) (short position). As no payment is
made at the beginning of the forward contract, the main problem is to find the forward price F
(0, T) such that both parties are willing to enter into such an agreement. One possible
approach would be to compute the present value, which we know that is zero, by discounting
the expected payoff of the contract. That is,
0 = V (0) = e−rTE[S (T) − F (0, T)] which yields F (0, T) = E[S (T)]. Note that F (0, T) would
depend on the distribution of S (T), hence, we would only have translated the problem to
agree on which distribution use.
• The solution comes from the fact that we can also invest in the money market and there
exists only one value for F (0, T) such avoid arbitrages.
• The price obtained does not depend on the distribution of S(T).

Rules 1
Buy and hold strategy:
• Borrow S (0) NOK, to buy the asset at time zero.
• Hold it until time T.
• At time T, the amount S(0) erT to be paid to settle the loan is a natural candidate for F (0, T).
The forward price F (0, T) is given by:
F (0, T) = S (0) erT where r is the constant risk free interest rate under continuous
compounding. If the contract is initiated at time t ≤ T, then;
F (t, T) = S (t) er(T−t).

Remark 1
The formula in the previous theorem applies as long as the underlying asset does not generate
an income (dividends) or a cost (storage and insurance costs for commodities).

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In this section we will, many times, be implicitly assuming that the underlying is a stock
which does not pay dividends.

Remark 2
In the case considered here we always have;
F (t, T) = S (t) er(T−t) > S (t) .
Moreover, the difference ;F (t, T) − S (t) , called the basis, converges to 0 as t converges to T.
In a forward contract, a party agrees to buy or sell an asset at a given price at a future date τ .
The party that agrees to buy the asset, is taking a long position. The party that is selling is
taking a short position. The spot price Sτ is the price in the open market of the asset of time τ
. The delivery price Kτ is the price agreed in the forward contract for the transaction that is to
be enacted at time τ , when the money is paid and the delivery is taken.
The forward price Fτ|t is the price prevailing at time t for a delivery that is scheduled for time
τ . When the contract is written, the delivery price is the prevailing forward. We denote this
by writing Kτ = Fτ|t. After time t, the forward price and the delivery price may diverge.
The returns to the party taking the short position in the forward contract is
Kτ − Sτ . The party taking the short position is paid a sum of Kτ at time τ and they relinquish
an asset that is valued at Sτ on the open market at that time. The returns to the party taking the
long position in the forward contract is Sτ − Kτ .
They must pay Kτ for the delivery of an asset that is valued at Sτ at the time. The party taking
the short position hopes that the returns will be positive and that they will be sufficient to
compensate for the opportunity cost of tying up their capital by holding the asset until time τ
. This opportunity cost is the return R that they would obtain from the best riskless
alternative investment of their capital. They will gain from the transition only if Kτ − Sτ > R.

MEASURING AND MANAGING THE RISK OF EQUITIES

Futures provide the best way to manage the risk of diversified equity portfolios. Although the
standard deviation, or volatility, is a common measure of stock market risk, we prefer a
measure that more accurately reflects the risk of a diversified stock portfolio. One reason for
this preference is that we shall use futures that are based on broadly diversified portfolios.
The most common risk measure of this type is the beta. Beta is an important factor in capital
market and asset pricing theory and, as we see here, it plays a major role in risk management.

ILLUSTRATION
BB Holdings (BBH) is a U.S. conglomerate. Its pension fund generates market forecasts
internally and receives forecasts from an independent consultant. As a result of these
forecasts,
BBH expects the market for large-cap stocks to be stronger than it believes everyone else is
expecting over the next two months.
Action
BBH decides to adjust the beta on $38,500,000 of large-cap stocks from its current level of
0.90 to 1.10 for the period of the next two months. It has selected a futures contract deemed
to have sufficient liquidity; the futures price is currently $275,000 and the contract has a beta
of 0.95. The appropriate number of futures contracts to adjust the beta would be:
NF = (BT – BS/Br) (S/F) = (1.10 – 0.09/0.95) (38,500,00 /275,000) = 29.47
So it buys 29 contracts.

Scenario (3 December)
The market as a whole increases by 4.4 percent. The stock portfolio increases to $40,103,000.
The stock index futures contract rises to $286,687.50, an increase of 4.25 percent.

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Outcome and Analysis

The profit on the futures contract is 29($286,687.50 - $275,000.00) = $338,937.50. The rate
of return for the stock portfolio is:
40,103,000/38,500,000 – 1 = 0.0416 or 4.16 percent. Adding the profit from the futures gives
a total market value of $40,103,000.00 + $338,937.50 = $40,441,937.50. The rate of return
for the stock portfolio is: 40,441,937.50/38,500,000 – 1 = 0.0504 or 5.04 percent. Because
the market went up by 4.4 percent and the overall gain was 5.04 percent, the effective beta of
the portfolio was: 0.0504/0.044 = 1.15 Thus, the effective beta is quite close to the target beta
of 1.10.
Of course, be aware that increasing the beta increases the risk. Therefore, if the beta is
increased and the market falls, the loss on the portfolio will be greater than if beta had not
been increased. Decreasing the beta decreases the risk, so if the market rises, the portfolio
value will rise less. As an example, consider the outcome described above. Suppose that
instead of being optimistic, the fund manager was very pessimistic and wanted to decrease
the beta to zero. Therefore, the target beta, PT, is 0.0. Then the number of futures contracts
would be:

Nf = (0.0 – 0.90/0.95) (38,5000 /275,000) = -132.63

So the fund sells 133 futures. Given the same outcome, the profit on the futures contracts
would be:
-133(286,687.50 – 275,000) = - $1554437.50
There would be a loss of more than $1.5 million on the futures contracts. The market value of
the stock after it moved up was $40,103,000, but with the futures loss, the market value is
effectively reduced to $40,103,000.00 - $1,554,437.50 = $38,548,562.50. This is a return of:
38,548,562.50/38,500,000 – 1 = 0.0013
Thus the effective beta is: 0.0013/0.044 = 0.030
The beta has been reduced almost to zero. This reduction costs the company virtually all of
the upward movement, but such a cost is to be expected if the beta were changed to zero.

EXAMPLE
Equity Analysts Inc. (EQA) is an equity portfolio management firm. One of its clients has
decided to be more aggressive for a short period of time. It would like EQA to move the beta
on its $65 million portfolio from 0.85 to 1.05. EQA can use a futures contract priced at
$188,500, which has a beta of 0.92, to implement this change in risk.
Required:
1) Determine the number of futures contracts EQA should use and whether it should buy or
sell futures.
2) At the horizon date, the equity market is down 2 percent. The stock portfolio falls 1.65
percent, and the futures price falls to $185,000. Determine the overall value of the position
and the effective beta.
Solution
The number of futures contracts EQA should use is: (1.05 – 0.85/0.92) (65,000,000 /
188,500)
= 74.96
So EQA should buy 75 contracts.
The value of the stock portfolio will be $65,000,000(1 - 0.0165) = $63,927,500.
The profit on the futures transaction is 75($185,000 - $188,500) = -$262,500.
The overall value of the position is $63,927,500 - $262,500 = $63,665,000.
Thus the overall return is: 63,665,000 / 65,000,000 - 1 = - 0.0205
Because the market went down by 2 percent, the effective beta is 0.020510.02 = 1.025.

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ASSIGNMENT

DECEMBER 2023
Q.4.C – Hassan Korir manages the equity portion of the Bold Beverage Pension Fund which
is converting its pension plan from defined benefit scheme to defined contribution scheme
effective three months from now. Plan participants have three months to elect various
investments for the new plan. the trustees inform Hassan that they wish to keep the value of
the pension fund stable during these three months.
Accordingly, Hassan wants to eliminate systematic risk in the equity portion of the fund by
using futures on the Securities Exchange (SE) 100 index which is the benchmark for the
fund’s equity portfolio. He collects the information shown below:

Value of Bold Beverage pension fund equity portfolio Sh. 235,400,000

Level of SE 100 index 4,650
Level of three month SE 100 futures contract 4,667
Futures multiplier Sh. 10
Beta of Bold Beverage pension fund equity portfolio 1.04
Beta of SE futures contract 0.98

Additional information:
1. Three months after Hassan implements the hedge, the Se 100 index is up 3.75%.
2. The equity portion of the beta Beverage pension fund is up 3.5% and the level of the
expiring three month SE 100 futures contract that Hassan sold is 4,824.
3. The trustees as Hassan to assess the effectiveness of the hedge that has been in place.
Required:
i. State the target beta for Hassan’s hedging strategy. (1 mk)
ii. Determine the number of futures contract that Hassan should sell to achieve the target. (4
mks)
iii. Determine the effective beta of the Bold Beverage pension fund equity portfolio including the
futures assuming that Hassan sold 5,200 futures contract. (5
mks)

REVISION QUESTIONS

DECEMBER 2023
Q.1.C – Peter Mwangangi owns Taifa Limited shares currently trading at sh. 150 at the
securities exchange. Peter plans to sell the shares in 250 days from now. The risk free rate is
5.25%. Taifa limited plans to pay dividends to its common shareholders according to the
following schedule:
Days to payment from now Dividends per share (sh)
30 1.25
120 1.25
210 1.25

There are 365 days in a year.

Required:
i. State the position that Peter Mwangangi should take in the forward markets in order to
hedge against a possible price decline. (1 mk)

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ii. Determine the no-arbitrage forward price of a contract established now expiring in
250 days. (3 mks)
iii. At expiration, the price of Taifa limited’s shares is at sh. 130. Determine the value of
the forward contract. (2 mks)
iv. Elaborate whether the value in (iii) above was a gain or loss to Peter Mwangangi. (2 mks)
Refer to chapter two: November 2019 question 1.b and August 2022 question 4.a. (it is the
same question with the same approach to the answers)
The following solution was provided for by one of the Fatima institute CIFA students. To
what extent do you agree /disagree with her solution?

Since Peter Mwangangi wants to sell the shares, he should take a short position. Short
position is for the seller while long position is for the buyer.
1) When the forward price (FP) calculated is less than the actual trading value, borrow the
security at the currently quoted price at risk free rate, buy the bond at the currently quoted
price and take the short position in the forward contract. Deliver the bond and receive the
actual trading value. Use the actual trading value received to settle the forward contract.
The total amount that we receive, pay the loan plus the interest to get the arbitrage.
2) When the forward price (FP) calculated is greater than the actual trading value, sell the
bond today at the currently quoted price and take a long position which obligates us to buy
the bond at the actual trading value. Invest the bond at the current quoted value at the risk
free rate. On settlement date receive the investment proceeds (calculated FP), deliver the
bond at the actual trading value and close out the short position.
Arbitrage profit = calculated FP – Actual trading value.

FP = (S0 – PVD) x (1 + RF)T

PVD = 1.25/(1.0525)30/365 + 1.25/(1.0525)120/365 + 1.25/(1.0525)210/365
PVD = 1.25/(1.0525)0.082 + 1.25/(1.0525)0.329 + 1.25/(1.0525)0.575
PVD = 1.25/1.004 + 1.25/1.017 + 1.25/1.030
PVD = 1.25 + 1.23 + 1.21
PVD = sh. 3.69
FP = (150 – 3.69) x (1.0525)250/365
FP = (146.31) x (1.0525)0.685
FP = 146.31 x 1.0357
FP = 151.53
Clearly, 151.53 which is the intrinsic value is greater than the market value of sh. 150. The
security in this situation is said to be undervalued.
Vt (long position) = (St – PVDt) – FP/(1 + RF)T-t
There is only one dividend remaining before the contract matures (250 – 210) = 40 days
Long positioning = 130 – (151.53/(1.0525)40/365
Long positioning = 130 – (151.53/1.006)
Long positioning = 130 – 150.63
Long positioning = - 20.63
Short positioning = + 20.63
The long has lost money while the short has made money.
This is a loss because the concept entails a zero sum game where the gain by one party is a
loss to the other party. The long position (buyer) will have a loss while the short position
(seller) will have a gain of the same value.

AUGUST 2023

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Q.2.C – Wastaafu pension fund owns a sh. 100 million large-cap position for which the fund
manager expects a poor market performance over the next three months. Fund managers have
decided to create synthetic cash equal to sh. 100 million exposure.
Additional information:
1. Three-month forward contracts are currently at sh. 1,400 with a multiplier of sh. 250.
2. Three-month Treasury rates are estimated at 2.8%
Required:
i. The appropriate number of forward contracts to meet the fund manager’s desire to
create the synthetic cash. (3 mks)
ii. Justify why the fund manager’s decision to create synthetic cash equal to sh. 100
million exposure is appropriate. (3 mks)
iii. Explain to the fund managers of Wastaafu pension fund the relevance of pre-investing
in risk management. (2 mks)

Q.3.C – A portfolio manager expects to purchase a portfolio of stocks in 90 days. In order to

hedge against a potential price increase over the next 90 days, he decides to take a long
position on a 90 day forward contract on the NSE 20 share index. The index is currently at
1145. The continuously compounded dividend yield is 1.75%. The discrete risk free rate is
4.25%. Twenty eight days (28) days after the portfolio has entered the forward contract, the
index value is 1225 and at expiration, the index value is 1235. Assume a 365 day year.
Required:
Calculate the following:
i. The no-arbitrage forward price on this contract. (3 mks)
ii. The value of the forward contract 28 days into the contract. (3 mks)
iii. The value of the forward contract at expiration. (2 mks)
Solution
FP (on an equity index) = S0 x e(Rfc – dc) x T
= (S0 x e-dcxT) x eRfc x T
RFc = continuously compounded risk free rate.
dc = continuously compounded dividend yield.

Vt (of the long positioning) = St FP

edc x (T –t) - eRfc x (T – t)

S0 = 1145
Dc = 1.75% = 0.0175
RFc = 4.25% = 0.0425

FP = 1145 x e (0.0425 – 0.0175) x (90/365)

FP = 1145 x e0.0062
FP = 1145 x 1.0062
FP = sh. 1152.12
Alternatively:
S0 = sh. 1145
T = 90/365 = 0.2466
r = 0.0425
rc = In(1 + 0.0425) = 0.0416
σc = 0.0175
F(0,T) = sh. 1145 x e-0.0175(0.2466) (e0.0416x0.2466 = sh. 1151.83

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The value of the forward contract 28 days into the contract

St = sh.1, 225
T = 90/365 = 0.2466
t = 28/365 = 0.0767
T - t = 0.1699
r = 0.0425
r" = In(1 + 0.0425) = 0.0416
σc = 0.0175
vt (O,T) = sh. 1225 x e-0.0175(0.1699) – 1151.83e-0.0416(0.1699) = sh. 61.36
This is a gain to the long position.
Vt of long positioning = (1225 / e0.0175 x (62/365) ) - (1152.12 / (e0.0425 x (62/365) )
= 1225 / (2.718 0.0030) - (1152.12 / (2.718 0.0072)
= 1225/1.003 – 1152.12 / 1.0072
= 1221.336 – 1143.88
= + 77.456
The value of the forward contract at expiration:
ST = sh.1,235
F(0,T) = sh.1,151.83
VT(O,T) = sh.1,235.00 – sh.1,151.83 = sh.83.17
The contract expires with a value of sh.83.17, a gain to the long.

APRIL 2023
Q.3.A – Explain the purpose of the following price movement limits in futures contract
trading:
i. Daily price limits. (2 mks)
ii. Position limits. (2 mks)

PRICE LIMITS AND POSITION LIMITS

For most contracts, daily price movement limits are specified by the exchange. If in a day the
price moves down from the previous day’s close by an amount equal to the daily price limit,
the contract is said to be limit down. If it moves up by the limit, it is said to be limit up. A
limit move is a move in either direction equal to the daily price limit. Normally, trading
ceases for the day once the contract is limit up or limit down. However, in some instances the
exchange has the authority to step in and change the limits.
The purpose of daily price limits is to prevent large price movements from occurring because
of speculative excesses. However, limits can become an artificial barrier to trading when the
price of the underlying commodity is advancing or declining rapidly. Whether price limits
are, on balance, good for futures markets is controversial.
Position limits are the maximum number of contracts that a speculator may hold.
The purpose of position limits is to prevent speculators from exercising undue influence on
the market.

Q.3.B – An investor contracts his broker to buy two gold futures contracts. The current
futures prices of gold is observed at sh. 1,450 per ounce. The investor contracts to buy 200
ounces and that each contract size is 100 ounces.
Additional information:
1. Initial margin requirements is sh. 6,000 per contract.
2. Maintenance margin is sh. 4,500 per contract.
3. The contract is entered into on day 1 and closed out on day 7.
4. Daily settlement prices were observed as follows:

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Day Settlement price (Sh)

1 1,441.00
2 1,438.30
3 1,444.60
4 1,441.30
5 1,440.10
6 1,436.20
7 1,429.90

Required:
i. Determine the end of the day account balance for a long position in two gold futures
contracts for day 2 to day 7. (8 mks)
ii. Determine the variation margin balance amount by end of day 7. (2 mks)

Solution

Day Settlement price Daily Cumulative Margin Margin call

gain/loss gain/loss account
balance
1 1441.00 -1800 -1800 12000
2 1438.30 -540 -2340 10200
3 1444.60 +1260 -1080 9660
4 1441.30 -660 -1740 10920
5 1440.10 -240 -1980 10260
6 1436.20 -780 -2760 10020
7 1429.90 -1260 -4020 9240
8 7980 4020

This is how we have computed the values in the third column (daily gain/loss)
1441 – 1450 = -9x 200 = -1800
1438.30 – 1441 = -2.7 x 200 = -540
1444.60 – 1438.30 = 6.3 x 200 = +1260……………………
The margin account balance (fourth column) numbers have been computed as follows:
12000 – 1800 = 10,200
10200 – 540 = 9660
9660 + 1260 = 10920……………………..
9240 – 1260 = 7980
12000 – 7980 = 4020
The maintenance margin is sh. 4500 per contract thus for two contracts it will be sh. 9,000.
On Day 7, the balance in the margin account falls $1,020 (9000 – 7980) below the
maintenance margin level. This drop triggers a margin call from the broker for an additional
$4,020 to bring the account balance up to the initial margin level of $12,000 (7980 + 4020). It
is assumed that the investor provides this margin by the close of trading on Day 8.

Q.3.C – A portfolio manager manages a portfolio of sh. 5,000,000 and desires to increase the
beta of this portfolio from its current value of 0.8 to 1.1 using futures contracts. The beta of
the chosen future contract is 1.05 with a price of sh. 240,000.
Required:
i. The number of futures contracts to achieve a beta of 1.1 for the portfolio. (2 mks)

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ii. The unhedged portfolio value increased in value by 5.1% and the futures price
increases in value by 5.1% with one month remaining to the futures contract
expiration. The market had a return of 5.2%.
Required:
The realized effective beta (ex-post beta) for the hedged portfolio (4 mks)

DECEMBER 2022
Q.2.B – Babito Fund manager is evaluating various investment holdings in their portfolio and
they have gathered the following information:
1. They are exposed to a four month forward to buy a zero coupon bond that will mature in
one year. The current price of the bond is sh. 930 and the continuously compounded risk
free rate of return is 6% per annum.
2. A three month all share index (currently at 400) futures contract with a continuously
compounded dividend yield of 1% per annum and 6% interest rate (risk free rate)
3. A one year futures contract on gold costs 20 per 10 gm to store it with payment made at
the end of the year. Spot rate is observed at sh. 900 with a risk free rate of 7% per annum
compounded continuously.
Required:
Using the cost-of-carry model, calculate:
i. The appropriate forward price on the zero coupon bond (2 mks)
ii. The arbitrage free future price of the index. (2 mks)
iii. The theoretical price of the futures price on gold. (2 mks)
Q.5.B – Eliud Dande is a portfolio manager and oversees a balanced fund. The balanced fund
has a current market value of sh. 700 million and a current allocation of 65% equity with an
equity beta of 1.12 and 35% fixed income with a modified duration of 6.55.
EliudDande believes that reported earnings will be better than those anticipated by the market
and based on this short-term market view, he decides to use futures contract to adjust the
allocation of the balanced fund to 80% equity and 20% fixed income for the next three
months. Dande wants to maintain the balanced fund’s current equity beta and modified
duration.
Dande plans to use the stock equity index futures and Treasury bond futures to execute his
transaction. He gathers the data for the two contracts as shown below:
Selected futures contract data:
Contract underlying index price (sh) Futures beta Implied modified duration
Broad equity index 94,505 0.97 -
Broad government bond index 99,100 - 7.15
Additional information:
1. Both contracts expire three months from today.
2. The risk free rate is 1.85%
3. Yield beta for the Treasury bond contract is 1.00.
Required:
Compute:
i. The number of stock index futures contract that Eliud Dande should buy in order to
achieve the adjusted allocation. (3 mks)
ii. The number of Treasury bond contracts that EliudDande should sell in order to
achieve the adjusted allocation. (3 mks)

AUGUST 2022
Q.3.E – In 60 days, a bank plans to lend sh. 10 million for 180 days. The lending rate is
secured overnight financing rate (SOFR) plus 200 basis points. The current SOFR is 4.5%.

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The bank buys an interest rate put that matures in 60 days with a notional principal of sh. 10
million and a strike rate of 4.3%. The put premium is sh. 4,000.
At expiration, SOFR is at 4.1%.
Required:
Calculate the effective annual rate of the loan. (6 mks)
Q.4.C – An investor holds a futures contract whose underlying is the MSE share index.
Assume the following:
 The maturity of the futures contract is close to the maturity hedge.
 Ignore the daily settlement of futures contract.
Additional information:
1. The value of the MSE share index is 2000 and the portfolio value is sh. 5,000,000.
2. The risk free rate is 10% per annum and dividend yield is 4% per annum.
3. The beta of the portfolio is 1.5.
4. A future contract on the MSE share index with four months to maturity is used to
hedge the portfolio value over the next three months where one futures contract is for
delivery of 250 times the index.
Required:
i. The current futures price. (2 mks)
ii. The number of futures contracts needed to be shorted to hedge the portfolio. (2 mks)
APRIL 2022
Q.4.C – Bureti Ltd is a floating rate borrower. It takes out a sh. 20 million one year loan on 1
March. The loan is an interest-only loan requiring quarterly interest payments on the first day
of each corresponding month. 1 June. 1 September, 1 December and 1 March of the
following year and the full principal payment at the end. The interest rate is a 90 day secured
overnight Finance Rate (SOFR) plus 1.5%. Current 90 day SOFR is 6% which sets the rate
for the first three month period at 7.5%. The rates are reset every three months. The firm
manages the risks of rising interest rates over the life of the loan by purchasing an interest
rate cap and offsetting the cost of the cap by selling an interest rate floor. It chooses an
interest rate cap with an exercise rate of 6.25%. The component caplets expire on the rate
reset dates. To generate a floor premium sufficient to offset the cap premium, Bureti Ltd sells
a floor with an exercise rate of 5.25%. Assume there are 360 days in a year.
The SOFR on the following dates is given as follows:
1 June 6.50%
1 September 5.50%
1 December 5.00%
Required:
Determine the effective interest payments. (5 mks)
DECEMBER 2021
Q.2.C – Makao limited decided to venture into the bond market by buying a newly issued
bond 200 days ago. The bond is a 10 year, 8% bond paying interest semi-annually and has a
face value of sh. 1,000. Currently, the bond is selling at sh. 1,146.92.
The first four coupons are paid in 181 days followed by the coupons paid 365 days, 547 days
and 730 days. Makao limited would like to sell the bond 365 days from today. The company
is concerned about locking in the price at which they can sell the bond.
Required:
i. AdviseMakao limited whether it should enter into a long or short forward contract to
lock in the price. (1 mk)
ii. Calculate the non- arbitrage value of contract 180 days after forward contract was
entered into. Assume risk free risk is 6% at the start of contract and 4% 180 days into

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the forward contract. Price of the bond 180 days into forward contract is sh. 1,302.26.
(8 mks)
Q.5.D – NEXT is the Nairobi Securities Exchange (NSE) derivatives market that facilitates
futures trading in the Kenyan market.
Required:
i. Name the two futures products that one can trade in NEXT. (2 mks)
ii. Identify the equity index that that constitute the equity index futures contracts of
NEXT. (1 mk)
SEPTEMBER 2021
Q.1.C – A financial manager is considering hedging against possible decrease in short term
interest rates in the country. He decides to hedge his risk exposure by going short on a
forward rate agreement (FRA) that expires in 90 days based on the 90 day London
interchange offered rate (LIBOR)
The current term structure for the LIBOR is as follows:
Term (days) Interest rate (%)
30 5.83
90 6.00
180 6.14
360 6.51
Required:
i. Identify the type of FRA used by the financial manager. (2 mks)
3 x 6 FRA expires in 90 days and is based on 90-day LIBOR.
ii. The interest rate that the financial manager would receive on the FRA identified in (i)
above.
h = 90
m = 90
h + m= 180
Lo(h) = 0.06
Lo(h + m) = 0.0614

FRA(0,h,m) = 1 + 0.0614)(180/360) - 1 (360/90) = 0.0619 = 6.19%

1+0.06(90/360)
( 3 mks)
iii. It is now 30 days since the financial manager took a short position in the FRA.
Interest rates have shifted down and the new term structure for the LIBOR is as
follows:
Term (days) Interest rate (%)
60 5.50
150 5.62
Calculate:
Calculate the market value of the FRA using a notional principal of sh. 15,000,000. (5 mks)
h = 90
m = 90
g = 30
h – g = 60
h + m – g = 150
L30(h + m – g) = 0.0562
Vt (o,h,m) = 1/1+0.055(60/360) – 1 + 0.0619(90/360) /1+0.0562(150/360)
= -0.001323

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For sh.15,000,000 notional principal, the value of the FRA would be = -0.001323 x
15,000,000 = -sh.19,845. Because the manager is short, this represents a gain to his company.

Q.2.B – Explain the following types of hedging:

i. Carrying charge hedging. (2 mks)
ii. Operational hedging. (2 mks)
iii. Selective hedging. (2 mks)

Carrying charge hedging:

In this case, if the spread (difference between futures and spot price) covers the carry cost
too, then stocks should be bought.

Operational hedging:
According to this approach, future markets are supposed to be more liquid and investors
(hedger) use futures as a substitute for cash market.

Selective / discretionary hedging:

This hedging is done only on selected occasions or when there may be some adverse price
movements in future.

Q.3.C – Martin Orwa, a client of a derivative consulting firm is planning to acquire a

competing firm in 109 days. The acquisition will initially be financed by a sh. 80 million
bridge loan with a term of 180 days at an interest rate of 180 day LIBOR plus 300 basis
points. Principal and interest will be paid at the end of the loan term. Martin is concerned
about a potential increase in interest rates before the initiation of the loan and asks for advice
on fully hedging this interest rate risk.
A derivative analyst at the consulting firm advises Martin to buy an interest rate call option
on 180 day LIBOR with an exercise rate of 2.0% for a premium of sh. 86,000. The call
expires in 109 days and any pay off occurs at the end of the loan term. Current 180 day
LIBOR is 2.2%. The client can finance the call option premium at a current 180 day LIBOR
plus 300 basis point. At initiation of the loan 109 days later, 180 LIBOR is 3.5%.
Required:
The effective annual rate in basis point on the loan (8 mks)
Q.4.D – Samla Investment Limited uses different strategies in management. One of its
popular strategies is to invest when it does not have money but expects to receive it later. The
company expects to receive sh. 6 million at a later date but would like to proceed and take a
position of sh. 3 million in equity and 3 million in bonds. The desired equity Beta is 1.0 and
the desired bond duration is 6.2. A stock index futures contract is priced at sh. 195,000 with a
Beta of 0.97. Bond futures contract goes for sh. 110,000 and it has an implied modified
duration of 6.0.
At expiration share prices goes down by 5% and the stock index futures is down to sh. 185,
737.50. Bonds are up 2% and bonds futures price is up to sh. 112,090.
Required:
i. The profit (loss) using futures contract. (3 mks)
ii. The profit (loss) using direct investment in the actual securities. (2 mks)
iii. Compare your results in (i) and (ii) above. (1 mk)
iv. Explain the term “pre-investing” investment approach. (2 mks)

Pre investing refers to buying contracts in anticipation of cash that will be received. Buying
contracts does not require initial cash flow which makes contracts a natural vehicle for such

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transactions. It is assumed that the account has other assets that can be posted to meet margin
requirements. Because pre-investing is entails hedging a future value amount, it is most
appropriate to refer to it as a synthetic position.

MAY 2021
Q.2.C – An investor has an equity portfolio with a 60% allocation to small – cap stocks and a
40% allocation to large cap stocks. The portfolio is currently valued at sh. 150 million. The
investor wishes to reduce the small cap allocation to 45% and increase the large cap
allocation to 55% for a period of nine months. The large cap Beta is 1.15 and the small cap
Beta is 1.25. A small cap futures contract that expires in nine months is priced at sh. 195,750
and has a beta of 1.12. A large cap futures contract that expires in nine months is priced at sh.
215,750 and has beta of 0.92. both contracts have multipliers of 1. After nine months, the
large cap stocks are up 4.75% and small cap stocks are up 6.25%. The large cap futures price
is sh. 223,762 and the small cap futures price is sh. 206,712.
Required:
i. The market value of the portfolio using futures to adjust the allocation. (8 mks)
ii. Citing two reasons explain why the returns on the futures overlay strategy is not the
same as that of a cash market strategy.
(2 mks)
Q.3.C – A firm has entered into a receive-floating 6 x 9 FRA – forward rate agreement at a
rate of 0.86%. with a notional amount of sh. 10 million LIBOR. The six-month spot shilling
London interbank offered rate (LIBOR) was 0.628% and the nine month shilling LIBOR was
0.712%. The 6 x 9 FRA rate is quoted in the market at 0.86%. After 90 days have passed, the
three month shilling LIBOR is 1.25% and the six month shilling LIBOR is 1.35%.
Required:
Calculate the value of the original receive – floating 6 x 9 FRA after 90 days. (4 mks)
NOVEMBER 2020
Q.4.B – Craft Brewers ltd. Intends to carry out the following transactions in the coming
months:
1. Issue a loan note of 30 million U.S Dollar (USD) in three months (90 days) time. The note
will have a six month (180 days) term. These proceeds will be used to meet the working
capital requirements of the company.
2. Receive new capital injection of 90 million British pounds (GBP). This will occur in eight
months (244 days time)
The company reports in Euros (EUR)
Hassan Ndegwa, the treasury manager decides to hedge the interest rate exposure on the US
borrowing with a forward rate agreement (FRA) and also hedge the conversion of pounds to
euros.
Using the information below, and a 30/360 day count, Hassan Ndegwan calculates the FRA
rates implicit in the term structure. A large investment bank offers Craft Brewers Ltd. a FRA
rate of 4.68% for the USD 30 million note in three months time.
Current term structure of USD LIBOR rates (annualized)
Term (days) Rate (%)
30 3.10
60 3.40
90 3.71
180 3.99
270 4.12
360 4.22
Hassan analyses the GBP per Euro (EUR) exchange rate using the data below:

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Interest rate and exchange rate data:

United Kingdom interest rate 4.17%
Euro interest rate 3.28%
Spot exchange rate (GBP per EUR) 0.6892

244 days interest rate, discrete and annualized.

A year has 365 days.
Required:
i. Calculate the six month FRA rate three months from now, implicit in the current term
structure of USD LIBOR rates. (4 mks)
ii. Using a 180 day spot rate of 4.48% at expiration of the FRA, calculate the pay off to
Craft Brewers Ltd. from the FRA offered by the investment bank. (4 mks)
iii. Calculate the arbitrage free 244 day forward exchange rate (GBP per EUR) (4 mks)
Q.5.D – An asset manager has short equity forward exposure over the Nairobi Securities
Exchange (NSE) index. The forward contract was entered during the past quarter at a forward
price of sh. 2,240.28 and it matures in 127 days .
The following rates and prices are current at the end of the quarter:
 NSE index is at 2,231.72.
 Continuously compounded risk free rate is 4.87% per annum.
 Continuously compounded dividend yield on the index is 3.08% per annum.
Required:
Calculate the end of quarter value of the NSE index equity forward to the asset manager. (4 mks)
Assume the year has 365 days.
MAY 2019
Q.3.C – John Sang is a financial and investments analyst in Telco Traders Limited. He is
concerned about the price changes of a stock that Telco Traders owns. He would also like to
lock in a price at which they can sell the stock in the next 100 days.
The stock currently costs sh. 3,000 and is expected to pay dividends of sh. 40 in 15 days, sh.
40 in 85 days and sh. 50 in 175 days. The annual risk free rate is 5% and the yield curve is
flat.
Assume a 365 – day year.
Required:
i. The appropriate price that John Sang could receive in 100 days using forward contract.(2 mks)
ii. Assume that John Sang enters into a forward contract on the stock to sell it after 100 days,
and after 60 days, the stock value is sh. 3,600. Determine the value of the short position in
a such a forward contract assuming that the risk free rate remains unchanged. (3 mks)

iii. Determine the value of the forward contract assuming that the holder holds a long position
and the stock price is sh. 3,800. (2 mks)
Q.3.D – An asset is priced at sh. 50, the risk free interests rate is 8% and a futures contract on
this asset expires in 45 days. The net overall cost of carry for the underlying asset is sh. 3.55.
assume a 365 – day year.
Required:
Advise an investor whether an arbitrage transaction exists, assuming such futures contract is
trading at sh. 60. (3 mks)
NOVEMBER 2019
Q.1.C – A bank has committed to lend sh. 25 million to a corporate borrower in 30 days. The
loan will mature in 180 days and carries an interest rate of London – Interchange Offered
Rate (LIBOR) plus 150 basis points. The bank is concerned that interest rates will fall and in

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order to lock the lending rate, it decides to short a forward rate agreement (FRA) with an
interest rate of 5.5%.
Required:
The effective rate on the loan assuming 180 day LIBOR in 30 days is 3.25%. (4 mks)
Q.4.A – Assess four interest rate hedging strategies that could be used by a borrower of a
variable interest rate loan. (4 mks)

MAY 2018
Q.1.C – A corporation sold 10 million Euros against a British pound forward at a forward
rate of 0.8000 GBP/Euro at time 0. The current spot rate at time t is 0.7500 GBP/Euro and the
annually compounded risk free rates are 0.80% for the British pound and 0.40% for the Euro.
Assume that at time t, there are three months until the forward contract expiration.
Required:
The value of the foreign exchange forward contract at time t (3 mks)
Q.2.D – A sh. 30 million portfolio consists of sh. 20 million of equity with a beta of 1.15 and
sh. 10 million of bonds with a modified duration of 6.25 and a yield – to – maturity of 7.15%.
The portfolio manager would like to change the allocation to sh. 15 million of equity and sh.
15 million of bond. In addition, the portfolio manager would like to adjust the equity beta to
1.05 and the modified duration on the bonds to 7. Equity index futures contract has a price of
sh. 225,000 and a beta of 1.0. A bond futures contract is priced at sh. 92,000 with an implied
modified duration of 5.9 and an implied yield to maturity of 5.65%.
The portfolio manager intends to use futures to synthetically sell sh. 5 million of equity,
reduce the beta on the remaining equity, synthetically buy sh. 5 million of bond and increase
the modified duration on the remaining bonds. The investment horizon date is three months
after which the equity index future price is expected to be sh. 217,800 and the bond futures
price is expected to be sh. 92,878. The equity portfolio declines by 3% and the bond portfolio
increases by 1% in three months period.
Required:
The overall value of the portfolio in three months period (6 mks)
NOVEMBER 2018
Q.1.B.i – Explain the term “cross – hedging” (2 mks)
This refers to the process of hedging risk using two distinct assets with positively correlated
price movements.
Q.1.B.ii – Argue three cases against hedging. (3 mks)
Cross hedging
A cross hedge is a hedge where characteristics of futures and spot prices do not match
perfectly which is known as mismatch. It may occur due to following reasons:
1) The quantity to be hedged may not be equal to the quantity of futures contract.
2) Features of assets to be hedged are different from the future contract asset.
3) Same futures period (maturity) on a particular asset is not available.
Suppose a wire manufacturer requires copper in the month of June but in exchange the
copper futures trade in long delivery in Jan, March, July, and September. In this case hedging
horizon does not match with the futures delivery date. Suppose that the copper required by
the manufacturer is substandard quality but the available trading is of pure 100% copper and
in quantity aspect too, copper may be traded in different multiples than required actually.
These are examples of cross hedging.
A cross hedging is the hedging where there is a mismatch between future and spot prices,
quantity and time.
Mismatch situations which make the hedge a cross hedge:
1) The hedging horizon (maturity) may not match the futures expiration date.

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2) The quantity to be hedged may not match with the quantity of the futures contract.
3) The physical features of the asset to be hedged may differ from the futures contract
asset.
In general, one cannot expect a cross-hedge to be as effective in reducing risk as a direct
hedge. However, cross hedges are commonly used to reduce the price risk. Now, the question
is which futures contracts are good candidates for a cross hedge. For example, if we want to
hedge a portfolio of silver coins then a silver futures contract will be more effective cross-
hedge rather than a gold futures contract. Thus, if the price of the underlying asset and the
price of correlated asset, one can analyze the nature of hedging. If perfectly correlated, it is
perfect, in closely correlated, it is cross hedge, and if negatively correlated, there will be no
hedging, rather more risk will be added by taking a position in the futures.

MAY 2017
Q.2.C – Andrew Makori is a global equity manager who manages a sh. 95 million large
capitalization United States (US) equity portfolio and he is currently forecasting that equity
markets will decline soon. Andrew prefers to avoid the transactions cost of making sales but
intends to hedge sh. 15 million of the portfolio’s current value using standard and poor (S &
S ) 500 index futures. Andrew realizes that his portfolio will not track the S & P 500 index
exactly. He decides to perform a regression analysis on his actual portfolio returns versus the
S & P futures returns over the past year. This regression analysis will indicate a risk
minimizing beta of 0.88 with a coefficient of determination of (R2 ) of 0.92.
Futures contract data:
S & P 500 futures price Sh. 1,000
S & P 500 index 999
S & P 500 index multiplier 250
Required:
i. The number of futures contracts required to hedge sh. 15 million of the equity
manager’s portfolio.
(3 mks)
ii. Advise Andrew Makori on three alternative methods that he should use to replicate
the futures strategy. (6 mks)
Q.3.A – Explain two uses of index futures. (2 mks)
1) Hedging – Used by the investors looking to hedge their position.
2) Speculation – Used by traders speculating on how the market or the index will move.
Q.3.C – Diamond Financial Services (DFS) offers fixed income portfolio management
services to institutional investors. DFS would like to execute a duration changing strategy for
a sh. 150 million bond portfolio of a particular client. This portfolio has a modified duration
of 8. DFS plans to change the modified duration to 6 by using a futures contract priced at sh.
150,000 which has an implied modified duration of 7. The yield beta is 1.5. after one year,
the yield on the bond has decreased by 30 basis points. The bond portfolio increases in value
by 1.5% and the futures price increases to sh. 152,000.
Required:
The overall gain on the portfolio (3 mks)
Q.3.E – Melly Odhiambo, a corporate treasurer at Suneka Ltd. needs to hedge the risk of the
interest rate on a future transaction. The risk is associated with the rate on the 180 – day
London Inter-bank Offer rate (LIBOR) in 30 days. The relevant term structure of LIBOR is
given as follows:
30 day LIBOR 5.75%
210 day LIBOR 6.15%

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20 days later, interest rates are expected to move significantly downward to the following:
10 day LIBOR 5.45%
190 day LIBOR 5.95%
On the expiration day, 180 day LIBOR is expected to be 5.72%. Melly Odhiambo decides to
long this forward rate agreement (FRA) for a notional principal of sh. 20 million.
Required:
i. Compute the market value of the FRA, 20 days later. (2 mks)
ii. Calculate the payment to be made to or by the company so as to settle the FRA
contract on its expiration. (2 mks)
Q.5.A – Kansanga Ltd. a Ugandan company exports products to Kenya. Kansanga Ltd. has
just closed a sale worth Kenya shillings (KES) 200,000,000. The amount will be received in
two months. Since it will be paid in KES, the Ugandan company bears the exchange rate risk.
In order to hedge this risk, Kansanga Ltd. intends to use a forward contract that is priced at
Ugandan shillings (UGX)
1 KES = 28.544 UGX
Required:
i. Illustrate how the company would go about constructing the hedge. (3 mks)
ii. Explain what happens when the forward contract expires in two months. (1 mk)
DECEMBER 2017
Q.2.D – Susan Cheptoo is an investor who seeks to arbitrage pricing discrepancies in the
market over the next six months. She has observed the following data in the market:
Investment Spot price Futures price for Income from Finance charge
(sh) contract expiring in Treasury Note for six months
six months (sh) for six months (sh)
(sh)
Treasury Note 101 100 (invoice price) 4.50 2.50
deliverable on
the futures
contract
Required:
i. Describe the process that Cheptoo would follow to carry out the arbitrage transaction.
(3 mks)
ii. Calculate the arbitrage profit, if any, that is available to exploit a possible pricing
discrepancy. (3 mks)
MAY 2016
Q.1.C – Fredrick Oloo offers fixed income portfolio management services to institutional
investors. He would like to execute a duration changing strategy for a sh. 100 million bond
portfolio for a particular client. This portfolio has a modified duration of 7.2. Fredrick plans
to change the modified duration of the portfolio to 5.0 by using a futures contract priced at sh.
120,000 which has an implied modified duration of 6.25 and a yield beta of 1.15.
Required:
i. Determine the number of futures contracts that Fredrick Oloo should sell. (2 mks)
ii. Suppose that the yield on the bond has decreased by 20 basis points at the horizon date, the
bond portfolio has increased in value by 1.5% and the futures price has increased to sh.
121,200.
Determine the overall gain on the portfolio and the ex-post modified duration as a result of
the futures transaction. (4 mks)
Q.3.D – An airline expects to purchase 2 million barrels of jet fuel in 1 month and decides to
use heating oil futures for hedging.

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The table below gives the data on the change in the jet fuel prices per barrel and the
corresponding change in the futures price for the contract on heating oil that would be used
for hedging price changes during the month:
Month Change in futures price per barrel (X1) Change in fuel price per barrel (Y1)
1 0.021 0.029
2 0.035 0.020
3 -0.046 -0.044
4 0.001 0.008
5 0.044 0.026
6 -0.029 -0.019
7 -0.026 -0.010
8 -0.029 -0.07
9 0.048 0.043
10 -0.06 0.011
11 -0.036 -0.036
12 -0.011 -0.018
13 0.019 0.009
14 -0.027 0.032
15 0.029 0.032
The summarized calculations are as follows:
∑x1 = - 0.013
∑y1 = 0.003
∑x12 = 0.0138
∑y1 2 = 0.097
Each heating oil contract traded has 42,000 barrels heating oil.
Required:
The optimal number of contracts required for hedging. (8 mks)
Q.5.C – TSST Ltd. plans to borrow sh. 10 million in 30 days at 90 day LIBOR plus 100 basis
points. To lock in a borrowing rate at 7%, TSST Ltd. purchases a forward rate agreement
(FRA) at a rate of 6%. 30 days later, LIBOR is 7.5%.
Required:
Demonstrate that TSST Ltd’s effective borrowing rate is 7% if LIBOR in 30 days is 7.5%. (4 mks)
NOVEMBER 2016
Q.3.B – Argue three cases against hedging in the derivatives markets. (3 mks)
Q.3.C – The board of directors of Palex Ltd. is concerned about the down side risk of a sh.
100 million equity portfolio in its pension plan. The board’s consultant has proposed hedging
the equity portfolio with either futures or options in a temporary period of one month.

Required:
Using the following factors, describe how the use of futures differ from the use of the options
when hedging a portfolio’s equity exposure:
i. Initial cost. (2 mks)
ii. Effect of implied volatility in pricing. (2 mks)
iii. Sensitivity to movement in the value of the underlying. (2 mks)
iv. Risk exposure. (2 mks)
Q.4.D – The spot price of corn is sh. 3.50 and it costs sh. 0.017 to store a bushel of corn for a
1 month while the relevant cost of financing is 1% per month. The corn futures contract
matures in 6 months and the current futures price for this contract is sh. 3.95 per bushel. The
storage cost is paid at the onset of the transaction. There are 5,000 bushels per contract.
Required:

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The arbitrage profit from the transaction (5 mks)

Q.5.A – Assess three types of margins that an investor participating in a futures exchange
could assess. (6 mks)
1) Initial margin
2) Maintenance margin
3) Variation margin

Initial margin – This is the amount that must be deposited in the margin account at the time a
futures contract is first entered into.
Maintenance margin - This is set aside so as to ensure that the balance in the margin
account never falls to a negative.

Q.5.B – Boaz Miriti manages the family investment portfolio which initially consisted of sh.
46 million of equities and sh. 32 million of bonds. As a result of a change in family
circumstances, the portfolio is rebalanced using the transaction shown below:
Type of futures contract Action Number of futures contract to Price per futures
buy or sell contract (sh)
Equity futures contract Buy 42 160,000
Bond futures contract Sell 35 190,000
Three months after the above transactions, the market value of the family portfolio’s equities
has increased by 300% and the market value of its bonds has increased by 240%. The prices
of the equity futures contract and bond futures contract are now sh. 165,000 and sh. 185,250
respectively.
Required:
The profit or loss of the family investment portfolio over the past three months (4 mks)
NOVEMBER 2015
Q.2.A – Explain two arrangements that could be used to settle the obligations of the parties to
a forward contract when it expires. (4 mks)
1) Delivery.
2) Cash settlement.
Q.2.C – Baimunge Mugenda is a Kenyan- based importer of machinery from Britain. He
expects the value of the Sterling pound to appreciate against the Kenyan Shilling (Ksh) over
the next 30 days. He will be making payment on a shipment of imported machinery in 30
days and intends to hedge the currency exposure. The Kenyan risk-free rate is 16.5 per cent
and the United Kingdom risk-free rate is 5.0 per cent. These rates are expected to remain
constant in the next 30 days.
The current spot rate is Ksh. 150 per Sterling Pound.
Required:
i. Justify whether BaimungeMugenda should use a long or a short contract to hedge
against the currency risk. (2 mks)
ii. The no – arbitrage price at which BaimungeMugenda should enter into for a forward
contract that expires in 30 days. (4 mks)
Assume a 345day year.
iii. Compute the value of BaimungeMugenda’s forward position if he moves forward 10
days and the spot rate changes to Ksh. 153 per Sterling Pound while the interest rates
remain constant. (4 mks)
SEPTEMBER 2015
Q.4.A – The Dennevax Company Ltd. is an import – export company based in Kenya.
On 1 May 2015, the company exported coffee to South Africa on two months credit
amounting to South African Rands (SAR) 14,000,000.

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Additional information:
1. The rates in the forex and money markets were as follows:

Ksh/1 SAR
1 May 2015 8.45
1 July 2015 8.40
Interest rates
Kenya 21% per annum
South Africa 9% per annum

2. In the forex market, the SAR was quoted forward at an annual premium of 27%.
3. The customer settled the amount due on 1 July 2015.
Required:
i. The expected two month forward exchange rate as at 1 July 2015. (2 mks)
ii. Advise the Dennevax Company Ltd. on the better hedging strategy between forward
contract and money market hedges. (6 mks)
Q.5.D – A medium sized manufacturing company in South Africa is tendering for an order in
Kuwait. The tender conditions state that payment will be made in Kuwait dinars 18 months
from now. The company is unsure as to what price to tender. The company’s marginal cost of
production at the time of tendering is estimated to be SA rand 1 million and a 25% mark up is
normal for the company.
Exchange rates:
Dinars / 1 SAR
Spot 5.467 – 5.5.3
No forward rate exists for 18 months period.
South Africa Kuwait
Annual inflation rate 9% 3%
Annual interest rates available
to the manufacturing company:
Borrowing 14% 9%
Lending 9% 3.5%
Required:
a) Explain how the manufacturing company might protect itself against foreign
exchange rates changes.
(8 mks)
b) Recommend the tender price that should be used. (6 mks)

FATIMA TRAINING INSTITUTE – MOCKS

QUESTION 1
ABC Limited plans to borrow $10 million in 30 days at 90-day LIBOR plus 100 basis points.
To lock in a borrowing rate of 7 percent, it purchases an FRA at a rate of 6 percent. This
contract would be referred to as a 1 x 4 FRA because it expires in one month (30 days) and
the underlying Eurodollar matures four months (120 days) from now. Thirty days later,
LIBOR is 7.5 percent. Demonstrate that ABC Limited effective borrowing rate is 7 percent if
LIBOR in 30 days is 7.5 percent.

Solution
If LIBOR is 7.5 percent at the expiration of the FRA in 30 days, the payoff of the
FRA is:

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(Underlying rate at expiration – forward contract rate) x (days in underlying rate / 360)
1 + underlying rate (days in underlying rate) / 360
= 10,000,000 (0.075 – 0.06) (90/360)
1 + 0.075(90/360)
= $ 36,810
Because this amount is a cash inflow, ABC will not need to borrow a full $10,000,000.
Instead, it will borrow $10,000,000 - $36,8 10 = $9,963,190.
The amount it will pay back in 90 days is:
9963190(1 + (0.075 + 0.01) (90/360) = $10,174,908.
($10,174,908 / $10,000,000 ) – 1 (360/90) = 0.07
ABC borrows at LIBOR plus 100 basis points. Therefore, using an FRA, it should be able to
lock in the FRA rate (6 percent) plus 100 basis points, which it does.

QUESTION 2
Debt Management Associates (DMA) offers fixed-income portfolio management services to
institutional investors. It would like to execute a duration-changing strategy for a €100
million bond portfolio of a particular client. This portfolio has a modified duration of 7.2.
DMA plans to change the modified duration to 5.00 by using a futures contract priced at
€120,000, which has an implied modified duration of 6.25. The yield beta is 1.15.
Required:
1) Determine how many futures contracts DMA should use and whether it should buy or
sell futures.
2) Suppose that the yield on the bond has decreased by 20 basis points at the horizon
date. The bond portfolio increases in value by 1.5 percent. The futures price increases
to €121,200. Determine the overall gain on the portfolio and the ex post modified
duration as a result of the futures transaction.
Solution
Part one
The appropriate number of futures contracts is:
NF = (5 – 7.2 / 6.25) (100,000,000 / 120,000) 1.5 = - 337.33
So DMA should sell 337 contracts.
Part two
The value of the bond portfolio will be € 100,000,000(1.015) = € 101,500,000. The profit on
the futures transaction is -337(€121,200 - 120,000) = -€404,400; a loss of €404,400. Thus,
the overall value of the position is €101,500,000 - €404,400 = €101,095,600, a return of
approximately 1.1 percent. The bond yield decreases by 20 basis points and the portfolio
gains 1.1 percent. The ex post modified duration would be 0.01 1010.0020 = 5.50.
QUESTION 3
Equity Analysts Inc. (EQA) is an equity portfolio management firm. One of its clients has
decided to be more aggressive for a short period of time. It would like EQA to move the beta
on its $65 million portfolio from 0.85 to 1.05. EQA can use a futures contract priced at
$188,500, which has a beta of 0.92, to implement this change in risk.
Required:
1) Determine the number of futures contracts EQA should use and whether it should buy
or sell futures.
2) At the horizon date, the equity market is down 2 percent. The stock portfolio falls
1.65 percent, and the futures price falls to $185,000. Determine the overall value of
the position and the effective beta.
Solution
The number of futures contracts EQA should use is:

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NF = (1.05 – 0.85 / 0.92) (6,500,000 / 188,500) = 74.96

So EQA should buy 75 contracts.

Part two
The value of the stock portfolio will be $65,000,000(1 - 0.0165) = $63,927,500.
The profit on the futures transaction is 75($185,000 - $188,500) = -$262,500.
The overall value of the position is $63,927,500 - $262,500 = $63,665,000.
Thus, the overall return is:
($63,665,000 / $65,000,000) – 1 = - 0.0205
Because the market went down by 2 percent, the effective beta is 0.0205/0.02 = 1.025.

QUESTION 4
Elliot company plans to borrow $50,000,000 in 25 days. The loan will have a maturity of 270
days and carry a rate of LIBOR plus 125 basis points. The company is concerned that interest
rates will rise, so in order to lock in the borrowing rate, it decides to purchase an FRA at a
rate of 6.75 percent.
Required:
Demonstrate that the effective cost of the loan is approximately 8 percent if 270-day LIBOR
in 25 days is 8.25 percent.
Solution
The payoff on the FRA 25 days later, with 270-day LlBOR at 8.25 percent, is:
$50m [(0.0825 – 0.0675) (270/360)]
1 + 0.0825(270/360)
= $ 529,723
This payoff reduces the amount that has to be borrowed. The amount borrowed is
$50,000,000 - $529,723 = $49,470,277. In 270 days, Elliot company will repay principal and
interest in the amount of:
$49,470,277 (1 + (0.0825 + 0.0125) (270/360) = $ 52,995,034.
The effective rate is, therefore, ($52,995,034 / $50,000,000) – 1 (360/270) = 0.799.
This rate is approximately the FRA rate plus 125 basis points, or 0.0675 + 0.0125 = 0.08.

QUESTION 5
A fixed income money manager has a bond portfolio with a 70 percent allocation to long-
term bonds and a 30 percent allocation to short-term bonds. The portfolio is currently valued
at $75 million. The manager wishes to reduce the long-term bonds allocation to 55 percent
and increase the short-term bonds allocation to 45 percent for a period of three months. The
modified duration of the long-term bonds is 7.5 and of the short-term bonds is 4.5. A bond
futures contract that expires in three months is priced at $95,750 and has a modified duration
of 6.25. Assume that the modified duration of cash equivalents is 0.25. Also assume that
interest rates that drive long-term and short-term bond prices have a yield beta of 1 with
respect to interest rates that drive the bond futures market.
Required:
1) Show how the manager can achieve his goals by using bond futures. Indicate the
number of contracts and whether the manager should go long or short.
2) After three months, the short-term bonds are down 5.63 percent and long-term bonds
are down 9.38 percent. The bond futures price is $88,270. Compare the market value
of the portfolio using futures to adjust the allocation with the market value of the
same portfolio using direct bond trading to adjust the allocation.
Solution
Part one

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The current allocation is as follows: long-term bonds, 0.70($75 million) = $52.5 million;
short-term bonds, 0.30($75 million) = $22.5 million. The desired allocation is as follows:
long-term bonds, 0.55($75 million) = $41.25 million; short term bonds, 0.45($75 million)
= $33.75 million. So to achieve the desired allocation, the manager must use futures to
synthetically buy $33.75 million - $22.5 million = $1 1.25 million of short-term bonds, with
proceeds from the synthetic sale of an equal amount of long-term bonds.
To synthetically sell $11.25 million in long-term bonds and convert into cash, the manager
must sell futures:
Nf = (0.25 – 7.5 / 6.25) (11,250,000 / 95,750) = - 136.29
He should sell 136 contracts and create synthetic cash.
To synthetically buy $11.25 million of short-term bonds with synthetic cash, the manager
must buy futures:
Nf = (4.5 – 0.25 / 6.25) (11,250,000 / 95,750) = 79.89
He should buy 80 contracts. This nets out to 136 - 80 = 56 contracts.
Now the manager effectively has $41.25 million (55 percent) in long-term bonds and $33.75
million (45 percent) in short-term bonds.

Part two
The value of long-term bonds will be $52,500,000(1 - 0.0938) = $47,575,500.
The value of short-term bonds will be $22,500,000(1 - 0.0563) = $21,233,250.
The profit on the bond futures will be (-136 + 80)($88,270 - $95,750) = $418,880.
The total value of the position with futures, therefore, is $47,575,500 + $21,233,250 +
$418,880 = $69,227,630.
If the reallocation were carried out by trading long-term and short-term bonds:
The long-term bonds would be worth $41,250,000(1 - 0.0938) = $37,380,750.
The short-term bonds would be worth $33,750,000(1 - 0.0563) = $31,849,875.
The overall value of the portfolio would be $37,380,750 + $31,849,875 = $69,230,625.
The difference between the two approaches is $2,995, only 0.004 percent of the original
value of the portfolio.

QUESTION 6
A portfolio manager has an equity portfolio with a 60 percent allocation to small-cap stocks
and a 40 percent allocation to large-cap stocks. The portfolio is currently valued at $150
million. The manager wishes to reduce the small-cap allocation to 45 percent and increase the
large-cap allocation to 55 percent for a period of nine months. The large-cap beta is 1.15, and
the small-cap beta is 1.25. A small-cap futures contract that expires in nine months is priced
at $195,750 and has a beta of 1.12. A large-cap futures contract that expires in nine months is
priced at $215,570 and has a beta of 0.92.
Assume that both contracts have multipliers of 1.
Required:
A. Show how the manager can achieve the reallocation using stock index futures.
Indicate the number of contracts and whether the manager should go long or short.
B. After nine months, the large-cap stocks are up 4.75 percent and small-cap stocks are up
6.25 percent. The large-cap futures price is $223,762, and the small-cap futures price is
$206,712. Compare the market value of the portfolio using futures to adjust the allocation
with the market value of the same portfolio using direct stock trading to adjust the allocation.
Solution
Part one
The current allocation is as follows: small-cap stocks, 0.60($150 million) = $90 million;
large-cap stocks, 0.40($l50 million) = $60 million. The desired allocation is as follows:

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small-cap stocks, 0.45($150 million) = $67.5 million; large-cap stocks, 0.55($150 million) =
$82.5 million. So, to achieve the desired allocation, the manager must use futures to
synthetically buy $82.5 million - $60 million = $22.5 million of large-cap stocks, with
proceeds from the synthetic sale of an equal amount of small-cap stocks. To synthetically sell
$22.5 million in small-cap stocks and convert into cash, the manager must sell the following
number of futures contracts on small-cap stock:
Nf = (0 – 1.25 / 1.12) (22,500,000 / 195,750) = - 128.28
He should sell 128 contracts and create synthetic cash.
To synthetically buy $22.5 million of large-cap stock with synthetic cash, the manager must
buy the following number of futures on large-cap stock:
Nf = (1.15 – 0 / 0.92) (22,500,000 / 215,570) = 130.47
He should buy 130 contracts.
Now the manager effectively has $67.5 million (45 percent) in small-cap stocks and $82.5
million (55 percent) in large-cap stocks.

Part two
The value of large-cap stocks will be $60,000,000(1 + 0.0475) = $62,850,000.
The value of small-cap stocks will be $90,000,000(1 + 0.0625) = $95,625,000.
The profit on the large-cap futures will be 130($223,762 - $215,570) = $1,064,960.
The profit on the small-cap futures will be -128($206,712 - $195,750) = -$1,403,136.
The total value of the position with futures, therefore, is $62,850,000 + $95,625,000 +
$1,064,960 - $1,403,136 = $158,136,824.
If the reallocation were carried out by trading large-cap and small-cap stocks:
The large-cap stocks would be worth $82,500,000(1 + 0.0475) = $86,418,750.
The small-cap stocks would be worth $67,500,000(1 + 0.0625) = $71,718,750.
The overall value of the portfolio would be $86,418,750 + $71,718,750 = $158,137,500.
The difference between the two approaches is $676, or only 0.0005 percent of the original
value of the portfolio.

QUESTION 7
Consider a portfolio with a 65 percent allocation to stocks and 35 percent to bonds.
The portfolio has a market value of $750 million. The beta of the stock position is 1.20, and
the modified duration of the bond position is 7.65. The portfolio manager wishes to decrease
the stock allocation to 45 percent and increase the bond allocation to 55 percent for a period
of six months. Assume that the modified duration of cash equivalents is 0.25. The portfolio
manager intends to use a stock index futures contract, which is priced at $272,500 and has a
beta of 0.90, and a bond futures contract, which is priced at $139,120 and has an implied
modified duration of 5.35. The stock futures contract has a multiplier of 1.
Required
1) Show how the portfolio manager can achieve her goals by using stock index and bond
futures. Indicate the number of contracts and whether the manager should go long or
short.
2) After six months, the stock portfolio is down 5 percent and bonds are down 1.75
percent. The stock futures price is $262,280, and the bond futures price is $137,420.
Compare the market value of the portfolio using futures to adjust the allocation with
the market value of the same portfolio using direct stock and bond trading to adjust
the allocation.
Solution
Part one

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The current allocation is as follows: stocks, 0.65($750 million) = $487.5 million; bonds,
0.35($750 million) = $262.5 million. The new allocation desired is as follows: stocks,
0.45($750 million) = $337.5 million; bonds, 0.55($750 million) = $412.5 million. So, to
achieve the new allocation, the manager must use futures to synthetically buy $412.5 million
- $262.5 million = $150 million of bonds with proceeds from the synthetic sale of $150
million of stock. To synthetically sell $150 million in stock and convert into cash, the
manager must sell the following number of futures on stock:
Nf = (0 – 1.20 / 0.90) (150,000,000 / 272,500) = - 733.94
She should sell 734 contracts and create synthetic cash.
To synthetically buy $150 million of bonds with synthetic cash, the manager must buy the
following number of futures on bonds:
Nf = (7.65 – 0.25 / 5.35) (150,000,000 / 139,120) = 1491.35
She should buy 1,49 1 contracts.
Now the manager effectively has $337.5 million (45 percent) in stock and $412.5 million (55
percent) in bonds.

Part two
The value of the stock will be $487,500,000(1 - 0.05) = $463,125,000.
The profit on the stock index futures will be -734($262,280 - $272,500) = $7,501,480.
The value of the bonds will be $262,500,000(1 - 0.0175) = $257,906,250.
The profit on the bond futures will be 1,491($137,420 - $139,120) = -$2,534,700.
The total value of the position with futures, therefore, is $463,125,000 + $7,501,480 +
$257,906,250 - $2,534,700 = $725,998,030.
If the reallocation were carried out by trading bonds and stocks:
The stock would be worth $337,500,000(1 - 0.05) = $320,625,000.
The bonds would be worth $412,500,000(1 - 0.0175) = $405,281,250.
The overall value of the portfolio would be $320,625,000 + $405,281,250 = $725,906,250.
The difference between the two approaches is $91,780, only 0.012 percent of the original
value of the portfolio.

QUESTION 8
Consider a U.S. asset management firm that wishes to allocate €50,000,000 to the French
stock market. This portfolio has a beta of 0.95. The spot exchange rate is $0.8823 per euro.
The foreign interest rate is 5.75 percent a year, and the domestic interest rate is 6.45 percent a
year. A one-year forward contract on the euro is priced at $0.8881. A stock index futures
contract on the CAC 40 (French stock index) is priced at €46,390, with the multiplier taken
into account. The stock index futures contract has a beta of 1.05.
Required:
A. Would the asset manager take a long or short position to hedge the equity market risk?
Calculate the number of contracts needed.
B. Suppose the firm also wished to hedge the currency risk using a forward contract on the
euro. What should be the notional principal of the forward contract?
C. Assume that at the end of one year, the French market is up by 8 percent. The exchange
rate is $0.8765 per euro, and the futures price is €47,550. Calculate the return if
i. the portfolio is unhedged.
ii. only the equity position is hedged.
iii. both equity and currency risks are hedged.

Solution
Part one

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In order to hedge against a decline in the French equity market, the manager must take a short
position in the equity futures contract. The number of contracts to be sold is:
Nf = (0 – 0.95 / 1.05) (50,000,000 / 46,390) = - 975.17
Rounded, 975 contracts would be sold.

Part two
In order to hedge the currency risk, the manager would have to enter into a forward contract
to sell euros one year from now. If the equity position were fully hedged, then the portfolio
would earn the foreign risk-free rate of 5.75 percent. The portfolio would be worth
€50,000,000(1.0575) = €52,875,000. Therefore, the notional principal on the forward contract
should be €52,875,000.

Part three
The French equity market went up by 8 percent during the year. The portfolio is thus worth
€50,000,000(1 + 0.08) = €54,000,000. Because the exchange rate at the end of one year is
$0.8765 per euro, the dollar value of the portfolio is €54,000,000($0.8765/€) = $47,33 1,000.
The initial dollar value of the portfolio was €50,000,000($0.8823/€) = $44,115,000.
i. The return on the unhedged portfolio is : (47,331,000 / 44,115,000) – 1 = 0.0729
ii. If only equity market risk is hedged, the return is calculated as follows:
Foreign currency (euro) value of the portfolio = €54,000,000.
Profit on stock index futures = -975(€47,550 - €46,390) = -€1,131,000.
Total value of position = €54,000,000 - € 1,13 1,000 = € 52,869,000.
The dollar value of the position is €52,869,000($0.8765/€) = $46,339,679.
The return is ($46,339,679 / $44,115,000) – 1 = 0.0504
iii. If both currency risk and equity risk are hedged, the return is calculated as follows:
The value of the equity portfolio and the stock index futures one year later is €52,869,000,
which is $46,339,679. The amount of foreign currency shorted is €52,875,000.
The profit on the currency forward is -€52,875,000($0.8765/€ - $0.8881/€) = $613,350.
So the total value of the position is $613,350 + $46,339,679 = $46,953,029.

The return is ($46,953,029 / $44,115,00) – 1 = 0.0643

Therefore, if both equity and currency risk are hedged, the return is approximately the same
as the domestic risk-free rate of 6.45 percent.

QUESTION 9
A bank has committed to lend $25,000,000 to a corporate borrower in 30 days. The loan will
mature in 180 days and carries a rate of LIBOR plus 150 basis points. The bank is concerned
that interest rates will fall, and in order to lock in the lending rate, it decides to short an FRA
with a rate of 5.5 percent. Determine the effective rate on the loan if 180-day LIBOR in 30
days is 3.25 percent.
Solution
The payoff on the short FRA position 30 days later, with 180-day LIBOR at 3.25 percent, is:
$25,000,000 [ (0.0325 – 0.055) (180/360)
1 + 0.0325(180/360)
-$ 276,752
Because this position is short, it represents a gain of $276,752 to the bank.
The bank lends $25,000,000. In 180 days, the bank will receive principal and interest in the
amount of $25m (1 + (0.0325 + 0.015) (180/360) = $ 25,593,750.

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Because the bank had a $276,752 gain on the short FRA position, the effective amount
loaned by the bank is $25,000,000 - $276,752 = $24,723,248. The effective interest rate on
the loan, therefore, is: ($25,593,750 / $24,723,247) – 1 (360/180) = 0.0704.
This rate is approximately the FRA rate plus 150 basis points, or 0.055 + 0.015 = 0.07.

QUESTION 10
A $500 million bond portfolio currently has a modified duration of 12.5. The portfolio
manager wishes to reduce the modified duration of the bond portfolio to 8.0 by using a
futures contract priced at $105,250. The futures contract has an implied modified duration of
9.25. The portfolio manager has estimated that the yield on the bond portfolio is about 8
percent more volatile than the implied yield on the futures contract.
Required
1) Indicate whether the portfolio manager should enter a short or long futures position.
2) Calculate the number of contracts needed to change the duration of the bond portfolio.
3) Assume that on the horizon date, the yield on the bond portfolio has declined by 50
basis points and the portfolio value has increased by $31,343,750. The implied yield
on futures has decreased by 46 basis points, and the futures contract is priced at
$109,742. Calculate the overall gain on the position (bond plus futures). Determine
the ex post duration with and without the futures transaction.
Solution
Part one
In order to reduce duration, the portfolio manager will have to sell futures contracts (i.e., a
short futures position).
Part two
The number of futures contracts that must be traded is:
Nf = (8 – 12.5 / 9.25) ($5,000,000 / 105,250) 1.08 = - 2,495.99
Rounded off, this is -2,496 contracts.
Part three
The loss on the short futures position is -2,496($109,742 - $105,250) = -$11,212,032.
The overall gain on the position is $31,343,750 - $1 1,212,032 = $20,131,718.
The return with futures is $20,13 1,7 18/$500,000,000 = 4.026 percent.
The ex post duration with futures is 0.04026/0.005 = 8.05, which is close to the target
duration of 8.0.
The return without futures is $31,343,750/$500,000,000 = 6.267 percent.
The ex post duration without futures is 0.0626710.005 = 12.54.

NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this
by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

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CHAPTER FIVE

SWAP MARKETS AND CONTRACTS

PAGE
5.1 Introduction: ………………………………………………………………………
Definition of Swap contracts, Types of swaps: currency swaps; interest rate swaps; equity
swaps; commodity and other types of swaps
5.2 Characteristics of swap contracts………………………………………………….
5.3 The structure of global swap markets……………………………………………..
5.4 Pricing and valuation of swaps; pricing and valuation of swaps………………….
5.5 Swaptions: basic characteristics of swaptions; uses of swaptions; swaption payoffs;
pricing and valuation of swaptions…………………………………………………….
5.6 Termination of a swap……………………………………………………………..
5.7 Forward swaps…………………………………………………………………….
5.8 The role of swap markets………………………………………………………….
5.9 Uses of Swap Contracts: Credit risks and swaps………………………………….
Revision questions – 2015 – 2023……………………………………………………………

KEY TOPIC ISSUES

EXAMPLE
Two parties entered into a 2-year fixed-for-floating interest rate swap with semi-annual
payments. The floating-rate payments are based on LIBOR. The 180-, 360-, 540-, and 720-
day annualized LIBOR rates and present value factors are as given below:

Rate Present value factors

180-day LIBOR 5.0% 0.9756
360-day LIBOR 6.0% 0.9434
540-day LIBOR 6.5% 0 .9112
720-day LIBOR 7.0% 0.8772

After 180 days, the swap is marked-to-market when the 180-, 360-, and 540-day annualized
LIBOR rates are 4.5%, 5%, and 6%, respectively. The present value factors, respectively, are
0.9780, 0.9524, and 0.9174. What is the market value of the swap per $ 1 notional principal,
and which of the two counterparties (the fixed-rate payer or the fixed-rate receiver) would
make the payment to mark the swap to market.

L180 (180) = 0.9780

L180 (360) = 0.9524
L180 (540) = 0.9174

Required:
1) Swap rate / semi-annual swap rate.
2) Value of fixed rate side.

Solution

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Semi-annual swap rate = 1 – 0.8772

0.9756 + 0.9434 + 0.9112 + 0.8772

= 0.0331

Swap rate = 0.0331 x 360/180 = 0.0662 = 6.62%

Value of fixed rate side = 0.0331 x (0.9780 + 0.9524 + 0.9174) + (1 x 0.9174) = $ 1.01166
The market value of the floating-rate side is $ 1 .0000 because we're at a payment date.
The market value of the swap per $ of notional principal to the receiver-fixed (and pay
floating) side is $ 1 .01 166 - $ 1 .0000 = $0.01166. As the swap is marked to market, the
pay-fixed swap holder makes a payment of $0.0 1166 to the receive-fixed holder for each $ 1
of notional principal.

Example
A bank entered into a $5,000,000, 1-year equity swap with quarterly payments 300 days ago.
The bank agreed to pay an annual fixed rate of 4% and receive the return on an international
equity index. The index was trading at 3,000 at the end of the third quarter, 30 days ago. The
current 60-day LIB OR rate is 3.6%, the discount factor is 0.9940, and the index is now at
3,150.
Required:
The value of the swap to the bank

Solution
Value of fixed-rate side = 0.9940 x $5,050, 000 = $5,019, 700
Value of index return side = 5,000,000 x 3150/3000 = sh. 5,250,000
Value of swap to bank = 5,250,000 – 5,019,700 = sh. 230,300

A receiver swaption is the right to enter into a specific swap at some date in the future as the
fixed-rate receiver (i.e., the floating-rate payer) at a rate specified in the swaption.
If swap fixed rates increase (as interest rates increase), the right to enter the pay-floating side
of a swap (a receiver swaption) becomes less valuable.
A payer swaption is the right to enter into a specific swap at some date in the future as the
fixed-rate payer at a rate specified in the swaption. If swap fixed rates increase (as interest
rates increase), the right to enter the pay-fixed side of a swap (a payer swaption) becomes
more valuable.

REVISION QUESTIONS

DECEMBER 2023
Q.3.A – Explain three uses of a swaption. (6 mks)
A swaption is an option to enter into a swap.
1) Swaptions are used by parties who anticipate the need for a swap at a later date but would
like to establish the fixed rate today, while providing the flexibility to not engage in the
swap later or engage in the swap at a more favorable rate in the market. These parties are
often corporations that expect to need a swap later and would like to hedge against
unfavorable interest rate moves while preserving the flexibility to gain from favorable
moves.
2) Swaptions are used by parties entering into a swap to give them the flexibility to terminate
the swap.

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3) Swaptions are used by parties to speculate on interest rates. As with any interest rate
sensitive instrument, swaptions can be used to speculate. Their prices move with interest
rates and, like all options, they contain significant leverage. Thus, they are appropriate
instruments for interest rate speculators.
The two types of swaptions are a payer swaption and a receiver swaption. A payer
swaption allows the holder to enter into a swap as the fixed-rate payer and floating-rate
receiver.
A receiver swaption allows the holder to enter into a swap as the fixed-rate receiver and
floating-rate payer. Therefore, these terms refer to the fixed rate and are comparable to the
terms call and put used for other types of options. Although it is not apparent at this point, a
payer swaption is a put and a receiver swaption is a call.
A swaption, also known as a swap option, refers to an option to enter into an interest
rate swap or some other type of swap. In exchange for an options premium, the buyer gains
the right but not the obligation to enter into a specified swap agreement with the issuer on a
specified future date.
Swaptions come in two main types: a payer swaption and a receiver swaption. In a payer
swaption, the purchaser has the right but not the obligation to enter into a swap contract
where they become the fixed-rate payer and the floating-rate receiver. A receiver swaption is
the opposite i.e. the purchaser has the option to enter into a swap contract where they will
receive the fixed rate and pay the floating rate.
The holder of a swaption has the option to enter into a swap in the future. Swaptions can be
European-style, American-style, or Bermudan-style. The holder of a European-style swaption
can enter into the swap only on a specified date (the expiration date of the swaption). The
holder of an American style swaption can enter into the swap at any time prior to the
expiration date of the swaption. The holder of a Bermudan-style swaption can enter into the
swap only on specific dates prior to the expiration date of the swaption. In the jargon of the
swaps market, a payer swaption gives the holder the right to enter into a swap as the fixed-
rate payer. A receiver swaption gives the holder the right to enter into a swap as the fixed-rate
receiver.

USES OF SWAPTION
There are three primary uses of swaptions/swaps:
1) Lock in fixed rate - If an investor anticipates a floating-rate exposure at some future date
(e.g., he will be issuing bonds or getting a loan), a payer swaption would “lock in” a fixed
rate and provide floating-rate payments for the loan. It would be exercised if the yield
curve shifted up to give the investor (effectively) a loan at the fixed rate on the swaption.
2) Interest rate speculation - Swaptions can be used to speculate on changes in interest
rates. The investor would buy a payer swaption if he expects rate to rise, or buy a receiver
swaption if he expects rates to fall.
3) Swap termination -Swaptions can be used to terminate a swap. A fixed-rate payer on a 5-
year swap could buy a 2x5 receiver swaption (at the same fixed rate as the swap).
AUGUST 2023
Q.1.B – Distinguish between a “credit default swap” (CDS) and a “credit linked swap”
(CLS) (2 mks)
A credit swap is a privately negotiated, over-the-counter derivative to transfer credit risk from
one counterparty to another. The payoff of a credit swap is linked to the credit characteristics
of an underlying reference asset, also called a reference credit. Credits swaps enable financial
institutions and corporations to manage credit risks. The market for credit swaps is small
relative to other types of swaps. Surveys of the market by several sources show the size of the

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market, in terms of outstanding notional principal, to be less than one trillion dollars as of
December 2001.
In a credit default swap, two parties enter into a contract where company A makes a fixed
periodic payment to company B for the life of the agreement. Company B makes no
payments unless a specified credit event occurs. Credit events are typically defined to
include a failure to make payments when due, bankruptcy, debt restructuring, change in
external credit rating, or a rescheduling of payments for a specified reference asset. If such an
event occurs, the party makes a payment to the first party, and the swap then terminates. The
size of the payment is usually linked to the decline in the reference asset’s market value
following the credit event.
The credit default swap offers insurance in case of default by a third-party borrower.
Assume Peter bought a 15-year long bond issued by ABC, Inc. The bond is worth $1,000
and pays annual interest of $50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may
default so he executes a credit default swap contract with Paul. Under the swap agreement,
Peter (CDS buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc.
and is ready to take the default risk on its behalf. For the $15 receipt per year, Paul will offer
insurance to Peter for his investment and returns. If ABC, Inc. defaults, Paul will pay Peter
$1,000 plus any remaining interest payments. If ABC, Inc. does not default during the 15-
year long bond duration, Paul benefits by keeping the $15 per year without any payables to
Peter.
Benefits: The CDS works as insurance to protect lenders and bondholders from borrowers’
default risk.

CREDIT LINKED SWAP (CLS)

A credit-linked note (CLN) is a security with an embedded credit default swap permitting
the issuer to shift specific credit risk to credit investors. Credit-linked notes are created
through a special purpose vehicle (SPV), or trust, which is collateralized with AAA-rated
securities. Investors buy credit-linked notes from a trust that pays a fixed or floating coupon
during the life of the note. In return for accepting exposure to specified credit risks, investors
who buy credit-linked notes typically earn a higher rate of return compared to other bonds.
Based on the fact that credit-linked notes are backed by specified loans, there is an
innate risk of default associated with the security. To create a credit-linked note, a loan must
be issued to a customer. Meanwhile, an institution may choose to hold the loan and
earn income based on interest payments received as the loan is repaid, or it may sell the loan
to another institution.
In the latter option, loans are sold to an SPV or trust, which ultimately divides the loan into
various parts, often bundling similar parts together based on the overall risk or rating. The
bundled parts are used to create securities that investors can purchase.
At maturity, the investors receive par unless the referenced credit defaults or declares
bankruptcy, in which case they receive an amount equal to the recovery rate. The trust enters
into a default swap with a deal arranger.
A credit-linked note functions similarly to a bond in that payments are made semi-annually,
but with a credit default swap attached. The SPV or trust pays the dealer par minus the
recovery rate in exchange for an annual fee, which is passed on to the investors in the form
of a higher yield on the notes.
Under this structure, the coupon, or price of the note, is linked to the performance of a
reference asset. It offers borrowers a hedge against credit risk and gives investors a higher
yield on the note for accepting exposure to a specified credit event.

Q.5.A – Examine three applications of swaps in derivatives markets. (6 mks)

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Refer to the uses of swaption – December 2023.Q.3.A above.

1) To lock in fixed rate.
2) For interest rate speculation.
3) Swap termination.
Swap can be defined as a series of forward derivatives. It is essentially a contract between
two parties where they exchange a series of cash flows in the future. One party will consent
to pay the floating interest rate on a principal amount while the other party will pay a fixed
interest rate on the same amount in return. Currency and equity returns swaps are the most
commonly used swaps in the markets.
Swaps are derivative instruments that represent an agreement between two parties to
exchange a series of cash flows over a specific period of time. Swaps offer great flexibility
in designing and structuring contracts based on mutual agreement. This flexibility
generates many swap variations, with each serving a specific purpose.
There are multiple reasons why parties agree to such an exchange:
1) Investment objectives or repayment scenarios may have changed.
2) There may be increased financial benefit in switching to newly available or
alternative cash flow streams.
3) The need may arise to hedge or mitigate risk associated with a floating rate loan
repayment.

APRIL 2023
Q.2.D – An investor takes a short position in 1,000 European call options on stock futures.
The option matures in 8 months and the futures contract underlying the call options expires
in 9 months. The current 9 months futures price is sh. 8 per stock. The exercise price of the
options is sh. 8, the risk free rate is 12% per annum and the volatility is 18% per annum.
Required:
Calculate the delta of a short position in 1,000 futures options. (4 mks)

Q.4.A – With respect to swap markets and contracts, distinguish between a “plain vanilla
interest rate swap” and a “basis swap.” (4 mks)
The plain vanilla interest rate swap involves trading fixed interest rate payments for
floating rate payments while a basis swap involves trading one set of floating rate payments
for another.
Plain Vanilla’ Interest Rate Swap
Usually, interest rate swaps involve payment/receipt of fixed rate of interest for
receiving/paying a floating rate of interest. The basis of exchange of cash flows under interest
rate swap is the interest rate. This fixed-to-floating swap, commonly known as ‘plain vanilla
swap’, is depicted in the below figure, where company A agrees to pay company B fixed
interest rate of 8.50% in exchange of receiving from it the interest at 30 bps (100 bps =
111/6) above the floating interest rate, Mumbai Inter Bank Offer Rate (MIBOR), at
predetermined intervals of time.

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Assuming that the swap between company A and company B is (a) for a period of three
years, (b) with semi-annual exchange of interest, (c) on notional principal of sh. 50 crores the
cash flows for company A for 6 semi-annual periods for an assumed MIBOR would be as
per the below Table. What is received/paid by company A is paid/received by company B.
With the context of the example just described, the following salient features of the swap
may be noted.
1) Effective Date - All the cash flows pertaining to fixed leg are known at the time of
entering the swap at T = 0, referred as effective date.
2) Resetting of Floating Leg Cash Flow - The cash flow for floating leg of the swap is
determined one period in advance when the floating rate becomes known. Therefore, at the
time of entering the swap both the amounts of interest are known. The first receipt of cash
flow at T = 6 months is known at T = 0 and is done at MIBOR of 8% plus 30 bps. The
date on which the next floating rate payment is decided is called reset date.

Cash Flow under Swap for Company A

Time (Months) Assumed MIBOR Fixed Leg Floating Leg Net

0 8.00%
6 8.15% -212.50 207.50 -5.00
12 8.20% -212.50 211.25 -1.25
18 8.45% -212.50 212.50 0.00
24 8.30% -212.50 218.75 6.25
30 8.50% -212.50 215.00 2.50
36 8.75% -212.50 220.00 7.50

3) Notional Principal - No principal amount is exchanged either at initiation or conclusion

of the swap. It remains a notional figure for determination of amount of interest on both
the legs.
4) Exchange Differential Cash Flow- The exchange of interest is done on net basis as
depicted in last column of the Table, with positive sign as cash inflows and negative signs
as cash outflows for company A. The cash flows for company B would be opposite to that
of company A.
5) Different Convention to Calculate Fixed and Floating Interests - The method of
calculation of interest on the two legs can be defined in the swap agreement being an over-
the-counter (OTC) product between two parties. However, the convention is to calculate
the two legs of interest are different and as follows: For Fixed Leg : Actual/365, and For
Floating Leg : Actual/360

Interest rate swaps

It is a financial agreement to exchange interest payments or receipts for a predetermined
period of time traded in the OTC market. The swap may be on the basis of fixed interest rate
for floating interest rate.
Interest rate swap agreements are the contracts between two parties to exchange cash flows
arising out of payments or receipts of the interest rates in same currency. In notional principal
basis of swap there is only the exchange between the interest and no exchange of principal
amount. Interest rate swaps can be further classified as: plain vanilla swap, zero coupon to
floating, floating to floating, forward swap, swaptions, equity swap etc.

Basis SWAP

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In contrast to the fixed-to-floating or floating-to-fixed where one leg is based on fixed rate of
interest, the basis swaps involve both the legs on floating rate basis. However, the reference
rates for determining the two legs of payment are different. Basis swaps are used where
parties in the contract are tied to one asset or liabilities based on one reference rate and want
to convert the same to other reference rate. For example, if a firm having liabilities based on
T-bills rate wants to convert it to MIBOR-based rate, then the firm can enter a basis swap
where it pays MIBOR-based interest to the swap dealer in exchange of receiving interest
based on T bills rate.

DECEMBER 2022
Q.2.C – Zipro Limited is considering a swap in which they will pay the floating rate and
receive the return on equity. The equity swap is for one year involving floating quarterly
payments on 90 day, 180 day, 270 day and 360 day whose underlying is a 90 day London
interbank offered rate (LIBOR) and receiving return on equity.
Annualized LIBOR rates are as follows:

Lo(90) = 3.45% Lo(270) = 3.7%

Lo(180) = 3.58% Lo( 360) = 3.75%
Required:
i. Calculate the swap fixed rate (4 mks)
ii. 60 days into the swap, the stock index is at 1436.59 while at the swap initiation the
index was at 1405.72. The present value factors are 0.9965, 0.9858, 0.9751 and
0.9643 respectively, 60 days into the swap. Calculate the swap market value with a
sh. 1 notional principal. (4 mks)
Q.3.B – A British company intends to issue a five year bond with £ 100 million at 4.5% but
actually needs an equivalent amount in dollars, $ 1.50 million (current $/£ exchange rate is
$1.50/£ ) to finance operations in the United States (US) A US company intends to issue $
150 million bond at a 6% maturing in 5 years and needs £100 million to invest in London.
To meet each other’s needs, both parties enter into a swap.
Required:
i. Explain the structure of the swap agreement. (2 mks)
ii. Determine the amount that the British and US companies would spend on interest. (2 mks)
iii. Evaluate the transactions that would take place at maturity of the swap. (2 mks)
AUGUST 2022
Q.1.D – Good Life Investment Consultants are managing bond investments portfolio for
their clients worth sh. 100 million with a duration of 1.5 years. They are considering
increasing the duration of their bond portfolio to 3.5 years through the use of a swap. They
estimate that the duration of a fixed rate bond is 75% of its maturity.
Required:
i. Advise Good Life Investment Consultants on whether to enter into a swap paying
fixed and receiving floating or paying floating and receiving fixed. Justify your
answer. (2 mks)
ii. Using suitable computations, advise whether Good Life Investment Consultants on
whether it should choose a four year swap with quarterly payments or a three year
swap with a semi-annual payments. (2 mks)
iii. Determine the most appropriate notional principal of the swap to be employed. (2 mks)
Q.2.C – An investor is considering a one year currency swap with semi annual payments.
The two currencies are the Kenya Shilling (KES) and the United States Dollar (USD). The
current exchange rate is 110 KES per USD.
The current Kenya term structure is as follows:

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Lo(180) = 0.0623
Lo(360) = 0.0665
The secured overnight financing rate (SOFR) term structure is:
Lo(180) = 0.0563
Lo(360) = 0.0580
60 days later the new exchange rate is 115 KES per USD.
The new Kenyan term structure is:
L60 (120) = 0.0585
L60 (300) = 0.0605
The new SOFR term structure is
L60 (120) = 0.0493
L60 (300) = 0.0505
The notional amount is sh. 1
Required:
i. The annualized fixed rates for shilling and dollar. (4 mks)
ii. The market value (in shillings) of pay shilling fixed and receive dollar fixed swap. (2 mks)
iii. The market value (in shillings) of pay floating and receive dollar fixed swap. (2 mks)
iv. The market value (in shillings) of pay floating and receive dollar floating swap. (2 mks)
v. The market value (in shillings) of pay fixed and receive dollar floating swap. (2 mks)
Q.3.B – Pepino Limited is a company incorporated in Kenya and has a South African
subsidiary that generates 10 million South African Rands (ZAR) a year. Pepino Limited
would like to lock in the rate at which it converts ZAR to Kenya shillings using a currency
swap. The fixed rate on a currency swap in South African Rands is 4% and the fixed rate on
a currency swap in Kenya Shillings is 5%.
The current exchange rate is 1 KES = 0.825 ZAR
Required:
i. The notional principal in South African Rands and Kenya Shillings for a swap with
annual payments that will achieve Pepino Limited’s objective. (2 mks)
ii. The overall periodic cash flow from the subsidiary operations and the swap. (3 mks)
Q.3.C – An asset manager enters into an equity swap in which he receives the return of MSE
share index in return for paying the return on BJIA index. At the start of the swap, the MSE
share index is at 4781.9 and the BJIA is at 9867.33.
Required:
The market value of the swap three months later when the MSE share index is at 5242.9 and
BJIA is at 10016.
Assume that notional principal of the swap is sh. 15 million. (3 mks)
APRIL 2022
Q.2.C – Monica Chebet is the corporate treasurer of BPR investment Bank Ltd. which has a
4 – year sh. 200 million floating rate Note (FRN)outstanding at London Interbank Offered
Rate (LIBOR). Monica Chebet is concerned about rising interest rates in the short term and
she would like to refinance the loan at a fixed rate for the next two years. A swap dealer
arranges a 2 year plain vanilla interest rate swap with annual payments of 8.1% and receives
LIBOR. The counterparty receives 7.9% and pays LIBOR. The company has a sh. 200
million fixed rate debt outstanding at 8%.
One year LIBOR is currently quoted at 7%.
Required:
i. The net borrowing costs to BPR Investment Bank Ltd. and counterparty’s net
borrowing costs. (2 mks)

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ii. The swap dealer’s spread and BPR Investment Bank Ltd. fixed rate payment at the
end of the first year LIBOR being 7%. (2 mks)
iii. Total interest costs borne by BPR Investment Bank Ltd. and the counterparty’s fixed
rate receipt under the swaps. (2 mks)
iv. Cash flows to the swap dealer. (2 mks)
Q.3.D – A portfolio manager has a portfolio with a floating market value of sh. 1,000,000.
The portfolio is allocated 60% to MSE all share index and 40% to Matunda Limited shares
which are currently trading for sh. 30 per share. The portfolio manager wishes to reduce
exposure to Matunda Limited to not more than 25% of the overall portfolio.
He plans to achieve this by entering into a 2- year equity swap which will use the MSE 20
share index. The settlements will be made at the end of each year. The return on the
Matunda Limited shares is projected at 5%and the return on the MSE 20 share index at 6%.
Required:
i. Explain the structure of the swap by calculating the amount involved. (3 mks)
ii. Evaluate the net cash flow for the swap at the end of year one. (2 mks)

Q.4.A – Assess three applications of swaptions in derivatives markets. (6 mks)

1) Lock in fixed rate.
2) Interest rate speculation.
3) Swap termination.
- Refer to December 2023 Q.3.Q above for more details.
Q.5.B – A derivative analyst is considering a European receiver swaption that expires in two
years and is on a one year swap that will make quarterly payments. The swaption has an
exercise rate of 6.5%. The notional principal is sh. 100 million. At expiration, the term
structure of interest rates is as follows:
Lo(90) = 0.0373
Lo(180) = 0.0429
Lo(270) = 0.0477
Lo(360) = 0.0538
Required:
i. The market value of the swaption at expiration. (6 mks)
ii. Show that the payoff is equivalent to that of a call option on a bond with an exercise
price of sh. 1 (2 mks)
Solution
The present value factors for 90, 180, 270, and 360 days are as follows:
B0(180) = 1/1+0.0373(90/360) = 0.9908
B0(360) = 1/1+0.0429(180/360) = 0.9790
B0(540) = 1/1+0.0477(270/360) = 0.9655
B0(720) = 1/1+0.0538(360/360) = 0.9489
The quarterly fixed payment per sh.1 of notional principal is calculated as:

1 – 0.9489
0.9908 + 0.9790 + 0.9655 + 0.9489

= 0.0132
The annualized fixed payment per sh.1 of notional principal is 0.0132(360/90) = 0.0528. The
market value at expiration of the receiver swaption is:
Max {0,[0.065 x (90/360) - 0.0132](0.9908 + 0.9790 + 0.9655 + 0.9489)} = 0.012. Based on
notional principal of sh.100,000,000, the market value is 100,000,000(0.012) = sh.1,200,000.

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DECEMBER 2021
Q.4.B – Juhudi Ltd. is planning to acquire a competing firm in 109 days. The acquisition
will initially be financed by sh. 80 million bridge loan with a term of 180 days and at a rate
of 180 day LIBOR plus 300 basis points. Principal and interest will be paid at the end of the
loan term. Juhudi Ltd. is concerned about a potential increase in interest rates before the
initiation of the loan and seeks your guidance on fully hedging this interest rate risk. The
year has 365 days.
You advise Juhudi Ltd. to buy an interest rate call option on 180 day LIBOR with an
exercise interest rate of 2% for a premium of sh. 86,000. The call expires in 109 days and
any payoff occurs at the end of the loan term. Current 180 ay LIBOR is 2.2%. Juhudi Ltd.
can finance the call option premium at current 180 day LIBOR plus 300 basis points. At
initiation of the loan 109 days later, 180 days LIBOR is 3.5%.
Required:
The effective annual rate in basis points on the loan (8 mks)
SEPTEMBER 2021
Q.3.A – Discuss four applications of swaps. (8 mks)
A swaption is an option that gives the holder the right to enter into an interest rate swap. The
notation for swaptions is similar to FRAs. For example, a swaption that matures in two years
and gives the holder the right to enter into a 3-year swap at the end of the second year is a
2x5 swaption. A payer swaption is the right to enter into a specific swap at some date in the
future as the fixed-rate payer at a rate specified in the swaption. If swap fixed rates increase
(as interest rates increase), the right to enter the pay-fixed side of a swap (a payer swaption)
becomes more valuable. The holder of a European payer swaption would exercise if the
market rate for fixed-rate swaps is greater than the exercise rate at maturity.
A receiver swaption is the right to enter into a specific swap at some date in the future as the
fixed-rate receiver (i.e., the floating-rate payer) at a rate specified in the swaption.
If swap fixed rates decrease (as interest rates decrease), the right to enter the receive-fixed
side of a swap (a receiver swaption) becomes more valuable. The holder of a European
receiver swaption would exercise at maturity if market rates are less than the exercise rate.
Swaptions can be American- or European-style options. Like any option, a swaption is
purchased for a premium that depends on the strike rate (the fixed rate) specified in the
swaption.
There are three primary uses of swaptions:
1) Lock in fixed rate - If an investor anticipates a floating-rate exposure at some future date
(e.g., he will be issuing bonds or getting a loan), a payer swaption would "lock in" a fixed
rate and provide floating-rate payments for the loan. It would be exercised if the yield
curve shifted up to give the investor (effectively) a loan at the fixed rate on the swaption.
2) Interest rate speculation - Swaptions can be used to speculate on changes in interest rates.
The investor would buy a payer swaption if he expects rate to rise, or buy a receiver
swaption if he expects rates to fall.
3) Swap termination - Swaptions can be used to terminate a swap. A fixed-rate payer on a 5-
year swap could buy a 2x5 receiver swaption (at the same fixed rate as the swap). This
swaption would give the investor the right to enter into an offsetting 3-year swap at the
end of two years, effectively terminating the 5-year swap at the end of the second year.

MAY 2021
Q.1.A – Modern financial markets employ a wide range of derivative instruments that could
suit different needs of their clients.

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In light of the above statement, describe four types of swaps available to market participants
in your country.
(4 mks)
1) Currency swaps.
2) Interest rate swaps.
3) Equity swaps.
4) Commodity swaps.

NOVEMBER 2020
Q.2.A – Examine five benefits of swaps as a form of derivative (5 mks)
1) Hedging risk.
2) Informational advantage.
3) Longer term than futures and options.
4) Its cheaper.
MAY 2019
Q.3.B – Summarize four ways of terminating a swap contract. (4 mks)
1) Mutual termination.
2) Offsetting the contract.
3) Resale.
4) Swaption.
NOVEMBER 2019
Q.5.C – A one year swap with a quarterly payments pays a fixed rate and receives a floating
rate. The term structure of the beginning of the swap was as follows:
Lo (90) = 0.0252
Lo (180) = 0.0305
Lo (270) = 0.0373
Lo (360) = 0.0406
In order to mitigate the credit risk of the parties engaged in the swap, the swap was marked
to market in 90 days. After 90 days, the swap was marked to market. The new term structure
of the swap was as follows:
L90(90) = 0.0539
L90 (180) = 0.0608
L90 (270) = 0.0653
Required:
i. The market value of the swap per sh. 1 notional principal at the beginning of the
swap (6 mks)
ii. The new fixed rate on the swap at which the swap would proceed after marking to
market. (2 mks)

Solution
The present value factors for 90, 180, 270, and 360 days are as follows:
Lo (90) = 0.0252 1/1+(0.0252 x 90/360) 0.9937
Lo (180) = 0.0305 1/1+(0.0305 x 180/360) 0.9850
Lo (270) = 0.0373 1/1+(0.0373 x 270/360) 0.9728
Lo (360) = 0.0406 1/1+(0.0406 x 360/360) 0.9610
3.9124

The quarterly fixed payment per sh.1 of notional principal is calculated as

Swap rate = 1 – 0.9610

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0.9937 + 0.9850 + 0.9728 + 0.9610

= 0.01
The annualized fixed payment per sh.1 of notional principal is calculated as 0.01(360/90) =
0.04.
The new present value factors for 90, 180, and 270 days are as follows:

B90(90) = 1 = 0.9867
1 + 0.0539(90/360)

B90 (180) = 1 = 0.9705

1 + 0.0608(180/360)

B90 (270) = 1 = 0.9533

1 + 0.0653(270/360)

The present value of the remaining fixed payments plus the sh.1 notional principal is:
0.01(0.9867 + 0.9705 + 0.9533) + l(0.9533) = 0.9824.
Because we are on the payment date, the present value of the remaining floating payments
plus hypothetical sh.1 notional principal is automatically 1.0. The market value of the swap to
the pay-floating, receive-fixed party is (0.9824 - 1) = - sh.0.0176. So, the market value of the
swap to the pay-fixed, receive-floating party is sh.0.0176. Because the swap is marked to
market, the party that pays floating will now pay sh.0.0176 per sh.1 of notional principal to
the party that pays fixed. The two parties would then re-price the swap.
The new fixed-rate payment per sh.1 of notional principal is:
1 – 0.9610/0.9937 + 0.9850 + 0.9728 + 0.9610 = 0.01

MAY 2018
This topic was not tested.
NOVEMBER 2018
Q.5.D.i – Explain the term “swaption” in the context of derivatives. (1 mk)
Q.5.D.ii – Examine three primary uses of swaptions. (3 mks)
A swaption, also known as a swap option, refers to an option to enter into an interest
rate swap or some other type of swap. In exchange for an options premium, the buyer gains
the right but not the obligation to enter into a specified swap agreement with the issuer on a
specified future date.
There are three primary uses of swaptions:
1) Lock in fixed rate - If an investor anticipates a floating-rate exposure at some future date
(e.g., he will be issuing bonds or getting a loan), a payer swaption would “lock in” a fixed
rate and provide floating-rate payments for the loan. It would be exercised if the yield
curve shifted up to give the investor (effectively) a loan at the fixed rate on the swaption.
2) Interest rate speculation - Swaptions can be used to speculate on changes in interest
rates. The investor would buy a payer swaption if he expects rate to rise, or buy a receiver
swaption if he expects rates to fall.
3) Swap termination -Swaptions can be used to terminate a swap. A fixed-rate payer on a 5-
year swap could buy a 2x5 receiver swaption (at the same fixed rate as the swap).
- Refer to December 2023.Q.3.A.

MAY 2017

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This topic was not tested

DECEMBER 2017
Q.2.B – Argue three cases for the existence of swaptions in the financial markets (3 mks)
MAY 2016
Q.1.A – Discuss the following terms as used in the swaps market:
i. Index amortizing swap. (2 mks)
ii. Arrears swap. (1 mk)
iii. Index differential swap. (2 mks)
iv. Overnight index swap. (1 mk)

Solution
Index amortizing swap
Index amortizing swap is the opposite of an Accreting Principal Swap, in which the notional
principal increases. Typically, the reduction in the principal value is tied to a reference
interest rate, such as the London Interbank Offered Rate (LIBOR).
Like any interest rate swap, an IAS is an over-the-counter (OTC) derivative contract
between two parties. One party wishes to receive a series of cash flows based on a fixed rate
of interest, while the other party wishes to receive cash flows based on a floating rate of
interest.
The difference between an IAS and a regular interest rate swap is that, in an IAS, the
principal balance on which the interest payments are calculated can decrease over the life of
the agreement. The underlying financial instrument might be a mortgage or other loan with
an amortizing principal balance.
Typically, IASs will be indexed to LIBOR. In this situation, the principal will be reduced
more rapidly when LIBOR declines and less rapidly when LIBOR rises.
By convention, most IAS agreements use a starting notional principal value of $100 million,
with a maturity period of five years and an initial lock-out period of two years. This means
that the principal balance would only begin declining as of year three. Of course, because
IAS agreements are OTC contracts, the exact terms can vary based on the needs of the
parties involved.

Arrears swap
An arrears swap is a type of interest rate swap that sets and pays the interest rate at the end
of the coupon period, rather than in the beginning. On the contrary, a standard swap sets the
interest rate at the beginning and pays the interest at the end.

Index differential swap

An index differential swap allows a company to take a position linked to an interest rate
index denominated in a currency that differs from the currency of the loan/deposit without
running exchange rate risk.
Overnight index swap
An Overnight Index Swap (OIS) is a derivative contract in which two parties agree to
exchange, or 'swap', interest rates over a specified period. One party will pay a fixed interest
rate and receive a floating interest rate, which is pegged to an overnight rate, such as the
Federal funds rate in the US.

Q.1.B – A two year swap with semi-annual payments pays a floating rate and receives a
fixed rate. The term structure at the beginning of the swap is as follows:

Lo (180) = 0.0583

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Lo (360) = 0.0616
Lo (540) = 0.0680
Lo (720) = 0.0705
Where; Li(m) is the m-day LIBOR on day i.
In order to mitigate credit risk of the parties engaged in the swap, the swap will be marked to
market in 180 days. Suppose it is now 180 days later and the swap is being marked to
market. The new term structure is as follows:
L180 (180) = 0.0429
L180 (360) = 0.0538
L180 (540) = 0.0618
Required:
i. The market value of the swap per sh. 1 notional principal. Indicate the amount paid
by each party.
(6 mks)
ii. The new fixed rate on the swap at which the swap would proceed after marking to
market. (2 mks)

Solution
The present value factors for 180, 360, 540, and 720 days are as follows:

Lo (180) = 0.0583 1/1+(0.0583 x 180/360) 0.9717

Lo (360) = 0.0616 1/1+(0.0616 x 360/360) 0.9420
Lo (540) = 0.0680 1/1+(0.0680 x 540/360) 0.9074
Lo (720) = 0.0705 1/1+(0.0705 x 720/360) 0.8764
The semi-annual fixed payment per sh.1 of notional principal is calculated as:

Swap rate = 1 – 0.8764

0.9717 + 0.9420 + 0.9074 + 0.8764

= 0.0334

The annualized fixed payment per sh.1 of notional principal is calculated as 0.0334(360/180)
= 0.0668.
The new present value factors for 180, 360, and 540 days are as follows:
B(180) (180) = 1/1+ 0.0429(180/360) = 0.9790
B(180) (360) = 1/1+ 0.0583(360/360) = 0.9489
B(180) (540) = 1/1+ 0.0618(540/360) = 0.9152

The present value of the remaining fixed payments plus the sh.1 notional principal is
0.0334(0.9790 + 0.9489 + 0.9152) + l(0.9152) = 1.0102.
Because we are on the payment date, the present value of the remaining floating payments
plus hypothetical sh.1 notional principal is automatically 1.0.
The market value of the swap to the pay-floating, receive-fixed party is (1.0102 - 1) =
sh.0.0102. So the market value of the swap to the pay-fixed, receive-floating party is –
sh.0.0102. Because the swap is marked to market, the party that pays floating will now
receive sh.0.0102 per sh.1 of notional principal from the party that pays fixed. The two
parties would then re-price the swap.

The new fixed-rate payment per sh.1 of notional principal is:

FS(0,n,m) = FS(0,3,180) = 1 – 0.9152/0.9790 + 0.9489 + 0.9152 + 0.8764 = 0.0298

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NOVEMBER 2016
This topic was not tested
NOVEMBER 2015
Q.4.A – Discuss three uses of swaptions. (6 mks)
1)Lock in fixed rate - If an investor anticipates a floating-rate exposure at some future date
(e.g., he will be issuing bonds or getting a loan), a payer swaption would “lock in” a fixed
rate and provide floating-rate payments for the loan. It would be exercised if the yield curve
shifted up to give the investor (effectively) a loan at the fixed rate on the swaption.
2) Interest rate speculation - Swaptions can be used to speculate on changes in interest rates.
The investor would buy a payer swaption if he expects rate to rise, or buy a receiver
swaption if he expects rates to fall.
3)Swap termination -Swaptions can be used to terminate a swap. A fixed-rate payer on a 5-year
swap could buy a 2x5 receiver swaption (at the same fixed rate as the swap).

SEPTEMBER 2015
Q.4.B.i – Explain the advantages of using interest rate swap techniques. (4 mks)
Interest rate swaps are financial instruments that allow parties to exchange interest rate cash
flows. They are an important tool for managing interest rate risk and can be used to lower
borrowing costs or increase investment returns.
The swap typically involves one party making fixed payments and receiving variable
payments based on a benchmark interest rate, while the other party makes variable payments
and receives fixed payments. Interest rate swaps allow parties to manage their interest rate
risk and can be used to lower borrowing costs or increase investment returns. The primary
purpose of interest rate swaps is to manage interest rate risk. Interest rates can have a
significant impact on the value of investments or debts, and by exchanging cash flows with a
counterparty, parties can lock in a fixed rate or convert a floating rate to a fixed rate, reducing
their exposure to interest rate fluctuations. It can also be used to reduce borrowing costs or
increase investment returns by taking advantage of lower floating rates or higher fixed rates.

BENEFITS OF INTEREST RATE SWAPS

Interest rate swaps offer the following benefits:
Risk Management
Interest rate swaps are an effective tool for managing interest rate risk, which is the risk that
interest rates will rise or fall and affect the value of investments or debts.
By exchanging cash flows with a counterparty, parties can lock in a fixed rate or convert a
floating rate to a fixed rate, reducing their exposure to interest rate fluctuations.
Cost Reduction
Interest rate swaps can be used to reduce borrowing costs or increase investment returns. By
entering into a fixed-for-floating swap, borrowers can take advantage of lower floating rates,
while investors can earn a higher return by receiving a fixed rate.
Flexibility
Interest rate swaps are a flexible instrument that can be customized to meet the specific needs
of parties. They can be structured with different terms and conditions and can be used for a
variety of purposes, including hedging, speculation, or to generate cash flows.

Q.4.B.ii – Explain the risk involved in using interest rate swap techniques. (2 mks)
1) Interest rate risk.
2) Credit risk.
3) Counterparty risk.

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FATIMA TRAINING INSTITUTE – MOCKS

QUESTION 1
Consider a currency swap in which the domestic party pays a fixed rate in the foreign
currency, the British pound, and the counterparty pays a fixed rate in U.S. dollars.
The notional principals are $50 million and £30 million. The fixed rates are 5.6 percent in
dollars and 6.25 percent in pounds. Both sets of payments are made on the basis of 30 days
per month and 365 days per year, and the payments are made semiannually.
Required:
A. Determine the initial exchange of cash that occurs at the start of the swap.
B. Determine the semiannual payments.
C. Determine the final exchange of cash that occurs at the end of the swap.
D. Give an example of a situation in which this swap might be appropriate.
Solution
A. At the start of the swap:
Domestic party pays counterparty $50 million
Counterparty pays domestic party £30 million
B. Semiannually:
Domestic party pays counterparty £30,000,000(0.0625)(180/365) = £924,658
Counterparty pays domestic party $50,000,000(0.056)(180/365) = $1,380,822
C. At the end of the swap:
Domestic party pays counterparty £30,000,000
Counterparty pays domestic party $50,000,000
D. This swap would be appropriate for a U.S. company that issues a dollar denominated bond
but would prefer to borrow in British pounds.

QUESTION 2
A mutual fund has arranged an equity swap with a dealer. The swap's notional principal is
$100 million, and payments will be made semiannually. The mutual fund agrees to pay the
dealer the return on a small-cap stock index, and the dealer agrees to pay the mutual fund
based on one of the two specifications given below. The small-cap index starts off at
1,805.20; six months later, it is at 1,796.15.
A. The dealer pays a fixed rate of 6.75 percent to the mutual fund, with payments made on
the basis of 182 days in the period and 365 days in a year. Determine the first payment for
both parties and, under the assumption of netting, determine the net payment and which party
makes it.
B. The dealer pays the return on a large-cap index. The index starts off at 1155.14 and six
months later is at 1148.91. Determine the first payment for both parties and, under the
assumption of netting, determine the net payment and which party makes it.
Solution
Part A
The fixed payment is $100,000,000(0.0675)182/365 = $3,365,753
The equity payment is: (1796.15 / 1805.20) – 1 ($100,000,000) = - $501,329
Because the fund pays the equity return and the equity return is negative, the dealer must pay
the equity return. The dealer also pays the fixed return, so the dealer makes both payments,
which add up to $3,365,753 + $501,329 = $3,867,082. The net payment is $3,867,082, paid
by the dealer to the mutual fund.

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Part B
The large-cap equity payment is: (1148.91 / 1155.14) – 1 ($100,000,000) = $539,329.
The fund owes -$501,329, so the dealer owes the fund $501,329. The dealer owes -$539,329,
so the fund owes the dealer $539,329. Therefore, the fund pays the dealer the net amount of
$539,329 - $501,329 = $38,000.

QUESTION 3
Consider a one-year interest rate swap with semiannual payments.
A. Determine the fixed rate on the swap and express it in annualized terms. The term
structure of LIBOR spot rates is given as follows:

Days Rate
180 7.2%
360 8.0%

B. Ninety days later, the term structure is as follows:

Days Rate
90 7.1%
270 7.4%

Required:
Determine the market value of the swap from the perspective of the party paying the floating
rate and receiving the fixed rate. Assume a notional principal of $15 million.

Solution
Part A
First calculate the present value factors for 180 and 360 days:
Bo(180) = 1 / 1 + 0.072(180/360) = 0.9753
B0(360) = 1 / 1 + 0.08(360/360) = 0.9259
The fixed rate is:
1 – 0.9259 / 0.9653 + 0.9259 = 0.0392
The fixed payment would therefore be 0.0392 per $1 notional principal. The annualized rate
would be 0.0392(360/180) = 0.0784.

Part B
Calculate the new present value factors for 90 and 270 days:
B90(180) = 1 /1 + 0.071(90/360) = 0.9826
B90(360) = 1 /1 + 0.0074(270/360) = 0.9474

The present value of the remaining fixed payments plus hypothetical $1 notional principal is
0.0392(0.9826 + 0.9474) + 1 .0(0.9474) = 1 .0231.
The 180-day rate at the start was 7.2 percent, so the first floating payment would be
0.072(180/360) = 0.036. The present value of the floating payments plus hypothetical $1
notional principal will be 1.036(0.9826) = 1.0180. The market value of a pay-floating,
receive-fixed swap is, therefore, 1.023 1 - 1.0180 = 0.005 1. For a notional principal of $15
million, the market value is $15,000,000(0.005 1) = $76,500.

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QUESTION 4
Consider a one-year interest rate swap with quarterly payments. Assume a notional
principal of $15 million.
A. Calculate the annualized fixed rate on the swap. The current term structure of LIBOR
interest rates is as follows:
L0(90) = 0.0656
L0(180) = 0.0640
L0(270) = 0.0621
L0(360) = 0.0500

B. Calculate the market value of the swap 30 days later 1) from the point of view of the party
paying the floating rate and receiving the fixed rate and 2) from the point of view of the party
paying the fixed rate and receiving the floating rate. The term structure 30 days later is as
follows:
L30(60) = 0.0384
L30(150) = 0.0379
L30(240) = 0.0382
L30(330) = 0.0406

Solution
Part A
The present value factors for 90, 180, 270, and 360 days are as follows:
B0(90) = 1 / 1 + 0.0656(90/360) = 0.9839
B0(180) = 1 / 1 + 0.0640(180/360) = 0.9690
B0(270) = 1 / 1 + 0.0621(270/360) = 0.9555
B0(360/360) = 1 / 1 + 0.0599 (360/360) = 0.9435
The quarterly fixed rate (or payment per $1 of notional principal) is calculated as:
Fs (0,n,m) = Fs(0,4,90) = 1 – 0.9435 / 0.9839 + 0.9690 + 0.9555 + 0.9435 = 0.0147
The annualized fixed rate (or payment per $1 of notional principal) is 0.0147(360/90)
= 0.0588. Because the notional principal is $15,000,000, the quarterly fixed payment is
15,000,000(0.0147) = $220,500.

Part B
The new present value factors for 60, 150, 240, and 330 days are as follows:
B30(90) = 1 / 1 + 0.0384(60/360) = 0.9936
B30(180) = 1 / 1 + 1 + 0.0379(150/360) = 0.9845
B30(270) = 1 / 1 + 0.0382(240/360) = 0.9752
B30(360) = 1 / 1 + 0.0406(330/360) = 0.9641
The present value of the remaining fixed payments plus the $1 notional principal is
0.0147(0.9936 + 0.9845 + 0.9752 + 0.9641) + l(0.9641) = 1.0217.
The present value of the floating payments plus hypothetical $1 notional principal is
1.0l64(0.9936) = 1 .0099, where 1.0164 is the first floating payment, 0.0656(90/360) + 1,
which is the market value of the remaining payments plus the $1 notional principal, and
0.9936 is the discount factor.
Based on a notional principal of $15,000,000, the market value of the swap to the pay-
floating, receive-fixed party is (1.02 17 - 1 .0099) 15,000,000 = $177,000.
Thus, the market value of the swap to the pay-fixed, receive-floating party is -$177,000.
QUESTION 5
A one-year swap with quarterly payments pays a fixed rate and receives a floating rate. The
term structure at the beginning of the swap is as follows:

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Lo(90) = 0.0252
Lo(180) = 0.0305
L0(270) = 0.0373
Lo(360) = 0.0406

In order to mitigate the credit risk of the parties engaged in the swap, the swap will be
marked to market in 90 days. Suppose it is now 90 days later and the swap is being marked to
market. The new term structure is:
L90(90) = 0.0539
L90(180) = 0.0608
L90(270) = 0.0653
Required:
A. Calculate the market value of the swap per $1 notional principal and indicate which party
pays which.
B. Calculate the new fixed rate on the swap at which the swap would proceed after marking
to market.

Solution
Part A
The present value factors for 90, 180, 270, and 360 days are as follows:
B0(90) = 1 / 1 + 0.0252(90/360) = 0.9937
B0(180) = 1 / 1 + 0.0305(180/360) = 0.9850
B0(270) = 1 / 1 + 0.0373(270/360) = 0.9728
B0(360) = 1 / 1 + 0.0406(360/360) = 0.9610
The quarterly fixed payment per $1 of notional principal is calculated as:
Fs(0,n,m) = Fs(0,4,90) = 1 – 0.9610 / 0.9937 + 0.9850 + 0.9728 + 0.9610 = 0.01.

The annualized fixed payment per $1 of notional principal is calculated as:

0.01(360/90) = 0.04. The new present value factors for 90, 180, and 270 days are as follows:
B90(90) = 1 / 1 + 0.0539(90/360) = 0.9867
B90(180) = 1 / 1 + 0.0608(180/360) = 0.9705
B90(270) = 1 / 1 + 0.0653(270/360) = 0.9533

The present value of the remaining fixed payments plus the $1 notional principal is
0.01(0.9867 + 0.9705 + 0.9533) + l(0.9533) = 0.9824.
Because we are on the payment date, the present value of the remaining floating payments
plus hypothetical $1 notional principal is automatically 1.0.
The market value of the swap to the pay-floating, receive-fixed party is (0.9824 - 1)
= -$0.0176. So, the market value of the swap to the pay-fixed, receive-floating party is
$0.0176. Because the swap is marked to market, the party that pays floating will now pay
$0.0176 per $1 of notional principal to the party that pays fixed. The two parties would then
re-price the swap.

Part B
The new fixed-rate payment per $1 of notional principal is:
Fs(0,n,m) = Fs(0,3,90) = 1 – 0.9533 / 0.9867 + 0.9705 + 0.9533 = 0.0160.

QUESTION 6
A two-year swap with semi annual payments pays a floating rate and receives a fixed rate.
The term structure at the beginning of the swap is:

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Lo (180) = 0.0583
Lo (360) = 0.0616
Lo (540) = 0.0680
Lo (720) = 0.0705
In order to mitigate the credit risk of the parties engaged in the swap, the swap will be
marked to market in 180 days. Suppose it is now 180 days later and the swap is being marked
to market. The new term structure is:
L180 (180) = 0.0429
L180 (360) = 0.0538
L180 (540) = 0.0618
Required:
1) Calculate the market value of the swap per $1 notional principal and indicate which
party pays which.
2) Calculate the new fixed rate on the swap at which the swap would proceed after
marking to market.

Solution
Part 1
The present value factors for 180, 360, 540, and 720 days are as follows:
B0(180) = 1 / 1 + 0.0583(180/360) = 0.9717
Bo(360) = 1 / 1 + 0.0616(360/360) = 0.9420
B0(540) = 1 / 1 + 0.0680(540/360) = 0.9074
B0(720) = 1 / 1 + 0.0705(720/360) = 0.8764
The semiannual fixed payment per $1 of notional principal is calculated as:
Fs(0,n,m) = Fs(0,4,180) = 1 – 0.8764 / 0.9717 + 0.9420 + 0.9074 + 0.8764 = 0.0334.
The annualized fixed payment per $1 of notional principal is calculated as 0.0334(360/180)
= 0.0668.
The new present value factors for 180, 360, and 540 days are as follows:
B180(180) = 1 / 1 + 0.0429(180/360) = 0.9790
B180(360) = 1 / 1 + 0.0583(360/360) = 0.9489
B180(540) = 1 / 1 + 0.0618(540/360) = 0.9152

The present value of the remaining fixed payments plus the $1 notional principal is
0.0334(0.9790 + 0.9489 + 0.9152) + l(0.9152) = 1.0102.
Because we are on the payment date, the present value of the remaining floating payments
plus hypothetical $1 notional principal is automatically 1.0.
The market value of the swap to the pay-floating, receive-fixed party is (1.0102 - 1)
= $0.0102. So the market value of the swap to the pay-fixed, receive-floating party is
-$0.0102. Because the swap is marked to market, the party that pays floating will now
receive $0.0102 per $1 of notional principal from the party that pays fixed. The two parties
would then re-price the swap.

Part 2
The new fixed-rate payment per $1 of notional principal is:
Fs(0,n,m) = Fs(0,3,180) = 1 – 0.9152 / 0.9790 + 0.9489 + 0.9152 + 0.8764 = 0.0298

NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this

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DERIVATIVES ANALYSIS

by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

CHAPTER SIX

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RISK MANAGEMENT APPLICATION OF SWAP STRATEGIES

PAGE
6.1 Introduction to risk exposures managed by Swaps……………………………..
6.2 Strategies and applications for managing interest rate risk: using interest rate swaps to
convert a floating-rate loan to a fixed-rate loan (and vice versa); using swaps to adjust the
duration of a fixed-income portfolio; using swaps to create and manage the risk of
structured notes, reducing the cost of debt…………………………………
6.3 Strategies and applications for managing exchange rate risk: converting a loan in one
currency into a loan in another currency; converting foreign cash receipts into domestic
currency; using currency swaps to create and manage the risk of a dual-currency bond
…………………………………………………………………………
6.4 Strategies and applications for managing equity market risk; diversifying a
concentrated portfolio; achieving international diversification; changing an asset
allocation between stocks and bonds; reducing insider exposure………………………
6.5 Strategies and applications using swaptions; using an interest rate swaption in
anticipation of a future borrowing; using an interest rate swaption to terminate a swap.….
Revision questions – 2015 – 2023………………………………………………………………….

REVISION QUESTIONS

DECEMBER 2023
Q.5.C – A company issues an inverse floating rate note with a face value of sh. 30 million
and a coupon rate of 14% minus SOFR (secured overnight financing rate). The company uses
the proceeds to buy a bond with a coupon rate of 8%.
Required:
i. Explain how the company would manage the risk of this position using a swap with a
fixed rate of 7%. (2 mks)
ii. Calculate the overall cash flow given that SOFR is less than 14%. (3 mks)
iii. Explain what would happen if SOFR exceeds 14%. (2 mks)
iv. Describe what the company would do to offset this problem if SOFR exceeds 14%. (2 mks)
Answer to part one
The company would enter into a swap in which it pays LIBOR and receives a fixed rate of
7% on notional principal of sh.30 million.

Answer to part two

The overall cash flows are as follows:
From the inverse floater: - (0. l4 - L) sh.30,000,000
From the bond it buys: +(0.08) sh.30,000,000
From the swap:
Fixed payment + (0.07) sh.30,000,000
Floating payment - (L) sh.30,000,000
Overall total + (0.01) sh.30,000,000
Answer to part three
If LIBOR is more than 14 percent, then the inverse floater payment of (0.14 - L) would be
negative. The lender would then have to pay interest to the borrower. For this reason, in most
cases, an inverse floater has a floor at zero. In such a case, the total cash flow to this company
would be (0 + 0.08 + 0.07 - L) sh.30,000,000. There would be zero total cash flow at L = 15

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percent. But at an L higher than 15 percent, the otherwise positive cash flow to the lender
becomes negative.

Answer to part four

To offset this effect, the lender would typically buy an interest rate cap with an exercise rate
of 14 percent. The cap would have caplets that expire on the interest rate reset dates of the
swap /loan and have a notional principal of sh.30 million. Then when L > 0.14, the caplet
would pay off L - 0.14 times the sh.30 million. This payoff would make up the difference.
The price paid for the cap would be an additional cost.

AUGUST 2023
Q.4.D – An Indian company needs to borrow 100 million Kenya shillings (Kes) for one year
for its Kenyan subsidiary. The company decides to issue Indian-dominated bonds in an
amount equivalent to Kes. 100 million. The company then enters into a one year currency
swap with a quarterly reset (30/360 day count) and the exchange of notional amount at
initiation and at maturity. At the swaps initiation, the Indian company receives the notional
amount in Kenya shillings and pays the countrer party the notional amount in Indian Rupee.
At the swaps expiration, the Indian company pays the notional amount in Kenya shillings and
receives from the counterparty the notional amount in Indian Rupee. Based on interbank
rates, the following spot rates are available today at time 0.
Days to maturity Kenya shillings (KES) spot interest Indian Rupee (INR) spot interest rates
rates (%) (%)
90 2.50 0.10
180 2.60 0.15
270 2.70 0.20
360 2.80 0.25

Assume that the counterparties in the currency swap agree to a KES/INR spot exchange rate
of 1.140 (expressed as number of Kenya shillings for 1 INR)
Required:
Calculate the fixed swap quarterly payments in the currency swaps in:
i. Kenya shillings (KES) (5 mks)
ii. Indian Rupee (INR) (2 mks)

APRIL 2023
Q.4.B – 300 days into a quarterly pay swap currency contract after initiation, a derivatives
analyst gathers the following data:
1. 60-day Dollar ($) interest rate is 5.4%
2. 60 –day pound (₤) interest rate is 6.6%
3. The exchange rate is ₤ 0.52 per $
4. The 90-day $ and ₤ interest rates on the last settlement date were 5.6% and 6.4%
respectively.
5. The fixed ₤ rate is 6.8%

Required:
i. The present value in Dollars ($) of a $ 5,000,000 swap of the $ floating side. (3 mks)
ii. The present value in pounds (₤) of a ₤ 2,500,000 counterparty to the swap in (ii)
above (₤ fixed side) (3 mks)
iii. The value of the receive $ floating pay ₤ fixed side of the swap. (3 mks)

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Q.5.C – A bond fund manager purchases a five-year credit default swap (CDS) on BBB rated
bond at the 2% spread. One year later the economy becomes weaker, causing credit spreads
on four year BBB rated bonds and new CDS spread to increase to 2.5%. The bond fund
manager sold his 2% CDS to a swap bank who hedged the CDS by selling a new 2.5% CDS
on the four year BBB rated bond. The discount rate is 6% and the national amount is sh. 100
million.
Required:
Determine the maximum amount that the swap bank would pay the bond manager for
assuming the CDS swap. (4 mks)

Q.4.D – A firm has entered into a swap agreement for a national principal of sh. 100 million
with a bank where bank paid 9% fixed and received secured overnight financing rate (SOFR)
semiannually. It has 3 more years to go and has just exchanged the cash flow. The 6 month
SOFR for the next payment of interest was reset at 8%. Next day, the market exhibited a fall
and the 6 month SOFR fell to 7% leading the firm to believe that it is overpaying. It wants to
cancel the swap arrangement
Required:
Determine how much the firm should ask the bank to pay to cancel the swap deal. (7 mks)

DECEMBER 2021
Q.5.C – An investor owns bonds issued by Marafiki Ltd. and buys a default protection from a
credit default swaps (CDS) dealer. The bonds mature in one year and have a par value of sh.
10 million.
Required:
i. Analyze the need for the use of this CDS to the investor. (2 mks)
ii. If the dealer reckons that the probability of default is 2% and the recovery rate in the
event of default to be 40%. Determine the fair premium for the CDS deal. (4 mks
SEPTEMBER 2021
Q.2.D – Brian Masaku works for an investment firm which is exposed to movement in the
Ugandan shilling. Brian desires to hedge the currency exposure. He prices one year fixed
cash for fixed currency swap involving the Uganda shilling and Kenya shilling with a
quarterly reset. He uses the interest rate data below to price the currency swap:

Days to maturity Ugandan shilling Kenya shilling

Spot interest rates ( %) Spot interest rates (%)
90 0.05 0.20
180 0.10 0.40
270 0.15 0.55
360 0.25 0.70
Required:
The annualized equilibrium fixed swap rate for the Uganda shilling (4 mks
MAY 2021
Q.2.B – A 1 year semi-annual equity swap which is based on an index is at 985 and has a
fixed interest rate of 4.4%.
90 days after the initiation of the swap, the index is at 982 and the London Interbank Offered
Rate (LIBOR) is at 4.6% for 90 days and 4.8% for 270 days. The notional value of the equity
swap is sh. 2 million.
Required:
The value of the swap to the equity payer (4 mks

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Q.3.D – Top-Tech Limited arranged a floating rate loan on 15 June 2019 to finance the
construction of one of its factories. The company’s Chief Executive Officer (CEO) has
approached you to help reduce the firm’s exposure to the risk of the rising interest rates. You
respond by purchasing caplets and selling floorlets to establish a zero-cost position. Details
concerning the loan transaction and hedging transaction are summarized below. The LIBOR
rates and the number of days falling within each settlement period are also provided:

Details concerning loan and hedging transaction is provided as follows:

Loan amount Sh. 50 million
Frequency of interest payments Semi- annually (June 15 and December 15)
Term of loan 2 years
Cap rate 10.20%
Floor rate 9.40%
Interest rate on loan LIBOR + 100 basis points
Loan settlement dates and LIBOR rates
Settlement date Number of days in period LIBOR (%)
15 June 2019 - 8.50
15 December 2019 183 9.00
15 June 2020 182 9.20
15 December 2020 183 9.95
15 June 2021 182 11.30
Required:
i. Calculate the effective interest due on 15 June 2020. (7 mks)
ii. Determine the caplet payoff on 15 June 2021. (2 mks
NOVEMBER 2020
Q.1.C – A company has an outstanding loan of sh. 50 million that matures in three years. The
interest rate on the loan is London Interbank Offered Rate (LIBOR) payable at the end of
each year. In order to hedge against an increase in interest rate, the company enters into a
swap to pay a fixed rate of 8% and receive LIBOR. In order to gain added flexibility incase
the interest rate falls, the company plans to purchase a swaption with an exercise interest rate
of 8.5%. The company is considering unwinding the swap at the first settlement date and that
the swaption is European style. It is assumed that if the company exercises the swaption, it
will do so by actually entering into the swap.
Required:
The net cash flows on the first settlement date assuming LIBOR if the fixed rate on the
underlying swap is 7.5%. (7 mks)
Q.2.B – A Kenyan firm (KF) enters into a 3 year annual currency swap with a foreign firm
(FF) with foreign currency units while the Kenyan firm has the Kenya shillings (KES) units.
The foreign currency are known as (FC) KF is the fixed rate per payer and FF is the floating
rate payer. The fixed interest rate at the swap initiation is 7% and 8% at the end of the swap.
The variable interest rate is 5% currently, 6% at the end of year 1, 8% at the end of year 2 and
7% at the end of year 3.
At the beginning of the swap, KES 1 million is exchanged at an exchange rate of 2 FC = 1
KES. At the end of the swap period the exchange rate is 1.5 FC = 1 KES.
Required:
i. Show the payments and the party at the swap initiation. (2 mks)
ii. Calculate the second net swap payment at the end of year 1. (3 mks)
iii. At the end of the swap, determine what FF will give to KF in terms of notional
principal. (2 mks)
iv. Demonstrate that at the end of 3 years FF pays KES 1,080,000. (2 mks)

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MAY 2019
Q.1.B – A local company has an outstanding loan of sh.250 million that carries a 5.15% fixed
interest rate. The company anticipates that the interest rates are going to decline and enters
into a one-year pay floating London Interbank Offered Rate (LIBOR) to receive fixed interest
rate swap with quarterly payments.
The notional principal on the swap is sh. 250 million.
The current term structure of interest rates is as provided below:
Days LIBOR (%)
90 1.42
180 1.84
270 2.12
360 3.42
45 days later, the global market experiences a financial crisis which causes interest rates to
rise dramatically and the term structure of interest rates changes as shown below:
Term structure of interest rates 45 days later
Days LIBOR (%)
90 2.21
180 2.62
270 3.73
360 4.92
Required:
i. The annualized fixed rate of swap entered by the local company. (4 mks)
ii. The market value of the swap after 45 days. (4 mks)
Q.4.B – A financial analyst reviews an equity swap with an annual reset that a local bank
entered into six months ago as the receive-fixed, pay – equity party. At the time of initiation, the
underlying equity index was trading at sh. 100. Selected data regarding the equity swap which is
linked to an equity index are presented below:
Swap notional amount Sh. 20 million
Original swap term 5 years with annual resets
Fixed swap rate 2%
The equity index is currently trading at sh. 103 and the relevant spot rate along with their
associated present value factors are presented below:
Maturity (years) Spot rate (%) Present value factors
0.5 0.40 0.998004
1.5 1.00 0.985222
2.5 1.20 0.970874
3.5 2.00 0.934579
4.5 2.60 0.895255
Required:
The fair value of the equity swap from the bank’s perspective. (4 mks)
Q.5.C – Nachu PLC, a Japanese company issued a bond with a face value of ¥ 1,200,000,000
with a coupon rate of 5.25%. The company would like to convert this bond into a Euro-
denominated bond using a swap contract. Currently, the exchange rate is ¥ 120 / €. The fixed
rate on Euro denominated swaps is 6% and the fixed rate on Yen ¥ denominated swap is
15%. Interest payments are done annually.
Required:
i. Describe how the swap will be executed clearly identifying the cash flows at start. (4 mks)
ii. Calculate all interest cash flows at each interest payment date. (2 mks)
iii. Determine the notional principal cash flows at maturity. (2 mks)
NOVEMBER 2019

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Q.3.C – Fanisi Limited issues a leveraged floating rate note (FRN) with a face value of sh. 5
billion that pays a coupon of 2.5 times 91 days Treasury bill rate. The company plans to
generate a profit by selling the notes, using the proceeds to purchase a bond with a fixed
coupon rate of 7% a year and hedging the risk by entering into an appropriate swap. A swap
dealer provides a quote with a fixed rate of 6% and a floating rate of 91 days Treasury bill
rate.
Required:
i. Determine the net cash flow from entering the swap. (5 mks)
ii. Explain two additional risks that the company might be exposed to by entering into
the above swap arrangement. (2 mks)
Q.5.B – A local pension fund has a 450,000 basis point value (BPV) duration gap with BPV
of assets being less than that of liabilities. The fund uses a swap with a BPV per 100 notional
of 0.2571 to construct a 50% hedge ratio. After setting up the 50% hedge, the manager forms
the opinion that the rates will increase and would like to benefit if his view is correct but
unaffected if he is wrong.
The manager would be willing to adjust the hedge position by 15% to a 35% or 65% hedge.
He checks and finds that both payer and receiver swaptions are available with a strike of
2.7%. The premiums for the payer and receiver swaptions are 55 and 75 basis points
respectively.
Required:
i. The notional principal of the 50% hedge ratio swap the manager could use. (2 mks)
ii. The initial cost of the swaption the manager could buy or sell to adjust his hedge to a
35% hedge (3 mks)
iii. The rate on new swaps and indicate whether new rates will have to be higher or lower
than the rate to make exercising the swaption profitable. (2 mks)
MAY 2018
Q.2.B – A Kenyan company enters into a currency swap in which it pays a fixed rate of 6 per
cent in United States dollars ($) and the counter party pays a fixed rate of 5 % in Kenyan
Shillings (Ksh). The notional principals are Ksh. 75 million and $ 105 million. Payments are
made semi-annually and on the basis of 30 days per month and 360 days per week.
Required:
i. The initial exchange of payments that takes place at the beginning of the swap. (2 mks)
ii. The semi-annual payments. (2 mks)
iii. The final exchange of payments that takes place at the end of the swap. (2 mks)
Q.3.C – A bank plans to make a sh. 10 million floating rate loan in 90 days. The loan period
will be 180 days and the rate will be 180-day LIBOR plus 150 basis points. The current 90-
day LIBOR is 10.5%. The bank is worried about falling interest rates over the period from
now until the loan starts and decides to use an interest rate put option with an exercise price
of 9% priced at sh. 5,023.
Required:
The effective rate on the loan given that the LIBOR at expiration is 5%. (6 mks)
Q.5.B – A financial institution has entered into a 10 – year currency swap with a company Y.
Under the terms of the swap, the financial institution receives interest at a rate of 3% per
annum in Swiss Francs and pays interest at a rate of 8% in U.S dollars. Interest payments are
exchanged once a year. The principal amounts are 7 million US dollars ($) and 10 million
Swiss Francs (SFr). Company Y happens to declare bankruptcy at the end of year 6 when the
exchange rate is $0.80 per Swiss Franc. At the end of year 6, the interest rate is 3% per
annum in Swiss Francs and 8% per annum in U.S dollars for all maturities. All interest rates
are quoted with annual compounding.
Required:

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The cost of currency swap to the financial institution. (5 mks)

Q.5.C – A currency swap has a remaining life of 15 months. It involves exchanging interest
rates at a rate of 10% on 20 million Sterling pounds for interest rate of 6% on 30 million USD
once a year. The term structure of interest rates in both the United Kingdom and the United
States is currently flat and if the swap were negotiated today, the interest rates exchanged
would be 4% in US dollars and 7% in Sterling pounds. All interest rates are quoted with
annual compounding.
The current exchange rate (US dollar per sterling pound) is 1.8500
Required:
Determine the value of the swap to the party paying US dollars (4 mks)
NOVEMBER 2018
Q.2.A – Three months ago, Zuhura Ltd. purchased a European receiver swaption that is
exercisable into a two year swap with semi-annual payments. The swaption has a semi-annual
exercise rate of 2.75% and a notional principal of sh. 25,000,000. The swaption has just
expired.
The relevant term structure of interest rate is presented below:
Days London Interbank Offered Rate (LIBOR) (%)
180 1.95
360 3.68
540 4.11
720 4.65
Required:
The market value of the receiver swaption. (4 mks)
Q.2.B – SM Bank entered into a sh. 5 million, 1 year equity swap with quarterly payments
300 days ago. The bank agreed to pay an annual fixed rate of 4% and receive the return on an
international equity index. The index was trading at 3000 at the end of the third quarter 30
days ago. The current 60 – day London Interbank Offered Rate (LIBOR) rate is 3.6%. The
discount factor is 0.9940 and the index is now at 3150.
Required:
The value of the swap to the bank (4 mks)
Q.5.E – Jedi Limited, a Japanese company issues a bond with a face value of 1.2 billion
Japanese Yen (¥) and a coupon rate of 5.25%. The company is contemplating to use a swap
to convert this bond into a Euro (€) denominated bond.
Additional information:
1) The current exchange rate is ¥ 120/€.
2) The fixed rate on Euro-denominated swap is 6%.
3) The fixed rate on Yen – denominated swaps is 5%.
4) All payments will be made annually so there is no adjustment such as Days/360.
Required:
i. Describe the terms of the swap between the two counter parties. (1 mk)
ii. Determine the cash flow at the start of the contract. (1 mk)
iii. Calculate all interest cash flows at each interest payment date. (2 mks)
iv. Calculate all principal cash flows at the maturity of the bond. (2 mks)
MAY 2017
Q.2.B.i – Explain the term “interest rate cap” in relation to derivatives markets. (1 mk)
An interest rate cap is essentially an insurance policy on a floating rate, most frequently
SOFR. It has three primary economic terms: notional, term, and strike rate.
An interest rate cap has three primary economic terms: the loan amount covered by the cap
(the notional), the duration of the cap (the term), and the level of rates (the strike rate) above
which the cap will pay out. As an example, a $100M, 3-year, 3% strike cap will pay out if

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SOFR exceeds 3% over the next 3 years. This puts a ceiling on the purchaser’s all-in loan
coupon of 3% plus their loan spread. Caps are typically purchased upfront with a single
premium payment and can be terminated at no cost by the cap purchaser. With a known
upfront payment and no prepayment penalty, caps are a commonly used interest rate hedge
by borrowers, particularly for shorter term debt on transitional assets that require flexibility
for a refinance or sale. As caps permit an investment to be underwritten to a worst-case
interest expense, floating-rate lenders commonly require their purchase as a condition to
closing a loan.
What determines the cost of an interest rate cap?
For a given interest rate environment, cap pricing is driven by three variables:

1. Notional: The notional is the “size” of the cap — the amount of loan it is hedging.
Generally, a cap with a larger notional is more expensive than one with a smaller
notional. Cap pricing tends to change linearly with notional (i.e., a $100M cap will be
roughly twice the cost of a $50M cap). This relationship may not hold true for caps on
either extreme (very small or very large loan amounts) or for caps that are relatively
inexpensive.
2. Term: The term of the cap describes the length of time that the cap is protecting the
borrower. The longer the term, the more expensive the cap. Generally, each additional
month of the cap term is more expensive than the previous month; pricing does not
increase linearly with term. For example, the third year of a cap is often materially
more expensive than the first two combined.
3. Strike rate: The strike rate defines the interest rate at which the cap provider begins
to make payments to the cap purchaser. The lower the strike rate, the more likely that
a cap provider will need to make a payment during the term of the cap. Consequently,
lower strike caps are more expensive than higher strike caps.

Q.2.B.ii – An institution has issued a floating rate note for which the interest rate is reset after
every 90 days using the prevailing 90-day spot interest rate. The next reset date is due in 42
days’ time. The institution has purchased an interest rate cap with a maturity of 42 days and
cap rate of 5.50%. The amount involved is sh. 10 million. The 90 day spot interest rate at 42
days is 5.80%.
Required:
Pay-off to the cap (2 mks)
Q.3.F – John Omulundo, an investment manager holds an asset portfolio with a total market
value of sh. 105 million. The allocation of the portfolio is as follows:
1. Sh. 65 million is invested in a broadly diversified portfolio of domestic stocks.
2. Sh. 40 million is invested in the stocks of Jimbo Corporation.
The investment manager wishes to reduce exposure to Jimbo Corporation stocks by sh. 30
million. The manager plans to achieve this objective by entering into a three year equity swap
using the standard and poor (S & P) 500 market index.
Assume that settlement is made at the end of each year and the return on S & P 500 market
index is -3%.
Required:
i. Explain the structure of the equity swap (2 mks)
ii. Calculate the net cash flow for the swap at the end of the year. (3 mks)
Q.4.D – A portfolio manager is entering into a two-year swap in which his firm will receive
the rate of return on the Rusell 2,000 index and will pay a fixed interest rate. The swap has
annual payments. The fixed rate of the swap to be initiated is 4.99%. The Rusell 2.000 index
is at 757.09 at the beginning of the swap and the notional principal of the swap is sh. 100

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million. One hundred days later, the Rusell 2,000 index is at 723.86 and the term structure is
presented below:
Term structure of LIBOR interest rates 100 days later
Days (T) L0 (T) B0 (T)
260 0.0442 0.9691
620 0.0499 0.9209
NOTE: Calculations are on a 360- day year basis. Where:
T = Time to expiration.
L0 (T) = LIBOR rate to time T
B0 (T) = Discount factor of sh. 1 from time T to the present.
Required:
The market value of the firm’s position in the swap 100 days after the initiation of the swap.
(4 mks)
Q.4.E – Silvia Makena is concerned about the risk level of a client’s equity portfolio. The
client has 60%of this portfolio invested in two equity positions: Hope industries and Hummer
securities.

Stock Shares Stock price (sh)

Hope industries 375,000 26.20
Hummer securities 300,000 34.00
Silvia investigates whether a privately negotiated equity swap could be used to reduce the
risk of the Hope industries and Hummer Securities holding. A swap dealer offers Silvia the
following two options:
 The dealer will receive the return on 250,000 shares of Hope industries and 200,000 shares
of Hummer Securities from client.
 The dealer will pay the client the return on an equivalent amount on the Rusell 3,000
index.
The dealer demonstrates the quarterly cash flows of this transaction under the assumption that
Hope Industries is up 2%, Hummer securities is up 4% and the Rusell 3,000 index is up 5%
for the quarter.
Required:
The pay off to the client in the equity swap (4 mks)
DECEMBER 2017
Q.2.C – Firm A plans to issue a sh. 100 million floating rate note today that has a 180-day
term and coupon payments after every 90-days equal to the 90 –day LIBOR. It plans to use a
plain vanilla interest rate swap to convert this floating rate debt to a fixed rate obligation.
Firm B plans to use a swaption to hedge its future interest rate exposure and it plans to issue a
sh. 100 million floating rate note in 90-days time that has a 180- day term and coupon
payments every 90-days equal to the 90-day LIBOR. The firm intends to buy a European
swaption with a notional principal amount of sh. 100 million and a 90-day expiry period at
the time of floating rate note issuance. The firm intends to exercise the swaption if yields
increase. The fixed rate on the swaption is 3.90% and if in 90 – days time the fixed rate on
the underlying equivalent swap was 4.32%, the swaption will be exercised.
The following information is also provided:

LIBOR, swap and swaption (Rates are annualized) Today In 90-days

90 – day LIBOR 3.50% 4.00%
180- day LIBOR 3.85% 4.35%
Fixed rate on swaption 3.90% Not applicable
Fixed rate on swap Not applicable 4.32%

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90-day discount factor 0.9913 0.9901

180-day discount factor 0.9811 0.9787
Required:
i. Determine the annualized fixed rate on the plain vanilla interest rate swap. (3 mks)
ii. Calculate the arbitrage profit, if any that is available to exploit a possible pricing
discrepancy. (3 mks)
Q.3.C – Peterson Mwanzia, a portfolio manager at Riora Investment Bank holds a portfolio
with a total market value of sh. 105 million. Sh. 65 million of this portfolio is invested in a
broadly diversified portfolio of domestic equity while the remaining sh. 40 million is invested
in the shares of EOBL Corporation. Mwanzia intends to reduce exposure to EOBL
Corporation’s shares by sh. 30 million and plans to achieve this objective by entering into a
three-year equity swap using the standard and poor (S&P) 500 index.
Assume that the settlement is made at the end of each year and that one year later, EOBL
share is 4% and the return on the S&P 500 market index is -3%.
Required:
i. Explain the structure of the equity swap. (2 mks)
ii. Calculate the net cash flow for the swap at the end of one year. (4 mks)

MAY 2016
Q.3.A – Differentiate between a “payer swaption” and a “receiver swaption.” (2 mks)
A payer swaption gives the holder the right to enter into a swap as the fixed-rate payer while
a receiver swaption gives the holder the right to enter into a swap as the fixed-rate receiver.
Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed rate and pay floating. A payer swaption is an option to pay fixed rate
and receive floating.

Q.3.C – A Kenyan corporation with a Tanzanian subsidiary generates cash flows of Tsh. 10
million in a year. The subsidiary is considering using a currency swap to lock in the rate at
which it converts to Kenya shillings. The current exchange rate is Ksh. 0.825/Tsh. The fixed
rate on a currency swap in Tanzania shillings is 5%.
Required:
Determine the overall periodic cash flow from the subsidiary operations and the swap (4 mks)
NOVEMBER 2016
Q.2.D – A European receiver swaption expires in one year and is on a two year swap that will
make semi-annual payments. The swaption has an exercise rate of 7.2%. The notional
principal is sh. 49 million. At the time of expiration, the term structure of interest rates is as
follows:
Lo (180) = 0.0412
L0 (360) = 0.0465
Lo (540) = 0.0533
Lo (720) = 0.0648

Required:
Illustrate four possible ways in which this swaption could be exercised, evaluating the
relevant cash flows in each case. (8 mks)
NOVEMBER 2015
Q.4.C – Omingo Ogot is an equity swap trader. He considers an equity swap in which he
would receive the return on index A in return for paying the return on index B. At the

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inception of the equity swap, Index A is at 956.38 and Index B is at 19,734.66. The notional
principal of the swap is sh. 30 million.
Required:
The market value of the swap, three months later when the Index A is at 1,048.58 and Index
B is at 20,032. (4 mks)
SEPTEMBER 2015
This topic was not tested.

FATIMA TRAINING INSTITUTE – MOCKS

QUESTION 1
Consider a bank that holds a $5 million loan at a fixed rate of 6 percent for three years, with
quarterly payments. The bank had originally funded this loan at a fixed rate, but because of
changing interest rate expectations, it has now decided to fund it at a floating rate. Although it
cannot change the terms of the loan to the borrower, it can effectively convert the loan to a
floating-rate loan by using a swap. The fixed rate on three-year swaps with quarterly
payments at LIBOR is 7 percent. We assume the number of days in each quarter to be 90 and
the number of days in a year to be 360.
Required:
1) Explain how the bank could convert the fixed-rate loan to a floating-rate loan using a
swap.
2) Explain why the effective floating rate on the loan will be less than LIBOR.
Solution
Part 1
The interest payments it will receive on the loan are $5,000,000(0.06)(90/360) = $75,000.
The bank could do a swap to pay a fixed rate of 7 percent and receive a floating rate of
LIBOR. Its fixed payment would be $5,000,000(0.07)(90/360) = $87,500. The floating
payment it would receive is $5,000,000L(90/360), where L is LIROR established at the
previous reset date. The overall cash flow is thus $5,000,000(L - 0.01)(90/360), LIROR
minus 100 basis points.
Part 2
The bank will effectively receive less than LIBOR because when the loan was initiated, the
rate was 6 percent. Then when the swap was executed, the rate was 7 percent. This increase
in interest rates hurts the fixed-rate lender. The bank cannot implicitly change the loan from
fixed rate to floating rate without paying the price of this increase in interest rates. It pays this
price by accepting a lower rate than LIBOR when the loan is effectively converted to
floating. Another factor that could contribute to this rate being lower than LIROR is that the
borrower's credit risk at the time the loan was established is different from the bank's credit
risk as reflected in the swap fixed rate, established in the LIBOR market when the swap is
initiated.

QUESTION 2
A $250 million bond portfolio has a duration of 5.50. The portfolio manager wants to reduce the
duration to 4.50 by using a swap. Consider the possibility of using a one year swap with
monthly payments or a two-year swap with semi annual payments.
Required:
1) Determine the durations of the two swaps under the assumption of paying fixed and
receiving floating. Assume that the duration of a fixed-rate bond is 75 percent of its
maturity.

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2) Choose the swap with the longer absolute duration and determine the notional
principal of the swap necessary to change the duration as desired. Explain your
results.
Solution
Part 1
The duration of a one-year pay-fixed, receive-floating swap with monthly payments is the
duration of a one-year floating-rate bond with monthly payments minus the duration of a one-
year fixed-rate bond with monthly payments. The duration of the former is about one-half of
the length of the payment interval. That is 1/24 of a year, or 0.042. Because the duration of
the one-year fixed-rate bond is 0.75 (75 percent of one year), the duration of the swap is
0.042 - 0.75 = -0.708.
The duration of a two-year swap with semiannual payments is the duration of a two-year
floating-rate bond with semiannual payments minus the duration of a two-year fixed-rate
bond. The duration of the former is about one-quarter of a year, or 0.25. The duration of the
latter is 1.50 (75 percent of two years). The duration of the swap is thus 0.25 - 1.50 = - 1.25.

Part 2
The longer- (more negative) duration swap is the two-year swap with semiannual payments.
The current duration of the $250 million portfolio is 5.50 and the target duration is 4.50.
Thus, the required notional principal is:
NP = B(MDURT – MDURB)
MDURS
= $250,000,000(4.50 – 5.50) / -1.25
= $ 200,000,000
So, to lower the duration requires the addition of an instrument with a duration lower than
that of the portfolio. The duration of a receive-floating, pay-fixed swap is negative and,
therefore, lower than that of the existing portfolio.

QUESTION 3
A company issues an inverse floating-rate note with a face value of $30 million and a coupon
rate of 14 percent minus LIBOR. It uses the proceeds to buy a bond with a coupon rate of 8
percent.
Required:
1) Explain how the company would manage the risk of this position using a swap with a
fixed rate of 7 percent, and calculate the overall cash flow given that LIBOR is less
than 14 percent.
2) Explain what would happen if LIBOR exceeds 14 percent. What could the company
do to offset this problem?
Solution
Part 1
The company would enter into a swap in which it pays LIBOR and receives a fixed rate of 7
percent on notional principal of $30 million. The overall cash flows are as follows:
From the inverse floater: -(0.l4 - L)$30,000,000
From the bond it buys: +(0.08)$30,000,000
From the swap:
Fixed payment + (0.07)$30,000,000
Floating payment - (L)$30,000,000
Overall total + (0.01)$30,000,000

Part 2

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If LIBOR is more than 14 percent, then the inverse floater payment of (0.14 - L) would be
negative. The lender would then have to pay interest to the borrower. For this reason, in most
cases, an inverse floater has a floor at zero. In such a case, the total cash flow to this company
would be (0 + 0.08 + 0.07 - L)$30,000,000.
There would be zero total cash flow at L = 15 percent. But at an L higher than 15 percent, the
otherwise positive cash flow to the lender becomes negative.
To offset this effect, the lender would typically buy an interest rate cap with an exercise rate
of 14 percent. The cap would have caplets that expire on the interest rate reset dates of the
swap/loan and have a notional principal of $30 million. Then when L > 0.14, the caplet
would pay off L - 0.14 times the $30 million.
This payoff would make up the difference. The price paid for the cap would be an additional
cost.

QUESTION 4
A company plans to take out a $10 million floating-rate loan in two years. The loan will be
for five years with annual payments at the rate of LIBOR. The company anticipates using a
swap to convert the loan into a fixed-rate loan. It would like to purchase a swaption to give it
the flexibility to enter into the swap at an attractive rate. The company can use a payer or a
receiver swaption. Assume that the exercise rate would be 6.5 percent.
Required:
A. Identify what type of swaption would achieve this goal and whether the company should
buy or sell the swaption.
B. Calculate the company's annual cash flows beginning two years from now for two cases:
The fixed rate on a swap two years from now to terminate five years later, FS(2,7), is 1)
greater or 2) not greater than the exercise rate. Assume the company takes out the $10 million
floating-rate loan as planned.
C. Suppose that when the company takes out the loan, it has changed its mind and prefers a
floating-rate loan. Now assume that the swaption expires in-the-money.
What would the company do, given that it now no longer wants to convert to a fixed-rate
loan?

Solution
A. The company wants the option to enter into the swap as a fixed-rate payer, so the company
would buy a payer swaption.
B. The outcomes based on the swap rate at swaption expiration, denoted as FS(2,7), are as
follows:
FS(2,7) > 6.5 percent
Exercise the swaption, entering into a swap. The annual cash flows will be as follows:
Pay 0.065($10 million) = $650,000 on swap
Receive L($10 million) on swap
Pay L($10 million) on loan
Net, pay $650,000
FS(2,7) ≤ 6.5 percent
Do not exercise swaption; enter into swap at market rate. The annual cash flows will be as
follows:
Pay FS(2,7)($10 million) on swap
Receive L($10 million) on swap
Pay L($10 million) on loan
Net, pay FS(2,7)($10 million)
(Note: This is less than $650,000

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C. In this situation, the company has changed its mind about converting the floating-rate loan
to a fixed-rate loan. If the swaption expires out-of-the-money, the company will simply take
out the floating-rate loan. If the swaption expires in-the-money, it has value and the company
should not fail to exercise it. But exercising the swaption will initiate a swap to pay fixed and
receive floating, which would leave the company in the net position of paying a fixed rate of
6.5 percent when it wants a floating-rate loan. The company would exercise the swaption and
then enter into the opposite swap in the market, receiving a fixed rate of FS(2,7) and paying
L. The net effect is that the company will pay 6.5 percent, receive FS(2,7), which is more
than 6.5 percent, and pay L. So in effect it will pay a floating-rate loan of less than LIBOR.

QUESTION 5
A company has issued floating-rate notes with a maturity of one year, an interest rate of
LIBOR plus 125 basis points, and total face value of $50 million. The company now believes
that interest rates will rise and wishes to protect itself by entering into an interest rate swap. A
dealer provides a quote on a swap in which the company will pay a fixed rate 6.5 percent and
receive LIBOR. Interest is paid quarterly, and the current LIBOR is 5 percent. Indicate how
the company can use a swap to convert the debt to a fixed rate. Calculate the overall net
payment (including the loan) by the company.
Assume that all payments will be made on the basis of 90/360.

Solution
The company can enter into a swap to pay a fixed rate of 6.5 percent and receive a floating
rate. The first floating payment will be at 5 percent.
Interest payment on the floating rate note = $50,000,000(0.05 + 0.01 25)(90/360) = $78 1,250
Swap fixed payment = $50,000,000(0.065)(90/360=) $8 12,500
Swap floating receipts = $50,000,000(0.05)(90/36=0) $ 625,000
The overall cash payment made by the company is $812,500 + $781,250 - $625,000 =
$968,750

QUESTION 6
A bank is currently lending $10 million at an interest rate of LIBOR plus 50 basis points. The
loan maturity is two years, and the loan calls for quarterly payments. The bank expects
interest rates to fall and wishes to hedge against this by entering into an interest rate swap. A
dealer provides a quote on a swap in which the bank will receive a fixed payment of 5 percent
and pay a floating rate of LIBOR.
Required:
Calculate the overall net payment by the bank if it enters the swap. Assume that all payments
will be made on the basis of 90/360.
Solution
By entering into a swap to receive a fixed rate of 5 percent and pay a floating rate of LIBOR,
the bank converts the floating rate to a fixed rate. Let L be the LIBOR established at the
previous settlement date.
Interest received on the loan = $10,000,000(L + 0.005)(90/360)
Swap floating payment = $10,000,000(L)(90/360)
Swap fixed receipt = $10,000,000(0.05)(90/360)
The overall cash payment is $10,000,000[L - (L + 0.005) - (0.05)](90/360) =
$l0,000,000(-0.055)(90/360) = -$137,500. So an amount of $137,500 will be paid to the
bank.

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NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this
by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

CHAPTER SEVEN

OPTION MARKETS AND CONTRACTS

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PAGES
7.1 Introduction: Basic definitions and illustrations of options contracts……………
7.2 Types of options: Financial options; options on futures; commodity options; other
types of options………………………………………………………………………..
7.3 Characteristics of Options Contracts: some examples of options…………………
7.4 The concept of moneyness of an option…………………………………………..
7.5 The structure of global options markets: over-the-counter options markets;
exchange-listed option markets………………………………………………………..
7.6 Options Valuation: Determinants of option price, Option pricing models,
sensitivity analysis options premiums………………………………………………….
7.7 Principles of option pricing; payoff values: Boundary conditions; the effect of a
difference in exercise price; the effect of a difference in time to expiration; put-call
parity; American options, lower bounds, and early exercise; the effect of cash flows
on the underlying asset; the effect of interest rates and volatility; option price
sensitivities……………………………………………………………………………..
7.6 Discrete-time option pricing: The binomial model; the one-period binomial model;
the two-period binomial model; binomial put option pricing; binomial interest rate
option pricing; American options: extending the binomial model……………………..
7.7 Continuous-time option pricing: The Black-Scholes-Merton model; assumptions
of the model; the black-Scholes-Merton formula; inputs to the black-Scholes-Merton
model; the effect of cash flows on the underlying; the critical role of volatility.
7.8 Pricing options on forward and futures contracts and an application to interest rate
option pricing: Put-call parity for options on forwards; early exercise of American
options on forward and futures contracts; the black model; application of the black
model to interest rate options …………………………………………………………..
7.9 The role of options markets…………………………………………………………
7.10 Uses of Options……………………………………………………………………
Revision questions – 2015 – 2023……………………………………………………………..

KEY TOPIC ISSUES

DETERMINANTS OF OPTION VALUE

The value of an option is determined by a number of variables relating to the underlying asset
and financial markets.
1) Current value of the underlying asset
2) Variance in value of the underlying asset
3) Dividends paid on the underlying asset
4) Strike price of option
5) Time to expiration on option
6) Riskless interest rate corresponding to life of the option

CURRENT VALUE OF THE UNDERLYING ASSET

Options are assets that derive value from an underlying asset.
Consequently, changes in the value of the underlying asset affect the value of the options on
that asset, since; calls provide the right to buy the underlying asset at a fixed price, an
increase in the value of the asset will increase the value of the calls, Puts, on the other hand,
become less valuable as the value of the asset increase.

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VARI ANCE IN VALUE OF THE UNDERLYING ASSET

The buyer of an option acquires the right to buy or sell the underlying asset at a fixed price.
The higher the variance in the value of the underlying asset, the greater the value of the
option. This is true for both calls and puts. While it may seem counter-intuitive that an
increase in a risk measure (variance) should increase value, options are different from other
securities since buyers of options can never lose more than the price, they pay for them: in
fact, they have the potential to earn significant returns from large price movements.

DIVIDENDS PAID ON THE UNDERLYING ASSET

The value of the underlying asset can be expected to decrease if dividend payments are made
on the asset during the life of the option, consequently, the value of a call on the asset is a
decreasing function of the size of expected dividend payments, and the value of a put is an
increasing function of expected dividend payments. More intuitive way of thinking about
dividend payments, for call options, is as a cost of delaying exercise on in-the-money options.
To see why, consider an option on a traded stock: Once a call option is in the money
exercising the call option will provide the holder with the stock, and entitle him or her to the
dividends on the stock in subsequent periods, failing to exercise the option will mean that
these dividends are foregone.

STRIKE PRICE OF OPTION

A key characteristic used to describe an option is the strike price. In the case of calls, where
the holder acquires the right to buy at a fixed price, the value of the call will decline as the
strike price increases. In the case of puts, where the holder has the right to sell at a fixed
price, the value will increase as the strike price increases.

TIME TO EXPIRATION ON OPTION

Both calls and puts become more valuable as the time to expiration increases.
This is because the longer time to expiration provides more time for the value of the
underlying asset to move, increasing the value of both types of options, additionally, in the
case of a call, where the buyer has to pay a fixed price at expiration, the present value of this
fixed price decreases as the life of the option increases, further increasing the value of the
call.

RISKLESS INTEREST RATE CORRESPONDING TO LIFE OF THE OPTION

Since the buyer of an option pays the price of the option up front, an opportunity cost is
involved. This cost depends upon the level of interest rates and the time to expiration on the
option. The riskless interest rate also enters into the valuation of options when the present
value of the exercise price is calculated, since the exercise price does not have to be paid
(received) until expiration on calls (puts). Increases in the interest rate will increase the value
of calls and reduce the value of puts.

FACTORS AFFECTING OPTION PRICES

FACTOR CALL OPTION’S VALUE PUT OPTION’S VALUE

Increase in underlying asset’s value Increase Decreases
Increase in strike price Decrease Increases

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Increases in variance of underlying asset Increases Increases

Increase in time to expiration Increases Increases
Increases in interest rates Increases Decreases
Increase in dividends paid Decreases Increases

BSM MODEL
The formula for the BSM model is:
C0 = S0 x N(d1) – (X x e – RFC x T) x N(d2)
Where:
d1 = In (S0 /x) + (RFC + (0.5 x ά2) x T
α x √T

d2 = d1 – α x √ T
T = Time to maturity ( as a percentage of a 365 day – year)
S0 = Asset price
X = Exercise price
RFC = continuously compounded risk-free rate.
σ = continuously compounded returns on the stock.
N(d1 ) = cumulative normal probability of value in parentheses

The value of a call option in the Black-Scholes model can be written as a function of the
following variables:
S = Current value of the underlying asset
K = Strike price of the option
T = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
σ = Variance in the in(value) of the underlying asset
The model itself can be written as:
Value of call = SN(d1) – Ke-rtN(d2)
The process of valuation of options using the Black-Scholes model involves the following
steps:
Step 1: The inputs to the Black-Scholes are used to estimate d1 and d2
Step 2: The cumulative normal distribution functions, N(d1) and N(d2), corresponding to
these standardized normal variables are estimated,
Step 3: The present value of the exercise price is estimated, using the continuous time version
of the present value formulation: Present value of exercise price = Ke-rt
Step 4: The value of the call is estimated from the Black-Scholes model.

B-S MODEL ASSUMPTIONS AND LIMITATIONS

Just as with most other models in finance, BSOPM is also based on some assumptions, which
are as follows:
1) Frictionless markets.
2) The assets pay zero dividends.
3) The option is European style.
4) Asset prices follow a geometric Brownian motion.

Frictionless markets
More precisely it means there are no transaction costs, short selling is permitted, existence of
similar borrowing and lending rules und - finitely divisible assets. This is not a severely

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restrictive assumption since the intention is to separate the effect of market forces on option
prices.

The asset pays zero dividends

This is also net on implausible assumption at least in the short run. But subsequent models in
the literature proposed some adjustments in the basic BSOPM to incorporate dividend /
Intermediate income.
Asset prices follow a geometric Brownian motion
In other words, asset returns are normal and stationary. Many cities called this assumption as
the biggest hole in the B-S formula, including its inventor Prof. Fisher Black in an influential
article in the Journal of Applied Corporate Finance in 1989.

Option is a contract that gives one party the option to enter into a transaction either at a
specific time in the future or within a specific future period at a price that is agreed when the
contract is issued. Options are financial contracts which gives the buyer a right but not an
obligation to buy a specified number of securities at some time in future at a predetermined
price known as Exercise price.
The exercise or strike price is the price at which the future transaction will take place.
Premium
Premium is the price paid by the option buyer to the seller, or writer, for the right to buy or
sell the underlying shares.
There are two types of options i.e. (i) Call Option (ii) Put Option.
Call Option
It is the financial contract that gives the buyer a right but not an obligation to buy a specified
number of securities at some time in future at a predetermined price.
Put option
It is an option which gives the seller the right but not the obligation to sell a given number of
securities at some time in future at a predetermined price.
European, American and Bermudan options
A European option can only be exercised at expiration, whereas an American option can be
exercised any time prior to expiration. A Bermudan option is an option where early exercise
is restricted to certain dates during the life of the option. It derives its name from the fact that
its exercise characteristics are somewhere between those of the American and the European
style of options and the island of Bermuda lies between America and Europe.
Long and short positions
When an investor buys an option the investor is setting up a long position, and when the
investor sells an option the investor has a short position.

Limitations of Black-Scholes Option Pricing Model

1)This model can only apply on European Bonds and not American Bonds. European Bonds
would only be expected upon maturity while American Bonds can be exercised at any time
during the option period.
2)It assumes that the markets are perfect such that there are no transaction costs and taxes.
3)It assumes that risk free rate of return is known in advance and remains constant.
4)It assumes that the company does not distribute all its earnings as dividends i.e. No dividends
are paid out.
A protective put is a portfolio consisting of :
1) A long position in a European put option with an exercise price of X that matures in T
years.
2) A long position in the underlying stock.

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 The cost of a protective put is the cost of the put option (P 0) plus the cost of the stock
(S0). The payoff to a protective put is X if the put is in the money and S T if the put is out
of the money.
 The payoff to a fiduciary call is the same as the pay off to a protective put. Arbitrage
ensures that the two should have the same cost, which leads us to put-call parity for
European options.
C0 = X/(1+Rf)T = P0 + S0
 Put-call parity is very useful because it tells us how to create a synthetic position in
any one of the four instruments by combining the other three.
For example, if we solve for the value of the call option, we get:
C0 = P0+ S0 – X/(1 + Rf)T
Interpret the plus signs as a long position in the security and the negative signs as a short
positions. That means we can create a synthetic European call option by:
i. Buying a European put option on the same stock with the same exercise price (X)
and the same maturity (T)
ii. Buying the stock.
iii. Shorting (i.e borrowing) the present value of X worth of a pure-discount riskless
bond.
A synthetic European put option is formed by:
i. Buying a European call option.
ii. Shorting the stock.
iii. Buying (i.e investing in) the discount bond.
A synthetic stock position is formed by:
i. Buying a European call option
ii. Shorting (i.e writing) a European put option.
iii. Buying (i.e investing in) the discount bond.
A synthetic pure discount riskless bond is created by:
i. Buying a European put option.
ii. Buying the stock
iii. Shorting (i.e writing) a European call option.
Example
A one year call option of XYZ Ltd. with an exercise price of sh. 60 is trading for sh. 8. The
current stock price is sh. 62. The risk free rate is 4%.
Required:
Calculate the price of the synthetic put option implied by put-call parity.
Solution
Put call parity = C0 – S0 + X/(1 + Rf)T
Where;
C0 = call price
S0 = stock price
X = Exercise price
Rf = Risk free rate
T = Term to expiration.
According to put-call parity, the price of the synthetic put option is given by:

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P0 = C0 – S0 + X /(1+Rf)T

P0 = 8 – 62 + (60/1.04)
P0 = sh. 3.69

Illustration
European put and call options with an exercise price of 45 expire in 115 days. The
underlying is priced at 48 and makes no cash payments during the life of the options.
The risk-free rate is 4.5 percent. The put is selling for 3.75, and the call is selling for 8.00.
Required:
1) Identify the mispricing by comparing the price of the actual call with the price of the
synthetic call.
2) Based on your answer in Part A, demonstrate how an arbitrage transaction is executed.
Solution
Using put-call parity, the following formula applies:
C0 = P0 + S0 = X/(1 + r)T
The time to expiration is T = 115/365 = 0.3151. Substituting values into the right-hand side:
C0 = 3.75 + 48 – 45/(1.045)0.3151
= 7.37
Hence, the synthetic call is worth 7.37, but the actual call is selling for 8.00 and is, therefore,
overpriced.
Answer for part 2
Sell the call for 8.00 and buy the synthetic call for 7.37. To buy the synthetic call, buy the put
for 3.75, buy the underlying for 48.00, and issue a zero-coupon bond paying 45.00 at
expiration. The bond will bring in 45.00/(1.045)/(1.045)0.3151 = 44 .38 today. This transaction
will bring in 8.00 - 7.37 = 0.63.
THE BLACK-SCHOLES-MERTON (BSM) MODEL

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The above lead to the following formula for the price of a call option with exercise price K on
a stock currently trading at price S, i.e., the right to buy a share of the stock at price K after T
years. The constant interest rate is r, and the constant stock volatility is σ.

Where;

Here N is the standard normal cumulative distribution function. The price of a put option may
be computed from this by put-call parity and simplifies to:

CALCULATIONS OF THE GREEKS

CALLS PUT
Delta

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Gamma

Vega
Theta

Rho

Here, σ is the standard normal probability density function. Note that the Gamma and Vega
formulas are the same for calls and puts.
Instruments paying continuous dividends
The dividend payment paid over the time period [t,t + dt] is then modeled as:
for some constant q (the dividend yield).
Under this formulation the arbitrage-free price implied by the Black–Scholes model can be
shown to be:

Where now;
is the modified forward price that occurs in the terms d1 and d2:

Instruments paying discrete dividends

It is also possible to extend the Black–Scholes framework to options on instruments paying
discrete dividends. This is useful when the option is struck on a single stock.
A typical model is to assume that a proportion δ of the stock price is paid out at pre-
determined times T1,T2,.... The price of the stock is then modeled as:

Where n(t) is the number of dividends that have been paid by time t. The price of a call
option on such a stock is again:

Where now:
is the forward price for the dividend paying stock.
The Black-Scholes-Merton (BSM) model values options in continuous time and is derived
from the same no-arbitrage assumption used to value options with the binomial model. In the
binomial model, the hedge portfolio is riskless over the next period, and the no-arbitrage
option price is the one that guarantees that the hedge portfolio will yield the risk-free rate. To
derive the BSM model, an “instantaneously” riskless portfolio(one that is riskless over the
next instant) is used to solve for the option price based on the same logic.

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Example
Consider the situation where the stock price six months from the expiration of an option is
sh. 42. The exercise price of the option is sh. 40. The risk free interest rate is 10% per annum
and the volatility is 20% per annum.
This means that:
Current price of the share (S0) = sh. 42
Exercise price of the option (E) = sh. 40
Time period to expiration = 6 months; thus t = 0.5 years.
Standard deviation of the distribution of continuously compounded rate of return ; S = 0.2
Continuously compounded risk free interest rate (r) = 0.1
d1 = In (42/40) + (0.1 + 0.5 x 0.22) (0.50) = 0.7693
0.2 x √ 0.50
d2 =In (42/40) + (0.1 – 0.5 x 0.22) (0.50) = 0.6278
0.2 x √ 0.50
C = Theoretical call premium.
S = Current stock price.
t = Time until option expiration.
K= option striking price.
r = Risk free interest rate .
N = Cumulative standard normal distribution.
e = exponential term (2.7181)
To understand the concept, we divide the model into two parts:
The first part, SN(d1) derives the expected benefit from acquiring a stock outright. This is
found by multiplying stock price (s) by the change in the call premium with respect to a
change in the underlying stock price (Nd1).
The second part of the model ke(1-rt) (Nd2) gives the present value of paying the exercise on
the expiration date.
The fair market value of the call option is then calculated by taking the difference between
these two parts.

Example
Professor George Luchiri Wajackoyah is a distinguished financial analyst for Ganja and
Hyenas Ltd. International; a company dealing with highly expensive products such as meat
and chemicals. He is interested in using the Black-Scholes Model (BSM) to value the call
options on the stock:
The following information has been availed to the professor in the year 2022:
1) The price of the stock is sh. 35.
2) The strike price is sh. 30.
3) The option matures in 9 months.
4) The volatility of the returns of the stock is 0.30.
5) The risk-free rate is 10%.
Required:
The value of a call option using the Black-Scholes – Model.
Solution
d1 = In (35/30) + (0.1 + 0.5 x 0.32) (0.75) = 0.7693
0.3 x √ 0.75
= 0.154 + 0.10875

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0.2598
d1 = 1.01
N(d1) = 0.5 + 0.3438 = 0.8438
Alternatively, 0.8438 can be obtained from the standard normal cumulative probability table
directly (1.01). We can also get 0.3438 from the normal probabilities table plus 0.5.
d2 = (d1 – α √ t )
d2 = (1.01 – 0.3 x √ 0.75
= 1.01 – 0.2598 = 0.75
N(d2) = 0.5 + 0.2734
N(d2) = 0.7734
Value of the call option = (35 x 0.8438) - 30/(2.7183)0.1 x 0.75
= 29.533 – 21.525 = 8.01
Value of the call = sh. 8.01

Example
The following information relates to a certain Kenyan based listed company for the year
2023:
 Stock price (Po) = sh. 62
 Exercise price (X) = sh. 60
 Time to expiration (t) = sh. 40 days (40/365)
 Volatility (σ) = 32% = 0.32
 Risk free rate = 4% = 0.04
Required:
a) Value of the call
b) Value of the put option
Solution
d1 = In (po/x) + (Krf + 0.5σ2 )t

σ√❑ t
d1 = In (62/60) + (0.04 + 0.5) (0.32)2 (40/365)
0.32√❑ 40/365
d1 = 0.032279 + (0.04 + 0.0512) (0.10959)
(0.32) (0.33104)
d1 = 0.03279 + (0.912)(0.10959)
0.10593
d1 = 0.04278 / 0.10593
d1 = 0.404
d2= d1- σ√ ❑ t
d2 = 0.404 – 0.32 √ ❑ 40/365
d2 = 0.404 – 0.10593 = 0.298
d1 = 0.404
d2 = 0.30
The values of d1 and d2 can now be obtained from the standard normal distribution table.
Nd1(0.40) = 0.6554

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Nd2 (0.30) = 0.6179

Value of the call:

e
VC = (62)(0.6554) – (60) / (0.04 + 40/365)(0.6179)
VC = 40.65 – (60/1.004393)(0.6179)
VC = 40.65 – (59.74)(0.6179)
VC = 40.65 – 36.91
VC = sh. 3.72

Value of the put option

Vp = VC + X / e krft
– P0
Vp = 3.72 + (60) / e0.04 x (40/365) - 62
Vp = 3.72 + 59.74 – 62
Vp = sh. 1.46

Comment:
Call option was in the money (372) 72 is the speculation premium while put option was out
of the money. Speculation price was 46. Po = 62 X = 60

Example
XYZ Ltd. is considering a new project which requires a capital outlay of sh.10 million and
has an expected net present value of sh.2 million. However, the economic climate over the
next few years is thought to be very risky and the volatility attaching to the net present value
of the project is 20%. XYZ Ltd. is able to delay commencing the project for three years.
The risk free rate of interest is 6% p.a.
Required:
Estimate the value of the option to delay the start of the project for three years, using the
Black Scholes option pricing model.
Solution
P = current P.V. of project = sh.12 M [NPV = PV – Initial outlay therefore PV = NPV +
Initial outlay)
E = capital expenditure = sh.10M
t = 3 years
r = 6%
σ = 20%
d1=(𝑃/𝐸)+(𝑟+0.5𝜎2)𝑇
𝜎√𝑇
d1 = In(12/10) + (0.06 + 0.5) x (0.2)2 x 3
0.20 x √3
d1 = 0.1823+0.24
0.3464

= 1.22
d2 = 1.22 – 0.2 x √3 = 0.87

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N(d1) = 0.5 + 0.3888 = 0.8888

N(d2) = 0.5 + 0.3078 = 0.8078
C = Value of a call option.
C = 12 x 0.8888 – 10 x 0.8078/e0.06 x 3
= sh.3.92m
Therefore the total project value = NPV of project without option value + Option value
= 2 + 3.92 = sh.5.92m
Strategic Investment option – This is where the management undertakes a project irrespective
of the net present value since undertaking the project can give rise to new opportunities.
P = The fair value of the firm’s assets
E = Exercise price
r = The risk free rate of interest
t = The time to maturity
σ = The standard deviation of the value of the assets
In valuation of options, we use the Black Scholes Model.
Vc = PNd1 – ENd2/ert
Where P = Spot Price/Current Market Price
E = Exercise Price
e = Euler’s Function
Nd1& Nd2 = Normal distribution probabilities of d1& d2
r = Risk free rate of Return
t = Time in years
d1 = In(P/E) + (r + σ2/2) t
σ√t
d2 = d1 - σ√t

Value of European put options

The value of a European put option can be calculated by using the put call parity
relationship which is given by:
Put = C – P + E/ert
Where C is the value of call option and P = spot price
E = Exercise price.
Value of American call options
Although American options can be exercised any time during their lifetime, it is never
optimal to exercise an option earlier. The value of an American option will therefore be the
same as the value of an equivalent European option and the Black-Scholes model can be
used to calculate its price.

Illustration 1
Consider the situation where the stock price 6 months from the expiration of an option is
Sh.42, the exercise price of the option is Sh.40, the risk-free interest rate is 10% p.a. and the
volatility is 20% p.a. This means P = 42, E = 40, r = 0.1, 𝜎= 0.2, t = 0.5.
d2 = d1 - 𝜎√𝑇
d1 = In(42/40) + (0.1+ 0.22/2) 0.5
0.2√0.5
d1 = 0.7693
d2 = 0.7693 – 0.2 x √0.5
d2 = 0.63

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The values of the standard normal cumulative probability distribution N(d1) and N(d2) can be
found from the normal distribution tables.
Note: If d1> 0, add 0.5 to the relevant number above. If d1< 0, subtract the relevant number
above from 0.5.' So here, because d1 = 0.77, then N (d1) = 0.2794 + 0.5 = 0.7794.
On the same basis, N (d2) = N(0.63) = 0.7357 where the 0.7357 is calculated as 0.2357 from
the table + 0.5 (because d2 is a positive number). Hence if the option is a European call, its
value is given by:
C = (42 x 0.7794) – 42 x 0.7357/1.051
C = 4.74wt = e0.1 x 0.5
C = e0.05 = 1.051
If the option is a European put, its value is given by:
Put = C – P +𝐸/ert
= 4.74 – 42 + 40/1.051
= 0.8
The Black Scholes Option Pricing Model
The formulae that Black and Scholes developed are as follows:
Call option:
C = PN(d1) – EN(d2)/ert
Where
d1= (𝑃/𝐸)+(𝑟+0.5𝜎2)𝑡
𝜎√𝑡
d2 = d1− s √𝑡
Put option:
VP = C – P + E/ert
Where:
VP = value of put option
C = call option value
P = the current share price
E = the exercise price of the option
e = the exponential constant
r = the annual risk free rate of interest
t = the time (in years) until expiry of the option
σ = the share price volatility
N(d) = the probability that a deviation of less than d will occur in a normal distribution.

Illustration
Current share price is sh.290.
Exercise price sh.260 in 6 months’ time.
Risk free rate of interest is 6% p.a.
Standard deviation of rate of return on share is 40%
Required;-
What is the value of a call option?
Solution
P = 290
E = 260
r = 0.06
σ = 0.4
T = 6/12 = 0.5

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d1= (𝑃/𝐸)+(𝑟+0.5𝜎2)𝑇
𝜎√𝑡
d1 = In(290/260) + (0.06 + 0.42/2) x 0.5
0.4√0.5
d1 = 0.6335
d2 = 0.6335 – 0.4 x √0.5 = 0.3507
N(d1) = 0.5 + 0.2357 = 0.7357
N(d2) = 0.5 + 0.1368 = 0.6368
Option price = PNd1 – ENd2/ert
Option price = 290 x 0.7357 – 260 x 0.6368 / e 0.06 x 0.5
Option price = sh. 52.7

Illustration
Current share price is sh.150
Exercise price sh.180 in 3 months.
Risk free rate of interest is 10% p.a.
Standard deviation of rate of return on share is 40%
Required:
What is the value of a call option?
Solution
d1 = In(150/180) + (0.1+0.42/2) x 0.25
0.4√0.25
d1 = - 0.6866
d2 = -0.6866 – 0.4√0.25 = -0.8866
N(d1) = 0.5 - 0.2549 = 0.2451
N(d2) = 0.5 - 0.3133 = 0.1867
Option price = 150 x 0.2451 – 180 x 0.1867/e0.1 x 0.25
Option price = 3.989 = sh. 4 approximately.
Option price = sh. 4
The Greeks
From day to day the price of an option will change.
Black and Scholes also produced formulae to measure the rate of change in the options price
with changes in each of the factors listed. You do not need to know the formulae, but you
need to be aware of the names given to each of the measures, and they are as follows:
Delta
The rate at which the option price changes with the share price (=N(d1))
Theta
The rate at which the option price changes with the passing of time.
Vega
The rate at which the option price changes with changes in the volatility of the share
Rho
The rate at which the option price changes with changes in the risk-free interest rate
Gamma
The rate at which delta changes
Note: you need to know about the relevance of delta. This is because in the very short term,
delta enables us to predict the effect on the option price of movements in the share price. It

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will be equal to N(d1), and we can use it to decide how many options we need to trade in to
protect ourselves against movements in the share price.

The Delta Hedge

If you own shares and you are worried that the share price might fall, then sell some call
options. As the share price falls, so will the value of the options. (You can buy back at a
profit).
The problem is to decide how many call options we need to sell.
Illustration
Current share price is sh.150
Call option exercise price is sh.180 in 3 months
Risk free interest rate is 10% p.a.
Standard deviation of rate of return on share is 40%
Maria owns 1,000 shares.
Devise a delta hedge to protect against change in the share price

Solution
Number of options = number of shares/nd1
N(d1) = 0.2451 (illustration in the previous example above)
Number of options = 1000/0.2451 = sh. 4,080
Therefore the investor should sell 4080 options.

CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS

ON ASSETS USING ONE- AND TWO-PERIOD BINOMIAL MODELS.
A binomial model is based on the idea that, over the next period, some value will change to
one of two possible values (binomial). To construct a binomial model, we need to know the
beginning asset value, the size of the two possible changes, and the probabilities of each of
these changes occurring.
ONE-PERIOD BINOMIAL MODEL
Assume that a share of stock is currently priced at $30. The size of the possible price
changes, and the probability of these changes occurring, are as follows:
U = Size of up move = 1.333
D = size of down move = 1 / U = 1/1.333 = 0.75
ΠU = probability of an up move = 0.55
ΠD = probability of a down move = 1 – πu = 1 – 0.55 = 0.45
Note that the down-move factor is the reciprocal of the up-move factor, and the probability
of an up-move is one minus the probability of a down-move. The one-period binomial tree
for the stock is shown below. The beginning stock value of $30 is to the left, and to the right
are the two possible paths the stock can take, based on the starting point and the size of an up-
and down-move. If the stock increases by a factor of1.333 (a return of 33.3%), it ends up at
$40.00; if it falls by a factor of 0.75 (a return of–25%), it ends up at $22.50.
$30 x 1.333 = $40

$ 30

$30 x 0.750 = &22.50

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Today 1 year
The probabilities of an up-move and a down-move are calculated based on the size of the
moves and the risk-free rate as:
ΠU =Risk neutral probability of an up move = 1 + Rf – D
U–D
ΠD = Risk neutral probability of a down move = 1 – πu = 1 – ΠU
Rf = Risk free rate.
U = Size of an up move.
D = Size of a down move.
We can calculate the value of an option on the stock by:
• calculating the payoff of the option at maturity in both the up-move and down-move states.
• calculating the expected value of the option in one year as the probability-weighted average
of the payoffs in each state.
• Discounting the expected value back to today at the risk-free rate.
Example: Calculating call option value with a one-period binomial tree
Use the binomial tree in the above figure to calculate the value today of a one-period call
option on the stock with an exercise price of $30. Assume the risk-free rate is 7%, the current
value of the stock is $30, and the size of an up-move is 1.333.
Answer:
First, we have to calculate the parameters—the size of a down-move and the probabilities:
D = 1 / U = 1 / 1.333 = 0.75
ΠU =Risk neutral probability of an up move = 1 + Rf – D
U–D
= 1 + 0.07 – 0.75
1.333 – 0.75
= 0.55
πD = Risk neutral probability of a down-move = 1 – 0.55 = 0 45
Next, determine the payoffs to the option in each state. If the stock moves up to $40, a call
option with an exercise price of $30 will pay off $10. If the stock moves down to$22.50, the
call option will be worthless. The option payoffs are illustrated in the following figure.
Let the stock values for the up-move and down-move be S1+ and S1– and for the call values,
c1+ and c1– .
One-Period Call Option with X = $30

S1 + = 30 x 1.333 = $ 40
C1 + = Max (0, 40 – 30) = $ 10

ΠU = 0.55

S0 = $ 30

ΠD = 0.45

S1 = 30 x 0.750 = $ 22.50

C1 = Max (0, 22.50 – 30 ) = $ 0

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Today one year

The expected value of the option in one period is: e(call option value in 1 year) = ($10 ×
0.55) + ($0 × 0.45) = $5.50. The value of the option today, discounted at the risk-free rate of
7%, is:
C0 = 5.50 = $ 5.14
1.07
We can use the same basic framework to value a one-period put option. The only difference
is that the payoff to the put option will be different from the call payoffs.
Example: Valuing a one-period put option on a stock
Use the information in the previous two examples to calculate the value of a put option on the
stock with an exercise price of $30.
Answer:
if the stock moves up to $40, a put option with an exercise price of $30 will be worthless. If
the stock moves down to $22.50, the put option will be worth $7.50.
The risk-neutral probabilities are 0.55 and 0.45 for an up- and down-move, respectively. The
expected value of the put option in one period is:
e(put option value in 1 year) = ($0 × 0.55) + ($7.50 × 0.45) = $3.375.
The value of the option today, discounted at the risk-free rate of 7%, is:
P0 = 3.375
1.07
= $ 3 .154

Example
Suppose that a person has one share of M. ltd. and buys a put option at sh. 300 which can be
exercised T years in the future. In this case, the person faces no future downside risk below
sh. 300 since the put option gives him the right to sell M.ltd shares at sh. 300. Suppose in
addition, the person sells a call option on M.ltd. at sh. 300. In this case, if the price goes
above sh. 300, the call holder will exercise the call option and take away the share at sh. 300.
The sale of the call eliminates the upside risk above sh. 300.
Hence the following portfolio (one share plus a put option at sh. 300 minus a call option at sh.
300 riskless obtains sh. 300 on date T. This payoff is identical to a simple bond which yields
sh. 300 on date T.
Suppose the interest rate in the economy is r, then this bond has the present value (300 /(1 +
r)T
This is a situation to which the law of one price applies:
We have two portfolios which yield the identical payoff.
1)300 /(1 + r)T invested in a simple bond, which turns into sh. 300 on date T for sure and;
2)A portfolio formed of S + P – C which turns into sh. 300 on date T for sure.
 By the law of one price, if two portfolios yield identical payoffs, then they must cost the
same, hence we get the formula: S + P – C = X/(1+ r)T where;
S = spot price, P= Put price, C = Call price, X= Exercise price, T= Time to expiration.

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 If prices in any economy ever violate this formula, then the riskless profit can be obtained by
a suitable combination of puts, calls and shares. Put- call parity links up the price of a call
and the price of a put. If one is known, then we can infer the other.
 The put-call parity states that the difference in price between a call option and a put option
with the same terms should equal the price of the underlying asset less the present
discounted value of the exercise price. A put and call option written on the same stock with
the same exercise price and maturity date must sustain if there has to be a no riskless
arbitrage opportunities. This condition is known as the put-call-parity. This relationship can
be expressed as follows:
Vc – Vp = Pa – x
Where;
Vc = The price of a call option.
Vp = The price of a put option.
Pa = The price of the underlying asset.
X = Present discounted value of the exercise price.

ARBITRAGE WITH A ONE-PERIOD BINOMIAL MODEL

If the price of the one-period $30 call option from the previous example (above diagram) is
not $5.14,there is an arbitrage opportunity. This arbitrage will involve the call option and
shares of stock. If the option is overpriced, we would short the option and buy a fractional
share of the stock for each option we shorted. If the option is underpriced, we would purchase
the option and short a fractional share of stock for each option share.
The fractional share of stock in the arbitrage trade (commonly referred to as the hedge ratio)
for each option traded is derived from the option’s delta, which is calculated in the one-period
model as:
Delta = C1+ – C1-
S1+– S1-
Delta provides you with the information required to calculate a hedge ratio.
Example: Calculating arbitrage profit
Assume the option in the previous example is actually selling for $6.50. Illustrate how this
arbitrage opportunity can be exploited to earn an arbitrage profit. Assume we trade100 call
options.
Answer:
Because the option is overpriced, we will short 100 options and purchase a certain number of
shares of stock determined by the hedge ratio:
Delta = 10 – 0
40 – 22.50
= 0.5714 shares per option.
Total shares of stock to purchase = 100 x 0.5714 = 57.14
A portfolio that is long 57.14 shares of stock at $30 per share and short 100 calls at$6.50 per
call has a net cost of:
Net portfolio cost = (57.14 × $30) – (100 × $6.50) = $1,064.
The values of this portfolio at maturity if the stock moves up to $40 or down to $22.50
are: portfolio value in up-move = (57.14 × $40) – (100 × $10) = $1,286
portfolio value in down-move = (57.14 × $22.50) –(100 × $0) = $1,286
The return on the portfolio in either state is:
Portfolio return = 1286 - 1 = 0.209 = 20.9%
1064
This is a true arbitrage opportunity! We’ve created a portfolio that earns a return of20.9% no
matter what happens next period. That means its risk free. The actual risk-free rate in the

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market is 7%. The profitable arbitrage trades are to:

• Borrow $1,064 at 7% for one year. In one year, we’ll owe $1,064 × 1.07 =$1,138.48.
• Buy the hedged portfolio for $1,064.
• In one year, collect the $1,286, repay the loan at $1,138.48, and keep the arbitrage profits of
$147.52.

TWO-PERIOD BINOMIAL MODEL

Valuing an option using a two-period binomial model requires a little more work, but the
basic steps are still the same:
• Calculate the stock values at the end of two periods (there are three possible outcomes
because an up-then-down move gets you to the same place as a down then-up move).
• Calculate three possible option payoffs at the end of two periods.
• Calculate the expected option values at the end of two periods (t = 2) using the up and
down-move probabilities.
• Discount the expected option values (t = 2) back one period at the risk-free rate to find the
option values at the end of the first period (t = 1).
• Calculate the expected option value at the end of one period (t = 1) using up- and down-
move probabilities.
• Discount the expected option value at the end of one period (t = 1) back one period at the
risk-free rate to find the option value today.
Definition of arbitrage:
Arbitrage-free valuation -This method values securities such that no market participants can
earn an arbitrage profit in a trade involving that security.
Two types of arbitrage opportunities are:
Value additivity– when the whole differs from the sum of the values of the part.
Dominance– when one asset trades at a lower price than another asset with identical
characteristics.
Arbitrage-free valuation is consistent with value additivity principle and without dominance
of any security relative to others in the market.
Arbitrage involves no initial cash outlay but a positive riskless profit at some point in the
future.
Arbitrage-free valuation is the value of an asset or financial instrument based solely on the
real performance or cash flows that it generates. When an asset’s market price differs from
its arbitrage-free value, then an opportunity for arbitrage exists by trading the asset for
another asset or portfolio of assets that replicate its underlying performance or cash flows or
by buying and selling the assets in different markets where the price differs.
Arbitrage is a feasible cash flow (generated by a trading strategy) which is non-negative in
every state and positive with non-zero probability.
We often describe arbitrage as a strategy with no initial investment, no risk of a loss, and
positive expected profit. It’s a special case of the above definition.
Absence of arbitrage implies the Law of One Price: two assets with the same payoff must
have the same market price.
Absence of arbitrage may be a very weak requirement in some settings and quite strong in
others:
Equities have few securities and many states and are easy to avoid arbitrage.
Fixed income have many securities, few states and not easy to avoid arbitrage.
Arbitrage-free valuation of an asset is based solely on the value of the underlying asset
without taking into consideration derivative or alternative market pricing. It can be
calculated for various types of assets using financial formulas that account for all of the cash
flows generated by an asset.

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Arbitrage is when you buy and sell the same security, commodity, currency, or any other
asset in different markets or via derivatives to take advantage of the price difference of those
assets. For example, purchasing a stock on the Nairobi Securities Exchange and selling it on
the Uganda Stock Exchange for a higher price is arbitrage.
Arbitrage can only occur when some price difference exists between market prices for an
asset or between a market price and the underlying value of the asset. For a stock, the firm is
doing the same work and has the same underlying capital structure, asset mix, cash flow, and
every other metric regardless of what exchange it is listed on or derivative pricing of the
stock. Arbitrage-free valuation is when price discrepancies are removed, allowing for a more
accurate picture of the firm’s valuation based on actual performance metrics.
When such differences exist they present an opportunity for traders to profit from the price
spread by engaging in an arbitrage trade. However, every act of arbitrage (every arbitrage
trade) will tend to move the market price closer toward the arbitrage-free valuation,
eventually eliminating the opportunity for arbitrage profits.

BINOMIAL INTEREST RATE TREE FRAMEWORK

This way of modeling interest-rate dynamics is most frequently used in the market place. The
interest-rate tree concept is a simple description of the evolution of the short-term interest rate
over time.
In a binomial interest-rate tree model, it is assumed that, given today’s level of the short-term
interest rate r, the next-period short interest rate, in period 1, can take on only two possible
values: an upper value ru(where the subscript u stands for upper) and a lower value rl(where
the sub script stands for lower) with equal probability. In period 2, the short-term interest rate
can take on four possible values: ruu, rlu, rulandrll. More generally, in period n, the short-
term interest rate can take on 2n values.
The implementation of such a tree, which is called a no recombining tree, is very time-
consuming and computationally inefficient. For instance, pricing a 30-year callable bond
with annual coupon payments would require the computation of over 1 billion interest-rate
values in period 30. For a 30-year bond with semiannual coupon payments, the number of
values to be calculated in period 60 would be even greater than 1018!
In practice, market participants prefer to use a recombining binomial interest-rate tree, which
means that an upward–downward sequence leads to the same result as a downward–upward
sequence.
For example, rlu= rul. All in all, the short-term interest rate takes only 3, as opposed to 4,
value son period 2. There is a 0.25 probability of reaching the node ruuor the node rll, while
there is a 0.5 probability to reach the intermediate state, since rlu= rul. This is a binomial
distribution.
The binomial interest rate tree can be created by following these steps:
1. Observe the current interest rate of the relevant security (bond or derivative).
2. Determine the probability of the interest rate either going up or down. In most cases, the
risk-neutral probability (i.e., the probability of future outcomes adjusted for risk) is used to
calculate the future interest rate. Note that if the probability of the interest rate increase
equals p, the probability of the interest rate decrease equals (1-p). In addition, the risk-
neutral probability can be used for calculating the future rates in all time periods.
3. Calculate the forward (future) rates using the determined probability.
4. Create the binomial tree using the obtained interest rates.
Note that similar to other binomial trees, with the binomial interest rate tree, the current price
of a bond or derivative must be calculated backward. In other words, we must first calculate

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the prices of security in the latest periods and then calculate the prices in the previous
periods.

Period 4

Illustration:
Ruuuu
Period 0 period 1 period 2 period 3

Ruuu Ruuul

Ruu Ruul

Ru Ruull

R Rul Rull Rulll

Rl

Rll Rlll
Rllll

CALIBRATING BINOMIAL INTEREST RATE TREE

The following steps should be followed when calibrating binomial interest rate trees to match
a particular term structure:
 Step 1: Estimate the appropriate spot and forward rates for a known par value curve.
 Step 2: Construct the interest rate tree using the assumed volatility and the interest rate
model.
 Step 3: Determine the appropriate values for the zero-coupon bonds at each node using
backward induction.
 Step 4: Calibrate the tree to ensure it is arbitrage-free. The value of a bond produced by the
interest rate tree must be equal to its market price.

BINOMIAL LATTICE
A lattice-based model is used to value derivatives by employing a binomial tree to compute
the various paths the price of an underlying asset, such as a stock, might take over the
derivative's life. A binomial tree plots out the possible values graphically that option prices
can have over different time periods.
Lattice-based models can take into account expected changes in various parameters such as
volatility over the life of the options. Volatility is a measure of how much an asset's price
fluctuates over a particular period. As a result, lattice models can provide more accurate
forecasts of option prices than the Black-Scholes model, which has been the standard
mathematical model for pricing options contracts.
The lattice-based model's flexibility in incorporating expected volatility changes is
especially useful in certain circumstances, such as pricing employee options at early-stage
companies. Such companies may expect lower volatility in their stock prices in the future as

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their businesses mature. The assumption can be factored into a lattice model, enabling more
accurate options pricing than the Black-Scholes model, which assumes the same level of
volatility over the life of the option.
The binomial options pricing model (BOPM) is a lattice method for valuing options. The
first step of the BOPM is to build the binomial tree. The BOPM is based on the underlying
asset over a period of time versus a single point in time. These models are called "lattice"
because the various steps visualized in the model can appear to be woven together like a
lattice.
The binomial pricing model traces the evolution of the option's key underlying variables in
discrete-time. This is done by means of a binomial lattice (Tree), for a number of time steps
between the valuation and expiration dates. Each node in the lattice represents a possible
price of the underlying at a given point in time.
Valuation is performed iteratively, starting at each of the final nodes (those that may be
reached at the time of expiration), and then working backwards through the tree towards the
first node (valuation date). The value computed at each stage is the value of the option at that
point in time.
Option valuation using this method is, as described, a three-step process:
1. Price tree generation.
2. Calculation of option value at each final node.
3. Sequential calculation of the option value at each preceding node.
As the Black-Scholes model gained popularity, option holders sought a better model that
could be used to price American-style options. Along came the more flexible Binomial
Lattice Model to do the job.
Features of lattice model include:
 The binomial model divides the remaining life of the option into different time periods, and
calculates a value for the end of each one. So if an employee is planning to leave the
company, say a year from now, the binomial model can calculate a value for the option at that
date.
 It uses a binomial tree to represent different directions the company stock can take and
calculates a value for the option to match each price. That way the ABC employee can see a
range of values for the option based on the range of values the company stock might take.
 The range of values for the stock can be widened or tightened to reflect increasing or
decreasing levels of volatility for each node on the tree.
Arbitrage-free valuation of a fixed-rate, option-free bond entails discounting each of the bond
´s future cash flows using the corresponding spot rate.

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This valuation is not useful when valuing bonds with embedded options.
In case of bonds with embedded options we need a model that allows both rates and the
underlying cash flows to vary. One such model is the binomial interest rate tree framework.

BACKWARD INDUCTION

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The process to construct a binomial interest rate tree, conforms to three rules:
1. - The interest rate trees should generate arbitrage-free values for the benchmark security -
the value of bonds produced by the interest rate tree must be equal to their market price
which excludes arbitrage opportunities.
2. - Adjacent forward rates at any nodal period are two standard deviation apart (calculated as
𝑒2σ.
3. - The mid point for each nodal period is approximately equal to the implied one-period
forward rate for that period (i.e at period “n”, the midpoint ≈ (n,1)

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Binomial tree approach can value either option-free bonds or bonds with embedded options.
An option-free bond can be evaluated by using the zero-coupon yield or by using the
binomial tree method.
If the binomial tree is calibrated with the zero-coupon yield.
Then both valuations will lead to the same result.

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Valuation using zero-coupon yield

Valuation using an arbitrage-free binomial laticce

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Path wise valuation approach

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10.7383%

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5.7833%

3% 7.1981%

3.880%

4.8250
Mortgage-backed securities have path dependent cash flows on account of the embedded
prepayment option.
An important assumption of the binomial valuation process is that the value of the cash flows
at a given point in time is independent of the path that interest rates followed up to that point
(i.e. the binomial valuation process cannot be used when cash flows are path dependent)
Because of path dependency of cash flows of mortgage-backed securities, the binomial tree
backward induction process cannot be used to value such securities.
Monte Carlo simulation method should be used for valuing MBS, as this method can be used
when cash flows are path dependent.
Monte Carlo simulation method uses path wise valuation and a large number of randomly
generated simulated paths, using a model that incorporates a volatility assumption and an
assumed probability distribution

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EXAMPLE: VALUING A CALL OPTION ON A STOCK WITH A TWO-PERIOD MODEL

Suppose you have a stock currently priced at $50, and a two-period European call option is
available with a strike price of $45. The size of an up-move is 1.25. The risk-free rate per
period is 7%. Compute the value of the call option using a two-period binomial model.
Answer:
First compute the size and probability of up- and down-moves, and then compute the
theoretical value of the stock in each period:
D = 1 / 1.25 = 0.80
ΠU = 1.07 – 0.80
1.25 – 0.80
= 0.6
ΠD = 1 – 0.6 = 0.4

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The two-period binomial tree for the stock is shown in the following figure.

50 (1.25) = $62.50 50 (1.25)2 = 78.13

$ 150 50 (1.25) (0.80) = $ 50

50 (0.8) =$ 40
50 (0.8)2 = $ 32

Today Period 1 Period 2

We know the value of the option at expiration in each state is equal to max (0, stock price –
exercise price):
C2 ++ = Max (0, 78.13 – 45) = 33.13
C2 - + = Max (0, 50 – 45) = 5
C2 + = Max (0, 50 – 45) = 5
C2 -- = Max (0, 32 – 45) = 0
We will approach this problem by using the single-period binomial model and applying this
model to each period. Using this method, we can compute the value of the call option in the
up-state in period one as follows:
C1+= (πu x C2++) + (Πd x C2+ -)
1 + Rf
= E (call option)
1 + Rf
= (0.6 x 33.13) + (0.4 x 5)
1,07
= 21.88/1.07
= 20.45
The value of the call in the down-state in period one is computed as:
C1-= (πu x C2-+) + (Πd x C2- -)
1 + Rf
= E (call option value)
1 + Rf
= (0.6 x 5) + (0.4 x 0)
1,07
= 3/1.07
= 2.80
Now we know the value of the option in both the up-state c1+ and the down-statec1-one
period from now. To get the value of the option today, we simply apply our methodology one
more time. Therefore, bringingc1+ and c1- back one more period to the present, the value of
the call option today is:

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C0 = (πu x C+) + (Πd x C -)

1 + Rf
= E (call option value)
1 + Rf
= (0.6 x 20.45) + (0.4 x 2.80)
1,07
= 13.39/1.07
= 12.51
The binomial tree for the call option is shown below:
$20.45 $33.13

$12.51

$5.00

$2.80
$0.00

Today Period 1 Period 2

BINOMIAL INTEREST RATE TREES

An interest rate model makes assumptions about interest rate volatility along with a set of
paths that interest rates may follow over time. This set of possible interest rate paths is
referred to as an interest rate tree. The possible interest rate paths that are used to value bonds
with a binomial model is called a binomial interest rate tree. The diagram below depicts a
two-period binomial interest rate tree.
12UU
1iu

I0 I2DU

iiD

I2DD

Today Year 1 Year 2

A node is a point in time when interest rates can take one of two possible paths: an upper
path, U, or a lower path, D. Now consider the node on the right side of the diagram where the
interest rate i2,DU appears. this is the rate that will occur if the initial rate, i0, follows the
lower path from Node 0 to Node 1 to become i1,D, then follows the upper of the two possible
paths to Node 2, where it takes on the value i2,DU. At the risk of stating the obvious, the
upper path from a given node leads to a higher rate than the lower path. Notice also that an
upward move followed by a downward move gets us to the same place on the tree as a down-

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then-up move, so i2,DU = i2,UD. The interest rates at each node in this interest rate tree are
one-period forward rates
corresponding to the nodal period. Beyond the root of the tree, there is more than one one-
period forward rate for each nodal period (i.e., at year 1, we have two 1-yearforward rates,
i1,U and i1,D). The relationship among the set of rates associated with each individual nodal
period is a function of the interest rate volatility assumption of the model being employed to
generate the tree. A change in the assumed interest rate volatility will affect the rates at every
node in the tree.
The construction of an interest rate tree, binomial or otherwise, is a tedious process, one you
will not have to do on the exam. In practice, the interest rate tree is usually generated using
specialized computer software. There is one underlying rule governing the construction of an
interest rate tree—the values for on-the-run issues generated using an interest rate tree
should prohibit arbitrage opportunities. This means that the value of anon-the-run issue
produced by the interest tree must equal the value of its market price.
It should be noted that in accomplishing this, the interest rate tree must maintain the interest
rate volatility assumption of the underlying model.

OPTIONS ON FIXED INCOME SECURITIES

To price options on bonds, we need a binomial interest rate tree that shows possible future
one-period interest rates. We can then calculate the payoffs for a bond or an interest rate
option using the interest rate outcomes. Once we have payments for each node, we can take
the probability-weighted present value of these payments, just as we did in the stock call
example.
The difference is that the risk-free rate is not constant. Interest rate trees are straightforward
when interest rates are fixed. Because the tree gives us a series of one-period rates, we need
to discount the payments by one or more of these rates, depending on how many periods the
payoff is out (to the right) on the tree.
There are three basic steps to valuing an option on a fixed-income instrument using a
binomial tree:
Step 1: Price the bond at each node using the projected interest rates.
Step 2: calculate the intrinsic value of the option at each node at the maturity of the option.
Step 3: Bring the terminal option values determined in Step 2 back to today.
The risk-neutral probability of an up- and down-move in the interest rate tree is always 50%,
unlike with equity options, where the probabilities depend on the risk-free rate and the size of
the up- and down-moves.
Example: Calculating value of a call option on a coupon bond
You want to value a European call option with two years to expiration and a strike price (call
price) of $100.00. The underlying bond is a $100 par value, 7% annual coupon bond with
three years to maturity. The following figure represents the first two years of the binomial
tree for valuing the underlying bond.
Fill in the missing data in the binomial tree, and calculate the value of the European call
option (note that because the option is European, it can only be exercised at the end of year 2).

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Two-Period Binomial Tree for Option Price

Interest rate = 5.99% Interest rate = 8.56%

Bond price = ? Bond price = ?
Option value = ? Option value = ?

Interest rate = 3%
Bond price = ?
Option value = ?
Interest rate = 6.34%
Bond price = ?
Option value = ?

Interest rate = 4.44%

Bond price = ? Interest rate = 4.70%
Option value = ? Bond price = ?
Option value = ?

Today 1 year 2 years

Answer:
Step 1: Calculate the bond prices at each node using the backward induction methodology.
At the middle node in year 2, the price is $100.62. You can calculate this using your
calculator by noting that at the end of year 2, the bond has one year left to maturity:
N = 1; i/Y = 6.34; PMt = 7; Fv = 100; cPt → Pv = 100.62
At the bottom node in year 2, the price is $102.20, calculated as follows:
N = 1; i/Y = 4.70; PMt = 7; Fv = 100; cPt → Pv = 102.20
At the top node in year 1, the price is $100.57, calculated as follows:

Price = (98.56 + 7) x 0.5 + (100.62 + 7) x 0.5

1.0599

= 100.57
Don’t forget the coupon payment ($7 in this example).At the bottom node in year 1, the price
is $103.80, calculated as follows:
Price = (100.62 + 7) x 0.5 + (102.20 + 7) x 0.5
1.0444
= 103.80
Today the price is $106.00, calculated as follows:
Price = (100.57 + 7) x 0.5 + (103.8 + 7) x 0.5
1.03
= 106.00
As shown here, the price at a given node is the average of the present value of the cash flows
associated with the two nodes that “feed” into the given node. The discount rate applied is the
prevailing interest rate at the given node.
Note that because this is a European option, you really only need the bond prices at the

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maturity date of the option (end of year 2) if you are given the arbitrage-free interest rate tree.
However, it is good practice to compute all the bond prices.
Step 2: Determine the intrinsic value of the option at maturity in each node. For example, the
intrinsic value of the option at the bottom node at the end of year 2 is $2.20 (= $102.20 –
$100.00). At the top node in year 2, the intrinsic value of the option is zero because the bond
price is less than the call price.
Step 3: calculate the option value at each node prior to expiration. For example, at the top
node for year 1, the option price is $0.29, calculated as follows:
Price = (0.00 x 0.5) + (0.62 x 0.5)
1.0599
= 0.29
Two-Period Binomial Tree for Option Price

Interest rate = 5.99% Interest rate = 8.56%

Bond price = $100.57 Bond price = $98.56
Option value = $0.29 Option value = $0.00

Interest rate = 3%
Bond price = $106
Option value = $0.80
Interest rate = 6.34%
Bond price = $100.62
Option value = $0.62

Interest rate = 4.44%

Bond price = $103.80 Interest rate = 4.70%
Option value = $1.35 Bond price = $102.20
Option value = $2.20

Today 1 year 2 years

The option value today is computed as:

(0.29 x 0.5) + (1.35 x 0.5)

1.03

= $0.80
If this were an American option, we would have to check to make sure that the option value
at each node was not less than the intrinsic value of the option. For example, the lowest node
at year 1 shows an option value of $1.35. However, the intrinsic value of the option at that
node (if the option were exercisable) is $3.80 (= 103.80 – 100). Hence, if the option were
American style, arbitrage would be possible (i.e., buy the option for $1.35, and exercise
immediately for a profit of $3.80 – $1.35 = $2.45).

OPTIONS ON INTEREST RATES: CAPS AND FLOORS

Interest rate caps and floors are bundles of European-style options on interest rates, called
caplets and floorlets. The value of a cap or floor is the sum of the values of the individual

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caplets or floorlets.
An interest rate caplet is similar to a call option on interest rates. The value of a caplet is:
Expiration value of caplet = max (0, 1 year rate – cap rate) x Nominal principal
1 + one year rate
Likewise, an interest rate floorlet is equivalent to a put option on interest rates:
Expiration value of floorlet = max (0, floor rate – one year rate) x Nominal principal
1 + one year rate
To value a cap (floor), you simply value each caplet (floorlet) and then add them up.
Example: Valuing an interest rate cap
Suppose you purchase a 2-year cap with annual reset and a strike rate of 5.0% on a notional
principal of $25 million. This represents a bundle containing a 1-year option and a 2-year
option. Fill in the binomial trees, and calculate the value of the 2-year caplet, the 1-year
caplet, and the 2-year cap.
2-Year Caplet.

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Two-Period Binomial Tree for Option Price

Interest rate = 5.99% Interest rate = 8.56%

Cap value = $? Cap value = $819,823

Interest rate = 3%
Cap value = $?
Interest rate = 6.34%
Cap value = $?

Interest rate = 4.44%

Cap value = $? Interest rate = 4.70%
Cap value = $?

Today 1 year 2 years

Year 1 caplet
Interest rate = 5.99%
Cap value = $?

Interest rate = 3%
Cap value = $?

Interest rate = 4.44%

Cap value = $?

Today 1 year

Answer:
The value of the 2-year caplet is $333,094, as shown in the figure.

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Value of a 2-Year Caplet

Interest rate = 5.99% Interest rate = 8.56%

Cap value = $535,357 Cap value = $819,823

Interest rate = 3%
Cap value = $333,094
Interest rate = 6.34%
Cap value = $315,027

Interest rate = 4.44%

Cap value = $150, 817 Interest rate = 4.70%
Cap value = $0

Today 1 year 2 years

Follow these steps to see how the values in the boxes were obtained:
Step 1: Determine the value of each caplet at expiration. Because this is a 2-year option, this
means at the end of year 2. For example, the caplet value in the middle box at the end of year
2 was determined as follows:
Caplet value = max (0, 25m x (0.0634 – 0.0500)
1.0634
= 335,000 / 1.0634
= 315,027
Step 2: calculate option prices at all prior nodes (note that because the option is European
style, we do not need to compare our calculated value with the intrinsic value at each node).
For the top node at the end of year 1, this was calculated as:
Value = (819,823 x 0.5) + (315,027 x 0.5)
1.0955
= 535,357
2- Year caplet = (535,357 x 0.5) + (150,817 x 0.5)
1.0300
= 333,094
Step 3: replicate the previous procedure for the 1-year caplet.
Value of a 1-Year Caplet

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Year 1 caplet
Interest rate = 5.99%
Cap value = $233,513

Interest rate = 3%
Cap value = $113,356

Interest rate = 4.44%

Cap value = $0

Today 1 year

Caplet value = max (0, 25m x (0.0599 – 0.0500)

1.0599
= 247,500 / 1.0599
= $233,513
1- Year caplet = (233,513 x 0.5) + (0 x 0.5)
1.0300
= $113,356
Step 4: Add the two values together to get the value of the cap: value of 2-year cap =
$113,356 + $333,094 = $446,450.
The procedure for the valuation of a floor is identical, except that the expiration value of each
floorlet is:
Expiration value of floorlet = max (0, floor rate – one year rate) x Nominal principal
1 + one year rate
Assignment
August 2023 – Question 5.b
November 2020 – Question 5.c
PUT – CALL – PARITY call parity
Recall that the actions and payoffs corresponding to a call/put are:
If ST < K If K < ST
long call no action buy the stock
short call no action sell the stock
long put sell the stock no action
short put buy the stock no action

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If ST < K If K < ST
long call 0 ST – K
short call 0 −(ST − K)
long put K – ST 0
short put −(K − ST ) 0

1) If we have a K–strike long call and a K–strike short put, we are able to buy the asset at
time T for K. Hence, having both a K–strike long call and a K–strike short put is
equivalent to have a K–strike long forward contract with price K.
2) Entering into both a K–strike long call and a K–strike short put is called a synthetic long
forward.
3) Reciprocally, if we have a K–strike short call and a K–strike long put, we are able to sell
the asset at time T for K. Having both a K–strike short call and a K–strike long put is
equivalent to have a short forward contract with price K.
4) Entering into both a K–strike short call and a K–strike long put is called a synthetic short
forward.
The no arbitrage cost at time T of buying an asset using a long forward contract is F0,T . The
cost at time T for buying an asset using a K–strike long call and a K–strike short put is
(Call(K,T) − Put(K,T))erT + K.
If there exists no arbitrage, then:
Theorem 1
(Put–call parity formula)
(Call(K,T) − Put(K,T))erT + K = F0,T .
If we use effective interest, the put–call parity formula becomes:
(Call(K,T) − Put(K,T))(1 + i)T + K = F0,T .
Often, F0,T = S0(1 + i)T . This forward price applies to assets which have neither cost nor
benefit associated with owning them. In the absence of arbitrage, we have the following
relation between call and put prices:
Theorem 2
(Put–call parity formula) For a stock which does not pay any dividends,
(Call(K,T) − Put(K,T))erT + K = S0erT .

Proof
Consider the portfolio consisting of buying one share of stock and a K–strike put for one
share; selling a K–strike call for one share; and borrowing S0 − Call(K,T) + Put(K,T). At
time T, we have the following possibilities:
1) If ST < K, then the put is exercised and the call is not. We finish without stock and with a
payoff for the put of K.
2) If ST > K, then the call is exercised and the put is not. We finish without stock and with a
payoff for the call of K. In any case, the payoff of this portfolio is K. Hence, K should be
equal to the return in an investment of S0 + Put(K,T) − Call(K,T) in a zero–coupon bond,
i.e. K = (S0 + Put(K,T) − Call(K,T))erT

Example
The current value of XYZ stock is 75.38 per share. XYZ stock does not pay any dividends.
The premium of a nine–month 80–strike call is 5.737192 per share. The premium of a nine–
month
80–strike put is 7.482695 per share. Find the annual effective rate of interest.

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Example
The current value of XYZ stock is 75.38 per share. XYZ stock does not pay any dividends.
The premium of a nine–month 80–strike call is 5.737192 per share. The premium of a nine–
month 80–strike put is 7.482695 per share. Find the annual effective rate of interest.
Solution: The put–call parity formula states that:
(Call(K,T) − Put(K,T))(1 + i)T + K = S0(1 + i)T
(5.737192 − 7.482695)(1 + i)3/4 + 80 = 75.38(1 + i)T .
80 = (75.38 − (5.737192 − 7.482695))(1 + i)3/4
= (77.125503)(1 + i)3/4, and i = 5%.
Example
The current value of XYZ stock is 85 per share. XYZ stock does not pay any dividends. The
premium of a six–month K–strike call is 3.329264 per share and the premium of a one year
K–strike put is 10.384565 per share. The annual effective rate of interest is 6.5%. Find K.
Solution: The put–call parity formula states that:
(Call(K,T) − Put(K,T))(1 + i)T + K = S0(1 + i)T .
So, (3.329264 − 10.384565)(1.065)0.5 + K = 85(1.065)0.5 and
K = (85 − 3.329264 + 10.384565)(1.065)0.5 = 95.
Example
XYZ stock does not pay any dividends. The price of a one year forward for one share of XYZ
stock is 47.475. The premium of a one year 55–strike put option of XYZ stock is 9.204838
per share. The annual effective rate of interest is 5.5%. Calculate the price of a one year 55–
strike call option for one share of XYZ stock.
Solution: The put–call parity formula states that:
(Call(K,T) − Put(K,T))(1 + i)T + K = F0,T .
So, (Call(55, 1) − 9.204838)(1.055) + 55 = 47.475 and
Call(55, 1) = 9.204838 + (47.475 − 55)(1.055)−1 = 2.072136578.
If prices of put options and call options do not satisfy the put–call parity, it is possible to do
arbitrage.
If (S0 − Call(K,T) + Put(K,T))erT > K,
We can make a profit by buying a call option, selling a put option and shorting stock. The
profit of this strategy is = − K + (S0 − Call(K,T) + Put(K,T))erT .
If (S0 − Call(K,T) + Put(K,T))erT < K,
We can do arbitrage by selling a call option, buying a put option and buying stock. At
expiration time, we get rid of the stock by satisfying the options and make
K − (S0 − Call(K,T) + Put(K,T))erT .

Example
XYZ stock trades at $54 per share. XYZ stock does not pay any dividends. The cost of an
European call option with strike price $50 and expiration date in three months is $8 per share.
The risk free annual interest rate continuously compounded is 4%.

Example
XYZ stock trades at $54 per share. XYZ stock does not pay any dividends. The cost of an
European call option with strike price $50 and expiration date in three months is $8 per share.
The risk free annual interest rate continuously compounded is 4%.
(i) Find the no–arbitrage price of a European put option with the same strike price and
expiration time.
Solution: (i) With continuous interest, the put–call parity formula is:

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(Call(K,T) − Put(K,T))erT + K = S0erT .

Hence,
(8 − Put(50, 0.25))e0.04(0.25) + 50 = 54e0.04(0.25)
and Put(50, 0.25) = 8 − 54 + 50e−0.04(0.25) = 3.502491687.

Example
XYZ stock trades at $54 per share. XYZ stock does not pay any dividends. The cost of an
European call option with strike price $50 and expiration date in three months is $8 per share.
The risk free annual interest rate continuously compounded is 4%.
(ii) Suppose that the price of an European put option with the same strike price and expiration
time is $3, find an arbitrage strategy and its profit per share.

Example
XYZ stock trades at $54 per share. XYZ stock does not pay any dividends. The cost of an
European call option with strike price $50 and expiration date in three months is $8 per share.
The risk free annual interest rate continuously compounded is 4%.
(ii) Suppose that the price of an European put option with the same strike price and expiration
time is $3, find an arbitrage strategy and its profit per share.
Solution: (ii) A put option for $3 per share is undervalued. An arbitrage portfolio consists in
selling a call option, buying a put option and stock and borrowing $−8 + 3 + 54 =$49, with
all derivatives for one share of stock. At redemption time, we sell the stock and use it to
execute the option which will be executed. We also repaid the loan.
The profit is 50 − (49)e(0.04)(0.25) = 50 − 49.49245819 = 0.50754181.

Example
Suppose that the current price of XYZ stock is 31. XYZ stock does not give any dividends.
The risk free annual effective interest rate is 10%. The price of a three–month 30–strike
European call option is $3. The price of a three–month 30–strike European put option is
$2.25. Find an arbitrage opportunity and its profit per share.
Solution: We have that:
(S0 + Put(K,T) − Call(K,T))(1 + i)T
= (31 + 2.25 − 3)(1.1)0.25 = 30.97943909 > 30.
We conclude that the put is overpriced relatively to the call. We can sell a put, buy a call and
short stock. The profit per share is:
(2.25 − 3 + 31)(1.1)0.25 − 30 = 0.9794390948
Notice that at expiration time, one of the options is executed and we get back the stock which
we sold.

SYNTHETIC FORWARD
A synthetic long forward is the combination of buying a call and selling a put, both with the
same strike price, amount of the asset and expiration date.
The payments to get a synthetic long forward are
(Call(K,T) − Put(K,T)) paid at time zero.
K paid at time T.
The future value of these payments at time T is:
K + (Call(K,T) − Put(K,T))(1 + i)T .
The payment of long forward is F0,T paid at time T.
In the absence of arbitrage (put–call parity)
F0,T = K + (Call(K,T) − Put(K,T))(1 + i)T .

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The premium of a synthetic long forward, i.e. the cost of entering this position, is:
(Call(K,T) − Put(K,T)).
1) If F 0,T = K, the premium of a synthetic long forward is zero. You will be buying the asset
at the estimated future value of the asset.
2) If F 0,T > K, the premium of a synthetic long forward is positive. You will be buying the
asset lower than the estimated future value of the asset.
3) If F 0,T < K, the premium of a synthetic long forward is negative. You will be buying the
asset higher than the estimated future value of the asset.

CONSTRUCTIVE SALE
An investor owns stock. He would like to sell his stock. But, he does not want to report
capital gains to the IRS this year. So, instead of selling this stock, he holds the stock, buys a
K–strike put, sells a K–strike call, and borrows K(1 + i)−T . The payoff which he gets at time
T is
ST + max(K − ST , 0) − max(ST − K, 0) − K
=max (ST ,K) − max(ST ,K) = 0.
At time zero, the investor gets:
Call(K,T) − Put(K,T) + K(1 + i)−T = F0,T (1 + i)−T .
At expiration time, the investor can use the stock to meet the option which will be executed.
Practically, the investor sold his stock at time zero for F 0,T (1 + i)−T . According to the
current USA tax laws, this is considered a constructive sale. He will have to declare capital
gains when the options are bought.

FLOOR
Suppose that you own some asset. If the asset losses value in the future, you lose money. A
way to insure this long position is to buy a put position. The purchase of a put option is called
a floor. A floor guarantees a minimum sale price of the value of an asset.
The profit of buying an asset is ST − S0(1 + i)T , which is the same as the profit of a long
forward. The minimum profit of buying an asset is −S0(1 + i)T .
The profit for buying an asset and a put option is:
ST − S0(1 + i)T + max(K − ST , 0) − Put(K,T)(1 + i)T
= max (ST ,K) − (S0 + Put(K,T))(1 + i)T .
The minimum profit for buying an asset and a put option is:
K − (S0 + Put(K,T))(1 + i)T .
We know that −S0(1 + i)T < K − (S0 + Put(K,T))(1 + i)T .
Here is the graph of the profit for buying an asset and a put option:

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Notice that this is the graph of the profit of a purchased call.

Here is a joint graph for the profits of the strategies: (i) buying an asset, (ii) buying an asset
and a put.

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DERIVATIVES ANALYSIS

The above diagram: Profit for long forward and buying an asset and a put.

REVISION QUESTIONS
DECEMBER 2023
Q.2.B – The following information has been obtained from Zig trading exchange:
Day Futures price (sh)
0 82
1 84
2 78
3 73
4 79
5 82
6 84
Additional information:
1. Initial margin requirement is sh. 5 per contract.
2. Maintenance margin requirement is sh. 2 per contract.
3. An investor establishes a long position of 20 contracts, meets all margin calls and does
not withdraw any funds.
Required:
Determine the ending balance of the long position account from day 1 to day 6. (6 mks)

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DERIVATIVES ANALYSIS

Day Beginning Funds deposited Futures Price Gains/loss Ending

balance price change balance
0 0 100 82 0 0 100
1 100 0 84 2 40 140
2 140 0 78 -6 -120 20
3 20 80 73 -5 -100 0
4 0 100 79 6 120 220
5 220 0 82 3 60 280
6 280 0 84 2 40 320

On Day 0, you deposit $100 because the initial margin requirement is $5 per contract and you
go long 20 contracts. At the end of Day 2, the balance is down to $20, which is $20 below the
$40 maintenance margin requirement ($2 per contract times 20 contracts). You must deposit
enough money to bring the balance up to the initial margin requirement of $100 ($5 per
contract times 20 contracts). So on Day 3, you deposit $80. The price change on Day 3 causes
a gain/loss of -$100, leaving you with a balance of $0 at the end of Day 3. On Day 4, you
must deposit $100 to return the balance to the initial margin level.

Workings
(84 – 82) x 20 = 40
(78 – 84) x 20 = -120
(73 – 78) x 20 = -100………………
Initial margin = 5 x 20 = sh. 100
100 + 40 = 140
140 – 120 = 20
20 – 100 = -80………………………
Maintenance call = 2 x 20 = sh. 40
Note: The margin account balances column in the below table shows the ending balances
from day 1 to day 6 which we have adjusted with the changes in the daily gain/loss column.
Days Futures price Daily gain/loss Cumulative Marginal account Marginal call
gain/loss balance
0 82 - - 100
1 84 40 40 140
2 78 -120 -80 20 80
3 73 -100 -180 -80 180
4 79 120 -60 40 60
5 82 60 0 100
6 84 40 40 140

Q.2.C – A Kenyan businessman deals with imports from United Kingdom (UK). Due to the
recent exchange rate movement, he has been advised that the value of the pound is likely to
increase against the Kenyan shilling over the next 30 days. The businessman is expected to
make payment of imported goods in 30 day’s time and wants to hedge the currency
exposure. The applicable Kenyan risk free rate is 5.5% and the UK risk free rate is 4.5%.
These rates are expected to remain unchanged over the next month.
The current spot rate is sh. 150/₤.
Required:

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i. Explain whether the businessman should use a long or short forward contract to hedge the
currency risk. (2 mks)
Solution
The risk to you is that the value of the British pound will rise over the next 30 days and it will
require more Kenya shillings to buy the necessary pounds to make payment. To hedge this
risk you should enter a forward contract to buy British pounds. (use long to hedge the
currency risk.)
ii. Calculate the no-arbitrage price at which the businessman should enter into a forward
contract that expires in 30 days. (3 mks)
S0 = sh. 1.50
T = 30/365
R = 0.055
Rf = 0.045
F(0,T) = sh. 1.50/(1.04)30/365 x (1.055)30/365
= sh. 1.5018
iii. Assume it is 10 days later into the life of the forward contract and the spot rate is sh. 153/₤.
Interest rates are unchanged. Calculate the value of the forward contract held by the
businessman. (3 mks)
Solution
St = sh. 1.53
T = 30/365
t = 10/365
T – t = 20/365
R = 0.055
Rf = 0.045
Vt (0,T) = sh. 1.53/(1.045) 20/365 – sh.1.5018/(1.055)20/365 = sh. 0.0295.
Because you are long, this is a gain of sh.0.0295 per British pound.
Q.3.B – Hilda Mwongeli is a financial analyst at Bottomline Bank, a commercial bank based
in South Africa. One of the bank’s investments is exposed to movements in the South
African Rand and Hilda Mwongeli desires to hedge the currency exposure. He prices a one
year fixed for fixed currency swap involving Rand and Kenyan shilling with a quarterly
reset. Mwongeli uses the interest rate data presented below to price the currency swap.
Days to maturity Rand spot interest rates (%) Kenya shillings spot interest rates (%)
90 0.05 0.20
180 0.10 0.40
270 0.15 0.55
360 0.25 0.70
Required:
Determine the annualized equilibrium fixed swap rate for South African Rand. (4 mks)
Q.3.D – Washington Omondi gathers the following information from a financial service data
terminal on 14 May 2023 relating to TMA Ltd (option data)

Calls Put

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DERIVATIVES ANALYSIS

Exercise May (sh) June (sh) July (Sh) May (sh) June (sh) July (Sh)
price (sh)
120 8.75 15.40 20.90 2.75 9.25 13.65
125 5.75 13.50 18.60 4.60 11.50 16.60
130 3.60 11.35 16.40 7.35 14.25 19.65
Additional information:
1. The current stock price : sh. 125.94
2. Expirations: 21 May 2023, 18 June 2023, 16 July 2023.
3. The applicable annualized risk free rate is 4.56%.
4. An option contract is for 100 shares of the stock employed.
5. Washington Omondi decides to examine the TMA Ltd. June box spread using the 125
and 130 options.
He undertakes the following transactions:
 Buy the 125 call at sh. 13.50, buy the 130 put at sh. 14.25, write the 130 call at 11.35
and write the 125 put at sh. 11.50. The premiums paid for the 125 call and 130 put
minus the premium received for the 130 call and 125 put net out to sh. 4.90
Required:
i. Determine the payoff at expiration. (1 mk)
ii. Calculate the net present value (NPV) of the box spread. (4 mks)
Solution omitted deliberately. (Study carefully the below given illustrations then attempt
the above question as part of your assignment.)
Illustration
Consider a box spread consisting of options with exercise prices of 75 and 85. The call prices
are 16.02 and 12.28 for exercise prices of 75 and 85, respectively. The put prices are 9.72 and
15.18 for exercise prices of 75 and 85, respectively. The options expire in six months and the
discrete risk-free rate is 5.13 percent.
Required:
1) Determine the value of the box spread and the profit for any value of the underlying at
expiration.
2) Show that this box spread is priced such that an attractive opportunity is available.
Solution
Answer for part 1
The box spread always has a value at expiration of X2 - XI = 85 - 75 = 10
Profit = VT - (C1 - C2 + P2 – P1) = 10 - (16.02 - 12.28 + 15.18 - 9.72) = 0.80
Answer for part 2
(X2 – X1)/(1 + r)T
(85 – 75) / (1.0513)0.5 = 9.75
The cost of the box spread is 16.02 - 12.28 + 15.18 - 9.72 = 9.20. The box spread is thus
underpriced. At least one of the long options is priced too low or at least one of the short
options is priced too high; we cannot tell which. Nonetheless, we can execute this box spread,
buying the call with exercise price X1 = 75 and put with exercise price X2 = 85 and selling the
call with exercise price X2 = 85 and put with exercise price X1 = 75. This would cost 9.20.
The Net present value (NPV) of the payoff is 9.75. Therefore, the box spread would generate
an immediate increase in value of 0.55.
Illustration

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A box spread can also be used to exploit an arbitrage opportunity but it requires that neither
the binomial nor Black-Scholes-Merton model holds, it needs no estimate of the volatility,
and all of the transactions can be executed within the options market, making '
implementation of the strategy simpler, faster, and with lower transaction costs. In basic
terms, a box spread is a combination of a bull spread and a bear spread. Suppose we buy the
call with exercise price X1 and sell the call with exercise price X2. This set of transactions is a
bull spread. Then we buy the put with exercise price X2 and sell the put with exercise price
X1. This is a bear spread. Intuitively, it should sound like a combination of a bull spread and a
bear spread would leave the investor with a fairly neutral position, and indeed, that is the
case.
The value of the box spread at expiration is:
VT = Max(0,ST – X1) – Max(0,ST – X2) + Max(0,X2 – ST) – Max(0,X1 – ST)
Broken down into ranges, we have:
 VT = 0 – 0 + X2 – ST – (X1 – ST) = X2 – X1 : If ST ≤ X1
 VT = ST – X1 – 0 + X2 – ST – 0 = X2 – X1 : If X1 < ST < X2
 VT = ST – X1 – (ST – X2) + 0 – 0 = X2 – X1 : If ST ≥ X2
These outcomes are all the same. In each case, two of the four options expire in-the-money,
and the other two expire out-of-the-money. In each case, the holder of the box spread ends up
buying the underlying with one option, using either the long call at X1 or the short put at XI,
and selling the underlying with another option, using either the long put at X2 or the short call
at X2. The box spread thus results in buying the underlying at X1 and selling it at X2. This
outcome is known at the start.
The initial value of the transaction is the value of the long call, short call, long put, and short
put, V0 = C1 - C2 + P2 – P1. The profit is, therefore, II = X2 - X1 - C1 + Cz - P2 + P1.
In contrast to all of the other strategies, the outcome is simple. In all cases, we end up with
the same result. Using the options with exercise prices of 1950 and 2050, which have
premiums of C1 = 108.43, C2 = 59.98, P1 = 56.01, and P2 = 107.39, the value at expiration is
always 2050 - 1950 = 100 and the profit is always II = 100 - 108.43 + 59.98 - 107.39 + 56.01
= 0.17. This value may seem remarkably low. We shall see why momentarily.
The initial value of the box spread is C1 - C2 + P2 - Pl. The payoff at expiration is
X2 - XI. Because the transaction is risk free, the present value of the payoff, discounted using
the risk-free rate, should equal the initial outlay. Hence, we should have:
(X2 – X1) / (1 + r)T = C1 – C2 + P2 – P1
If the present value of the payoff exceeds the initial value, the box spread is underpriced and
should be purchased. In this example, the initial outlay is Vo = 108.43 - 59.98 + 107.39 -
56.01 =
99.83. To obtain the present value of the payoff, we need an interest rate and time to
expiration.
The prices of these options were obtained using a time to expiration of one month and a risk-
free rate of 2.02 percent. The present value of the payoff is:
(X2 – X1) / (1 + r)T = C1 – C2 + P2 – P1
= (2050 – 1950) / (1.0202)1/12 = 99.83
In other words, this box spread is correctly priced. This result should not be surprising,
because we noted that we used the Black-Scholes-Merton model to price these options. The
model should not allow arbitrage opportunities of any form. Recall that the profit from this
transaction is 0.17, a very low value. This profit reflects the fact that the box spread is
purchased at 99.83 and matures to a value of 100, a profit of 0.17, which is a return of the
risk-free rate for one month. The reason the profit seems so low is that it is just the risk-free
rate.

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Let us assume that one of the long options, say the put with exercise price of 2050,is
underpriced. Let its premium be 105 instead of 107.39. Then the net premium would be
108.43 - 59.98 + 105 - 56.01 = 97.44. Again, the present value of the payoff is 99.83.
Hence, the box spread would generate a gain in value clearly in excess of the risk-free rate.
If some combination of the options was such that the net premium is more than the present
value of the payoff, then the box spread would be overpriced. Then we should sell the X1
call and X2 put and buy the X2 call and XI put. Doing so would generate an outlay at
expiration with a present value less than the initial value.
So to summarize the box spread, we say that:

Value at expiration: VT = X2 – X1
Profit: II = X2 – X1 - (C1 - C2 + P2 – P1)
Maximum profit = (same as profit)
Maximum loss = (no loss is possible, given fair option prices)
Breakeven: no breakeven; the transaction always earns the risk-free rate, given fair option
prices.
Q.4.B – The following information relates to put and call options on an asset:
Call price Sh. 3.5
Put price Sh. 9.0
Exercise price Sh. 50
Forward price Sh.45
Days to option expiration 175
Risk free rate 4%

Required:
i. The synthetic call option price. (2 mks)
ii. Price of the synthetic put option. (2 mks)
iii. Price of the synthetic forward contract. (2 mks)
Solution
Synthetic call option:
Call price, Co = sh.3.50
Put price, Po = sh.9
Exercise price, X = sh.50
Forward price, F(0,T) = sh.45
Days to option expiration = 175
Risk-free rate, r = 4 percent
Time to expiration = 175/365 = 0.4795
Bond price = [X - F(O,T)] l(l + r)T = (50 - 45)/(1 +0.04)0.4795 = sh.4.91
Synthetic call = Long forward + Po - [X - F(O,T]/(l + r)T = 0 + 9 - 4.91 = 4.09
Synthetic put option
Synthetic put = Co + Short forward + [X - F(O,T)]l(l + r)T = 3.5 + 0 + 4.91 = 8.41

Synthetic forward contract

Synthetic forward = Co - Po + [X - F(O,T)]/(l + r)T = 3.5 - 9 + 4.91 = -0.59

Instrument Actual Price Synthetic price Mispricing/Profit

Call 3.50 4.09 0.59

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Put 9 8.41 0.59

Forward 0 -0.59 0.59

Q.5.B – The following information relates to a call option on Bendera Limited’s shares
trading at a securities exchange:
1. The exercise price is sh. 70.
2. The risk free rate is 6%.
3. The volatility is 0.4.
4. The days to option expiration is 90 days.
5. The current share price is sh. 60.
Required:
The price of a call option on Bendera Limited’s shares using the Black-Scholes-Merton
(BSM) pricing model. (5 mks)
The formula for BSM is given as follows:

Solution
Exercise price = sh. 70
Risk free rate = 6/100 = 0.06
Volatility = 0.4
Days to expiration = 90 days = 90/365 = 0.25
Current price = sh. 60
d1 = In(60/70) + (0.06 + 0.5 x 0.4 2) x 0.25
0.4 x √0.25
d1 = - 0.1542 + 0.035 / 0.2
d1 = - 0.596 = -0.60
N(d1) = 0.5 – 0.2258
N(d1) = 0.2742
d2 = d1 – σ √t
d2 = -0.60 – 0.4√0.25
d2 = - 0.60 – 0.2
d2 = - 0.8
Nd2 = 0.5 – 0.2881
Nd2 = 0.212
Value of the call option = 60 x 0.2742 – (70/(2.7183) 0.06 x 0.25
Value of the call option = 16.452 – 70/1.015
Value of the call option = 16.452 – 68.97
Value of the call option = - 52.52

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AUGUST 2023
Q.1.D – An investor is considering a two period binomial model in which the underlying is
at sh. 50 and can go up 4.88% or down 2.53% each period. The risk free rate is 1.25%. The
exercise price of the call is sh. 50.
Required:
i. Calculate the payoffs of the call option at expiration. (4 mks)
ii. Calculate the value of the call option expiring in two periods. (4 mks)
Solution omitted deliberately.
Read the below given illustration then answer the above question as part of your assignment.
Illustration
Consider a two-period binomial model in which the underlying is at 30 and can go up 14
percent or down 11 percent each period. The risk-free rate is 3 percent per period.
Required:
1) Find the value of a European call option expiring in two periods with an exercise price of 30.
2) Find the number of units of the underlying that would be required at each point in the
binomial tree to construct a risk-free hedge using 10,000 calls.
Solutions
First find the underlying prices in the binomial tree: We have u = 1.14 and d = 1 - 0.11 = 0.89.
S+ = Su = 30(1.14) = 34.20
S - = Sd = 30(0.89) = 26.70
S++ = su2 = 30(1.14)2 = 38.99
S+ - = Sud = 30(1.14)(0.89) = 30.44
S - - = Sd2 = 30(0.89)2 = 23.76
Then find the option prices at expiration: Then find the option prices at expiration:
C+ + = Max(0,38.99 - 30) = 8.99
C+ - = Max(0, 30.44 – 30) = 0.44
C - - = Max(0, 23.76 – 30) = 0
We will need the value of T (profit):
T = 1.03 – 0.89 / 1.14 – 0.89 = 0.56 and 1 - T = 0.44. Then step back and find the option
prices at time 1:
C+ = 0.56(8.99) + 0.44(0.44) / 1.03 = 5.08
C - = 0.56 (0.44) + 0.44(0) / 1.03 = 0.24
The price today is:
C = 0.56(5.08) + 0.44(0.24) / 1.03 = 2.86

The number of units of the underlying at each point in the tree is found by first computing the
values of n.

n = 5.08 – 0.24 = 0.6453

34.20 – 26.70

n + = 8.99 – 0.44 = 1.00

38.99 – 30.44

n - = 0.44 – 0 = 0.0659
30.44 – 23.76
The number of units of the underlying required for 10,000 calls would thus be 6,453 today,
10,000 at time 1 if the underlying is at 34.20, and 659 at time 1 if the underlying is at 26.70.
Illustration

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Repeating the data from the above example, consider a one-period binomial model in which
the underlying is at 65 and can go up 30 percent or down 22 percent. The risk-free rate is 8
percent. Determine the price of a European put option with exercise price of 70.
Solution
First find the underlying prices in the binomial tree. We have u = 1.30 and d = 1 - 0.22 =
0.78.
S + = Su = 65(1.30) = 84.50
S = Sd = 65(0.78) = 50.70
Then find the option values at expiration:
P+ = Max(0,70 - 84.50) = 0
P- = Max(0,70 - 50.70) = 19.30
The risk-neutral probability is:
T = 1.08 – 0.78 = 0.5769
1.30 – 0.78

1 - IT = 1 – 0.5769 = 0.4231. The put price today is:

P = 0.5769(0) + 0.423(19.30) / 1.08 = 7.56

Q.2.A – Explain the following option spread strategies:

i. Bull spread. (2 mks)
ii. Bear spread. (2 mks)
iii. Butterfly spread using calls. (2 mks)
Solution – Refer to September 2015.Q.4.C of this chapter a few pages ahead.
Q.3.B – Samson Ole Kina manages a family investment portfolio which initially consist of
sh. 46 million of equities and sh. 32 million of bonds. As a resultof a change in famlily
circumstances, the portfolio is rebalanced using the transactions shown below:
Types of futures Action Number of futures Price per futures contract
contracts contracts to buy/sell (sh)
Equity futures Buy 42 160,000
Bond futures contract Sell 35 190,000
Three months after these transactions, the market value of the portfolio’s equities has
increased by 3.00% and the market value of its bonds has decreased by 2.40%. The prices of
the equity and bond futures are now quoted at sh. 165,000 and sh. 185,250 respectively.
Required:
Calculate the profit or loss on the portfolio over the past three months. (6 mks)
Solution omitted deliberately.
Q.4.B – Jacob Imanyara, a derivatives trader has obtained the following information about a
call option:
Time to maturity 3 years
Continuous risk free rate 3%
Continuous dividend yield 2%
N(d1) 0.70
Required:
The delta of the call option. (3 mks)
Solution omitted deliberately.
Illustration

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Use the Black-Scholes-Merton model to calculate the prices of European call and put options
on an asset priced at 68.5. The exercise price is 65, the continuously compounded risk-free
rate is 4 percent, the options expire in 110 days, and the volatility is 0.38. There are no cash
flows on the underlying.

Solution
The time to expiration will be T = 110/365 = 0.3014. Then d1and d2 are:
d1 = In(68.5/65) + 0.04 (0.38)2 / 2) (0.3014) = 0.4135
0.38√0.3014
d2 = 0.4135 – 0.38√0.3014 = 0.2049
Looking up in the normal probability table, we have:
Nd1(0.41) = 0.6591
Nd2(0.20) = 0.5793
Plugging into the option price formula,
P = 65e-0.04(0.3014) (1-0.5793) – 68.5(1-0.6591) = 3.67

UNDERLYING PRICE: DELTA AND GAMMA

The price of the underlying is generally one of the easiest sources of input information.
Suffice it to say that if an investor cannot obtain the price of the underlying, then she should
not even be considering the option. The price should generally be obtained as a quote or trade
price from a liquid, open market. The relationship between the option price and the
underlying price has a special name: It is called the option delta. In fact, the delta can be
obtained approximately from the Black-Scholes-Merton formula as the value of N(d1) for
calls and N(dl) - 1 for puts.
More formally, the delta is defined as:
Delta = change in option price / change in underlying asset.
The above definition for delta is exact; the use of N(d1) for calls and N(dl) - 1 for puts is
approximate.
Let us consider the example, where S = 52.75, X = 50, RC = 0.0488, T = 0.75, and u = 0.35.
Using a computer to obtain a more precise Black-Scholes-Merton answer, we get a call
option price of 8.6186 and a put option price of 4.0717. N(d1), the call delta, is 0.6733, so the
put delta is 0.6733 - 1 = -0.3267. Given that Delta = (Change in option price /change in
underlying price), we should expect that Change in option price = Delta x Change in
underlying price.
Therefore, for a $1 change in the price of the underlying, we should expect:
Change in call option price = 0.6733(1) = 0.6733
Change in put option price = -0.3267(1) = -0.3267
This calculation would mean that:
Approximate new call option price = 8.6186 + 0.6733 = 9.2919
Approximate new put option price = 4.0717 - 0.3267 = 3.7450
To test the accuracy of this approximation, we let the underlying price move up $1 to
$53.75 and re-insert these values into the Black-Scholes-Merton model. We would then
obtain:
Actual new call option price = 9.3030
Actual new put option price = 3.7560
The delta approximation is fairly good, but not perfect.
Delta is important as a risk measure. The delta defines the sensitivity of the option price to a
change in the price of the underlying. Traders, especially dealers in options, use delta to

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construct hedges to offset the risk they have assumed by buying and selling options. For
example, recall that FRA dealers offer to take either side of an FRA transaction. They then
usually hedge the risk they have assumed by entering into other transactions. These same
types of dealers offer to buy and sell options, hedging that risk with other transactions. For
example, suppose we are a dealer offering to sell the call option we have been working with
above. A customer buys 1,000 options for 8.619. We now are short 1,000 call options, which
exposes us to considerable risk if the underlying goes up. So we must buy a certain number of
units of the underlying to hedge this risk. We previously showed that the delta is 0.6733, so
we would buy 673 units of the underlying at 52.75.
Assume that for the moment that the delta tells us precisely the movement in the option for a
movement in the underlying. Then suppose the underlying moves up $1:
Change in value of 1,000 long units of the underlying: 673(+$1) = $673
Change in value of 1,000 short options: 1,000(+$1)(0.6733) = $673

Because we are long the underlying and short the options, these values offset. At this point,
however, the delta has changed. If we recalculate it, we would find it to be 0.6953. This
would require that we have 695 units of the underlying, so we would need to buy an
additional 22 units. We would borrow the money to do this. In some cases, we would need to
sell off units of the underlying, in which case we would invest the money in the risk-free
asset.
In fact, even if the underlying price does not change, the delta would still change as the
option moves toward expiration. For a call, the delta will increase toward 1.0 as the
underlying price moves up and will decrease toward 0.0 as the underlying price moves down.
For a put, the delta will decrease toward - 1.0 as the underlying price moves down and
increase towards 0.0 as the underlying price moves. If the underlying price does not move, a
call delta will move toward 1.0 if the call is in-the-money or 0.0 if the call is out-of-the-
money as the call moves toward the expiration day. A put delta will move toward - 1.0 if the
put is in-the money or 0.0 if the put is out-of-the-money as it moves toward expiration. So the
delta is constantly changing, which means that delta hedging is a dynamic process.
In fact, delta hedging is often referred to as dynamic hedging. In theory, the delta is
changing continuously and the hedge should be adjusted continuously, but continuous
adjustment is not
possible in reality. When the hedge is not adjusted continuously, we are admitting the
possibility of much larger moves in the price of the underlying. Let us see what happens in
that case.
Using our previous example, we allow an increase in the underlying price of $10 to $62.75.
Then the call price should change by 0.6733(10) = 6.733, and the put option price should
change by -0.3267(10) = -3.267. Thus, the approximate prices would be:
Approximate new call option price = 8.619 + 6.733 = 15.3520.
Approximate new put option price = 4.0717 - 3.267 = 0.8047
The actual prices are obtained by recalculating the option values using the Black-Scholes-
Merton model with an underlying price of 62.75. Using a computer for greater precision, we
find that these prices are:
Actual new call option price = 16.3026
Actual new put option price = 1.7557

Q.5.B – Gem Holdings Limited purchases a 1 – year cap with annual reset and a strike rate
of 5.0% on a notional principal of sh. 25 million. The binomial model below represents a
bundle of 1-year option.

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1 year caplet Interest rate = 5.99%

Interest rate = 3%

Interest rate = 4.44%

Required:
The value of a 1-year caplet (4 mks)
Solution
we just summarize this question because we have done it as part of our examples above.
(Where you do not understand how the figures were calculated, refer to our above given
example/notes.
We had also given it as part of your assignment.
The value of the 2-year caplet is $333,094, as shown in the figure.
Value of a 2-Year Caplet

Interest rate = 5.99% Interest rate = 8.56%

Cap value = $535,357 Cap value = $819,823

Interest rate = 3%
Cap value = $333,094
Interest rate = 6.34%
Cap value = $315,027

Interest rate = 4.44%

Cap value = $150, 817 Interest rate = 4.70%
Cap value = $0

Today 1 year 2 years

Follow these steps to see how the values in the boxes were obtained:
Step 1: Determine the value of each caplet at expiration. Because this is a 2-year option, this
means at the end of year 2. For example, the caplet value in the middle box at the end of year
2 was determined as follows:
Caplet value = max (0, 25m x (0.0634 – 0.0500)
1.0634
= 335,000 / 1.0634
= 315,027
Step 2: calculate option prices at all prior nodes (note that because the option is European
style, we do not need to compare our calculated value with the intrinsic value at each node).
For the top node at the end of year 1, this was calculated as:
Value = (819,823 x 0.5) + (315,027 x 0.5)
1.0955

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= 535,357
2- Year caplet = (535,357 x 0.5) + (150,817 x 0.5)
1.0300
= 333,094
Step 3: replicate the previous procedure for the 1-year caplet.
Value of a 1-Year Caplet

Year 1 caplet
Interest rate = 5.99%
Cap value = $233,513

Interest rate = 3%
Cap value = $113,356

Interest rate = 4.44%

Cap value = $0

Today 1 year

Caplet value = max (0, 25m x (0.0599 – 0.0500)

1.0599
= 247,500 / 1.0599
= $233,513
1- Year caplet = (233,513 x 0.5) + (0 x 0.5)
1.0300
= $113,356
Step 4: Add the two values together to get the value of the cap: value of 2-year cap =
$113,356 + $333,094 = $446,450.
The procedure for the valuation of a floor is identical, except that the expiration value of each
floorlet is:
Expiration value of floorlet = max (0, floor rate – one year rate) x Nominal principal
1 + one year rate
Q.5.C – Mutemi Karuri is considering a three year receiver swaption with an exercise rate of
11.75% in which the underlying swap is a sh. 20 million notional principal four year swap.
The underlying rate is secured overnight financing rate (SOFR). At expiration of the
swaption, the SOFR rates are as follows:

Days Rate (%)

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360 10
720 10.5
1080 10.9
1440 11.2

Assume 360 days in a year.

Required:
i. Calculate the swap fixed rate. (4 mks)
ii. Calculate the payoff value of the swaption. (6 mks)
Solution omitted deliberately.
APRIL 2023
Q.2.A – Explain three changes that have taken place in the regulation of the over the
counter market since 2008 financial crisis.
(6 mks)
Solution omitted deliberately.
Q.2.B – James Kamonya previously bought ABC Ltd. shares at sh. 12 and now buys the
November 15 put for sh. 1.46 and simultaneously writes the November 17 covered call for
sh. 1.44.
Required:
Calculate the following for a dollar position created:
i. The maximum gain. (2 mks)
ii. The minimum gain. (2 mks)
Solution omitted deliberately.
Q.2.C – Explain the following terms as used in the option markets:
i. Calendar spread. (2 mks)
ii. Long straddle. (2 mks)
Calendar spread
We have assumed in the other types of spreads that the options used to create a spread all
expire at the same time. We now move on to calendar spreads in which the options have the
same strike price and different expiration dates.
A calendar spread can be created by selling a European call option with a certain strike price
and buying a longer-maturity European call option with the same strike price.
The longer the maturity of an option, the more expensive it usually is. A calendar spread
therefore usually requires an initial investment. Profit diagrams for calendar spreads are
usually produced so that they show the profit when the short-maturity option expires on the
assumption that the long-maturity option is closed out at that time.
Long straddle
A long straddle comprises buying a call option and a put option on the same stock with the
same strike price and expiry.
A straddle is appropriate when an investor is expecting a large move in a stock price but does
not know in which direction the move will be. Consider an investor who feels that the price
of a certain stock, currently valued at $69 by the market, will move significantly in the next 3
months. The investor could create a straddle by buying both a put and a call with a strike
price of $70 and an expiration date in 3 months. Suppose that the call costs $4 and the put
costs $3. If the stock price stays at $69, it is easy to see that the strategy costs the investor $6.
(An up-front investment of $7 is required, the call expires worthless, and the put expires
worth $1.) If the stock price moves to $70, a loss of $7 is experienced. (This is the worst that
can happen.) However, if the stock price jumps up to $90, a profit of $13 is made; if the stock
moves down to $55, a profit of $8 is made; and so on.

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DERIVATIVES ANALYSIS

iii. The underlying stock sells for sh. 50 and an investor selects 30 day options with an
exercise price of sh. 50. The call sells for sh. 2.29 and the put for sh. 2.28.
Required:
Calculate the break even points from the above investment strategy. (2 mks)
Q.5.B – The price of a 1-year put on a stock of KM limited with an exercise price of sh. 70
is sh. 5 and the forward price of the contract expiring in one year is sh. 81. The annual risk
free rate is 10%.
Required:
Calculate the price of call option on a stock of KM Limited with an exercise price of sh. 70
that expires in one year using the put-call forward parity. (3 mks)

DECEMBER 2022
Q.1.C – Joan Akoth believes she has identified an arbitrage opportunity for a commodity as
indicated by the information provided below:
Spot price for commodity Sh. 120
Futures price for commodity expiring in 1 year Sh. 125
Interest rate for one year 8%
Required:
i. Describe three transactions necessary to take advantage of this specific arbitrage
opportunity. (3 mks)
ii. Calculate the arbitrage profit. (3 mks)
iii. Describe four market imperfections that could limit Joan’s ability to implement this
arbitrage strategy. (4 mks)
Q.3.C – Fanaka Investments are considering a share worth sh. 49 at the securities exchange.
They establish that a call option with an exercise price of sh. 50 costs sh. 6.25 and a put with
an exercise price of sh. 50 cost sh. 5.875. Suppose Fanaka Investments goes ahead and buys
a straddle.
Required:
i. Differentiate between a straddle and a strangle as used in option derivatives. (2 mks)
A straddle involves buying a European call and put with the same strike price and expiration
date while a strangle, sometimes called a bottom vertical combination, an investor buys a
European put and a European call with the same expiration date and different strike prices.
ii. Determine the value and profit at expiration from the straddle if price of the share at
expiration is sh. 61. (2 mks)
iii. The maximum loss from the straddle. (2 mks)
iv. The breakeven price at expiration from the straddle. (2 mks)
Q.4.C – European put and call options with an exercise price of sh. 90 expire in 115 days.
The underlying is priced at sh. 96 and makes no cash payments during the life of the options.
The applicable risk free rate for these instruments is 4.5%. The put recently has sold for sh.
7.50and the call sh. 16.00.
Assume a 365 day year.
Required:
Determine whether there is any mispricing present in the option markets by comparing the
price of the actual call with the price of the synthetic call. (4 mks)

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Q.4.D – Salim Karisa is a derivatives analyst and is interested in the valuation of a call
option on Beta company using a one period binomial option pricing model. The underlying
stock is a non dividend paying stock. Salim gathers the following data:
1. The current share price is sh. 50 and the call option exercise price is sh. 50.
2. In one period, the share price will either rise to sh. 56 or decline to sh. 46.
3. The risk free rate of return is 5%.
Required:
Calculate the following:
i. The optimal hedge ratio for the call option. (2 mks)
ii. The risk-neutral probability of the up move for the Beta stock. (2 mks)
iii. The value of the call option using the binomial model. (2 mks)
Q.5.A – Discuss three weaknesses of delta hedging as a risk management strategy in
derivatives contracts. (6 mks)
Q.5.C – An investor has a short position in put options on 5000 shares of stock. Call option
delta is given as 0.532 while put option delta is given as – 0.419. Assume that each option
has one share of stock as the underlying.
Required:
i. The pre-existing portfolio given that the hedging instrument is stock. (3 mks)
ii. The pre-existing portfolio given that the hedging instrument is call options. (3 mks)
iii. Outline two assumptions of the Black model used in the valuation of European
options on futures. (2 mks)
AUGUST 2022
Q.1.C – Describe two reasons for hedging an equity portfolio. (4 mks)
Q.2.B – Daniel Kioko is analyzing a recently purchased call option on Nebo Ltd’s share
with an exercise price of sh. 35 and a premium of sh. 3.20.
Required:
i. The payoffs and profits for the call option at expiration assuming the prices of Nebo
Ltd’s shares are estimated at sh. 30, sh. 35 and sh. 40 respectively. (2 mks)
ii. The break-even price assuming that there are no transaction costs. (2 mks)
Q.3.D – Raki Limited is a Kenyan company that occasionally undertakes short term loans
denominated in US dollars. Raki Limited uses forward rate agreement (FRA) to lock in the
rate of such loans as soon as it determines that it will need the money. The underlying being
the 180 – day London Interbank Offered Rate (LIBOR) at FRA rate of 5.25%.
On 15 April 2022, Raki Limited determines that it will borrow sh. 40 million on 20 August
2022. The loan is to be repaid 180 days later (16 February 2023) and the rate will be at
LIBOR plus 200 basis points. Raki Limited decides to go long on FRA thereby enabling it to
receive the difference between LIBOR on 20 August 2022 and the FRA rate quoted by the
dealer on 15 April 2022 of s.25%. Raki Limited locks in a 7.25% rate that is 5.25% plus 200
basis points. At contract expiration, that is 20 August 2022, 180 day LIBOR is at 6%.
Required:
i. Describe how the FRA will be executed. (1 mk)
ii. Compute the FRA payoff (2 mks)
Q.5.A – With reference to credit derivatives:
i. Explain three applications of index credit default swaps (CDS) deals. (3 mks)
ii. Highlight four terms and conditions that a protection buyer and seller need to agree
in a credit default swap (CDS)
(4 mks)
Q.5.B – Discuss the following concepts of option moneyness:
i. In-the-money options. (2 mks)

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ii. At-the-money options. (2 mks)

iii. Out-of-the-money options. (2 mks)

Options are referred to as in the money, at the money, or out of the money. If S is the stock
price and K is the strike price, a call option is in the money when S > K, at the money when
S = K, and out of the money when S < K. A put option is in the money when S < K, at the
money when S = K, and out of the money when S > K. Clearly, an option will be exercised
only when it is in the money. In the absence of transactions costs, an in-the-money option
will always be exercised on the expiration date if it has not been exercised previously.

Q.5.C – Wembe Ltd.’s shares are currently trading at sh. 6.10 per share. The dividend paid
was sh. 0.50 per share. Assume that dividends are only paid annually. A European option
exists on shares with an exercise price of sh. 5 with one year to maturity. The risk-free rate
is 8% and the variance of the rate of return on the share is 12%.
Required:
The value of the call option using the Black –Scholes Option pricing model. (7 mks)
APRIL 2022
Q.1.A – Explain three advantages of options compared to futures contracts in derivatives
market. (6 mks)
Q.1.D – Prestige Investment Limited anticipates that it will require sh. 15 million for an
upcoming project that is supposed to start 60 days from now. The company intends to
borrow the sh. 15 million in 60 days time at 90-day London Interbank Offered Rate
(LIBOR) plus 100 Basis Points using a forward rate agreement (FRA) expiring in 60 days.
The FRA that will lock the interest rate at 6% per annum based on a Eurodollar that matures
150 days from today. 60 days later the LIBOR is at 7.5% per annum.
Required:
The effective borrowing rate that the company will pay assuming the LIBOR in 60 days is
7.5%. (Assume a 360 day year) (6 mks)
Q.3.C – A derivative trader is considering a two period binomial model in which a share
currently trades at a price of sh. 65. The share price can either go up by 20% or down 17%
each period. The risk free rate is 5%. The exercise price is sh. 70.
Required:
The price of the put option expiring in two periods (7 mks)
Q.4.B – Propose two applications of Artificial intelligence (AI) and financial technology in
derivatives markets. (4 mks)
Q.4.D – ABW Ltd. shares currently sells for sh. 36. In the next 6 months, the share price will
either increase to sh. 42 or decrease to sh. 31. The risk free rate of return is 4% per year.
Required:
The current market price on a call option on the ABW ltd’s shares assuming its term to
expiration is 6 months and its strike price is sh. 35. (4 mks)
Q.5.A – In relation to the Black-Scholes Merton Model (BSM) used in options valuation:
i. Describe three inputs of the BSM. (3 mks)
ii. Outline three criticisms of the BSM (3 mks)
There are five inputs to the BSM model: asset price, exercise price, asset price volatility, time
to expiration, and the risk-free rate. The relationship between each input and the option price
(except exercise price) is captured by a sensitivity factor designated as one of the “Greeks.”
Delta describes the relationship between asset price and option price. Call option deltas are
positive because as the underlying asset price increases, call option value also increases. In
contrast, the delta of a put option is negative because the put value falls as the asset price
increases.

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1) Asset price
2) Exercise price
3) Asset price volatility.
4) Time to expiration.
5) Risk free rate.

Criticisms of BSM
1) The current selling price of the stock (S) can only take two possible values i.e. an upper
value (Su) and a lower value (Sd).
2) The value of (1+r) is greater than d1 but smaller than u i.e. u<1+r<d. This
condition/assumption ensures that there is no arbitrage opportunity.
3) The investors are prone to wealth maximization and lose no time in exploiting the
arbitrage opportunities.
4) It assumes that we are operating in a perfect and competitive market i.e.
a) There are no transaction costs, taxes and margin requirements.
b) The investors can lend or borrow at the riskless rate of interest which is the only interest
rate prevailing.
c) The securities are tradeable in fractions i.e. they are divisible infinitely. The interest rate
and the upswings / downswings in the stock prices are predictable.

DECEMBER 2021
Q.3.A – Explain the following terms as used in options market:
i. Bull spreads (2 mks)
ii. Bear spread (2 mks)
Refer to September 2015.Q.4.C
Q.3.B – An investor simultaneously purchases an underlying having a price of sh. 77 and
writes a call option on it with an exercise price of sh. 80 and selling at sh. 6.
Required:
i. Justify why the investor should take this position (2 mks)
ii. Calculate the value at expiration for the above strategy if the underlying at expiration
is:
 Sh. 75 (1 mk)
 Sh. 85 (1 mk)
iii. Determine the maximum profit. (1 mk)
iv. Determine the break even point (1 mk)
Q.3.C – The following information relates to call and put options on a stock:
Call price C0 = sh. 4.50
Put price P0 = sh. 6.80
Exercise price X0 = sh. Sh. 70
Current stock price S0 = sh. 67.32
Days to option expiration = 139 days.
Risk free rate, rf = 5%
Number of days in a year is 365.
Required:
Using the put-call parity, evaluate the prices of the following:
i. Synthetic call option (2 mks)
ii. Synthetic put option (2 mks)
iii. Synthetic underlying stock (2 mks)
iv. Synthetic bond (2 mks)

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v. Identify any mispricing of each of the synthetic instruments in (b) (i) – (b) (iv) above
(2 mks)
Solution
Time to expiration = 139/365 = 0.3808
Bond price = X/(1 + r)T = 70/(1 + 0.05)0.3808 = sh. Sh.68.71
Synthetic call = Po + So – X/(1 + r)T = 6.8 + 67.32 - 68.71 = sh.5.41
Synthetic put = Co + X/(1+r)T - So = 4.5 + 68.71 - 67.32 = sh.5.89
Synthetic underlying = Co + X/(1 + r)T - Po = 4.5 + 68.71 - 6.8 = sh.66.41
Synthetic bond = Po + So - Co = 6.8 + 67.32 - 4.5 = sh. 69.62

Mispricing

Instrument Actual Price Synthetic Price Mispricing/Profit

Call 4.50 5.41 0.91
Put 6.80 5.89 0.91
Bond 68.7 69.62 0.91
Stock 67.32 66.41 0.91

Thus, the mispricing is the same regardless of the instrument used to look at it.

Q.4.C – Consider a one-period binomial model in which the price of underlying is at sh. 65
and can go up 30% or down 22%. The risk free rate is 8%.
Required:
Determine the price of a European call option with an exercise price of sh. 70. (4 mks)

Q.5.A – Explain the following terms in relation to the options Greeks:

i. Rho (2 mks)
ii. Vega (2 mks)
iii. Gamma (2 mks)
Rho
The rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the interest rate.
It measures the sensitivity of the value of a portfolio to a change in the interest rate when all
else remains the same.
Rho measures the sensitivity of the option price to changes in the risk-free rate. The price of
a European call or put option does not change much if we use different inputs for the risk-
free rate, so rho is not a very important sensitivity measure.

Vega
The Vega of a portfolio of derivatives, V, is the rate of change of the value of the portfolio
with respect to the volatility of the underlying asset.
If Vega is highly positive or highly negative, the portfolio’s value is very sensitive to small
changes in volatility. If it is close to zero, volatility changes have relatively little impact on
the value of the portfolio.

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Vega measures the sensitivity of the option price to changes in the volatility of returns on the
underlying asset. Both call and put options are more valuable, all else equal, the higher the
volatility, so Vega is positive for calls and puts.

Gamma
Gamma measures the rate of change in delta as the underlying stock price changes. Call and
put options on the same underlying asset with the same exercise price and time to maturity
will have equal gammas. Long positions in calls and puts have positive gammas.

Q.5.B – A European option on a futures contract priced at sh. 139.19 has an exercise price of
sh. 125. The futures option expires in 215 days. The continuously compounded risk-free rate
is 4.25% while the volatility is given as 0.15.
Required:
The futures call option price using the Black model. (5 mks)

SEPTEMBER 2021
Q.4.A – Explain the following terms as used in option trading:
i. Calendar spread (2 mks)
ii. Implied volatility (2 mks)

A calendar spread can be created by selling a call option with a certain strike price and
buying a longer-maturity call option with the same strike price. The longer the maturity of an
option the more expensive it is. A calendar spread, therefore requires an initial investment.

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Implied volatility – This is a measure of volatility assigned to a series by the current market
price.
Implied Volatility is calculated by inspecting the current option premium, and determining
what the volatility should be in order to justify that premium. It is determined by plugging the
actual option price into our Theoretical Value model and solving for volatility. This implied
volatility can be compared to the historical volatility of the underlying in search of
underpriced and overpriced options.

Q.4.B – Describe two uses of implied volatility in option trading (4 mks)

The term implied volatility refers to a metric that captures the market's view of the
likelihood of future changes in a given security's price. Investors can use implied volatility
to project future moves and supply and demand, and often employ it to price options
contracts. Implied volatility isn't the same as historical volatility (also known as realized
volatility or statistical volatility), which measures past market changes and their actual
results.
Implied volatility helps to quantify market sentiment. It estimates the size of the movement
an asset may take. However, it does not indicate the direction of the movement. Option
writers will use calculations, including implied volatility, to price options contracts. Also,
many investors will look at the Implied volatility when they choose an investment. During
periods of high volatility, they may choose to invest in safer sectors or products.
Implied volatility does not have a basis on the fundamentals underlying the market assets,
but is based solely on price. Also, adverse news or events such as wars or natural disasters
may impact the implied volatility.
Why Is Implied Volatility Important?
Future volatility is one of the inputs needed for options pricing models. The future, however,
is unknown. The actual volatility levels revealed by options prices are therefore the market's
best estimate of those assumptions. If somebody has a different view on future volatility
relative to the implied volatility in the market, they can buy options (if they think future
volatility will be higher) or sell options (if it will be lower).

PROS
 Quantifies market sentiment, uncertainty
 Helps set options prices
 Determines trading strategy
CONS
 Based solely on prices, not fundamentals
 Sensitive to unexpected factors, news events
 Predicts movement, but not direction

Q.4.C – The price of an asset will either rise by 25% or fall by 40% in year 1, with equal
probability.
A European put option on this asset matures after 1 year.
Additional information:
1) The price of the asset today is sh. 100.
2) The strike price of the put option is sh. 130.
3) Put option premium is sh. 7.
4) Annual effective risk free rate is 3%.
Required:
The expected profit of the put option (4 mks)

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Q.5.A – In relation to options markets:

i. Explain the term “market makers” (2 mks)
ii. Highlight two roles played by market makers in options market (2 mks)

A market maker or liquidity provider is a company or an individual that quotes both a

buy and a sell price in a tradable asset held in inventory, hoping to make a profit on
the bid–ask spread, or turn. The benefit to the firm is that it makes money from doing so;
the benefit to the market is that this helps limit price variation (volatility) by setting a
limited trading price range for the assets being traded. Market maker refers to a firm or an
individual that engages in two-sided markets of a given security. It means that it provides
bids and asks in tandem with the market size of each security. A market maker seeks to
profit off of the difference in the bid-ask spread and provides liquidity to financial
markets.

WHY ARE MARKET MAKERS IMPORTANT?

The purpose of market makers in a financial market is to keep up the functionality of the
market by infusing liquidity. They do so by ensuring that the volume of trades is large
enough such that trades can be executed in a seamless fashion.
In the absence of market makers, an investor who wants to sell their securities will not be
able to unwind their positions. It is because the market doesn’t always have readily available
buyers.
If a bondholder wants to sell the security, the market maker will purchase it from them.
Similarly, if an investor wants to purchase a given stock, market makers will ensure that
shares of that company are available for sale. Thus, they act as wholesalers in financial
markets.
The prices set by market makers are a reflection of demand and supply. Stockbrokers can also
perform the function of market makers at times. It, however, represents a conflict of interest
because brokers may be incentivized to recommend securities that make the market to their
clients.

Q.5.B – The current market price per share of Flamingo Ltd. is sh. 55. A one year call option
with an exercise price of sh. 55 is trading at sh. 4.92. The share price can increase by 20% or
decrease by 15% over the next year.
The risk free rate is 5%.
Required:
i. Using suitable computations, determine whether any arbitrage profit exists in trading
the company’s shares. (4 mks)
ii. Describe the transaction necessary to earn the arbitrage profit (if any) in (b) (i) above
(2 mks)
Q.5.C – A pension fund has accumulated sh. 10 million worth of Ndovu Limited’s shares.
The market price per share is sh. 50. The following information on options on both Ndovu
Limited shares and NSE index is provided below:
Ndovu Limited (sh) NSE Index (sh)
European call 6.31 6.31
European put 4.83 4.83
American call 6.28 6.28
American put 4.96 4.96

Ndovu Limited share option sensitivities:

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Delta
European call 0.5977
European put -0.4023
American call 0.5973
American put -0.4258
The pension fund would like to consider neutralizing its Ndovu Limited’s equity position
from changes in the share price of Ndovu Limited.
As a consultant, the fund has approached you to assist in creating a delta-neutral portfolio.
Required:
i. The number of standard Ndovu Limited’s European call options to be sold or bought.
(3 mks)
ii. The number of standard Ndovu Limited’s European put options to be bought or sold.
(3 mks)
Q.5.D – A derivatives specialist uses a strategy that involves creating a synthetic call from
other instruments at a cost less than the market value of the call itself and then selling the
call. During the course of his research, he observes that ABC Limited’s share is currently
priced at sh. 56 while a European style put option with a strike price of sh. 55 is trading at
sh. 0.40 and a European- style call option with the same strike price is trading at sh. 2.50.
Both options have 6 months remaining until expiration. The risk-free rate is currently 4%.
Required:
The arbitrage profit he would earn if he were to establish a long protective put position. (4
mks)
MAY 2021
Q.4.A.i – Outline three advantages and three limitations of the Black-Scholes- Merton
(BSM) model. (6 mks)
Advantages
1) It’s accurate.
2) It can price the option contracts very fast.
3) It is flexible.
Limitations
1) It ignores many other factors.
2) It is based on many assumptions.
3) Another problem with the Black Scholes model is that while calculating American style
options contracts it calculates the option price at expiration but in the case of early
exercise of American style options there will be a mismatch between the pricing of options
thus limiting the use of this model as the majority of exchange traded options are
American style options and not European style options.

Q.4.A.ii – The underlying is priced at sh. 225 and the continuously compounded dividend
yield is 2.7%. The exercise price is sh. 200. The continuously compounded risk-free rate is
5.25%. The time to expiration is three years and the volatility is 0.15.
Required:
The price of a call option using the Black-Scholes- Merton (BSM) model adjusted for cash
flows on the underlying (4 mks)
Q.4.B – Tyson Mkubwa is a financial analyst and would like to obtain the value of a
European call option with two years to expiration and an exercise price of sh. 100. The
underlying bond is sh. 100 par value, 7% annual coupon bond with three years to maturity.
The interest rate at the start of the call option contract is 3% and it is expected to either go
up to 5.99% or down to 4.44% in year 1. Interest rates are expected to change into 3 levels in
years 2, that is, 8.56%, 6.34% or 4.7% respectively.

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The bond price at the end of year 2 is expected to be sh. 98.56 at 8.56%, sh. 100.62 at 6.34%
and 102.20 at 4.7% interest rates respectively.
Required:
i. Construct a two-period binomial tree for option price (8 mks)
ii. Determine the option value today (2 mks)
Q.5.B – Proton Ltd is a Kenyan company that issues a bond with a face value of sh. 1.2
billion and a coupon rate of 5.25%. Proton Ltd. decides to use a swap to as to convert this
bond into a dollar-dominated bond.
The current exchange rate is sh. 120/$. The fixed interest rate on the dollar-denominated
swap is 6% and the fixed interest rate of the shilling denominated swaps is 5%. All
payments to be made annually.
Required:
i. Assess how swap will be executed (3 mks)
ii. Identify the cash flows at start (2 mks)
iii. Generate all interest cash flows of each interest payment date (2 mks)
iv. Identify the cash flows at the expiration of the bond (2 mks)
Q.5.C – The following information is available on put and call options on an asset:
Call price Sh.3.50
Put price Sh.9
Exercise price Sh.50
Forward price Sh.45
Days to option expiration 175 days
Risk-free rate 4%
Required:
Using put-call forward parity, calculate prices of the following:
i. Synthetic call option (1 mk)
ii. Synthetic put option (1 mk)
iii. Synthetic forward contract (1 mk)
iv. For each of the 3 synthetic instruments in (i) (ii) (iii) above, identify mispricing by
comparing the actual price with the synthetic price. (2 mks)
Solution
Synthetic call option:
Call price, Co = sh.3.50
Put price, Po = sh.9
Exercise price, X = sh.50
Forward price, F(0,T) = sh.45
Days to option expiration = 175
Risk-free rate, r = 4 percent
Time to expiration = 175/365 = 0.4795
Bond price = [X - F(O,T)] l(l + r)T = (50 - 45)/(1 +0.04)0.4795 = sh.4.91
Synthetic call = Long forward + Po - [X - F(O,T]/(l + r)T = 0 + 9 - 4.91 = 4.09

Synthetic put option

Synthetic put = Co + Short forward + [X - F(O,T)]/(l + r)T = 3.5 + 0 + 4.91 = 8.41

Synthetic forward contract

Synthetic forward = Co - Po + [X - F(O,T)]/(l + r)T = 3.5 - 9 + 4.91 = -0.59

Instrument Actual Price Synthetic price Mispricing/Profit

Call 3.50 4.09 0.59

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Put 9 8.41 0.59

Forward 0 -0.59 0.59

Based on the mispricing in your above calculation, illustrate how to earn a risk-free profit
using a synthetic call.
Solution
The actual call is cheaper than the synthetic call. Therefore, an arbitrage transaction in which
you buy the actual call (underpriced) and sell the synthetic call (overpriced) will yield a risk-
free profit up front of sh.4.09 – sh.3.50 = sh.0.59. The initial up-front cash is generated as
follows:

Buy call - 3.50

Sell synthetic call
Short forward 0
Short put 9
Long bond -4.91
Totals 0.59

NOVEMBER 2020
Q.1.A.i – Explain the meaning of the term “no-arbitrage principle” as used in derivatives
market. (2 mks)
Q.1.A.ii – Highlight three assumptions of no-arbitrage principle. (3 mks)
Q.2.C – Kassim Mohamed is a derivatives manager who is considering using option
strategies to profit from his views on share prices. He collects the information given below
for the listed options on the shares of Mavuno Limited which are currently trading at a price
of sh. 25 per share.
Expiry
Calls June August November
30 0.77 1.38 1.85
Strike 25 1.09 3.50 4.25
20 5.71 7.84 8.36
Expiry
Put June August November
30 5.45 5.93 6.21
Strike 25 0.73 2.89 3.26
20 0.53 0.93 1.23
Required:
Calculate the following:
i. Maximum loss from a bull spread using August puts with strike prices of sh. 30 and
sh. 25. (4 mks)
ii. The net cost to enter a box spread using August options with strike prices of sh. 20
and sh. 25. (2 mks)
Q.3.A.i – Evaluate four factors that could determine the value of option prices (4 mks)
Q.3.A.ii – The risk or volatility of an individual asset could be reduced either by writing a
covered call option against the asset or by purchasing a put option on the asset.
Required:
Explain the difference in the extent to which each of these two options strategies modify an
individual asset’s risk. (4 mk)
Q.3.B – Juliet Nambuye, a derivatives analyst has been asked to value the 1 – year put and
call options for PKQ limited, exercisable at sh. 49 with the underlying asset trading at sh.

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49.25. Based on current estimates in one year, the share price of PKQ limited is expected to
either move by 15% or move down by 20%. The current risk free rate for 30 days is 3.30%
per annum.
Required:
The value of PKQ’s options using a one period binomial model (4 mks)
Q.3.C – An investor owns 60,000 shares of Pelfex limited that are currently trading at sh. 50
per share at the securities exchange. A call option on the company’s shares with and exercise
price of sh. 50 is selling at sh. 4.
Ten minutes ago, the call price was sh. 3.6 while the share price has increased by sh. 0.672
in the last ten minutes settle at the current price of sh. 50.
Required:
Determine the number of call options required to create a delta-neutral hedge for
Pelfexlimited’s shares (4 mks)
Q.5.B – The standard deviation of monthly changes in the spot price of gold is 1.2. The
standard deviation of monthly changes in the futures price of gold for the closest contract is
1.4. The correlation between the futures price changes and the spot price changes is 0.7. It is
now November 15. An ornament maker is committed to buying 200,000 units of gold on
December 15. The ornament maker wants to use the January gold futures contract to hedge
its risk.
Required:
Describe the strategy that the ornament maker should follow (3 mks)
Q.5.C – An analyst would like to price an option for Kimbo Ltd. which does not currently
pay any dividend. KimboLtd’s shares currently trade at sh. 173.77 at the securities
exchange.
The price is expected to move as shown in the following diagram over the next 2 years:

MAY 2019

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Q.1.C – An investor decides to hedge a sh. 200,000 portfolio by writing index call options.
The index stands at 550 and an out of the money index stock with a strike price of sh. 560
sells for sh. 800. The stock index call option hedge ratio is 0.4. The market declines by 2%
which causes the price of the index option to decline to sh. 350.
Required:
The net gain or loss to the investor after the market decline (5 mks)

Q.2.A – Explain the impact of the following risk management strategies on a European call
option:
i. Delta (1 mk)
ii. Gamma (1 mk)
iii. Vega (1 mk)
iv. Rho (1 mk)
v. Theta (1 mk)

Delta
Delta is the measure of an option's sensitivity to changes in the price of the underlying asset.
Therefore, it is the degree to which an option price will move given a change in the
underlying stock or index price, all else being equal.
Delta = Change in option premium
Change in underlying price
For example, an option with a delta of 0.5 will move sh. 5 for every change of sh.10 in the
underlying stock or index.

Illustration:
A trader is considering buying a Call option on a futures contract, which has a price of sh. 19.
The premium for the Call option with a strike price as of sh.19 is 0.80. The delta for this
option is +0.5. This means that if the price of the underlying futures contract rises to sh.20 -a
rise of sh. 1 -then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium
will be 0.80 + 0.50 = sh. 1.30.
Far out-of-the-money calls will have a delta very close to zero, as the change in underlying
price is not likely to make them valuable or cheap. At-the-money call would have a delta of
0.5 and a deeply in-the-money call would have a delta close to 1.
While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option
price and the underlying stock price are inversely related. This is because if one buys a put
his view is bearish and expects the stock price to go down. However, if the stock price moves
up it is contrary to his view therefore, the value of the option decreases. The put delta equals
the call delta minus 1. It may be noted that if delta of one‘s position is positive, he desires
the underlying asset to rise in price. On the contrary, if delta is negative, he wants the
underlying asset's price to fall.
Uses: The knowledge of delta is of vital importance for option traders because this
parameter is heavily used in margining and risk management strategies. The delta is often
called the hedge ratio. e.g. if you have a portfolio of 'n' shares of a stock then 'n' divided by
the delta gives you the number of calls you would need to be short (i.e. need to write) to
create a riskless hedge -i.e. a portfolio which would be worth the same whether the stock
price rose by a very small amount or fell by a very small amount. In such a "delta neutral"
portfolio any gain in the value of the shares held due to a rise in the share price would be
exactly offset by a loss on the value of the calls written, and vice versa. Note that as the delta
changes with the stock price and time to expiration the number of shares would need to be

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continually adjusted to maintain the hedge. How quickly the delta changes with the stock
price are given by gamma.

Theta
It is a measure of an option's sensitivity to time decay. Theta is the change in option price
given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk).
Theta is generally used to gain an idea of how time decay is affecting your portfolio.

Theta = Change in an option premium

Change in time expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases.
This is due to the fact that the uncertainty element in the price decreases.
Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to
2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of
the underlying stock will alter the premium. Theta is only concerned with the time value.
Unfortunately, we cannot predict with accuracy the change's in stock market's value, but we
can measure exactly the time remaining until expiration.

Vega
This is a measure of the sensitivity of an option price to changes in market volatility. It is the
change of an option premium for a given change -typically 1 % -in the underlying volatility.
Vega = Change in an option premium
Change in volatility

If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a
Vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor
increased by 1 % to 31 %. As the stock becomes more volatile the changes in premium will
increase in the same proportion. Vega measures the sensitivity of the premium to these
changes in volatility.
What practical use is the Vega to a trader? If a trader maintains a delta neutral position, then
it is possible to trade options purely in terms of volatility -the trader is not exposed to changes
in underlying prices.

Rho
Rho measures the change in an option's price per unit increase -typically 1 % -in the cost of
funding the underlying.

Rho = Change in an option premium

Change in cost of funding underlying

Example:
Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the price of the
option will move by sh. 0.14109. To put this in another way: if the risk-free interest rate
changes by a small amount, then the option value should change by 14.10 times that
amount.
For example, if the risk-free interest rate increased by 0.01 (from 10% to 11 %), the option
value would change by 14.10*0.01 = 0.14. For a put option, inverse relationship exists. If the
interest rate goes up the option value decreases and therefore, Rho for a put option is
negative. In general Rho tends to be small except for long-dated options.

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Gamma
This is the rate at which the delta value of an option increases or decreases as a result of a
move in the price of the underlying instrument.

Gamma = Change in option delta

Change in underlying price

For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of +/- 1 in
the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall.
Gamma is rather like the rate of change in the speed of a car -its acceleration -in moving from
a standstill, up to its cruising speed, and braking back to a standstill. Gamma is greatest for an
A TM (at-the- money) option (cruising) and falls to zero as an option moves deeply ITM (in-
the-money ) and OTM (out-of-the-money) (standstill). If you are hedging a portfolio using
the delta-hedge technique described under "Delta", then you will want to keep gamma as
small as possible as the smaller it is the less often you will have to adjust the hedge to
maintain a delta neutral position. If gamma is too large a small change in stock price could
wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using
options --unlike delta, it can't be done by buying or selling the underlying asset as the gamma
of the underlying asset is, by definition, always zero so more or less of it won't affect the
gamma of the total portfolio.

Q.2.C – John Mativo , a derivatives trader is considering European put and call options with
exercise price of sh. 45 and expiration of 115 days. The underlying price is sh. 48 and does
not make any cash payments in the life of the options. The risk-free rate is 4.5%. The put is
selling at sh. 3.75while the call is selling at sh. 8.00.
Required:
i. The value of the call option (3 mks)
ii. Advise the investor on whether to buy the call option based on your answer in (c) (i)
above (2 mks)
Q.4.A – A financial analyst gathered the following information relating to a stock:
Stock price Sh. 52
Strike price Sh. 50
Time to expiration 3 months
Standard deviation 20%
Interest rate (annual) 10%
Required:
The value of the call option using the Black-Scholes-Merton model (4 mks)
Solution
Stock price = sh. 52
Strike price = sh. 50
Time to expiration = 3/12 = 0.25
Standard deviation = 20% = 0.20
Risk free rate = 10% = 0.1
d1 = In(52/50) + (0.1 + 0.5 x 0.2 2) x 0.25
0.2 x √0.25
d1 = 0.039 + 0.03
0.1
d1 = 0.69

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Nd1 = 0.5 + 0.2549

Nd1 = 0.7549
d2 = d1 - σ√t
d2 = 0.69 – 0.2√0.25
d2 = 0.69 – 0.1
d2 = 0.59
Nd2 = 0.5 + 0.2224
Nd2 = 0.7224

Value of the call option

= 52 x 0.7549 – (50/(2.7183) 0.1 x 0.25
= 39.25 – 50/1.03
= 39.25 – 48.54
= sh. -9.29

Q.4.C – An interest rate put option based on a 90-day underlying rate has an exercise rate of
7.5% and expires in 180 days. The forward rate is 7.25% and volatility is 0.04. The
continuously compounded risk free rate is 5%.
Required:
The price of the interest rate put option using the Black model. (4 mks)
Q.4.D – A box spread consists of options on a stock trading at sh. 27.95. The options have
exercise price of sh. 25 and sh. 30 and they mature in six months. The call options for the
exercise prices of sh. 25 and sh. 30 have a premium of sh. 5.30 and sh. 2.75 respectively.
The put options for these exercise prices have a premium of sh. 2.00 and sh. 4.30
respectively.
Required:
The discrete risk-free rate assuming that the options are correctly priced. (5 mks)
Q.4.E – Examine three sources of gains and losses from delta hedging for a market maker.
(3 mks)
Q.5.D – An investor has gathered the following information on put and call options on
stock:
Call price Sh. 6.64
Put price Sh. 2.75
Exercise price Sh. 30
Days to option expiration 219 days
Current stock price Sh. 33.19
Required:
Put-call parity given that the stock price at expiration is sh. 20 and risk free rate is 4%. (4 mks)
Point of correction: we have assumed 219 days and not 2.19 days as it appears in the exam
paper.
Solution
We can illustrate put-call parity by showing that for the fiduciary call and the protective put,
the current values and values at expiration are the same.
Call price, Co = sh.6.64
Put price, Po = sh.2.75
Exercise price, X = sh.30
Risk-free rate, r = 4%
Time to expiration = 219/365 = 0.6

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Current stock price, So = sh.33.19

Bond price, X/(1 + rlT = 30/(1 + 0.04)0.6 = sh. 29.3
Transaction Current value ST = 20
Fiduciary call
Buy call 6.64 0
Buy bond 29.30 30
Total 35.94 30
Protective put
Buy put 2.75 30 - 20 = 10
Buy stock 33.19 20
Total 35.94 30

The values in the table above show that the current values and values at expiration for the
fiduciary call and the protective put are the same. That is, Co + X/(1 + r)T = Po + So.

NOVEMBER 2019
Q.2.C – An investment manager uses various hedging strategies. One of the is the box
spread. The options have exercise prices of sh. 75 and sh. 85.
The call prices are sh. 16.02 and sh. 12.28 for exercise prices of sh. 75 and sh. 85
respectively.
The put prices are sh. 9.9.72 and sh. 15.18 for exercise prices of sh. 75 and sh. 85
respectively.
The options expire in 6 months. The discrete risk free rate is 5.13%.
Required:
i. Evaluate the value of the box spread and the profit at expiration. (3 mks)
ii. Show that the box spread is mispriced thereby giving rise to an arbitrage opportunity.
(3 mks)
Q.3.A – Explain the following terms in the context of options strategies for managing equity
portfolios:
i. Protective put (2 mks)
ii. Money spread (2 mks)
iii. Zero cost collar (2 mks)
Solution
A protective put is a portfolio consisting of:
• A long position in a European put option with an exercise price of X that matures in T
years.
• A long position in the underlying stock.
The cost of a protective put is the cost of the put option (P0) plus the cost of the stock (S0).
The payoff to a protective put is X if the put is in-the-money and ST if the put is out-of-the-
money.
Therefore, a protective put ensures that the unlimited gains associated with stock price rally
will accrue to the buyer and if the stock price moves down, the unlimited losses associated
with stock are nullified by the long put option and the twin benefits come at a cost equal to
the put option’s premium.
Money spread – This is a type of option strategy which involves the purchase and sale of two
options of the same type (that is either calls or puts) with the same expiry date.
An interest rate collar is a simultaneous position in a floor and a cap on the same benchmark
rate over the same period with the same settlement dates. There are two types of collars:

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1) The first type of collar is to purchase a cap and sell a floor. For example, an investor with
a LIBOR-based liability could purchase a cap on LIBOR at 8% and simultaneously sell a
floor on LIBOR at 4% over the next year. The investor has now hedged the liability so that
the borrowing costs will stay within the "collar" of 4% to 8%. If the cap and floor rates are
set so that the premium paid from buying the cap is exactly offset by the premium
received from selling the floor, the collar is called a "zero-cost" collar.
2) The second type of collar is to purchase a floor and sell a cap. For example, an investor
with a LIBOR-based asset could purchase a floor on LIBOR at 3% and simultaneously
sell a cap at 7% over the next year. The investor has now hedged the asset so the returns
will stay within the collar of 3% to 7%. The investor can create a zero-cost collar by
choosing the cap and floor rates so that the premium paid on the floor offsets the premium
received on the cap.

Q.3.B – A portfolio manager believes that the market will be volatile in the near future, but
does not feel particularly strongly about the direction of the movement. With this
expectation, he decides to buy both a call and a put option with the same exercise price and
the same expiration date on the same underlying stock trading at sh. 49. He buys one call
option and one put option on this stock, both with an exercise price of sh. 50.
The premium on the call is sh. 6.25 and the premium on the put is sh. 5.875.
Required:
i. The profit that the manager realizes when the price of the stock at expiration is sh.
37. (3 mks)
ii. The maximum loss from the strategy above. (2 mks)
iii. The break-even stock price at expiration of the option. (2 mks)
Q.5.A – Explain the effect of the following factors on the value of a European put option
and call option price:
i. The underlying price (1 mk)
ii. The exercise price (1 mk)
iii. Time to expiration (1 mk)
iv. Risk-free rate (1 mk)
v. Volatility of the underlying (1 mk)
Solution
In this section, we consider what happens to option prices when one of these factors changes
with all the others remaining fixed.
1. Current stock price - If it is exercised at some time in the future, the payoff from a call
option will be the amount by which stock price exceeds the strike price. Therefore call option
becomes more valuable as the stock price increases.
2. Exercise price - If it is exercised at some time in the future, the payoff from a call option
will be the amount by which stock price exceeds the strike price. Therefore call option
becomes less valuable as the strike price increases.
3. Time to expiration - Both put and call American options become more valuable as the time
to expiration increases. To see this, consider two options that differ only as far as the
expiration date is concerned. The owner of the long-life option has all the exercise
opportunities open to the owner of the short-life option -- and more. The long-life option

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must therefore always be worth at least as much as the short-life option. European put and
call options do not necessarily become more valuable as the time to expiration increases.
[why?]
4. Volatility [or Variance ] in stock prices - Roughly speaking, the volatility of a stock price
is a measure of how uncertain we are about future stock price movements. As volatility
increases, the chance that the stock will do very well or very poorly increases. The owner of a
call benefits from price increases but has limited downside risk in the event of price
decreases. [why?] Therefore value of calls increases as volatility increases. The same logic
applies to put options.
5. Risk free interest - If the stock price is expected to increase, an investor can choose to
either buy the stock or buy the call. Purchasing the call will cost far less than purchasing the
stock. The difference can be invested in risk-free bonds. If interest increase, the combination
of calls and risk-free bonds will be more attractive. This means that the call price will tend to
increase with increases in interest rates. However, when you sell the stock by exercising the
put, you receive E dollars. If interest rates increase, the E dollars will have a lower present
value. Thus, higher interest rates make put less attractive.
MAY 2018
Q.2.A – Describe the following four possible options positions:
i. Long call (1 mk)
ii. Short call (1 mk)
iii. Long put (1 mk)
iv. Short put (1 mk)
Long call
A call option that has been purchased (i.e. a long call) will be exercised at expiration only if
the price of the underlying is higher than the exercise price.
For example, if a call option to buy a BP share at a price of sh.500 has been purchased, if the
BP share price at the expiry date of the option is sh.600 then the option to buy the share for
sh.500 will be exercised (because the option price is a better price than the market price). If
the price of the underlying asset is lower than the exercise price (e.g. the share price at the
expiry date of the option is sh.400) then the option will not be exercised.
The value of a call option at expiration is the higher of:
The difference between the value of the underlying security at expiration and the exercise
price, if the value of the underlying security > exercise price.
Short call
The seller of a call loses money when the option is exercised and gains the premium if the
option is not exercised. The value of the call option for a seller is exactly the opposite of the
value of the call option for the buyer.
The profit of the short position at expiration is:
Profit = premium received – value of call option
A short call option has a maximum profit, which is the premium, but unlimited losses.

Long put
A put that has been purchased (i.e. a long put) will be exercised at expiration only if the price
of the underlying asset is lower than the exercise price of the option. The value of the option
when exercised is the difference between the exercise price and the value of the underlying.

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The profit from a long position is the difference between the value of the option at expiration
and the premium paid.
Short put
The seller of a put loses money when the option is exercised and gains the premium if the
option is not exercised. The value of the put option for a seller is exactly the opposite of the
value of the put option for the buyer.
The profit of the short position at expiration is:
Profit = premium received – value of put option
The maximum profit for the writer of a put option is the premium paid which occurs when
the put option is not exercised (that is, when the value at expiration = 0). This happens when
the value of the underlying at expiration is greater than the exercise price.
The profit will be zero when the value of the underlying at expiration is equal to the sum of
the exercise price and the premium paid. The highest loss occurs when the value of the
underlying = 0. The maximum loss will be equal to the exercise price.
Q.2.C – An investor wishes to purchase a European put option on Tausi Limited shares. The
details of the put option on Tausi limited shares are provided below:
Time to expiration 1 year
Current market price per share Sh. 52
Exercise price per share Sh. 45
Model predicted up move 15%
Model predicted down move 20%
Annualized risk-free rate 6%
Required:
Using a one period binomial model, calculate the value of a one year put option on Tausi
Limited shares. (4 mks)
Q.4.A – Named after its founder’s, Fisher Black, Myron Scholes and Robert Merton, the
Black- Scholes- Merton (BSM) model earned Scholes and Merton a Nobel prize in 1997 for
developing the model two years after the death Fisher Black in 1995.
In relation to the above statement, discuss the five inputs of the Black-Scholes – Merton
(BSM) model (5 mks)
Q.4.B – An interest rate call option based on a 90 day underlying rate has an exercise rate of
7.5% and expires in 180 days. The forward rate is 7.25% and volatility is 0.04. The
continuously compounded risk-free rate is 5%. Assume that the value of d 1 is – 1.1928.
Required:
The price of the interest rate call option using the Black model. (6 mks)
Q.4.C – The current share price of ABC Ltd. is sh. 100. The shares volatility is 15%. The
risk free rate is 5% and the company pays no dividend. The strike price on the ABC shares is
sh. 100.
Required:
Show that the put-call parity holds. (5 mks)
Q.4.D – An option trader has the following four transactions:
Transaction Exercise price (sh)
Long 1 call 95
Short 1 call 105
Long 1 put 105
Short 1 put 95
Additional information:
1. The stock price at expiration is sh. 102.
2. Options expire in 1 year.

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3. The risk-free interest rate is 10%.

Required:
i. The value of the trader’s box spread (2 mks)
ii. The cost of the box spread (2 mks)
Q.5.D – A party has entered a receive-floating 6 x 9 FRA (forward rate agreement) at a rate
of 0.86% with a notional amount of 10,000,000 Canadian dollars (C$) at time 0. The six
months spot C$ LIBOR was 0.628% and the nine months C$ LIBOR was 0.712%. The 6 x 9
FRA rate is quoted in the market at 0.68%. After 90 days have passed, the three month C$
LIBOR is 1.25% and the six months C$ LIBOR is 1.35%.
Required:
Using the appropriate discount rate, calculate the value of the original receive-floating 6 x 9
FRA. (4 mks)
Q.5.E – A put option with an exercise price of sh. 45.00 is currently trading at sh. 3.50. The
underlying share is trading at a market price per share (MPS) of sh. 45.00. The MPS is
expected to increase to sh. 50.00.
Required:
In relation to the above statement, explain the effect of the following:
i. Put option’s delta (2 mks)
ii. Put option’s Gamma (2 mks)
Solution
Delta is the change in the price of an option for a one-unit change in the price of the
underlying security. N(d1) from the BSM model is the delta of a call option for small changes
in stock price. N(d1) – 1 is the put option delta. The following approximations are reasonably
accurate for small changes in stock price:
ΔC ≈ N(d1) × ΔS
ΔP ≈ [N(d1) –1]× ΔS
Call option deltas will increase from zero to +1 as the underlying asset price increases.
Put option deltas will increase from –1 to zero as the stock price increases.
The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a
stock with a short position in a call option so that the portfolio value does not change when
the stock value changes.
A delta-neutral portfolio is a risk-free combination of a long stock position and short calls
where the number of calls to sell is equal to number of shares hedged divided by delta of the
call option.
A key consideration in delta-neutral hedging is that the delta-neutral position only holds for
very small changes in the value of the underlying stock. Hence, the delta-neutral portfolio
must be continually rebalanced to maintain the hedge. This is called a dynamic hedge. As the
underlying stock price changes, so does the delta of the call option.

Gamma measures how much delta changes as the asset price changes and, thus, offers a
measure of how poorly a fixed hedge will perform as the price of the underlying asset
changes.
Gamma measures the rate of change in delta as the underlying stock price changes. Call and
put options on the same underlying asset with the same exercise price and time to maturity
will have equal gammas. Long positions in calls and puts have positive gammas.
For example, a gamma of 0.04 implies that a $1.00 increase in the price of the underlying
stock will cause a call option’s delta to increase by 0.04, making the call option more
sensitive to changes in the stock price.
Gamma is largest when a call or put option is at-the-money and close to expiration.

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In other words, delta is very sensitive to changes in the underlying stock price when call and
put options are at-the-money and close to expiration. If the option is either deep in- or deep
out-of-the-money, gamma approaches zero because changes in the underlying stock price do
not have a significant effect on delta.
In this context, gamma can be viewed as a measure of how poorly a dynamic hedge will
perform when it is not rebalanced in response to a change in the asset price. Hedges with at-
the-money options will have higher gammas, and consequently small changes in stock price
will lead to large changes in delta and frequent rebalancing. In contrast, hedges with deep in-
or deep out-of-the money options will have small gammas, and stock price changes will not
affect the delta of the hedge significantly. This lowers rebalancing and transaction costs.

NOVEMBER 2018
Q.1.C – Using illustrative examples, examine two ways of writing a call option. (4 mks)
1) Sell covered calls.
2) Sell naked calls.

Q.1.D – Jeremy Cheposin is an equity analyst at ABC ltd. He believes that call options are
an alternative approach to establish a long position in Triple M stock. The current market
price of a six-month put option a strike price of sh. 100 is sh. 5.35.
The risk-free interest rates are provided below:

Maturity Risk- free interest rate (%)

3 months 0.50
6 months 0.50
1 year 1.00
Required:
The price of a six-month call option using the put – call parity (3 mks)
Q.1.E – A stock currently trades at a price of sh. 65 and has an exercise price of sh. 60. The
stock price can go up by 20% or down by 17% each period. The risk free rate is 5%.
Required:
The price of a call option expiring in two periods using a two-period binomial model. (6
mks)
Q.2.C – After examining its long term liabilities, Lake Bank Limited has decided that it
needs to borrow sh. 100 million over the next two years to finance its operations. For this
type of funding, Lake Bank Limited issues quarterly coupon short term floating Rate Note
(FRN) based on 90 day London Interbank Offered Rate (LIBOR). The bank is concerned
that interest rates may shift upwards and is considering using interest rate derivatives. The
managers at the bank have collected quotes on the Over The Counter (OTC) interest rate
caps and floors from the markets based on a notional principal of sh. 100 million.
Interest rate caps and floors

Interest rate caps Interest rate floors

Term (yrs) LIBOR Settlement Rate (%) Price (sh) Rate (%) Price (sh)
1 90-day Quarterly 3.50 2,000,000 2.55 1,900,000
1 180-day Semi-annual 3.50 2,000,000 2.55 1,900,000
2 90-day Quarterly 3.65 2,200,000 2.70 2,090,000
2 180-day Semi-annual 3.65 2,200,000 2.70 2,090,000
Required:

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i. Explain the term “interest rate collar” (1 mk)

An interest rate collar uses interest rate options contracts to protect a borrower against
rising interest rates while also setting a floor on declining interest rates. An interest rate
collar can be an effective way of hedging interest rate risk associated with holding bonds.

ii. The payoff from this derivative 360 days after the contract initiation assuming that
the LIBOR at expiration is expected to be 3.75%. (3 mks)
iii. The expected payoff after 720 days from a short position in the year 2 semi annual
interest rate floor assuming that the LIBOR at expiration is expected to be 2.40%.
Q.2.D – On 1 March 2018, the one-month London Interbank Offered Rate (LIBOR) was
5.50% and the two month LIBOR rate was 6.00%. The April treasury futures were quoted at
93.75. The contract size was sh. 5,000,000. The one month LIBOR rate observed on 1 April
2018 was 7.25%.
(Assume that there is no basis risk and that one year has 360 days.)
Required:
Determine whether an arbitrage opportunity exists. (5 mks)
Q.4.D – Martin Opondo believes that the stock price of XYZ Ltd. will have little volatility
over the next three months. He wants to construct a butterfly spread option strategy to take
advantage of the opportunity he believes exists.
The following data show 3- months options which are available on XYZ Ltd’s stock:

Option Strike price (sh) Option price (sh)

Put 35 1.25
Put 40 3.50
Put 45 5.50
Call 40 5.90
Martin can use any number of contracts of the above options to construct this strategy.
Required:
The total profit (loss) on a properly constructed butterfly spread assuming that the price of
the underlying stock at expiration is sh. 41. (4 mks)
Q.5.A – James Kivuva sells a September 2018 call on Delta Ltd’s shares with an exercise
price of sh. 45 for a sh. 3 premium. He also buys a September 2018 call on the same Delta
Ltd’s shares with an exercise price of sh. 40 for a sh. 5 premium.
Required:
i. Identify with a reason the type of option strategy employed by James Kivuva. (1 mk)
ii. Determine the maximum profit and loss for James Kivuva. (2 mks)
Q.5.B – An investor wishes to purchase a European put option which has the following
characteristics:
Current market price of a share Sh.25
Strike price for a six months put option Sh.20
Annual standard deviation of the underlying stock 25%
Current continuously compounded risk-free rate 4.25%
N (d1) 0.9737
N (d2) 0.9651
Required:
The value of the put option using the Black-Scholes-Merton (BSM) model (3 mks)
Q.5.C – Josovina Investments Bank has sh. 400 million portfolio available for investment.
The cost of funds is 5.5%. The bank lends 50% of the assets to domestic customers for an

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average annual interest rate of 7.35%. The balance of the portfolio is lent to some Ugandan
clients at an annual interest rate of 8%. The post exchange rate is KES 0.0266/UGX.
At the same time, the bank sells a forward contract to eliminate exchange rate risk equal to
the expected receipts one year from now.
The forward exchange rate is KES 0.0250/UGX.
Required:
The net interest margin on the balance sheet of Josovina Investment Bank (4 mks)
MAY 2017
Q.1.B – Justify why a portfolio manager would prefer to create a put option synthetically
instead of buying it in the market. (2 mks)

Q.1.C – Differentiate between “strip hedge” and “stack hedge” as used in derivative
markets. (2 mks)

Strip Hedge
A strip hedge happens when futures contracts over many maturities ranges are purchased to
hedge the underlying cash positions. In other words strips of futures contracts are used. This
normally happens when there is high liquidity for futures contracts over longer time horizons.
There is no basis risk due to the strip hedge as the basis becomes locked and changes cannot
affect the risk.

Stack Hedge
This type of hedging involves purchasing futures contracts for a nearby delivery date and on
that date rolling the position forward by purchasing a fewer number of contracts. This process
then continues for futures delivery dates until each position maturity exposure is hedged. It
normally happens when there is no adequate liquidity for the long term futures contract
traded in the market.

Q.1.D – A non dividend paying stock has a call option. The price of the stock is sh. 49. The
strike price is sh. 50. The risk free rate is 5%. The time-to-maturity is 0.3846 years and the
volatility is 20%. There are 365 days in a year.
Required:
i. The option’s theta (4 mks)
ii. The change in the option’s delta when price increases by 10% (2 mks)
iii. The change in the option’s value when volatility increases to 21% from 20%. (2 mks)
iv. The change in the option’s value when risk-free rate increases to 6% from 5%.(2
mks)
Hint:

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Q.2.A – Discuss three factors that could affect an option’s time value (3 mks)
1) Current stock price.
2) Exercise price.
3) Time to expiration.
4) Volatility.
5) Risk free interest.

DETERMINANTS OF OPTION VALUE

There are six factors affecting the price of a stock options.
1) The current stock price
2) The exercise [or strike] price
3) The time to expiration
4) The volatility of the stock price
5) The risk free interest rate
6) The dividends expected during the life of the option :
In this section, we consider what happens to option prices when one of these factors changes
with all the others remaining fixed.
1. Current stock price - If it is exercised at some time in the future, the payoff from a call
option will be the amount by which stock price exceeds the strike price. Therefore call option
becomes more valuable as the stock price increases.
2. Exercise price - If it is exercised at some time in the future, the payoff from a call option
will be the amount by which stock price exceeds the strike price. Therefore call option
becomes less valuable as the strike price increases.
3. Time to expiration - Both put and call American options become more valuable as the time
to expiration increases. To see this, consider two options that differ only as far as the
expiration date is concerned. The owner of the long-life option has all the exercise
opportunities open to the owner of the short-life option -- and more. The long-life option

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must therefore always be worth at least as much as the short-life option. European put and
call options do not necessarily become more valuable as the time to expiration increases.
[why?]
4. Volatility [or Variance ] in stock prices - Roughly speaking, the volatility of a stock price
is a measure of how uncertain we are about future stock price movements. As volatility
increases, the chance that the stock will do very well or very poorly increases. The owner of a
call benefits from price increases but has limited downside risk in the event of price
decreases. [why?] Therefore value of calls increases as volatility increases. The same logic
applies to put options.
5. Risk free interest - If the stock price is expected to increase, an investor can choose to
either buy the stock or buy the call. Purchasing the call will cost far less than purchasing the
stock. The difference can be invested in risk-free bonds. If interest increase, the combination
of calls and risk-free bonds will be more attractive. This means that the call price will tend to
increase with increases in interest rates. However, when you sell the stock by exercising the
put, you receive E dollars. If interest rates increase, the E dollars will have a lower present
value. Thus, higher interest rates make put less attractive.

Q.2.D - A box spread consists of options with exercise prices of sh. 75 and sh. 85. The call
prices are sh. 16.02 and sh. 12.28. for exercise prices of sh. 75 and sh. 85 respectively. The
put prices are sh. 9.72 and sh. 15.18 for exercise prices of sh. 75 and sh. 85 respectively. The
options expire in six months and the discrete risk free rate is 5.13%.
Required:
i. The profit of the box spread at expiration (2 mks)
ii. Show that this box spread is priced such that an attractive opportunity is available.
(3 mks)
Q.3.B – Evaluate three advantages of interest rate collar. (3 mks)
1) It protects the borrower against the rising rates.
2) It establishes the floor on declining rates.
3) It offers protection from risk.
4) The investor will incur low cost if not zero cost.
5) The investor can decide on lower and upper limits of the interest rate.
Q.4.C – A six month European call option on the spot price of gold exists. The strike price is
sh. 1,200. The six month futures price of gold is sh. 1,240. The risk free rate of interest is
5% per annum and the volatility of the futures price is 20%. The option is the same as the a
six-month European option on the six month futures price.
Required:
The value of the option (4 mks)
Q.5.B – Emase Omanyala, a Certified Investment and Financial Analyst (CIFA), is a risk
manager at Baraka Asset Managers (BAM). Emase works with individual clients to manage
their investment portfolios. One client John Mwajuma is worried about how short term
market fluctuations over the next three months might impact his equity position in Mnazi
Moja Corporation. While John is concerned about short-term downside price movements, he

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wants to remain with investments in Mnazi Moja corporation shares as he remains positive
about its long term performance. John has asked Emase to recommend an option strategy
that would keep him with investments in Mnazi Moja corporation shares while protecting
against a short-term price decline.
Emase gathers the following information to explore various strategies to address John’s
concerns:
Mnazi Moja Corporations European Options
Exercise price (sh) Market call price Call delta Market put price Put delta
(sh) (sh)
55.00 12.83 4.7 0.24 -16.7
65.00 3.65 12.0 1.34 -16.9
67.50 1.99 16.5 2.26 -15.3
70.00 0.91 22.2 3.70 -12.9
80.00 0.03 35.8 12.95 -5.0
Additional information:
1. Mnazi Moja Corporation’s current share price is sh. 67.79.
2. Each option has 106 days remaining until expiration.
Another client, Samuel Momanyi is a trader who does not currently own shares of Mnazi
Moja Corporation. Samuel has told Emase that he believes that Mnazi Moja Corporation
shares will experience a large move in a price after the upcoming quarterly earnings release
in two weeks. However, Samuel tells Emase that he is unsure of the direction that the stock
will move. Samuel asks Emase to recommend an option strategy that would allow him to
profit should the share price move in either direction.
A third client, Anthony Murungi does not currently own Mnazi Moja shares and has asked
Emase to explain the profit potential of three strategies using options in Mnazi Moja
Corporation: a bull call spread, a straddle and a butterfly spread. In addition, Anthony asks
Emase to explain the gamma of a call option. In response, Emase prepares a memo to be
shared with Anthony that provides analysis on three option strategies:
Strategy 1: A straddle position at the sh. 67.50 strike option.
Strategy 2: A bull call spread using the sh. 65 and sh. 70 strike options.
Strategy 3: A butterfly spread using the sh. 65, sh. 67 and sh. 70 strike call options.
Required:
i. Citing appropriate reason (s), explain the option strategy that Emase should
recommend to John Mwajuma. (2 mks)
ii. Citing appropriate reason (s), explain the option strategy that Emase should
recommend to Samuel Momanyi. (2 mks)
iii. Based on the information given above on MnaziMoja Corporation’s European
options, estimate the share price at expiration at which strategy 1 would be
profitable. (3 mks)
iv. In relation to the data given in the above table estimate the maximum profit on a per
share basis from investing in strategy 2. (3 mks)
v. Using the information given in the above table, and assuming that the market price of
MnaziMoja Corporation’s shares at expiration is sh. 66, estimate the profit or loss on
a per share basis from investing in strategy 3. (3 mks)
vi. In the context of the data given in the above table, determine the strike price of the
call option with the largest gamma. (3 mks)

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DECEMBER 2017
Q.1.D – European put and call options with an exercise price of sh. 45 is expected to expire
in 115 days. The underlying asset is price at sh. 48 and is expected to make no cash
payments during the life of the options. The risk free rate is 4.5%. The put option is selling
at sh. 3.75 and the call option is selling for sh. 8.00. Assume 365 day year.
Required:
i. Identify the mispricing by comparing the price of the actual call with the price of the
synthetic call. (2 mks)
ii. Based on your above answer, illustrate how an arbitrage transaction is executed. (4 mks)
Q.4.A – Discuss the following options strategies:
i. Box spread (2 mks)
ii. Straddle (2 mks)
iii. Collar (2 mks)
iv. Bull spread (2 mks)
Solution
Box spread - This refers to any combination of options that has a constant payoff at expiry.
For example combining a long butterfly made with calls, with a short butterfly made with
puts will have a constant payoff of zero, and at equilibrium will cost zero. In practice any
profit from these spreads will be eaten up by commissions (hence the name "alligator
spreads").
A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the
other a put. To "buy a straddle" is to purchase a call and a put with the same exercise price
and expiration date. To "sell a straddle" is the opposite: the trader sells a call and a put with
the same exercise price and expiration date. An investor with a bullish market outlook should
buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent
in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike
call. The combination of these two options will result in a bought spread. The cost of Putting
on this position will be the difference between the premium paid for the low strike call and
the premium received for the high strike call.
The investor's profit potential is limited. When both calls are in-the-money, both will be
exercised and the maximum profit will be realized. The investor delivers on his short call and
receives a higher price than he is paid for receiving delivery on his long call.

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The investor‘s potential loss is limited. At the most, the investor can lose is the net premium.
He pays a higher premium for the lower exercise price call than he receives for writing the
higher exercise price call than he receives for writing the higher exercise price call.
The investor breaks even when the market price equals the lower exercise price plus the net
premium. At the most, an investor can lose is the net premium paid. To recover the premium,
the market price must be as great as the lower exercise price plus the net premium.

Q.4.B – Omega Ltd. provides risk management consulting with regard to options and swaps
for institutional and individual clients. Ann Melinda is an investment advisor for Omega
Ltd. tasked to work with the firm’s High Networth (HNW) client’s accounts. She is
considering derivative strategies for several Omega Ltd’s clients.
Additional information:
1. SCM foundation owns 30,000 shares of Nasdag 100 index tracking stock which has a
current market price of sh. 30 per share. Ann Melinda believes that there is a substantial risk
of downside price movement in the index over the next six months. She has recommended
that SCM foundation uses a six month collar for the entire position of 30,000 shares as a
protection against the share price falling below sh. 27. The table below gives exercise prices
and option premiums (per share) for the tracking stock puts and calls expiring in six months:

Tracking stock puts and calls expiring in six months:

Option type Exercise price (sh) Option premium (sh)
Call 35 0.80
Put 27 0.95
The tracking stock index option is for 100 shares of the index tracking stock. SCM
foundation plans to hold the collar strategy until expiration of the puts and call options.
2. Michael Kirwa believes that the price of large capitalization stocks will rise slightly and he
intends to profit from this movement using a bull spread strategy. Melinda recommends
that Kirwa uses Dow Jones Industrial Average (DJIA) options that expire in two months.
The current market price of DJIA is sh. 91. The table below gives the exercise prices and
call options premium (per share) for two DJIA call options:
DJIA call options expiring in two months
Exercise price (sh) Option premium (sh)
88 4.40
94 1.00
The total cost of one contract is the quoted premium times the contract multiplier which is
100 shares per contract. Kirwa decides to use 100 contracts per position.
3. James Simbili expects the tracking stock on the DJIA to trade within narrow range around
its current price. Based on his expectation, he believes that a profitable trading opportunity
is to initiate a butterfly spread strategy using call options on DJIA. Melinda suggests the
need to use three one month call options on DJIA. Each option contract is for 100 shares.
The table below gives exercise prices and option premiums for three DJIA call options
expiring in one month.
DJIA Call options expiring in one month
Exercise price (sh) Option premium (sh)

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88 4.20
92 2.00
96 0.50
James intends to use a butterfly spread with a total of 200 long contracts and 200 short
contracts.
Required:
i. Calculate the profit from SCM foundation’s collar given that the market value of
index tracking is sh. 33. (3 mks)
ii. Calculate the maximum potential profit from SCM foundation’s collar at expiration.
(3 mks)
iii. Calculate the maximum potential profit form Michael Kirwa’s bull spread strategy at
expiration of the DJIA call options. (3 mks)
iv. Calculate the maximum potential loss at expiration for James Simbili’s butterfly
spread strategy. (3 mks)

Q.5.A – Evaluate three assumptions underlying the Black-Scholes-Merton (BSM) model of

options valuations. (6 mks)
The assumptions underlying the BSM model are:
1) The price of the underlying asset follows a log normal distribution.
2) The (continuous) risk-free rate is constant and known.
3) The volatility of the underlying asset is constant and known.
4) Markets are “frictionless.”
5) The underlying asset generates no cash flows.
6) The options are European.

Q.5.B – Using the relevant options Greeks, assess how an option price, as represented by the
Black-Scholes-Merton (BSM`) model is affected by a change in the value of each of the
following inputs:
i. Underlying asset price (2 mks)
ii. Underlying asset volatility (2 mks)
iii. Time – to – maturity (2 mks)
MAY 2016
Q.2.B – European put and call options with an exercise price of sh. 45 will expire in 115
days. The underlying asset is priced at sh. 48 and makes no cash payments during the life of
the options. The risk free rate is 4.5%. The put is selling for sh. 3.75 and the call is selling
for sh. 8.
Required:
i. Using suitable computations, identify the mispricing in the call (2 mks)
ii. Execute an arbitrage transaction (4 mks)
Q.2.C – On 10 January 2016, SCM Ltd. determined that it would need to borrow sh. 5
million on 15 February 2016 at 90 day LIBOR plus 300 basis points. The loan would be an
add on the interest rate in which SCM Ltd. would receive sh. 5million and pay it back plus
interest on 16 May 2016.
To manage the risk associated with the interest rate on 15 February 2016, SCM Ltd. buys an
interest rate call that expires on 15 February 2016 and pays off on 16 May 2016. The

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exercise rate is 5% and the option premium is sh. 10,000. The current 90 days LIBOR is
5.25%. Assume that this rate plus 300 basis points is the rate at which SCM Ltd. would
borrow at for any period of up to 90 days if the loan were taken out today
Interest is computed on the exact number of days dividend by 360.
Required:
Determine the effective annual rate on the loan when the 90 day LIBOR on 15 February
2016 is at 6% (5 mks)
Q.3.B – Discuss the following terms as used in the options markets:
i. Naked position (2 mks)
ii. Covered position (2 mks)
iii. Stop loss strategy (2 mks)

Solution
Naked or uncovered options are those which do not have offsetting positions, and therefore,
are riskier. On the other hand, where the writer has corresponding offsetting position in the
asset underlying the option is called covered option. Writing a simple uncovered (or naked)
call option indicates toward exposure of the option waiter’s unlimited potential losses. The
basic aim is to earn the premium. In period of stable or declining prices, call option writing
may result in attractive Profits by capturing the time value of an option. The strategy of
writing uncovered calls reflects an investor’s expectations and tolerance for risk.
A covered option position involves the purchase or sale of an option in combination with an
offsetting (or opposite) position in the asset which underlies the option. As observed earlier,
the writer of the call option incurs losses when stock prices rise, and put writers incur losses
when prices fall. In such situation, the writer can cover the short put with a short position and
short call with a long position in the underlying asset. This can be stated as:
Covered call sale = Short call + Long futures
Covered put sale = Short put + Short futures
The maximum loss for the writer of a put option is equal to the strike price. In general, the
risk for the writer of a call option is unlimited. However, an option writer who owns the
underlying instrument has created a covered position; he can always meet his obligations by
using the actual underlying. Where the seller does not own the underlying on which he has
written the option, he is called a "naked writer", and has created a "naked position".
We use as an example the position of a financial institution that has sold for $300,000 a
European call option on 100,000 shares of a non-dividend paying stock. We assume that the
stock price is $49, the strike price is $50, the risk-free interest rate is 5% per annum, the stock
price volatility is 20% per annum, the time to maturity is 20 weeks (0.3846 years), and the
expected return from the stock is 13% per annum. With our usual notation, this means that
S0 = 49; K = 50; r = 0:05; σ = 0:20; T = 0:3846; T = 0:13
The Black–Scholes–Merton price of the option is about $240,000 (that is, $2.40 for an option
to buy one share). The financial institution has therefore sold the option for $60,000 more
than its theoretical value. But it is faced with the problem of hedging the risks.
One strategy open to the financial institution is to do nothing. This is sometimes referred to as
a naked position. It is a strategy that works well if the stock price is below $50 at the end of
the 20 weeks. The option then costs the financial institution nothing and it makes a profit of
$300,000. A naked position works less well if the call is exercised because the financial
institution then has to buy 100,000 shares at the market price prevailing in 20 weeks to cover
the call. The cost to the financial institution is 100,000 times the amount by which the stock
price exceeds the strike price. For example, if after 20 weeks the stock price is $60, the option

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costs the financial institution $1,000,000. This is considerably greater than the $300,000
charged for the option.
As an alternative to a naked position, the financial institution can adopt a covered position.
This involves buying 100,000 shares as soon as the option has been sold. If the option is
exercised, this strategy works well, but in other circumstances it could lead to a significant
loss. For example, if the stock price drops to $40, the financial institution loses $900,000 on
its stock position. This is considerably greater than the $300,000 charged for the option.
Neither a naked position nor a covered position provides a good hedge. If the assumptions
underlying the Black–Scholes–Merton formula hold, the cost to the financial institution
should always be $240,000 on average for both approaches. But on any one occasion the cost
is liable to range from zero to over $1,000,000. A good hedge would ensure that the cost is
always close to $240,000. One interesting hedging procedure that is sometimes proposed
involves a stop-loss strategy. To illustrate the basic idea, consider an institution that has
written a call option with strike price K to buy one unit of a stock. The hedging procedure
involves buying one unit of the stock as soon as its price rises above K and selling it as soon
as its price falls below K. The objective is to hold a naked position whenever the stock price
is less than K and a covered position whenever the stock price is greater than K. The
procedure is designed to ensure that at time T the institution owns the stock if the option
closes in the money and does not own it if the option closes out of the money.

Q.4.A – Assess the effect of the following factors on option prices:

i. Interest rates (1 mk)
ii. Volatility (1 mk)

Volatility [or Variance ] in stock prices - Roughly speaking, the volatility of a stock price is
a measure of how uncertain we are about future stock price movements. As volatility
increases, the chance that the stock will do very well or very poorly increases. The owner of a
call benefits from price increases but has limited downside risk in the event of price
decreases. [why?] Therefore value of calls increases as volatility increases. The same logic
applies to put options.
Risk free interest - If the stock price is expected to increase, an investor can choose to either
buy the stock or buy the call. Purchasing the call will cost far less than purchasing the stock.
The difference can be invested in risk-free bonds. If interest increase, the combination of
calls and risk-free bonds will be more attractive. This means that the call price will tend to
increase with increases in interest rates. However, when you sell the stock by exercising the
put, you receive E dollars. If interest rates increase, the E dollars will have a lower present
value. Thus, higher interest rates make put less attractive.

Q.5.D – Fusions derivatives services (FDS) is an option trading company that trades in
variety of derivatives investments. FDS has just sold 500 call options on a stock currently
priced at sh. 125.75. The trading date is 18 May 2016. The call has an exercise price of sh.
125 , 60 days to expiration, a price of sh. 10.89 and a delta of 0.5649. FDS contemplates
delta-hedging this transaction by purchasing an appropriate number of shares. Any
additional transactions required to adjust the delta hedge will be executed by borrowing or
lending at the risk free rate of 4%.

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FDS has began delta-hedging the option. Two days later, on 20 May 2016, the following
information is provided:
Stock price Sh. 122.75
Option price Sh. 9.09
Delta Sh. 0.5176
Number of options 500
Number of shares 328
Bond balance -sh.6,076
Market value Sh.29,645
Required:
i. Assuming that at the end of 19 May 2016, the delta was 0.6564, show how 328
shares could be used to delta-hedge 500 call option. (2 mks)
ii. Show the allocation of the sh. 29, 645 market value of FDS’s total position among
stock, options and bonds on 20 May 2016. (2 mks)
iii. Demonstrate the transactions that must be done to adjust the portfolio to be delta-
hedged the following day (21 May 2016) (4 mks)
iv. On 21 May 2016, the stock is worth sh. 120.50 and the call is worth sh. 7.88.
Compute the market value of the delta-hedged portfolio and compare it with a
benchmark, based on the market value on 20 May 2016. (3 mks)

NOVEMBER 2016
Q.1.B – Consider a two-period binomial model in which a share currently trades at a price of
sh. 97.50. The share price can increase by 30% or reduce by 25.50% in each period. The risk
free rate is 7.50%.
Required:
i. The price of a put option today that is expiring in two periods with an exercise price
of sh. 90. (6 mks)
ii. Based on the above results, calculate the number of units of the underlying stock that
would be required at each point in the binomial tree in order to construct a risk free
hedge. Use 15,000 puts (6 mks)
Q.2.A – Explain three factors that could affect the price of an option. (3 mks)
1) Current stock price.
2) Exercise price.
3) Time to expiration.
4) Volatility.
5) Risk free interest.

Q.4.A – Johnson Mwakasi is a derivatives consultant handling three clients; A, B and C who
have the following investment positions:
1. Client A has invested in stocks with a strong European exposure and he says that his
portfolio has a positive delta.
2. Client B has invested in stocks of financial firms and she says that her portfolio has a
negative rho.
3. Client C has recently retired and managed to establish large option positions as a stock
investor. He says that his portfolio has a positive theta.
Required:
Explain the meaning of each claim made by each client. (6 mks)
Q.4.C – The following information relates to a European call option on the S&P 500 market
index with two months maturity:

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1. The current value of the index is sh. 930.

2. The exercise price is sh. 900.
3. The risk-free interest rate is 8% per annum.
4. The volatility of the index is 20% per annum.
5. Dividend yields of 0.2% and 0.3% are expected in the first and second month.
Required:
The call price using Black-Scholes-Merton (BSM) model (5 mks)
NOVEMBER 2015
Q.1.B – The following table illustrates three European call options with the same underlying
asset:

Time to expiration (months) Exercise price (sh)

Option A 6 2,000
Option B 9 2,000
Option C 9 2,500
Required:
Giving appropriate reasons, determine the option with the highest value. (3 mks)
Q.1.D – Samuel Mukungi simultaneously purchases an underlying asset priced at sh. 154
and writes a call option on it with an exercise price of sh. 160 and selling at sh. 12.
Required:
i. State the term commonly used to describe the position taken by Samuel Mukungi. (1 mk)
ii. Determine the value of the position at expiration and the profit/loss for Samuel
Mukungi if the price of the underlying asset at expiration is sh. 140, sh. 150, sh. 160
and sh. 170. (5 mks)
iii. The maximum profit and the maximum loss. (2 mks)
iv. The expiration price of the underlying which Samuel Mukungi would realize the
maximum profit and incur the maximum loss. (2 mks)
v. The break-even price at expiration. (1 mk)
Q.4.B – Assume that you have just been employed by Fiduciary Investment Bank after
completing the CIFA qualification. Your main responsibility is to trade and offer advisory
services on derivatives. You are provided with the following information:
Current market price of the share Sh. 92
Exercise price of the call option Sh. 90
Call premium Sh. 10
Delta 0.584
Number of calls sold 2,000
Delta at the end of the previous day 0.68
Continuously compounded risk free rate 9.0%
Required:
i. The number of shares needed to delta-hedge the call position at the end of the previous day.
(2 mks)
ii. The market value of the portfolio today given that the loan balance at the end of the previous
day was sh. 6,000. (3 mks)
iii. Illustrate the transactions that would need to be made to adjust the portfolio to be delta-
hedged for the following day. (5 mks)
Q.5.B – The following information relates to a put and a call option on a stock:
Call price, Co Sh. 9.0
Put price, Po Sh. 13.60
Exercise price, X Sh. 140

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Time to option expiration, T 142 days

Current stock price, So Sh. 134.64
Current –free rate, rf 6%
One year is assumed to have 365 days.
Required:
Compute the prices of the following using put-call parity:
i. Synthetic call option (2 mks)
ii. Synthetic put option (2 mks)
iii. Synthetic bond (2 mks)
iv. Synthetic underlying stock (2 mks)
Q.5.C – The price of a futures contract is sh. 278.38 and a European call option on this
futures contract has an exercise price of sh. 250.00 with a time to expiration of 220 days.
The continuously compounded risk-free rate is 21.25 per cent and the volatility is 0.19.
A year is assumed to have 365 days.
Required:
The price of the call using the Black Model (7 mks)
Hint: The formula for the Black Model is given by:

SEPTEMBER 2015
Q.1.B – Briefly discuss the meaning and importance of the terms “delta”, “theta”, and
“vega.” as applied in option pricing. (6 mks)

Greeks
The more sophisticated tools used to measure the potential variations of options premiums
are as follows:
1) Delta
2) Gamma
3) Vega
4) Rho
5) Theta

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Delta
Delta is the measure of an option's sensitivity to changes in the price of the underlying asset.
Therefore, it is the degree to which an option price will move given a change in the
underlying stock or index price, all else being equal.
Delta = Change in option premium
Change in underlying price
For example, an option with a delta of 0.5 will move sh. 5 for every change of sh.10 in the
underlying stock or index.

Illustration:
A trader is considering buying a Call option on a futures contract, which has a price of sh. 19.
The premium for the Call option with a strike price as of sh.19 is 0.80. The delta for this
option is +0.5. This means that if the price of the underlying futures contract rises to sh.20 -a
rise of sh. 1 -then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium
will be 0.80 + 0.50 = sh. 1.30.
Far out-of-the-money calls will have a delta very close to zero, as the change in underlying
price is not likely to make them valuable or cheap. At-the-money call would have a delta of
0.5 and a deeply in-the-money call would have a delta close to 1.
While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option
price and the underlying stock price are inversely related. This is because if one buys a put
his view is bearish and expects the stock price to go down. However, if the stock price moves
up it is contrary to his view therefore, the value of the option decreases. The put delta equals
the call delta minus 1. It may be noted that if delta of one‘s position is positive, he desires
the underlying asset to rise in price. On the contrary, if delta is negative, he wants the
underlying asset's price to fall.
Uses: The knowledge of delta is of vital importance for option traders because this
parameter is heavily used in margining and risk management strategies. The delta is often
called the hedge ratio. e.g. if you have a portfolio of 'n' shares of a stock then 'n' divided by
the delta gives you the number of calls you would need to be short (i.e. need to write) to
create a riskless hedge -i.e. a portfolio which would be worth the same whether the stock
price rose by a very small amount or fell by a very small amount. In such a "delta neutral"
portfolio any gain in the value of the shares held due to a rise in the share price would be
exactly offset by a loss on the value of the calls written, and vice versa. Note that as the delta
changes with the stock price and time to expiration the number of shares would need to be
continually adjusted to maintain the hedge. How quickly the delta changes with the stock
price are given by gamma.

Theta
It is a measure of an option's sensitivity to time decay. Theta is the change in option price
given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk).
Theta is generally used to gain an idea of how time decay is affecting your portfolio.

Theta = Change in an option premium

Change in time expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases.
This is due to the fact that the uncertainty element in the price decreases.
Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to
2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of
the underlying stock will alter the premium. Theta is only concerned with the time value.

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Unfortunately, we cannot predict with accuracy the change's in stock market's value, but we
can measure exactly the time remaining until expiration.

Vega
This is a measure of the sensitivity of an option price to changes in market volatility. It is the
change of an option premium for a given change -typically 1 % -in the underlying volatility.

Vega = Change in an option premium

Change in volatility

If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a
Vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor
increased by 1 % to 31 %. As the stock becomes more volatile the changes in premium will
increase in the same proportion. Vega measures the sensitivity of the premium to these
changes in volatility.
What practical use is the Vega to a trader? If a trader maintains a delta neutral position, then
it is possible to trade options purely in terms of volatility -the trader is not exposed to changes
in underlying prices.

Rho
Rho measures the change in an option's price per unit increase -typically 1 % -in the cost of
funding the underlying.

Rho = Change in an option premium

Change in cost of funding underlying
Example:
Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the price of the
option will move by sh. 0.14109. To put this in another way: if the risk-free interest rate
changes by a small amount, then the option value should change by 14.10 times that
amount.
For example, if the risk-free interest rate increased by 0.01 (from 10% to 11 %), the option
value would change by 14.10*0.01 = 0.14. For a put option, inverse relationship exists. If the
interest rate goes up the option value decreases and therefore, Rho for a put option is
negative. In general Rho tends to be small except for long-dated options.

Gamma
This is the rate at which the delta value of an option increases or decreases as a result of a
move in the price of the underlying instrument.

Gamma = Change in option delta

Change in underlying price

For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of +/- 1 in
the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall.
Gamma is rather like the rate of change in the speed of a car -its acceleration -in moving from
a standstill, up to its cruising speed, and braking back to a standstill. Gamma is greatest for an
A TM (at-the- money) option (cruising) and falls to zero as an option moves deeply ITM (in-
the-money ) and OTM (out-of-the-money) (standstill). If you are hedging a portfolio using
the delta-hedge technique described under "Delta", then you will want to keep gamma as
small as possible as the smaller it is the less often you will have to adjust the hedge to

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maintain a delta neutral position. If gamma is too large a small change in stock price could
wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using
options --unlike delta, it can't be done by buying or selling the underlying asset as the gamma
of the underlying asset is, by definition, always zero so more or less of it won't affect the
gamma of the total portfolio.

Q.1.C – Assume that your company has invested in 100,000 shares of Unglow Limited, a
manufacturer of light bulbs. You are concerned about recent volatility in UnglowLtd’s share
price due to unpredictable weather. You wish to protect your company’s investment from a
possible fall in Unglow Ltd’s share price until change of weather in three months time, but
do not wish to sell the shares at present.
No dividends are due to be paid by Unglow Ltd during the next three months.
Market data:
Unglow Ltd’s current price share Sh. 20
Call option exercise price Sh. 22
Time to expiry 3 months
Interest rates (annual) 6%
Volatility of Unglow Ltd’s shares 50% (standard deviation per year)
Assume that option contracts are for the purchase or sale of units of 1,000 shares.
Required:
i. Devise a delta hedge that is expected to protect the investment against changes in
share price until the change of weather. Delta may be estimated using N(d 1) (8 mks)
ii. Comment on whether such a hedge is likely to be totally successful. (2 mks)
Q.2.A – A stock price currently sells for sh. 36. In the next 6 months, the stock price will
either increase to sh. 42 or decrease to sh. 31. The risk free rate is 4% per year.
Required:
Calculate the current price of a call option on the above stock if it’s term to expiration is six
months and its strike price is sh. 35. (6 mks)
Q.2.C – The following information is provided about the current spot rate between the United States
(US) dollar ($) and British pound (£), inflation rates in Britain and United States and real interest
rates:
Current spot rate $1.4500/£
US inflation rate 1.5% per year
British inflation rate 2.0% per year
Real rate interest 2.5%
Required:
Using the parity condition:
i. Compute the expected spot rate in one year’s time. (2 mks)
ii. Assume that you could borrow $ 1,000,000 or £689,700 at the risk free interest rate ,
demonstrate how you could make an arbitrage profit if you were offered the chance to
sell or buy British pound (£) forward for delivery one year from now at the current spot
rate of $1.4500/£. (8 mks)
Q.3.A – State and briefly explain the relationship between a call option price and the
following determinants:
i. The underlying stock’s price (2 mks)
ii. The exercise price (2 mks)
iii. The time to maturity (2 mks)
iv. The risk-free rate (2 mks)

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1. Current stock price - If it is exercised at some time in the future, the payoff from a call
option will be the amount by which stock price exceeds the strike price. Therefore call option
becomes more valuable as the stock price increases.
2. Exercise price - If it is exercised at some time in the future, the payoff from a call option
will be the amount by which stock price exceeds the strike price. Therefore call option
becomes less valuable as the strike price increases.
3. Time to expiration - Both put and call American options become more valuable as the time
to expiration increases. To see this, consider two options that differ only as far as the
expiration date is concerned. The owner of the long-life option has all the exercise
opportunities open to the owner of the short-life option -- and more. The long-life option
must therefore always be worth at least as much as the short-life option. European put and
call options do not necessarily become more valuable as the time to expiration increases.
[why?]
4. Volatility [or Variance ] in stock prices - Roughly speaking, the volatility of a stock price
is a measure of how uncertain we are about future stock price movements. As volatility
increases, the chance that the stock will do very well or very poorly increases. The owner of a
call benefits from price increases but has limited downside risk in the event of price
decreases. [why?] Therefore value of calls increases as volatility increases. The same logic
applies to put options.
5. Risk free interest - If the stock price is expected to increase, an investor can choose to
either buy the stock or buy the call. Purchasing the call will cost far less than purchasing the
stock. The difference can be invested in risk-free bonds. If interest increase, the combination
of calls and risk-free bonds will be more attractive. This means that the call price will tend to
increase with increases in interest rates. However, when you sell the stock by exercising the
put, you receive E dollars. If interest rates increase, the E dollars will have a lower present
value. Thus, higher interest rates make put less attractive.
Q.3.B – Zawadi Ltd. is considering introducing an executive share option scheme. The
scheme would be offered to all middle level managers of the company. It would replace the
existing scheme of performance bonuses linked to the post tax earnings per share of the
company. Such bonuses in the last year ranged between sh. 500,000 and sh. 700,000. If the
option scheme is introduced new options are expected to be offered to the managers each
year.
It is proposed that for the first year, all middle level managers be offered options to purchase
500,000 shares at a price of sh. 500 per share, after the options have been held for one year.
If the options are not exercised at that time, they will lapse. Assume that the tax authorities
allow the exercise of such options after they have been held for one year.
The company’s shares have a current market price of sh. 6.10 per share. The dividend paid
was sh. 0.25per share, a level that has remained constant for the last three years.
Assume that dividends are only paid annually.
The company’s share has experienced a standard deviation of 38% during the last year. The
short term risk free interest rate is 6% per annum.
Required:
Evaluate whether or not the proposed share option scheme is likely to be attractive to
middle level managers of Zawadi Ltd.
(8 mks)
Q.3.C – When informed of the above scheme, one middle level manager of Zawadi Ltd.
stated that he would rather receive put options than call option, as they would be more
valuable to him:
i. Explain whether or not Zawadi Ltd. should agree to offer him put options. (2 mks)

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ii. Is the manager correct in his statement that put options would be more valuable to
him? Explain. (2 mks)

Q.4.C – In relation to options market, distinguish between the following terms:

i. Bull spread and bear spread (2 mks)
ii. Box spread and butterfly spread (2 mks)
iii. Straddle and strangles (2 mks)
Bull spread
A bull spread is designed to make money when the market goes up. In this strategy we
combine a long position in a call with one exercise price and a short position in a call with a
higher exercise price.
Bull spread — Long a call with a low exercise price and shorts a call with a higher exercise
price, or long a put with a low exercise price and short a put with a higher exercise price.
A bull spread in the options market is a combination of call options designed to profit if the
price of the underlying rises. Both calls in a bull spread have the same expiration, but they
have different exercise prices. The buyer of a bull spread buys a call with an exercise price
below the stock price and sells a call option with an exercise price above the stock price. The
spread is a “bull” spread because the trader hopes to profit from a price rise in the stock. The
trade is a “spread” because it involves buying one option and selling a related option.
Compared with buying the stock itself, the bull spread with call options limits the trader’s
risk. However, it also limits the profit potential compared with that of the stock.
Bear spread
If one uses the opposite strategy, selling a call with the lower exercise price and buying a call
with the higher exercise price, the opposite results occur.
Bear spread — Short a call with a low exercise price and long a call with a higher exercise
price, or short a put with a low exercise price and long a put with a higher exercise price.
A bear spread is a combination of options designed to profit from a drop in the stock price. It
is the opposite of the bull spread.

Box spread
Box spreads refers to any combination of options that has a constant payoff at expiry. For
example combining a long butterfly made with calls, with a short butterfly made with puts
will have a constant payoff of zero, and in equilibrium will cost zero. In practice any profit
from these spreads will be eaten up by commissions (hence the name "alligator spreads").
A box spread can also be used to exploit an arbitrage opportunity but it requires that neither
the binomial nor Black-Scholes-Merton model holds, it needs no estimate of the volatility,

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and all of the transactions can be executed within the options market, making '
implementation of the strategy simpler, faster, and with lower transaction costs. In basic
terms, a box spread is a combination of a bull spread and a bear spread. Suppose we buy the
call with exercise price X1 and sell the call with exercise price X2. This set of transactions is
a bull spread. Then we buy the put with exercise price X2 and sell the put with exercise price
XI. This is a bear spread. Intuitively, it should sound like a combination of a bull spread and a
bear spread would leave the investor with a fairly neutral position, and indeed, that is the
case. A box spread can also be used to exploit an arbitrage opportunity but it requires that
neither the binomial nor Black-Scholes-Merton model holds, it needs no estimate of the
volatility, and all of the transactions can be executed within the options market, making '
implementation of the strategy simpler, faster, and with lower transaction costs. In basic
terms, a box spread is a combination of a bull spread and a bear spread.

Butterfly Spreads
Butterfly spread is an option strategy that combines two bull or bear spreads and has three
exercise prices.
Butterfly — Butterflies require trading options with 3 different exercise prices. Assume
exercise prices X1 < X2 < X3 and that (X1 + X3) /2 = X2
 Long butterfly — long 1 call with exercise price X1, short 2 calls with exercise price X2,
and long 1 call with exercise price X3. Alternatively, long 1 put with exercise price X1,
short 2 puts with exercise price X2, and long 1 put with exercise price X3.
 Short butterfly — short 1 call with exercise price X1, long 2 calls with exercise price X2,
and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1,
long 2 puts with exercise price X2, and short 1 put with exercise price X3.
To buy a butterfly spread, a trader buys one call with a low exercise price and buys one call
with a high exercise price, while selling two calls with a medium exercise price. The spread
profits most when the stock price is near the medium exercise price at expiration. In essence,
the butterfly spread gives a payoff pattern similar to a straddle. Compared with a straddle,
however, a butterfly spread offers lower risk at the expense of reduced profit potential.

Straddles
Straddle is an option strategy involving the purchase of a put and a call with the same
exercise price. A straddle is based on the expectation of high volatility of the underlying.
Straddle — Long a call and long a put with the same exercise prices (a long straddle), or
short a call and short a put with the same exercise prices (a short straddle).
A straddle is an option position involving a put and a call option on the same stock. To buy a
straddle, an investor will buy both a put and a call that have the same expiration and the same
striking price. To sell a straddle, a trader sells both the call and the put.

Strangles
Strangle is a variation of a straddle in which the put and call have different exercise prices.
Strangle — Long a call and long a put with different exercise prices (a long strangle), or
short a call and short a put with different exercise prices (a short strangle).
A strangle is similar to a straddle, which involves buying a call and buying a put option with
the same striking price with the same term to expiration. A long position in a strangle consists
of a long position in a call and a long position in a put on the same underlying good with the
same term to expiration, with the call having a higher exercise price than the put.
We answer this question in a very detailed way.
Directional Strategies
Directional strategies are designed to speculate on the direction of the underlying market.

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So, they are simply trades that reflect the views of traders on the direction of the underlying
market like ‘bullish view’ (prices will rise) or ‘bearish view’ (prices will decline). Options
can be combined in such a way that investors will have exposures only to the market
direction while remaining neutral to the volatility. Therefore, directional strategies allow
traders not to worry about volatility changes and to make use of their expertise in predicting
the market direction.
It may appear that these are not very special strategies as one can always speculate about the
direction of the market with the help of the underlying assets directly or with the help of
futures. But it has to be noted that these two instruments allow traders to benefit only when
their predictions about the direction turn out to be right; but if their predictions or beliefs do
not turn up right, they will have to put up with unlimited losses. With options you get the best
of both worlds - have unlimited gains if you predict the market direction correctly otherwise
content with the limited losses. Options provide the investors with ample leverage, which is
another possibility that trading with the underlying assets alone would not be providing.

Bull Vertical Spread

Among the directional strategies vertical spreads are quite common and these involve two
options with different strike prices on the same underlying for the same maturity. Vertical
spreads are characterized by limited risk and profit potential. These spreads are termed as
vertical spreads since the spread consists of two options that appear one below the other (not
necessarily immediately below) in the options price quotations published in the business
press, are organized in an ascending order of strike prices.
A bull vertical spread involves buying a call option and simultaneously selling a call option
on the same stock with the same expiry but with a higher strike price. A bull spread can be
created with put options too and the principle remains the same - buy the lower strike option
and sell the higher strike option. So, in a bull spread:
Long call strike < Short call strike
Long put strike < Short put strike
Bull call spread is somewhat similar to a covered call but instead of holding shares, the
investor owns an ITM call option. This strategy permits the trader to initiate the position even
though he is tentative of his bullish expectations. This is because in the worst case the call
option he holds may expire worthless. Of course bull vertical spread can be constructed so as
to reflect his varying bullish expectations, viz., if the investor is very bullish, he can select the
strike prices which are farther apart, and if he is cautious of his expectations, the strike prices
will be closer to each other. Also, the more ITM the long call, the more wary the trader is.
Depending on the composition of the spreads and with respect to the spot price, a spread is
termed as ATM if it has one ITM and one OTM option, whereas in an ITM vertical both
options are currently ITM, and an OTM vertical is one where both options are currently
OTM. Consider the following data:

Stock price 100

Time to expiry 90 days
Volatility 25%
Interest rate 5%
Option price X = 100 5.55
Option price X = 105 3.40

If an investor constructs a 100/105 bull spread, he pays sh.5.55 for the long call and receives
sh.3.40 from the short call option, resulting in a net outflow of sh. 2.15. Since there is a net
outflow of money, this type of spreads is sometimes termed as debit spreads. It is evident that

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the investor is reducing the price of the option that was bought and aims to profit from his
bullish views. Since the trader is adding another option to the original position by selling
another call at a higher strike, he is actually limiting his gains and so also the risks.
The maximum loss occurs when the purchased option expires out-of-the-money and the loss
is equal to the net premium paid. The profit is highest when the sold option becomes in-the-
money and the gains are equal to the difference between the two strike prices less the
premium paid. Hence the breakeven point is (this is also clear from the profit/loss diagram)
Lower exercise price + Net premium paid

Bull call spread profit/(loss) diagram

For our example, let us see the cash flow consequences under different scenarios:
1) When the stock price is below sh.100: In this situation, both options expire worthless and
the net loss would be the net premium paid and will equal to sh.2.15.
2) When the stock price is between sh.100 and sh.105: At expiry, the investor exercises the
sh.100 call and sells the stock in the market at the going price. Since the breakeven point is
sh.102.15, he will exercise the option as long as the stock is in the range of sh. 100 and
sh. 102.15.
3) When the stock price is above sh.105: In this situation, both options are in-the-money
and the investor will exercise the sh. 100 call and simultaneously the higher call sold by
him will also be exercised by the counterparty. The total gain will be sh. 5 and net gain
will be sh. 2.85, considering ` 2.15 being the net premium paid to initiate the position. So
as long as the stock ends up higher than the sold call option, this represents the gains to the
bull spread holder.
Now let us see what insights the Greeks provide us. The below Table provides the Greeks for
the bull vertical spread.

Option Greeks for the bull vertical spread

Price Delta Gamma Theta Vega

Long call option -5.55 0.565 0.031 -0.034 0.196
Short call option 3.40 -0.415 -0.031 0.033 -0.193
Net -2.15 0.15 0 -0.001 0.003

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The Greeks make our comprehension of the strategy much more thorough – the investor is
exposed only to the market direction with a positive delta of 0.15 and all other Greeks are
negligible with a zero gamma and an insignificant Vega, implying that the position is neither
exposed to actual volatility nor to implied volatility. The best part of this bullish strategy is
that time decay is almost zero. Generally, with a long option position, the holder is subjected
to massive time decays, but with a bull spread, the position has a long bias towards the
market without being wrecked by time decay. In this case, the delta is just 0.15, meaning that
the traders’ exposure is only 15% of the underlying but if he desires more exposure to the
underlying, this can be achieved by driving the delta to any desired value. For example, if the
trader intends to have a delta equivalent to that of the underlying stock, i.e., 1.0, all he has to
do is add more bull spreads. In this case he needs around 6 to 7 spreads (1.0/0.15 = 6.67).
In a similar way, bull vertical spreads can be constructed using put options instead of call
options. This is done by selling the higher strike option and buying the lower strike put
option. Since we are writing an ITM put and buying an OTM put option, there will be a cash
inflow.
Hence these spreads are also termed as credit spreads. The more ITM the two exercise prices,
the more aggressive is the spread. The profit/loss diagram for the bull put spread is depicted
in the Figure below. The nature of the strategy and the consequences are as discussed in the
case of bull call spread.

Bull put spread profit/(loss) diagram

BEAR VERTICAL SPREADS

When the outlook for the market direction is bearish, an investor can benefit by trading bear
vertical spreads using either call options or put options. In a bear vertical spread the strike
prices are chosen as follows:
Long call strike > Short call strike
Long put strike > Short put strike
A bear spread is a versatile strategy when an investor expects the market to decline but is
unsure of the amount by which it will fall. An aggressive spread can be constructed by using
more out-of-the-money options. When an investor initiates a bear put spread as in the case of
a bull call spread, he pays the premium. So a bear put spread is also a debit spread. If the
underlying security rises subsequently, the loss will be limited to the net premium paid. For
instance, an investor who is having a bearish view on the market can profit from his forecast
by using a bear spread, which entails less investment than that involved in a long put option.

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Assume that the investor expects the earlier stock to come down and he constructs a bear
spread with the following information:
1) Buy a 105 put option at sh.7.33
2) Sell a 100 put option at sh. 4.44
3) Net premium paid is sh.2.89
The short put does two things - reduce the cost of buying the 105 put option and limits the
profits at expiry. At expiry if the stock price falls below sh. 100, then both the puts will be
exercised (long put will be exercised by the investor the 105 and the buyer of 100 put will
also exercise it) and this will result in sh.5 as inflow to the spread holder. However, since he
paid a premium of sh.2.89, his net gain will be sh. 2.11 (5 - 2.89). On the other hand, if the
stock ends up between ` 100 and ` 105, the investor will exercise the 105 long put and the 100
short put will be allowed to lapse. Since the breakeven point is sh. 102.11, to limit the losses
the investor will exercise the option as long as the stock is between sh.102.11 to sh.105.
The last possibility is when the stock price is over sh. 105 and in this case both options will
be worthless and this represents the worst case for the bear spread buyer and he has to bear a
maximum loss of sh. 2.89 being the initial premium paid by him. So, the bear put spread has
a limited upside and a limited downside risk which can be observed from the profit/loss
diagrams given below.

Price Delta Gamma Theta Vega

Long call option -7.33 -0.612 0.033 -0.02 0.193
Short call option 4.44 0.45 -0.033 0.022 -0.196
Net -2.89 -0.162 0 0.002 -0.003

Bear put spread profit/(loss) diagram

The option Greeks for the, bear put spread are presented in Table above.
The net delta of the spread is around —0.16, implying that the position will benefit if the
market price of the stock falls. Gamma and Vega are almost zero. Hence the position is
neutral to volatility and is exposed only to the market direction. Importantly, theta for the
spread is negligible (though for this spread it is in fact insignificantly positive). This is a

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major benefit over simply buying a put option, which is also a bearish strategy that is
subjected to serious time decay losses.
To sum up, we can say that the vertical spreads (bull/bear) achieve the following:
1) Provide a position that benefits if market rises/declines • Unaffected by volatility changes.
2) Time decay losses are almost negligible.

VOLATILITY STRATEGIES
Option markets actually facilitate securitization of risk. Hence options are one of the most
important and accessible tools to construct strategies that benefit from the traders’
knowledge of volatility changes without bothering about direction of the underlying price.
Therefore, volatility strategies benefit investors who have their expertise in forecasting
volatility but may not be proficient in forecasting the direction of the market. The following
are the important volatility trading strategies.

Straddles
This is the most popular strategy to trade volatility since this gives the buyer exposure only to
volatility with insignificant exposure to the underlying asset. Therefore, without bothering
about the market direction, one can take positions on changes in market expectations of price
volatility alone. A long straddle comprises buying a call option and a put option on the same
stock with the same strike price and expiry. Prima facie it may appear foolish to buy a call
and a put on the same underlying at the same strike and for the same expiry, but the real
purpose is to stay neutral to the market and get exposure only to volatility. Hence a long call
and a long put will just achieve that - remain unexposed to the underlying, but since the
buyer has paid the premium and is long in two options, he is long volatility (option buyers are
in fact buyers of volatility). In other words, the straddle buyer expects the volatility to rise
from the current levels.
The profit and loss diagram for a long straddle is shown in the diagram below. In this case,
the straddle was constructed for the following data:

Strike price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
Call option X = 60 2.81
Put option X = 60 3.15

It may be noticed that by buying a call option, and a put option, the investor is setting lower
and upper breakeven points for his position and the breakeven points corresponds to strike
price ± total premium paid.
The total premium paid by the straddle buyer is sh. 5.96. Hence the lower BEP is 60 - 5.96 =
54.04 and the upper BEP is 60 + 5.96 = 65.96. This implies that the trade will be profitable if
the price of the stock moves outside this range. So, the straddle buyer will be benefitted even
if the stock moves up or down but it should move significantly beyond the breakeven points.
He will be incurring losses if the stock remains range-bound and moves in the range depicted
between the lower and upper BEPs. The Greeks for the long straddle are given in Table
below.

Option Greeks for the long straddle

Price Delta Gamma Theta Vega

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Long call option -2.81 0.513 0.053 -0.02 0.117

Long put option -3.15 -0.505 0.057 -0.013 0.117
Net -5.96 0.008 0.110 -0.033 0.234

The delta of straddles can be insignificantly positive, negative or zero. Here the delta is
slightly positive at 0.008 but for all practical purposes this value is insignificant.
In general, if the delta is near 0.01, the position can be considered as delta neutral. Since long
straddle involves buying options, the gamma is almost doubled. Similar to delta, the gamma
of the straddle depends on where the stock price is compared to the strike price.
The gamma of a straddle is highest when it is made from ATM options because gamma for
an option is highest when the stock price is equal to the strike price. A positive gamma
signifies that the straddle buyer wants the stock price to change significantly. The higher the
positive gamma, the more positive delta will become as the stock price surges up, on the
contrary more negative delta will be as the stock price falls. As the stock price moves away
from the strike price of the straddle, gamma starts to decrease. When the stock price moves,
the options become either ITM or OTM, and their gamma drops accordingly.

Long straddle profit/(loss) diagram

Similarly, the Vega of the position is doubled and, positive stands at 0.234 i.e., if the
volatility of the underlying stock changes by 1%, the position will profit by sh. 0.234.
Assume that the implied volatility increases to 45% after initiating the position. Then the
position will gain in value by an amount of 20% x 0.234 = `sh.4.68 for each straddle. This is
almost equal to the initial premium paid by the straddle owner. So, straddle buyers look for
such a kind of volatility changes. So far so good, all the Greeks are working for the straddle
buyer except one - theta. The net theta is negative at 0.033. This is not unusual because the
straddle buyer is long in two options. So theta will also double up and is slowly eating into
the initial investment. Since the position loses due to time decay and theta is highest for
options that are near to expiration, few traders afford to maintain/hold straddles for long
periods or till expiration. By and large investors hold straddles for a short time period and
close out the position as soon as volatility changes. A straddle is an effective strategy
particularly before important economic events like budgets or any company-specific events
(like a judgment in a court case) that may have either a highly favorable/unfavorable impact
oil price of the underlying stock but the investor is unsure of the direction. Unfortunately if

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nothing happens and if the volatility and the underlying stock price remain stable, the trader
has to unwind his position before being ruined by time decay.
With a short straddle, the seller expects just the opposite of the buyer - the volatility will
come down in future. A short straddle comprises simultaneous selling of a call option and a
put option. If the strike prices are close to the market price, then the net delta will be close to
zero. Hence the writer’s exposure to the underlying market is negligible or neutral.
The position will be most profitable when the stock finishes at the strike price and both
options expire worthless. The profit/loss diagram for a short straddle is depicted in the below
Figure along with the Greeks in Table below which are exactly opposite in sign to that of a
long straddle.

Short straddle profit / (loss) diagram

Option Greeks for the short straddle

Price Delta Gamma Theta Vega
Short call option 2.81 -0.513 -0.053 0.02 -0.117
Short put option 3.15 0.505 -0.057 0.013 -0.117
Net 5.96 -0.008 -0.110 0.033 -0.234

It is very much evident that writing straddles is very risky since the upside is limited only to
the amount of premium collected from the two options but the downside is unlimited and
the risks are substantial if a large price move occurs. The theoretical price of the spread is sh.
5.96 that will be received by the seller. The delta is slightly negative, which can be
considered as neutral. Since two options were sold, gamma is negative and this means that if
extreme movements occur in the price of the underlying, the position will experience grave
losses in both the directions. Like the gamma, the Vega for the short straddle is also doubly
negative. If the volatility rises from 25% to 26%, the straddle’s price rises to sh. 6.19 and this
is the price the seller has to pay to close his position and in the process he will incur a loss of
sh. 0.234 per straddle.
The theta for the options stands at 0.033 and is positive. Hence among all the Greeks only
Theta works for the straddle seller and he gains from time decay and this time decay will
increase as time passes by. The heaviest decay is experienced by the straddle near expiration.
Hence many traders may be interested in writing straddles that are near to expiry. However,
they will be wary of Gamma as it will be highest for options that are closer to maturity. Short

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straddles may be suitable strategies particularly when the volatilities are near the historic high
levels.

STRANGLES
Strangle is another combination to trade volatility and is very much similar to a straddle but
the virtue of a strangle is that it costs far less than a straddle. In a strangle, the two options
have different strike prices and are normally OTM options. Since the options are out-of-the-
money, they cost less while a straddle is constructed usually with ATM options that have the
highest time value.
Therefore, a long strangle involves:
1) An OTM long call option
2) An OTM long put option
A strangle comprises a long position in a call as well as in a put option. The strike price of the
put option will be less than that of a call option’s strike price and they will have the same
expiry date, i.e., both of them are OTM and the farther they are from the current market
price, the cheaper the strangle will he. Consider the following example wherein a strangle is
established with the following information:

Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
Call option X = 65 1.42
Put option X = 55 0.87

The total premium paid in this case is sh. 2.29 and this is the maximum loss that will be
incurred by the buyer in the worst case while the profits are unlimited beyond the breakeven
points on either side, i.e., whether the stock moves up or down which can be noted from
below Figure. This is one reason why these spreads are termed as straddles and strangles as
these positions profit on both sides. Long straddles and strangles make money if the stock
price moves up or down significantly. A strangle buyer expects the volatility to go up and he
will start gaining if the price of the underlying stock goes beyond the upper BEP or falls
below the lower breakeven point. Even if the underlying does not move and the volatility
increases, then also he will be gaining. The maximum loss is incurred when the price of the
stock is in the range of strike price ± total premium paid.
Option Greeks for the long strangle

Price Delta Gamma Theta Vega

Long call option X = 65 -1.42 0.323 0.047 -0.017 0.106
Long put option X = 55 -0.87 -0.205 0.038 -0.01 0.082
Net -2.29 0.118 0.085 -0.027 0.188

To understand more about the strategy let us make use of the Greeks given in the above table:
The net delta is positive at 0.118 and this exposes the buyer to the underlying market to the
extent of 11.8%. If the trader wants exposure only to the volatility, then he can chose the calls
and puts in such a way that delta can be made negligible.

Long strangle profit/(loss) diagram

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The Gamma for the position is positive since both options were purchased and is equal to
0.085. This implies that extreme price movements will benefit the buyer in both directions.
The Vega for the combination is 0.188. This implies that the strangle buyer will gain if
implied volatility increases. Lastly, Theta for the strangle is negative at 0.027 and this is of
concern for the buyer since if nothing changes and the market is stable, the strangle buyer
will be losing everyday due to time decay. Hence many traders will take them off within a
short period of time after initiating the position but strangles can be held for a little longer
than straddles as Theta is less than that of straddles.
The seller of a strangle is betting that volatility will be low and it is a preferred way to sell
volatility since the position remains delta-neutral over a wide range of prices. In a short
strangle, the investor simultaneously sells OTM call and put options on the same underlying
stock with the same expiry date. The maximum gain is the total premium received which
happens when the stock closes between the strike prices. But beyond the breakeven points,
losses are unlimited.
The short strangle benefits from two sources:
1) Fall in volatility of the underlying and/or
2) Time decay due to passage of time
The consequences will become much more clearer if we look at the Greeks along with the
profit/loss diagram given in the below Table and in Figure respectively.

Option Greeks for the short strangle

Price Delta Gamma Theta Vega
Long call option X = 65 1.42 -0.323 -0.047 0.017 -0.106
Long put option X = 55 0.87 0.205 -0.038 0.01 -0.082
Net 2.29 -0.118 -0.085 0.027 -0.188

Short strangle profit/(loss) diagram

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As can be observed, a short strangle is a risky strategy as the losses are unlimited on either
side but the gains are at best equal to the premiums received from both the options sold.
Though the delta is positive, it can be forced to zero if desired. The gamma is negative and
this indicates that as the price volatility increases, the position will incur losses on either side.
The strangle seller has a negative Vega position. Hence if implied volatility is muted, the
seller will benefit. Finally, the seller will be benefitting from a positive Theta even if all
other things remain unchanged.

BUTTERFLY
The best way to sell volatility is to sell an option but when we sell an option, we inherently
assume a position in the underlying market also. Hence a pure volatility trader may wish to
be neutral to the market and would like to have a position that reflects his view on volatility
alone. This is possible with the help of strategies discussed above, viz., straddles and
strangles. But these strategies are very risky, particularly for selling volatility.
It is very clear from the profit/ loss diagrams that beyond the breakeven points, the losses are
unlimited on both sides and for comprehending this, one need not actually dip into the
Greeks. Using options skillfully we can reduce these unlimited losses in short straddles and
strangles too. For instance, if a trader is having a bearish view on the volatility and he is
assuming a short straddle to gain from his view and he is also concerned about the losses, he
can actually cut down these losses by buying two out of the money options (a call and a put
option) as some sort of protection on either side of the breakeven points. But this comfort is
achieved at the cost of sacrificing some of the potential profit.
A butterfly is an options strategy using multiple puts and/or calls speculating on future
volatility without having to guess in which direction the market will move. A long butterfly
comprises three types of either puts or calls having the same expiration date but different
exercise prices (strikes). For example, with the underlying asset trading at sh. 100, a long
butterfly strategy can be built by buying puts (or calls) at sh. 95 and sh. 105, and selling
(shorting) twice as many puts (or calls) at sh. 100. A long butterfly can also be created by
selling a Put and a call that are ATM and buying a put at the lowest strike and a call at the
highest strike. Such a strategy is termed as iron butterfly, probably named after the popular
rock group of the sixties (Tompkins (1994)). A long butterfly generates profits that are far
lesser than that of a short straddle.
So, this is meant for those investors who intend to profit from a forecast of a range-bound
trading of the underlying stock and are not keen on assuming the risks involved in a short
straddle. The maximum profit is equal to the premium received and the real gains occur in
the last few days to expiry from time decay. The maximum losses occur in either direction

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when the stock ends at a price equal to the (strike price of ATM options - net premium) or
above the (strike price of ATM options + net premium). In fact these two points are the
breakeven points. To make sense of this discussion, let us take the help of Greeks for the
following data:

Stock price 60 55 put 1.78

Time to expiry 90 days 60 call 4.51
Volatility 25% 60 put 3.84
Interest rate 5% 65 call 2.53

Option Greeks for the long butterfly

Price Delta Gamma Theta Vega

Long 55 put -1.78 -0.264 0.031 -0.017 0.096
Short 60 call 4.51 -0.565 -0.037 0.027 -0.117
Short 60 put 3.84 0.445 -0.038 0.02 -0.117
Long 65 call -2.53 0.389 0.036 -0.025 0.114
Net 4.04 0.005 -0.008 0.005 -0.024

Long butterfly profit/(loss) diagram

Long butterfly is an interesting strategy in that it is generally a short volatility strategy though
this is a long position. The strategy diagram in the above Figure shows very clearly that
losses are limited on both side and so are the profits. From the Greeks in the Table it can be
noted that the delta of the position is positive but very insignificant in magnitude. Hence for a
small change in the underlying, the position is unaffected. Just as with the premium, the delta
of a long butterfly is also interesting - delta is positive when the stock price is below the
middle strike of the butterfly, neutral when the stock price is at the middle strike and negative
when it is above the middle strike. Hence in this example the delta is almost zero since the
current price of the stock is equal to that of the mid strike (straddle’s strike price). Therefore,
the butterfly maximizes its value when the price of the stock is at the middle strike and if the
price of the stock is below the middle strike, it has to rise for the butterfly to make money;
hence the positive deltas. But if the price of the stock is above the middle strike, it has to fall
for the butterfly to make money; so the deltas are negative. The position is having a positive
theta and a negative Vega. Therefore, a long butterfly will profit from time decay. If the
underlying is near about sh. 60, the profits are maximum and will accelerate most rapidly in

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the last few days before expiry. For instance, net theta before three days is 0.259. It is
important to note that theta will be positive when the price of the stock is at the middle
strike, indicating that elapsing time helps the long butterfly realize its maximum benefit and
at the outer strikes theta is negative, indicating that the butterfly is losing value as time
passes.
However, the position is Vega negative. Hence any increase in implied volatility will be
unfavorable. The impact is felt more on the two ATM options than those that are OTM.
The extent of losses will depend to a large extent on the amount of time to expiry and how
near is the price of the underlying to the exercise price. When the underling’s price is at the
middle strike, the Vega of the long butterfly is negative, meaning that any rise in the implied
volatility will be a losing proposition. This is intuitively appealing since a butterfly’s value
depends on the likelihood that the stock price will be at its middle strike at expiration and
higher volatility decreases the possibility of the stock remaining at the middle strike price. As
a result, the butterfly will lose out when implied volatility rises. Considering the Vega, a long
butterfly will be initiated by a trader when the implied volatility is near to historic highs.
Finally, looking at the butterfly’s structure it can be understood that a butterfly is nothing but
a combination of:
1) Short straddle + Long strangle, or
2) Bear call spread + Bull put spread
Long butterfly = Short straddle +Long Strangle

Short butterfly strategy is just the opposite. It is a limited-risk, limited-gain strategy to

translate a bullish view (betting on an increase in) on the volatility of the underlying. A short
butterfly is established by buying a put and a call that are ATM and selling a put and a call
that are OTM. By buying the ATM options and selling OTM options, the position has its
greatest loss when the underlying does not move, and gains are maximized when the
underlying moves beyond either of the outside exercise prices. Therefore, a short butterfly
strategy profits as equally from a large move up as it does from a large move down. The
profit/loss diagram for a short butterfly with the following data is depicted by Figure below:
Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
55 put 1.78
60 call 4.51
60 put 3.84
65 call 2.53

The short butterfly is established by going long in the 60 ATM call and put options while
selling the 55 put and 65 call OTM options. Short butterfly can also be constructed using only
call options or only put options. These strategies are termed as regular butterflies.
A regular call butterfly involves a long position in two ATM 60 call options and a short
position in one 55 call and a 65 call option. Similarly, the regular butterfly from only put

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options include long position in two ATM 60 puts and a short position in one 55 put (OTM)
and one 65 put which is an ITM put option The profit/loss diagrams of regular butterflies will
be the same as that of iron butterflies and is shown in Figure below.

Short butterfly profit/(loss) diagram

A short butterfly can also be visualized as a combination of short strangles and a short
straddle. This will become obvious if we juxtapose the profit/loss diagrams of these two
strategies and compare it with the diagram of short butterfly.

Short butterfly = Long straddle + Short strangle

CONDORS
A condor is nothing but a modified butterfly. The major difference between a butterfly and a
condor is that while the butterfly’s body (the trapezoidal shape of the option profit/loss
diagram shown in Figure) consists of buying two units of ATM options, the condor’s body
uses separate strikes and is therefore wider. This means that it has a wider area in which its
body produces a profit. Therefore, by using a condor rather than a butterfly, the range in
which the maximum profit can be realized is stretched out and in the process, the breakeven
points also get extended.

Stock price 60
Time to expiry 90 days
Volatility 25%
Interest rate 5%
50 put 0.261
55 put 0.875

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65 call 1.42
70 call 0.33
A long condor is established by:
1) Selling 55 put option
2) Selling 65 call option
3) Buying 50 put option
4) Buying 70 call option
The two options that make up the body of the condor are the first OTM call and first OTM
put options instead of the ATM options while the wings of the condor are made up of deep
OTM options. However, in the case of a butterfly, the options used to insure are just OTM
options.
As can be noted, the two long positions will give rise to a long strangle and the two short
positions will give rise to a short strangle. In other words, a condor can be understood as the
combination of a long strangle plus a short strangle shown in the figure below.

Long condor profit/(loss diagram )

Long condor = long strangle + short strangle

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Price Delta Gamma Theta Vega

Buy 50 put -0.17 -0.057 0.015 -0.004 0.031
Sell 55 put 0.875 0.205 -0.038 0.01 -0.082
Sell 65 call 1.42 -0.323 -0.047 0.017 -0.106
Buy 70 call -0.495 0.149 0.03 -0.009 0.066
Net 1.63 -0.026 -0.04 0.014 -0.091

From the above table one can note that the long condor involves a cash inflow of ` 1.63 per
condor which is the maximum profit and occurs when the stock ends up between sh.55 and
Sh. 65. The position suffers the maximum loss when the stock is at or below sh.50 and at or
above sh. 70. At sh. 50, all the options excepting the sh.55 put will expire worthless and
since this option is written by the condor owner, he has to buy the stock at sh. 55 when the
spot market price is sh. 50. In the bargain he will be losing sh. 5 but since he received sh.
1.63 as the premium, his net loss will equal sh. 3.37 (-5 + 1.63 = ` -3.37). Similarly, if the
stock ends up at sh.70, all the options will be allowed to lapse except the 65 call which was
sold.
The condor buyer will be assigned this option and he has to deliver the underlying at sh. 65
when the going price is sh. 70, resulting in a loss of sh. 5. But since he received sh.1.63 as
premium, his losses will be pared to sh. 3.37 (-5 + 1.63 ` -3.37). The breakeven point on the
lower side is at sh. 53.37 (55 - 1.63 = ` 53.37) and ` sh.66.63 (65 + 1.63 = sh. 66.63) on the
other side.
In essence, a condor buyer expects that stock prices remain range-bound more clearly
between the strikes of the short strangle. i.e., sh. 55 and sh. 65 since only in this area his
profits are maximum. But if the stock ends up outside this range, it is certain that one of the
options will be in-the-money and he will start losing money beyond the breakeven points.
The Table presents the Greeks and the net delta of the position is almost negligible but the
gamma is almost five times that of a butterfly, which makes the condor more sensitive to
price swings. Since the position involves selling less OTM options, and buying deep OTM
options, the position will be benefited if implied volatility decreases and the benefits are
more than that for a butterfly since the Vega is more negative for condor than for a butterfly.
In addition to this, the position will benefit from positive theta and theta benefits will increase
as the spread’s expiry date nears by. However, the profits are generally low since it involves
selling OTM options that are traded at low prices.
A short condor involves the following:
1) Buying 55 put option
2) Buying 65 call option
3) Selling 50 put option
4) Selling 70 call option
The profit/loss diagram is as shown in the below Figure, with the maximum loss being
limited to the premium paid while the profits are also limited on either side equaling to sh.
3.37 when the stock ends up at or falls below sh.50 and at or over sh.70, i.e, the strike prices
of the sold options become a key reference point from where profits will be maximum.
Therefore, the seller will make money if there is a drastic fall or rise in the stock price.

Short condor profit/(loss) diagram

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Comparison of volatility strategies

FACTORS AFFECTING OPTION VALUE

There are primarily six factors that determine the value of an option.
Value of the Underlying
The call option can be viewed as buying the underlying and the put option can be viewed
as selling the underlying. So, the value of call option increases with an increase in the
value of the underlying and the value of put option decreases with an increase in the value
of the underlying.
Exercise Price
The lower the exercise price, the higher the value of the call option because we would be
able to buy the underlying at a lower price. The opposite is true for the put option i.e. the
higher the exercise price; the higher the value of the put option as we would be able to sell
the underlying at a higher price. Hence, the value of a European call option is inversely
proportional to the exercise price and the value of a European put option is directly
proportional to the exercise price.
Time to Expiration
The more the time to expiration, the greater the value of the option. The logic is that the
underlying has more potential for movement and thus the option will have a higher value.

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With the same logic, even the put option will increase with an increase in the time to
expiration. But there is some exception to the European put options. If the risk-free rate is
high, the volatility is lower, and the European put option is deep-in-the-money, then the
value of put option can decrease with increase in the time to expiration.
You can easily remember it with the example of a bankrupt company. Suppose you buy a
European put option with one year to expiry for the exercise price of $100. Just after the
option purchase, the company gets caught in a scandal and goes bankrupt. The price of
the stock falls to zero and is never going to recover and is going to remain at the price of
zero. Since the option is European, we cannot exercise the option before the expiration.
So, the value of the option will be simply the present value of $100. The value will keep
on increasing as the time to expiration decreases and we move closer to the expiry. The
long-dated European put option having 10-years, 15-years or 20-years to expiration
almost always decrease in value with increase in the time to expiration because the
negative impact of the discount factor of the risk-free rate dwarfs the positive impact of
the movement of the underlying due to longer time to expiration. Because the lower
movement is limited because the underlying price cannot fall below zero.
Risk-Free Interest Rate
The value of call option increases in the value with an increase in the risk-free rate and the
value of put option decreases with an increase in the risk-free rate. As per put-call parity,
c0 + X*(1+r)-T = p0 + S0. If we increase the risk-free rate, then the value of factor X*(1+r)-
T
falls and the value of call option has to increase for the parity of the equation.
Volatility
Both call options and put options increase in value with an increase in volatility. The call
option increases in value because the underlying price can increase to a higher price
because of high volatility. Similarly, the put option increases in value because the
underlying price can fall to a lower price due to higher volatility. The volatility factor and
time to expiration factor are combined to get the time value of an option. The volatility can
have more impact if the time to expiration is longer. The option prices generally decrease
as the options approach expiration date and this is referred to as time value decay.
Cost of Carry
The call option is equivalent to the long position in the underlying and the put option is
equivalent to the short position in the underlying. The value of the underlying decreases
with benefits and increases with the cost of carry. So, the value of European call option is
inversely proportional to the benefits and directly proportional to the cost incurred in
holding the underlying. The opposite is true for the European put option i.e. the value of
European put option increases with more benefits and decreases with more cost of carry.

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FATIMA TRAINING INSTITUTE – MOCKS

QUESTION 1
European put and call options with an exercise price of 45 expire in 115 days. The underlying
is priced at 48 and makes no cash payments during the life of the options.
The risk-free rate is 4.5 percent. The put is selling for 3.75, and the call is selling for 8.00.
Required:
1) Identify the mispricing by comparing the price of the actual call with the price of the
synthetic call.
2) Based on your answer in Part 1, demonstrate how an arbitrage transaction is executed.
Solution
Part 1
Using put-call parity, the following formula applies:
C0 = P0 + S0 – X/(1 + r)T
The time to expiration is T = 115/365 = 0.3151. Substituting values into the right-hand side:
C0 = 3.75 + 48 – 45/(1.045)0.3151 = 7.37
Hence, the synthetic call is worth 7.37, but the actual call is selling for 8.00 and is, therefore,
overpriced.

Part 2
Sell the call for 8.00 and buy the synthetic call for 7.37. To buy the synthetic call, buy the put
for 3.75, buy the underlying for 48.00, and issue a zero-coupon bond paying 45.00 at
expiration. The bond will bring in 45.00/(1.045)0.3151 = 44.38 today. This transaction will
bring in 8.00 - 7.37 = 0.63.
At expiration, the following payoffs will occur:

ST < 45 ST ≥ 45
Short call 0 -(ST – 45)
Long put 45 - ST 0
Underlying ST ST
Bond -45 -45
Total 0 0

Thus there will be no cash in or out at expiration. The transaction will net a risk free gain of
8.00 - 7.37 = 0.63 up front.

QUESTION 2
You are provided with the following information on put and call options on a stock:
Call price, Co = $6.64
Put price, Po = $2.75
Exercise price, X = $30
Days to option expiration = 219
Current stock price, So = $33.19
Put-call parity shows the equivalence of a call bond portfolio (fiduciary call) and a
put/underlying portfolio (protective put).
Required:
Illustrate put-call parity assuming stock prices at expiration (ST) of $20 and of $40. Assume
that the risk-free rate, r, is 4 percent.

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Solution
We can illustrate put-call parity by showing that for the fiduciary call and the protective put,
the current values and values at expiration are the same.
Call price, Co = $6.64
Put price, Po = $2.75
Exercise price, X = $30
Risk-free rate, r = 4 percent
Time to expiration = 219/365 = 0.6
Current stock price, So = $33.19
Bond price, X/(1 + r)T = 30/(1 + 0.04)0.6 = $29.3
Transaction Current value ST = 20 ST = 40
Fiduciary call
Buy call 6.64 0 40 – 30 = 10
Buy bond 29.30 30 30
Total 35.94 30 40
Protective put
Buy put 2.75 30 – 20 = 10 0
Buy stock 33.19 20 40
Total 35.94 30 40

The values in the table above show that the current values and values at expiration for the
fiduciary call and the protective put are the same. That is, Co + X /(1 + r)T = Po + So.

QUESTION 3
Consider the following information on put and call options on a stock:
Call price, Co = $4.50
Put price, Po = $6.80
Exercise price, X = $70
Days to option expiration = 139
Current stock price, So = $67.32
Risk-free rate, r = 5 percent.

Required:
A. Use put-call parity to calculate prices of the following:
i. Synthetic call option
ii. Synthetic put option
iii. Synthetic bond
iv. Synthetic underlying stock
B. For each of the synthetic instruments in Part A, identify any mispricing by comparing the
actual price with the synthetic price.
C. Based on the mispricing in Part B, illustrate an arbitrage transaction using a synthetic call.
D. Based on the mispricing in Part B, illustrate an arbitrage transaction using a synthetic put.

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Solution
Call price, Co = $4.50
Put price, Po = $6.80
Exercise price, X = $70
Risk-free rate, r = 5 percent
Time to expiration = 139/365 = 0.3808
Current stock price, So = $67.32
Bond price = X /(1 + r)T = 70/(1 + 0.05)0.3808 = $68.71
Part A
A. Synthetic call = Po + So – X /(1 + r)T = 6.8 + 67.32 - 68.71 = $5.41
Synthetic put = co + X /(1 + r)T - So = 4.5 + 68.71 - 67.32 = $5.89
= Co + X/(1+r)T – S0 = 4.5 + 68.71 – 67.32 = $ 5.89
Synthetic bond = Po + So - Co = 6.8 + 67.32 - 4.5 = $69.62
Synthetic underlying = Co + X /(1 + r)T - Po = 4.5 + 68.71 - 6.8 = $66.41
Part B
Instrument Actual price Synthetic price Mispricing / profit
Call 4.50 5.41 0.91
Put 6.80 5.89 0.91
Bond 68.71 69.62 0.91
Stock 67.32 66.41 0.91

Thus, the mispricing is the same regardless of the instrument used to look at it.
Part C
The actual call is cheaper than the synthetic call. Therefore, an arbitrage transaction where
you buy the call (underpriced) and sell the synthetic call (overpriced) will yield a risk-free
profit of $5.41 - $4.50 = $0.91. As shown below, at expiration no cash will be received or
paid out.

Value at expiration
Transaction ST < 70 ST > 70
Buy call 0 ST – 70
Sell synthetic call
Short put -(70 – ST) 0
Short stock -ST -ST
Long bond 70 70
Total 0 0

Part D
The actual put is more expensive than the synthetic put. Therefore, an arbitrage transaction in
which you buy the synthetic put (underpriced) and sell the put (overpriced) will yield a risk-
free profit of $6.80 - $5.89 = $0.91. As shown below, at expiration no cash will be received
or paid out.

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Value at expiration
Transaction ST < 70 ST > 70
Sell put -(70 – ST) 0
Buy synthetic put
Long call 0 ST – 70
Long bond 70 70
Short stock -ST -ST
Total 0 0

QUESTION 4
Consider an asset that trades at $100 today. Call and put options on this asset are available
with an exercise price of $100. The options expire in 275 days, and the volatility is 0.45. The
continuously compounded risk-free rate is 3 percent.
Required:
1) Calculate the value of European call and put options using the Black-Scholes- Merton
model. Assume that the present value of cash flows on the underlying asset over the life
of the options is $4.25.
2) Calculate the value of European call and put options using the Black-Scholes- Merton
model. Assume that the continuously compounded dividend yield is 1.5 percent.
Solution
Part 1
First calculate the values of dl and d2. The time to expiration is T = 275/365 = 0.7534. Adjust
the price of the asset So = $100 - $4.25 = $95.75.
d1 = In(95.75/100) + (0.03 + (0.45)2 / 2) (0.7534)
0.45 √0.7534
d1 = 0.1420
d2 = 0.1420 – 0.45√0.7534 = - 0.2486
Using the normal probability table:
N(0.14) = 0.5557 = N(dl)
N(-0.25) = 1 - N(0.25) = 1 - 0.5987 = 0.4013 = N(d2)
The value of the call option is:
C = 95.75(0.5557) - 100e-0.03 (0.7534)(0.4013) = 13.975
The value of the put option is:
P = 100e-0.03(0.7534)( 1 – 0.4013) - 95.75(1 - 0.5557) = 15.990

Part 2
First calculate the values of dl and d2. The time to expiration is T = 275/365 = 0.7534. Adjust
the price of the asset So = 100e -0.015(0.7534) = 98.87626.
d1 = In(98.876/100) + (0.03 + (0.45)2 / 2) (0.7534)
0.45 √0.7534
= 0.2242
d2 = 0.22423 – 0.45√0.7534 = - 0.1664
Using the normal probability table:
N(0.22) = 0.5871 = N(dl)
N(-0.17) = 1 - N(0.17) = 1 - 0.5675 = 0.4325 = N(d2)
The value of the call option is:
C = 98.876(0.5871) - 100e-0.03 (0.7534)(0.4325) = $15.767
The value of the put option is:
P = 100e-0.03(0.7534)( 1 – 0.4325) – 98.876(1 - 0.5871) = $14.656

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NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim
of helping the learner to answer all the questions. In as such you may have and you will
find that some few selected questions have no suggested answers/solutions. We have done
this by design so as to build the culture of research and serious reading among our
learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

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CHAPTER EIGHT
CONTEMPORARY ISSUES AND EMERGING TRENDS IN DERIVATIVES
CONTRACTS

PAGE
9.1 Numerical methods of Pricing Options: binomial model, finite difference method and
Monte Carlo method………………………………………………………………..
9.2 Credit derivatives: Credit default swaps (CDS), Credit linked notes (CLN), role of
credit derivatives, market participants, Valuation of credit derivatives, credit derivatives
institutional framework, spread volatility of credit default swaps………….
9.3 Financial Engineering; Construction, Uses and Abuses of Derivatives……………
9.4 Applications of Artificial intelligence and financial technology in derivatives
markets………………………………………………………………………………….
9.5 Benefits and Indispensability of derivatives………………………………………..
9.6 Trends and future of derivatives market globally………………………………….
9.7 Effects of Crises and Pandemic on global derivatives market……………………..
Revision questions – 2015 – 2023……………………………………………………………

REVISION QUESTIONS
DECEMBER 2023
Q.5.A – Assess three trends that will shape the future of derivatives markets globally.(6 mks)
1) Speculation and arbitrage.
2) Proportion used for hedging and speculation.
3) Hedging.
4) Mechanics and valuation.
AUGUST 2023
Q.4.A – Highlight four duties of a Derivatives Exchange in relation to derivative markets. (4 mks)
1) Risk management.
2) Price discovery.
3) Information dissemination.
4) Operational advantage.
Q.4.C – The current price of a share is sh. 25. A call option is available with sh. 20 strike
price that expires in three months. Assume that the underlying stock exhibits an annual
standard deviation of 25 and that the current risk free rate is 4.5%, N(d1) = 0.9737 and N(d2)
= 0.9652
Required:
i. The value of the call option using the Black-Scholes - Merton model. (3 mks)
ii. Suggest three assumptions of the Black-Scholes - Merton model. (3 mks)
Solution
Current price = sh. 25
Strike price = sh. 20
Maturity = 3/12 = 0.25
Standard deviation = 25
Risk free rate = 45% = 0.45
Nd1 = 0.9737
Nd2 = 0.9652

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Value of the call option = 25 x 0.9737 – 20/(2.7183)0.45 x 0.25

Value of the call option = 24.34 – 20/1.1191
Value of the call option = 24 – 17.87
Value of the call option = sh. 6.13

Assumptions of Black-Scholes-Merton model.

Limitations / assumptions of Black-Scholes Option Pricing Model
1) This model can only apply on European bonds and not American bonds. European bonds
would only be expected upon maturity while American bonds can be exercised at any time
during the option period.
2) It assumes that the markets are perfect such that there are no transaction costs and taxes.
3) It assumes that risk free rate of return is known in advance and remains constant.
4) It assumes that the company does not distribute all its earnings as dividends i.e. No
dividends are paid out.
Note:
Merton and Scholes received the 1997 Nobel Prize in Economics for this and related work;
Black was ineligible, having died in 1995.
The key assumptions of the Black–Scholes model are:
1) The price of the underlying instrument St follows a geometric Brownian motion with
constant drift μ and volatility σ:

2) It is possible to short sell the underlying stock.

3) There are no arbitrage opportunities.
4) Trading in the stock is continuous.
5) There are no transaction costs or taxes.
6) All securities are perfectly divisible (e.g. it is possible to buy 1/100th of a share).
7) A constant risk-free interest rate exists and is the same for all maturity dates.

APRIL 2023
This chapter was not tested.
DECEMBER 2022
Q.4.B – Discuss three challenges of Artificial intelligence (AI) in derivatives market. (6 mks)

THE CHALLENGES OF ARTIFICIAL INTELLIGENCE

Technology “evangelists” excel at creating the buzz around artificial intelligence by focusing
on its promises. In the real world, however, reaping the benefits from intelligent algorithms
can be very challenging.
1) Data quality.
2) Black box effect.
3) Narrow focus.
4) Responsibility.
5) Systems may produce bias, errors and are also sensitive to noise in data.
6) Reduced trust due to lack of transparency.

DATA QUALITY
The prediction power of an algorithm is highly dependent on the quality of the data fed as
input. Even in quality sources, biases can be hidden in the data. The time and effort
required to gather and prepare an appropriate set of data should not be underestimated.

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For the nascent self-driving automotive industry, for instance, most of the effort is spent
on labeling hours of videos. This need has led to the creation of an entire offshore industry
for video labeling.
In the financial industry, the reconciliation of the data from front to back is already
problematic, and data referential are often plagued with quality issues. Having a data-
quality program in place is a prerequisite to any large-scale artificial-intelligence initiative.

BLACK-BOX EFFECT
The results of intelligent algorithms are opaque and not verifiable. They deliver statistical
truths, meaning that they can be wrong on individual cases. The results could have a
hidden bias difficult to identify. The diagnosing and correcting of those algorithms is very
complex.
The fact that there is no explanation as to why the algorithm provided a positive or
negative answer to a specific question can be disturbing for a banker’s rational mind. This
is often a blocking point for the use of AI in trading.

NARROW FOCUS
By design, intelligent algorithms are good at solving specific problems and cannot deviate
from what they were designed for. An algorithm trained to detect suspicious payments
would not be able to detect any other suspicious activity related to trading, for instance.
In addition, algorithms are purely rational and lack essential factors such as emotional
intelligence and the ability to contextualize information, unlike human beings. That’s why
banking chatbots often disappoint: they are “smart” but lack empathy.

RESPONSIBILITY
The use of intelligent machines represents a challenge in terms of liability: who/what shall
be responsible in case something goes wrong? Financial institutions are reluctant to give
machines full autonomy because their behavior is not fully foreseeable. They tend to keep
a human supervisor to validate the machine’s decisions for critical activities such as
releasing/blocking payments or validating trades, partially defeating the purpose of using a
machine in the first place. Current compliance and operational security standards are quite
strict; I anticipate that they will loosen over time when the technology matures.

SEPTEMBER 2021
Q.1.A – Summarize six lessons that financial institutions could learn from recent derivatives
mishaps (6 mks)
Mishap as used in derivative markets means the potential for a dramatic disruption of the
financial system and overall disruption of the derivative markets.
1) Regulation should be designed to achieve specific, well-defined goals.
2) Fairness and Transparency: The trading rules should ensure that trading is conducted in a
fair and transparent manner. Experience in other countries shows that in many cases,
derivative brokers/dealers failed to disclose potential risk to the clients. In this context,
sales practices adopted by dealers for derivatives would require specific regulation.
3) Safeguard for clients' moneys: Moneys and securities deposited by clients with the trading
members should not only be kept in a separate clients' account but should also not be
attachable for meeting the broker's own debts. It should be ensured that trading by dealers
on own account is totally segregated from that for clients.
4) Competent and honest service: The eligibility criteria for trading members should be
designed to encourage competent and qualified personnel so that investors/clients are

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served well. This makes it necessary to prescribe qualification for derivatives

brokers/dealers and the sales persons appointed by them in terms of a knowledge base.
5) Market integrity: The trading system should ensure that the market's integrity is
safeguarded by minimizing the possibility of defaults. This requires framing appropriate
rules about capital adequacy, margins, clearing corporation, etc.
6) Quality of markets: The concept of "Quality of Markets" goes well beyond market
integrity and aims at enhancing important market qualities, such as cost-efficiency, price-
continuity, and price-discovery. This is a much broader objective than market integrity.

DERIVATIVES MISHAPS

LESSONS FOR NON-FINANCIAL CORPORATIONS

1) It is important to fully understand the products you trade in.
2) Beware of hedgers becoming speculators.
3) It can be dangerous to make the Treasurer’s department a profit center.

LESSONS FOR FINANCIAL INSTITUTIONS

1) Do not give too much independence to star traders
2) Separate the front middle and back office
3) Models can be wrong
4) Be conservative in recognizing inception profits
5) Do not sell clients inappropriate products
6) Liquidity risk is important
7) There are dangers when many are following the same strategy
8) Do not finance long-term assets with short-term liabilities
9) Market transparency is important

Q.2.A – Explain four reasons for regulation of the derivatives market. (4 mks)
1) So as to look after the public interest by ensuring that prices are communicated to the
public and that futures traders report their outstanding positions if they are above certain
levels.
2) To ensure that the contracts have useful economic purpose.
3) To serve the interests of all the parties such as hedgers, speculators among others.
4) To safeguard the public interest.
5) To ensure that all the participants adhere to the rules and regulations.
6) To ensure that all the participants are licensed.
7) To prevent frauds and other malpractices in the market.

NOVEMBER 2020
Q.5.A – Distinguish between the following derivatives market terms:
i. “Maintenance margin requirement” and “variation margin requirement.” (2 mks)
ii. “Position trader” and “scalper.” (2 mks)
iii. “Contango” and “normal backwardation.” (2 mks)

The Maintenance Margin

The maintenance margin is the minimum amount which must be retained (kept) in a margin
account. In other words, so much minimum, balance in the margin account must be
maintained by the investor.

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The Variation Margin

It refers to that additional amount which has to be deposited by the trader with the broker to
bring the balance of the margin account to the initial margin level.

Position traders vs scalpers

Speculators can be classified as scalpers, day traders, or position traders. Scalpers watch
the market for very short-term trends and attempt to profit from small changes in the contract
price. They usually hold their positions for only a few minutes. Day traders hold their
positions for less than one trading day. They are unwilling to take the risk that adverse news
will occur overnight. Position traders hold their positions for much longer periods of time.
They hope to make significant profits from major movements in the markets.
As it can be observed from the above explanation, the major difference between a scalper and
a position trader is that a scalper holds his position for a very short period of time usually
seconds while a position trader holds his position for a very long period of time usually
several days, weeks or months.
The term contango is sometimes used to describe situations where the futures price is an
increasing function of the maturity of the contract and the term backwardation is sometimes
used to describe the situation where the futures price is a decreasing function of the maturity
of the contract. Strictly speaking, these terms refer to whether the price of the underlying
asset is expected to increase or decrease over time.
When the futures price is below the expected future spot price, the situation is known as
normal backwardation; and when the futures price is above the expected future spot price,
the situation is known as contango. However, it should be noted that sometimes these terms
are used to refer to whether the futures price is below or above the current spot price, rather
than the expected future spot price.

MAY 2019
Q.3.A – Prices are set to eliminate the opportunity to profit at no risk with no commitment of
one’s own funds.
Discuss the above statement in relation to derivatives principles referred to as the “law of one
price.” (6 mks)
Refer to November 2015 question 1.Aii below.
Q.5.B – Explain the following terms as used in derivatives markets:
i. Initial margin (2 mks)
ii. Maintenance margin (2 mks)
iii. Price limits (2 mks)
The aim of margin money is to minimize the risk of default by either counter-party. The
payment of margin ensures that the risk is limited to the previous day's price movement on
each outstanding position. However, even this exposure is offset by the initial margin
holdings. Margin money is like a security deposit or insurance against a possible future loss
of value.
There are different types of margin:
Initial Margin - Based on 99% Value at Risk (VaR) and worst case loss over a specified
horizon, which depends on the time in which Mark to Market margin is collected. The basic
aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller
have to deposit margins. The initial margin is deposited before the opening of the position in
the Futures transaction.
Maintenance Margin - Some exchanges work on the system of maintenance margin, which
is set at a level slightly less than initial margin. The margin is required to be replenished to

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the level of initial margin, only if the margin level drops below the maintenance margin limit.
For instance if initial Margin is fixed at 100 and Maintenance margin is at 80, then the broker
is permitted to trade till such time that the balance in this initial margin account is 80 or more.
If it drops below 80, say it drops to 70, then a margin of 30 (and not 10) is to be paid to
replenish the levels of initial margin.
Some futures contracts impose limits on the price change that can occur from one day to the
next. Appropriately, these are called price limits. These limits are usually set as an absolute
change over the previous day.
Refer to November 2016 Q.3.A – below.
DECEMBER 2017
Q.3.A.i – Explain the term “derivative mishaps.” (2 mks)
The potential for a dramatic disruption of the financial system.
Q.3.A.ii – Assess five lessons that financial institutions could learn from derivative mishaps. (5 mks)
1) Do not give too much independence to star traders
2) Separate the front middle and back office
3) Models can be wrong
4) Be conservative in recognizing inception profits
5) Do not sell clients inappropriate products
6) Liquidity risk is important
7) There are dangers when many are following the same strategy
8) Do not finance long-term assets with short-term liabilities
9) Market transparency is important

MAY 2016
Q.5.B – Your country is in the process of establishing a derivatives market. After an
advertisement in the local dailies for an expert consultant to offer advisory services on
derivatives market, you are recruited and the first task you are given is to advise the relevant
committee on the challenges they expect to face while trading derivatives instruments.
Required:
Highlight three challenges that the prospective derivatives markets is likely to face. (3 mks)
1) Derivative markets entail a lot of speculations and gambling.
2) Instability in the financial markets because the markets are speculative.
3) Derivatives markets are very complex.
4) Derivative markets have a very high levels of systematic risk.

NOVEMBER 2016
Q.3.A.i – Distinguish between “price limit” and a “position limit” as applied in derivatives
markets. (2 mks)
Q.3.A.ii – Explain the purpose of price limit and position limit in derivatives markets. (2 mks)
For most contracts, daily price movement limits are specified by the exchange. If in a day the
price moves down from the previous day’s close by an amount equal to the daily price limit,
the contract is said to be limit down. If it moves up by the limit, it is said to be limit up. A
limit move is a move in either direction equal to the daily price limit. Normally, trading
ceases for the day once the contract is limit up or limit down. However, in some instances the
exchange has the authority to step in and change the limits.
The purpose of daily price limits is to prevent large price movements from occurring because
of speculative excesses. However, limits can become an artificial barrier to trading when the

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price of the underlying commodity is advancing or declining rapidly. Whether price limits
are, on balance, good for futures markets is controversial.
Position limits are the maximum number of contracts that a speculator may hold.
The purpose of position limits is to prevent speculators from exercising undue influence on
the market.
NOVEMBER 2015
Q.1.A.i – Describe how an arbitrage opportunity might exist in relation to derivatives
markets. (2 mks)
Arbitrage is when you buy and sell the same security, commodity, currency, or any other
asset in different markets or via derivatives to take advantage of the price difference of those
assets. For example, purchasing a stock on the Nairobi Securities Exchange and selling it on
the Uganda Stock Exchange for a higher price is arbitrage.
Arbitrage can only occur when some price difference exists between market prices for an
asset or between a market price and the underlying value of the asset. For a stock, the firm is
doing the same work and has the same underlying capital structure, asset mix, cash flow, and
every other metric regardless of what exchange it is listed on or derivative pricing of the
stock. Arbitrage-free valuation is when price discrepancies are removed, allowing for a more
accurate picture of the firm’s valuation based on actual performance metrics.

When such differences exist they present an opportunity for traders to profit from the price
spread by engaging in an arbitrage trade. However, every act of arbitrage (every arbitrage
trade) will tend to move the market price closer toward the arbitrage-free valuation,
eventually eliminating the opportunity for arbitrage profits.

Q.1.A.ii – Explain the law of one price as applied in derivatives markets. (2 mks)
First, we introduce the concept of arbitrage. Arbitrage occurs when equivalent assets or
combinations of assets sell for two different prices. This situation creates an opportunity to
profit at no risk with no commitment of money. Let us start with the simplest (and least
likely) opportunity for arbitrage: the case of a stock selling for more than one price at a given
time. Assume that a stock is trading in two markets simultaneously. Suppose the stock is
trading at $100 in one market and $98 in the other market. We simply buy a share for $98 in
one market and immediately sell it for $100 in the other. We have no net position in the
stock, so it does not matter what price the stock moves to. We make an easy $2 at no risk and
we did not have to put up any funds of our own. The sale of the stock at $100 was more than
adequate to finance the purchase of the stock at $98. Naturally, many market participants
would do this, which would create downward pressure on the price of the stock in the market
where it trades for $100 and upward pressure on the price of the stock in the market where it
trades for $98. Eventually the two prices must come together so that there is but a single price
for the stock. Accordingly, the principle that no arbitrage opportunities should be available is
often referred to as the law of one price. By the law of one price, if two portfolios yield
identical payoffs, then they must cost the same, hence we get the formula: S + P – C = X/(1+
r)T where;
S = spot price, P= Put price, C = Call price, X= Exercise price, T= Time to expiration.
If prices in any economy ever violate this formula, then the riskless profit can be obtained by
a suitable combination of puts, calls and shares. Put- call parity links up the price of a call and
the price of a put. If one is known, then we can infer the other.
Absence of arbitrage implies the Law of One Price: two assets with the same payoff must
have the same market price.
Q.2.B.i – Explain the term “credit derivatives.” (2 mks)

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Q.2.B.ii – Examine two types of credit derivatives. (4 mks)

A credit derivative is a financial contract in which one party has the right to claim a payment
from another in the event that a specific credit event occurs during the life of the contract.
A credit event is defined in precise terms in the contract and usually refers to such events as
failure to make a required payment, bankruptcy, repudiation of debts, a significant
restructuring of debt, and a few other specific events that materially affect the likelihood of
default on future payments. A credit event can even be defined as a change in the credit
rating, as determined by an outside credit rating company.
There are four primary forms of credit derivatives: credit swaps, total return swaps, credit
spread options, and credit-linked notes.
A credit derivative is a financial contract that allows parties to minimize their exposure
to credit risk. Credit derivatives consist of a privately held, negotiable bilateral
contract traded over-the-counter (OTC) between two parties in a creditor/debtor relationship.
These allow the creditor to effectively transfer some or all of the risk of a debtor defaulting
to a third party. This third party accepts the risk in return for payment, known as the
premium.
Several types of credit derivatives exist, including:
1) Credit default swaps (CDS)
2) Credit linked notes (CLNs)
3) Collateralized debt obligations (CDO)
4) Total return swaps
5) Credit spread options/forwards

CREDIT DEFAULT SWAPS (CDS)

Credit default swap (CDs) is a classic representative of the credit derivatives that is similar to
the insurance contracts. Its main purpose is to protect the investment portfolio in case of
decrease in market value. It is the OTC financial instrument that financial institutions protect
their portfolio of government bonds, corporate bonds, municipal bonds, mortgage bonds, the
loan portfolio in case of value depreciation. The CDs uses to protect the referent asset, where
the buyer insure his assets. The seller charges one-time or periodic fee but compensate the
buyer for loss of credit portfolio value. This happens in case of default.

CREDIT LINKED NOTES (CLN)

A credit-linked note (CLN) is a security with an embedded credit default swap permitting
the issuer to shift specific credit risk to credit investors. Credit-linked notes are created
through a special purpose vehicle (SPV), or trust, which is collateralized with AAA-rated
securities. Investors buy credit-linked notes from a trust that pays a fixed or floating coupon
during the life of the note. In return for accepting exposure to specified credit risks, investors
who buy credit-linked notes typically earn a higher rate of return compared to other bonds.

NOTE: As contained in our disclaimer, we did not develop this revision kit with the aim of
helping the learner to answer all the questions. In as such you may have and you will find
that some few selected questions have no suggested answers/solutions. We have done this
by design so as to build the culture of research and serious reading among our learners.
90% of the questions have been answered. The student should research on the remaining
10% of the questions on her/his own from the college where he/she studies.

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GLOSSARY

Accounting risk -The risk associated with Binomial model - A model for pricing options in
accounting standards that vary from country to which the underlying price can move to only one
country or with any uncertainty about how of two possible new prices.
certain transactions should be recorded. Binomial tree - A diagram representing price
Add-on interest - A procedure for movements of the underlying in a binomial
determining the interest on a bond or loan in model.
which the interest is added onto the face value Bond option - An option in which the
of a contract. underlying is a bond; primarily traded in over-
American option - An option that can be the-counter markets.
exercised on any day through the expiration Box spread - An option strategy that combines a
day. Also referred to as American-style bull spread and a bear spread having two different
exercise. exercise prices, which produces a risk-free payoff
Amortizing and accreting swaps - A swap in of the difference in the exercise prices.
which the notional principal changes according Brokers - See futures commission merchants.
to a formula related to changes in the Bull spread - An option strategy that involves
underlying. buying a call with a lower exercise price and
Arbitrage - The condition in a financial selling a call with a higher exercise price. It can
market in which equivalent assets or also be executed with puts.
combinations of assets sell for two different Butterfly spread - An option strategy that
prices, creating an opportunity to profit at no combines two bull or bear spreads and has three
risk with no commitment of money. In a well exercise prices.
functioning financial market, few arbitrage Call - An option that gives the holder the right to
opportunities are possible. Equivalent to the buy an underlying asset from another party at a
law of one price. fixed price , over a specific period of time.
Arrears swap - A type of interest rate swap in Cap - A combination of interest rate call options
which the floating payment is set at the end of designed to hedge a borrower against rate
the period and the interest is paid at that same increases on a floating-rate loan.
time. Caplet - Each component call option in a cap.
At the money - An option in which the Capped swap - A swap in which the floating
underlying value equals the exercise price. payments have an upper limit.
Backwardation - A condition in the futures Cash flow at risk (CFAR) - A variation of VAR
markets in which the benefits of holding an that reflects the risk of a company's cash flow
asset exceed the costs, leaving the futures price instead of its market value.
less than the spot price. Cash price or spot price -The price for
Basis point value (BPV) - Also called present immediate purchase of the underlying asset.
value of a basis point or price value of a basis Cash settlement - A procedure used in certain
point (PVBP), the change in the bond price for derivative transactions that specifies that the long
a 1 basis point change in yield. and short parties engage in the equivalent cash
Basis swap - A swap in which both parties value of a delivery transaction.
pay a floating rate.
Bear spread - An option strategy that
involves selling a put with a lower exercise
price and buying a put with a higher exercise
price. It can also be executed with calls.
Beta- A measure of the relationship between
the return on a stock portfolio and the return on

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the market portfolio, which is a portfolio

containing all risky assets in the market.

Cheapest to deliver - A bond in which the amount Convenience yield -The nonmonetary return offered by
received for delivering the bond is largest compared an asset when the asset is in short supply, often associated
with the amount paid in the market for the bond. with assets with seasonal production processes.
Cherry-picking -When a bankrupt company is allowed Conversion factor - An adjustment used to facilitate
to enforce contracts that are favorable to it while delivery on bond futures contracts in which any of a
walking away from contracts that are unfavorable to it. number of bonds with different characteristics are
Clearinghouse - An entity associated with a futures eligible for delivery.
market that acts as middleman between the contracting Cost of carry- The costs of holding an asset.
parties and guarantees to each party the performance Cost of carry model - A model for pricing futures
of the other. contracts in which the futures price is determined by
Closeout netting - Netting the market values of all adding the cost of carry to the spot price.
derivative contracts between two parties to determine Covariance -A measure of the extent to which the returns
one overall value owed by one party to another in the on two assets move together.
event of bankruptcy. Covered call - An option strategy involving the holding
Collar- An option strategy involving the purchase of a of an asset and sale of a call on the asset.
put and sale of a call in which the holder of an asset Covered interest arbitrage -A transaction executed in
gains protection below a certain level, the exercise the foreign exchange market in which a currency is
price of the put, and pays for it by giving up gains purchased (sold) and a forward contract is sold (purchased)
above a certain level, the exercise price of the call. to lock in the exchange rate for future delivery of the
Collars also can be used to provide protection currency. This transaction should earn the risk-free rate of
against rising interest rates on a floating-rate loan by the investor's home country.
giving up gains from lower interest rates. Credit derivatives - A contract in which one party has
Commodity forward -A contract in which the the right to claim a payment from another party in the event
underlying asset is oil, a precious metal, or some other that a specific credit event occurs over the life of the
commodity. contract.
Commodity futures- Futures contracts in which the Credit risk or default risk -The risk of loss due to
underlying is a traditional agricultural, metal, or nonpayment by a counterparty.
petroleum product. Credit spread option -An option on the yield spread on
Commodity option- An option in which the asset a bond.
underlying the futures is a commodity, such as oil, gold, Credit swap - A type of swap transaction used as a credit
wheat, or soybeans. derivative in which one party makes periodic payments
Commodity swap - A swap in which the underlying is to the other and receives the promise of a payoff if a third
a commodity such as oil, gold, or an agricultural party defaults.
product. Credit VAR, Default VAR, or Credit at Risk - A
Constant maturity swap or CMT swap - A swap in variation of VAR that reflects credit risk.
which the floating rate is the rate on a security known Credit-linked notes -Fixed-income securities in which
as a constant maturity treasury or CMT security. the holder of the security has the right to withhold payment
Constant maturity treasury or CMT - A of the full amount due at maturity if a credit event occurs.
hypothetical U.S. Treasury note with a constant Cross-product netting - Netting the market values of all
maturity. A CMT exists for various years in the range of contracts, not just derivatives, between parties.
2 to 10. Currency forward - A forward contract in which the
Contango - A condition in the futures markets in which underlying is a foreign currency.
the costs of holding an asset exceed the benefits, Currency option - An option that allows the holder to
leaving the futures price more than the spot price. buy (if a call) or sell (if a put) an underlying currency
Contingent claims - Derivatives in which the payoffs at a fixed exercise rate, expressed as an exchange rate.
occur if a specific event occurs; generally referred to as Currency swap -A swap in which each party makes
options. interest payments to the other in different currencies.
Continuous time - Time thought of as advancing in Current credit risk -The risk associated with the
extremely small increments. possibility that a payment currently due will not be made.

Daily settlement - See marking to market. Earnings at risk (EAR) -A variation of VAR that
Day trader -A trader holding a position open reflects the risk of a company's earnings instead of its
somewhat longer than a scalper but closing all market value.

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positions at the end of the day. Economic exposure -The risk associated with changes
Decentralized risk management -A system that in the relative attractiveness of products and services
allows individual units within an organization to offered for sale, arising out of the competitive effects of
manage risk. Decentralization results in duplication of changes in exchange rates.
effort but has the advantage of having people closer to Enhanced derivatives products companies (EDPC) or
the risk be more directly involved in its management. special purpose vehicles (SPVs) - A type of subsidiary
Deep in the money- Options that are far in-the engaged in derivatives transactions that is separated from
money. the parent company in order to have a higher credit
Deep out of the money - Options that are far out-of- rating than the parent company.
the money. Enterprise risk management - A form of centralized
Delivery -A process used in a deliverable forward risk management that typically encompasses the
contract in which the long pays the agreed-upon price management of a broad variety of risks, including
to the short, which in turn delivers the underlying insurance risk.
asset to the long. Equitizing cash -A strategy used to replicate an index. It
Delivery option -The feature of a futures contract is also used to take a given amount of cash and turn
giving the short the right to make decisions about it into an equity position while maintaining the liquidity
what, when, and where to deliver. provided by the cash.
Delta -The relationship between the option price and Equity forward -A contract calling for the purchase of
the underlying price, which reflects the sensitivity of an individual stock, a stock portfolio, or a stock index at
the price of the option to changes in the price of the a later date at an agreed-upon price.
underlying. Equity options - Options on individual stocks; also
Delta hedge - An option strategy in which a position known as stock options.
in an asset is converted to a risk-free position with a Equity swap -A swap in which the rate is the return on a
position in a specific number of options. The number stock or stock index.
of options per unit of the underlying changes through Eurodollar - A dollar deposited outside the United
time, and the position must be revised to maintain States.
the hedge. European option - An option that can be exercised only
Delta-normal method - A measure of VAR at expiration. Also referred to as European-style exercise.
equivalent to the analytical method but that refers to Exchange for physicals (EFP) - A permissible delivery
the use of delta to estimate the option's price procedure used by futures market participants, in
sensitivity. which the long and short arrange a delivery procedure
Derivative - A financial instrument that offers a other than the normal procedures stipulated by the
return based on the return of some other underlying futures exchange.
asset. Exercise or exercising the option - The process of
Derivatives dealers -The commercial and investment using an option to buy or sell the underlying.
banks that make markets in derivatives. Also referred Exercise price, strike price, striking price, or strike -
to as market makers. The fixed price at which an option holder can buy or
Diff swaps - A swap in which the payments are sell the underlying.
based on the difference between interest rates in two Exercise rate or strike rate - The fixed rate at which
countries but payments are made in only a single the holder of an interest rate option can buy or sell the
currency. underlying.
Discount interest - A procedure for determining the Expiration date - The date on which a derivative
interest on a loan or bond in which the interest is contract expires.
deducted from the face value in advance. Fiduciary call - A combination of a European call and a
Discrete time - Time thought of as advancing in risk-free bond that matures on the option expiration
distinct finite increments. day and has a face value equal to the exercise price of
Duration - A measure of the size and timing of the the call.
cash flows paid by a bond. It quantifies these factors
by summarizing them in the form of a single number.
For bonds without option features attached, duration
is interpreted as a weighted average maturity of the
bond.
Dynamic hedging - A strategy in which a position is
hedged by making frequent adjustments to the entity
of the instrument used for hedging in relation to
the instrument being hedged.

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Financial futures - Futures contracts in which the

underlying is a stock, bond, or currency.
Fixed-income forward - A forward contract in which Historical simulation method - Another term for the
the underlying is a bond. historical method of estimating VAR. This term is
Floating-rate loan -A loan in which the interest rate is somewhat misleading in that the method involves not
reset at least once after the starting date. a simulation of the past but rather what actually happened
Floor - A combination of interest rate put options in the past, sometimes adjusted to reflect the fact that a
designed to hedge a lender against lower rates on a different portfolio may have existed in the past than is
floating-rate loan. planned for the future.
Floor traders or locals- Market makers that buy and Homogenization - Creating a contract with standard and
sell by quoting a bid and an ask price. They are the generally accepted terms, which makes it more acceptable
primary providers of liquidity to the market. to a broader group of participants.
Floored swap - A swap in which the floating payments Implied repo rate - The rate of return from a cash-and
have a lower limit. carry transaction implied by the futures price relative
Floorlet -Each component put option in a floor. to the spot price.
Forward contract - An agreement between two parties Implied volatility -The volatility that option traders use
in which one party, the buyer, agrees to buy from the to price an option, implied by the price of the option
other party, the seller, an underlying asset at a later and a particular option-pricing model.
date for a price established at the start of the contract. Implied yield -A measure of the yield on the underlying
Forward price or forward rate - The fixed price or bond of a futures contract implied by pricing it as though
rate at which the transaction scheduled to occur at the the underlying will be delivered at the futures expiration.
expiration of a forward contract will take place. This Index amortizing swap - An interest rate swap in which
price is agreed on at the initiation date of the contract. the notional principal is indexed to the level of interest
Forward rate agreement (FRA) - A forward contract rates and declines with the level of interest rates according
calling for one party to make a fixed interest payment to a predefined scheduled. This type of swap is frequently
and the other to make an interest payment at a rate to be used to hedge securities that are prepaid as interest rates
determined at the contract expiration. decline, such as mortgage backed securities.
Forward swap - A forward contract to enter into a Index option - An option in which the underlying is a
swap. stock index.
Futures commission merchants (FCMs) - Initial margin requirement - The margin requirement on
Individuals or companies that execute futures the first day of a transaction as well as on any day in which
transactions for other parties off the exchange. additional margin funds must be deposited.
Futures contract - A variation of a forward contract Interest rate call - An option in which the holder has the
that has essentially the same basic definition but with right to make a known interest payment and receive an
some additional features, such as a clearinghouse unknown interest payment.
guarantee against credit losses, a daily settlement of Interest rate cap or cap - A series of call options on an
gains and losses, and an organized electronic or floor interest rate, with each option expiring at the date on which
trading facility. the floating loan rate will be reset, and with each option
Futures exchange -A legal corporate entity whose having the same exercise rate. A cap in general can have an
shareholders are its members. The members of the underlying other than an interest rate.
exchange have the privilege of executing transactions Interest rate collar - A combination of a long cap and a
directly on the exchange. short floor, or a short cap and a long floor. A collar in
Gamma - A numerical measure of how sensitive an general can have an underlying other than an interest rate.
option's delta is to a change in the underlying. Interest rate floor or floor - A series of put options on an
Hedge ratio - The relationship of the quantity of an interest rate, with each option expiring at the date on which
asset being hedged to the quantity of the derivative used the floating loan rate will be reset, and with each option
for hedging. having the same exercise rate. A floor in general can have
Hedging - A general strategy usually thought of as an underlying other than the interest rate.
reducing, if not eliminating, risk.
Historical method - A method of estimating VAR that
uses data from the returns of the portfolio over a recent
past period and compiles this data in the form of a
histogram.

Interest rate forward - (See forward rate agreement) London Interbank Offer Rate (LIBOR) – The
Interest rate option - An option in which the Eurodollar rate at which London banks lend dollars to
underlying is an interest rate. other London banks; considered to be the best
Interest rate parity - A formula that expresses the representative rate on a dollar borrowed by a private,

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equivalence or parity of spot and forward rates, after high quality borrower.
adjusting for differences in the interest rates. Long - The buyer of a derivative contract. Also refers to
Interest rate put -An option in which the holder has the position of owning a derivative.
the right to make an unknown interest payment and Long-term equity anticipatory securities (LEAPS) -
receive a known interest payment. Options originally created with expirations of several
Interest rate swap -A swap in which the underlying years.
is an interest rate. Can be viewed as a currency swap Lower bound - The lowest possible value of an option.
in which both currencies are the same and can be Macaulay duration - The duration before dividing by 1
created as a combination of currency swaps.
+ y,. The term, named for one of the economists who
In-the-money - Options that, if exercised, would
first derived it, is used to distinguish the calculation
result in the value received being worth more than the
from modified duration. See also modified duration.
payment required to exercise.
Maintenance margin requirement -The margin
Intrinsic value or exercise value - The value
requirement on any day other than the first day of a
obtained if an option is exercised based on current
transaction.
conditions.
Margin - The amount of money that a trader deposits in
Inverse floater - A floating-rate note or bond in
a margin account. The term is derived from the stock
which the coupon is adjusted to move opposite to a
market practice in which an investor borrows a portion
benchmark interest rate.
of the money required to purchase a certain amount of
Law of one price - The condition in a financial
stock. In futures markets, there is no borrowing so the
market in which two financial instruments or
margin is more of a down payment or performance bond.
combinations of financial instruments can sell for
Market risk - The risk associated with interest rates,
only one price. Equivalent to the principle that no
exchange rates, and equity prices.
arbitrage opportunities are possible.
Marking to market - A procedure used primarily in
Legal risk - The risk that the legal system will not
futures markets in which the parties to a contract settle
enforce a contract in case of dispute or fraud.
the amount owed daily. Also known as the daily
Leveraged floating-rate note or leveraged floater –
settlement.
A floating-rate note or bond in which the coupon is
Model risk - The use of an inaccurate pricing model for
adjusted at a multiple of a benchmark interest rate.
a particular investment, or the improper use of the right
Limit down - A limit move in the futures market in
model.
which the price at which a transaction would be made
Modified duration - An adjustment of the duration for
is at or below the lower limit.
the level of the yield. Contrast with Macaulay duration.
Limit move - A condition in the futures markets in
Moneyness - The relationship between the price of the
which the price at which a transaction would be made
underlying and an option's exercise price.
is at or beyond the price limits.
Monte Carlo simulation method - An approach to
Limit up - A limit move in the futures market in
estimating VAR that produces random outcomes to
which the price at which a transaction would be made
examine what might happen if a particular risk is faced.
is at or above the upper limit.
This method is widely used in the sciences as well as
Liquidity - The ability to trade a futures contract,
in business to study a variety of problems.
either selling a previously purchased contract or
Netting - When parties agree to exchange only the net
purchasing a previously sold contract.
amount owed from one party to the other.
Liquidity risk - The risk that a financial instrument
Non deliverable forwards (NDFs) - Cash-settled
cannot be purchased or sold without a significant
forward contracts, used predominately with respect to
concession in price due to the size of the market.
foreign exchange forwards.
Locked limit - A condition in the futures markets in
Normal backwardation - The condition in futures
which a transaction cannot take place because the
markets in which futures prices are lower than expected
price would be beyond the limits.
spot prices.

Normal contango -The condition in futures markets Present (price) value of a basis point (PVBP) -The
when futures prices are higher than expected spot change in the bond price for a 1 basis point change
prices. in yield. Also called basis point value (BPV).
Pre-investing - The strategy of using futures Price discovery - A feature of futures markets in which
contracts to which futures prices are higher than futures prices provide valuable information about
expected spot prices. the price of the underlying asset.
Off-market FRA - A contract in which the initial Price limits - Limits imposed by a futures exchange on
value is intentionally set at a value other than zero and the price change that can occur from one day to the next.
therefore requires a cash payment at the start from Protective put - An option strategy in which a long
one party to the other. position in an asset is combined with a long position in a

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Offsetting -A transaction in exchange-listed put.

derivative markets in which a party re-enters the Put -An option that gives the holder the right to sell an
market to close out a position. underlying asset to another party at a fixed price over a
Operations risk or operational risk - The risk of specific period of time.
loss from failures in a company's systems and Put-call parity - An equation expressing the equivalence
procedures (for example, due to computer failures or (parity) of a portfolio of a call and a bond with a
human failures) or events completely outside of the portfolio of a put and the underlying, which leads to the
control of organizations (which would include "acts relationship between put and call prices.
of God" and terrorist actions). Put-call-forward parity - The relationship among puts,
Option - A financial instrument that gives one party calls, and forward contracts.
the right, but not the obligation, to buy or sell an Ratio spread -An option strategy in which a long
underlying asset from or to another party at a fixed position in a certain number of options is offset by a
price over a specific period of time. Also referred to short position in a certain number of other options on
as contingent claims. the same underlying, resulting in a risk-free position.
Option price, option premium, or premium - The Receiver swaption - A swaption that allows the holder
amount of money a buyer pays and seller receives to to enter into a swap as the fixed-rate receiver and
engage in an option transaction. floating-rate payer.
Out-of-the-money - Options that, if exercised, would Regulatory risk - The risk associated with the
require the payment of more money than the value uncertainty of how derivative transactions will be
received and therefore would not be currently regulated or with changes in regulations.
exercised. Replacement value - The market value of a swap.
Overnight index swap - A swap in which the Rho - The sensitivity of the option price to the risk-free
floating rate is the cumulative value of a single unit rate.
of currency invested at an overnight rate during the Risk budgeting - The establishment of objectives for
settlement period. individuals, groups, or divisions of an organization
Payer swaption - A swaption that allows the holder that takes into account the allocation of an acceptable
to enter into a swap as the fixed-rate payer and level of risk.
floating rate receiver. Risk governance - The setting of overall policies and
Payment netting - A means of settling payments in standards in risk management.
which the amount owed by the first party to the Risk management - The process of identifying the level
second is netted with the amount owed by the second of risk an entity wants, measuring the level of risk
party to the first; only the net difference is paid. the entity currently has, taking actions that bring the
Payoff - The value of an option at expiration. actual level of risk to the desired level of risk, and
Performance guarantee - A guarantee from the monitoring the new actual level of risk so that it
clearinghouse that if one party makes money on a continues to be aligned with the desired level of risk.
transaction, the clearinghouse ensures it will be paid. Risk-neutral probabilities -Weights that are used to
Plain vanilla swap - An interest rate swap in which compute a binomial option price. They are the
one party pays a fixed rate and the other pays a probabilities that would apply if a risk-neutral investor
floating rate, with both sets of payments in the same valued an option.
currency.
Position trader - A trader who typically holds
positions open overnight.
Potential credit risk - The risk associated with the
possibility that a payment due at a later date will not
be made.
Pre-empting – The strategy of using futures contract
to enter the market without an immediate cash outlay.

Risk-neutral valuation - The process by which Structured note - A variation of a floating-rate note that
options and other derivatives are priced by treating has some type of unusual characteristic such as a
investors as though they were risk neutral. leverage factor or in which the rate moves opposite
Sandwich spread - An option strategy that is to interest rates.
equivalent to a short butterfly spread. Swap - An agreement between two parties to exchange a
Scalper - A trader who offers to buy or sell futures series of future cash flows.
contracts, holding the position for only a brief period of Swap spread - The difference between the fixed rate on
time. Scalpers attempt to profit by buying at the bid an interest rate swap and the rate on a Treasury note
price and selling at the higher ask price. with equivalent maturity; it reflects the general level

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Scenario analysis - A risk management technique of credit risk in the market.

involving the examination of the performance of a Swaption - An option to enter into a swap.
portfolio under specified situations. Closely related to Synthetic call - The combination of puts, the underlying,
stress testing. and risk-free bonds that replicates a call option.
Seats - Memberships in a derivatives exchange. Synthetic forward contract -The combination of the
Settlement date or payment date -The date on which underlying, puts, calls, and risk-free bonds that replicates
the parties to a swap make payments. a forward contract.
Settlement period -The time between settlement dates. Synthetic index fund - An index fund position created by
Settlement price - The official price, designated by the combining risk-free bonds and futures on the desired
clearinghouse, from which daily gains and losses will be index.
determined and marked to market. Synthetic put - The combination of calls, the underlying,
Settlement risk -When settling a contract, the risk that and risk-free bonds that replicates a put option.
one party could be in the process of paying the Tax risk - The uncertainty associated with tax laws.
counterparty while the counterparty is declaring Tenor - The original time to maturity on a swap.
bankruptcy. Termination date - The date of the final payment on a
Short - The seller of a derivative contract. Also refers to swap; also, the swap's expiration date.
the position of being short a derivative. Theta - The rate at which an option's time value decays.
Single-payment loan - A loan in which the borrower Time to expiration - The time remaining in the life of a
receives a sum of money at the start and pays back the derivative, typically expressed in years.
entire amount with interest in a single payment at Time value decay - The loss in the value of an option
maturity. resulting from movement of the option price toward its
Spread - An option strategy involving the purchase of payoff value as the expiration day approaches.
one option and sale of another option that is identical to Time value or speculative value - The difference
the first in all respects except either exercise price or between the market price of the option and its intrinsic
expiration. value, determined by the uncertainty of the underlying
Storage costs or carrying costs - The costs of holding over the remaining life of the option.
an asset, generally a function of the physical Total return swap - A swap in which one party agrees to
characteristics of the underlying asset. pay the total return on a security. Often used as a credit
Straddle - An option strategy involving the purchase of derivative, in which the underlying is a bond.
a put and a call with the same exercise price. A straddle Tracking error - The condition in which the performance
is based on the expectation of high volatility of of a portfolio does not match the performance of an
the underlying. index that serves as the portfolio's benchmark.
Strangle -A variation of a straddle in which the put and Transaction exposure - The risk associated with a foreign
call have different exercise prices. exchange rate on a specific business transaction such as a
Strap - An option strategy involving the purchase of purchase or sale.
two calls and one put. Translation exposure -The risk associated with the
Stress testing - A risk management technique in which conversion of foreign financial statements into domestic
the risk manager examines the performance of the currency.
portfolio under market conditions involving high Underlying - An asset that trades in a market in which
risk and usually high correlations across markets. buyers and sellers meet, decide on a price, and the
Closely related to scenario analysis. seller then delivers the asset to the buyer and receives
Strip - An option strategy involving the purchase of two payment. The underlying is the asset or other derivative on
puts and one call. which a particular derivative is based. The market for the
underlying is also referred to as the spot market.

Valuation - The process of determining the value of an Yield beta - A measure of the sensitivity of a bond's yield
asset or service. to a general measure of bond yields in the market that is
Value - The amount for which one can sell something, used to refine the hedge ratio.
or the amount one must pay to acquire something. Yield spread -The difference between the yield on a
Value at risk (VAR) - A probability-based measure of bond and the yield on a default-free security, usually
loss potential for a company, a fund, a portfolio, a a government note, of the same maturity. The yield
transaction, or a strategy over a specified period of spread is primarily determined by the market's perception
time. of the credit risk on the bond.
Variation margin - Additional margin that must be Zero-cost collar - A transaction in which a position in the
deposited in an amount sufficient to bring the balance underlying is protected by buying a put and selling a
up to the initial margin requirement. call with the premium from the sale of the call offsetting
Vega - The relationship between option price and the premium from the purchase of the put. It can also be
volatility. used to protect a floating-rate borrower against interest rate
increases with the premium on a long cap offsetting the

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DERIVATIVES ANALYSIS

premium on a short floor.

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