Option Tutorial Answers超级完整版

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School of Commerce
Optionsr, Futures and

Risk Management-
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Derivatives
Answers to Class Activities
Notes to Tutors:
A lot of work has gone into these questions.
1)
Under NO conditions are

provided
to the students. Exceptions to this
photocopies of the answers to be
case include material taken from websites. Answers are to be discussed in the
tutorials only. Students who do not attend the tutorials do not deserve to
receive the answers. If you think you are not going to be able to go through all
the exercises, then you can make your own notes and distribute that in class.
2)
Some questions can
be
attempted using
both
compounding/discounting. Either method is acceptable students will be told the method to apply for each question.
discrete/continuous
although for exams
you run out of questions to discuss in the tutorials, you should refer to the
supplementary questions & answers that students have been provided with in
their readers. Students may wish to go through in class some of these
questions as well.
3)
If
4)
If you are unsure of how to answer a question,
please
try and
see me at least a
few days before you tutor so you are prepared.

s)
If
you notice any mistakes in the class activities (including typos, etc.) please
highlight them and let me know. This will be much appreciated.
6) Have fun!
The Universitv of Adelaide
Page2
Derivatives
Topic l Activities
1.
Check out the ASX website for up-to-date details on the options market in
Australia. Acquire information on the following:
i)
What is the contract size for its share options derivatives?

1,000 shares
ii)
What is the contract expiry date for index options?

3'd Thursday of the month
iii)
What is the contract expiry date for share options?

Thursday of the last business Friday of the month
iv) What is the longest expiry length for an option?

3 years
v)
What is an index multiplier? What is the index multiplier for the ASX200
index option?
$10 is the index multiplier. The multiplier indicates the $ value of
each index point
Provide copies of the ASX website copies included in this solutions set U
students have not bothered to check the website, give them the copies and
allow them to read itfor 10 minutes. Then get them to answer the questions.
The University of Adelaide
Page 3
Derivatives
From the ASX website
Index options
lndex options give you exposure to the securities comprising a sharemarket
index.
They offer you similar flexibility to that provided by options over individual
or on the
stocks, while allowing you to trade a view on the market as a whole,
market sector covered by the particular index'

the
whereas the value of a share option varies according to movements in
value of the underlying shares, an index option varies according to
movements in the underlying index.
Underlying asset
ASX approved indices (currently the S&P/ASX

200 lndex, S&P/ASX 50 Index, S&P ASX 200
Property Trusts Index)
Exercise style
European
cash settled with reference to the OPIC (see below)
Expiry day
third Thursday of the month, unless otherwise

specified by ASX.
Last trading day
Trading wili cease at 12 noon on expiry

Thursday. This means trading will continue after
the settlement price has been determined.
expressed in points
Strike pnce
expressed in points
Index multiplier
a specified number of dollars per point e'g'
Contract value
ihe exercise price of the option multiplied by the

index multiplier
The UniversitY of Adelaide
AUD
Page 4
Derivatives
Some of the differences between index options and options over securities
are:
.
.
.
index options are cash settled.

index options are European in exercise style. This means the holder can only
exercise an index option on the expiry day.
the strike price and premium of an index option are expressed in points. A
multiplier is then applied to give a dollar figure.
lndex options are cash settled.

The settlement amount is based on the opening prices of the stocks in the
underlying index on the morning of the maturity date. As the stocks in the
relevant index open, the first traded price of each stock is recorded. Once all
stocks in the index have opened, an index calculation (the opening Price
Index Calculation (OPIC)) is made using these opening prices.
Options are currently available over the following ASX indices:
.
.
.
S&PTM/ASX 200TM Index - code XJO

S&PTM/ASX 200TM Property Trusts Index - code XPJ
S&PTM/ASX 50TM Index - code XFL
Benefits of index options:
Page 5
Derivatives
trrysi*yg:i/8 l.ihtip:/7*$yw. asx.corL
lndex options
ar.f markets44i
lndex(
The ability to trade all the stocks in an index with
just one trade - investing in index options approximates

trading a share poftolio that tracks thai pariicular index.
By using options over an index, you can trade a view on
the general direction of the market with just one trade.
For example, if you are bullish on the market, you could
buy a call option over an index. This gives you exposur
to the broader market which the index represents,
withoui having to choose a particular stock.
Leverage - index options, like ordinary options, provide

leveraged profit opportunities. When the market rises (or
falls), percentage gains {or losses) are greater than rises
(or falls) in the underlying index.
Protection for a share portfolio - when you buy shares

you afe exposed to two types of risk:
company risk - the ri$k that the specific
companies you have bought into will
underperform.
market risk - the risk that the whole market
underperforms, including your shares.
You can protect your shares against market risk by
buying an index put option. lf your bearish market view
proves correct, the proflts on your put option will at least
partly compensate you for the loss of value in the stocks
in your portfolio.
Low trading 6osts - since the amount of capital outlaid

in an option trade is usually much lower than that
involved in a share transaction providing similar market
exposure, brokerage costs are often lower in option
trades.
For more information on index options, please refer to
the ASX explanatory booklet Understandinq Options
Tfadinq.
Find out more about underlyinq indices.
Find out more about index strateqies.
Download the lndex Options brochure 157K
'pdf documents require Adobe Acrobat Reader

ASX200TM is a trade mark of ASX Operations Pty Ltd,
ABN 42 004 523 782, a member of the Australian Stock
Exchange Group of companies. S&PTM is a trade mark
of Slandard & Poor's, a division of The h4cGraw-Hill
Comoanies, Inc.
Terms of use I Pnvacy Statement I Last reviewed: 31107142

@ Austraiian Stock Exchange Limited ABN 98 008 624 691
&
cr0SSARY
Page 6
Derivatives
)ption feaiures
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GLOSSI1nY
In order to make it easier for investors to trade into and

out of options positions, three features of option
contracts have been standardised. They are:
the underlying securities

the expiry date
lhe exercise price (or strike price)
These components are found in all options traded on
ASX. They may change if, during the life of the option,
an adjustment is required to be made in accordance with
ASX Business Rules (for example as a result of a new
issue or a reorganisation of capital in the underlying
share).
'
'r
The only other variable is the premium, which is the
t_
market price of the option.
Underlying securities
Options traded on ASX's derivatives market are
available for certain securities. These securities mav be
ihe shares of approved ASX listed companies. or a'
share price index.
The companies over which options are listed are

selected by OCH in accordance with ASX Business
Rules.
An option contract size is standardised at 1,000

underlying securities. This means that one option
contract represents 1,000 underlying securities, unless
an adjustment has taken place.
t__
I
In the case of index options, the contract value is fixed at

a certain number of dollars per index point, (for example,
i-
AUD $10 per index point). The size of the contract is
equal to the index level multlplied by the dollar value per

index point.
t-
Exercise Price
I
I
I
This is the price at which you may buy or sell the

underlying securities if you exercise your option.
t-
OCH lists a range of exercise prices for all options listed

on ASX's derivatives market. Usually there is a range of
i
I
exercise prices available for options with a given expiry

day. New exercise prices are listed as the underlying
share price moves. Typically, the range of exercise
prices includes one exercise price close to the cunent
market price of the underlying share with two exercise
prices above and two exercise prices below the current
share price.
Exercise prices may also be adjusted during the life of
the option in accordance with ASX Business Rules.
Expiry Date
ru!
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'
Derivatives
wysirvyg:
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asx. corn au/markeJsn4lOptionFearu l.ss-
The Expiry Day is the day on which all.unexercised

ootions in a particular seiies expire, lt is the last day of
traOing for that particular sefies. For shares ihis is
usuatf the Thuisday before the last business Friday in
the month.
For index options, the expiry date is the third Friday of
the contraci month providing this is a trading day' The
last trading date wilf be the trading day prior to the expiry
date.
OCH lists options over underlying securities in various
expiry cycles that usually extend for a period of nine to
tw;lv-e months. As one series expires a new, more
distant one is created.
ln addition to quarterly expiry cycles, a current or spot
month is availible for most classes of options' These
optiont that expire at the end of the current month
"iu dt. used to trade short term price changes in the
"nO
shares.
underlying
There are also longer term option contracts listed over

certain classes, with terms of up to three years'
For details of expiry cycles and expiry dates, refer to the
Expirv Calendar.
Premium
The premium is the price of the option' lt is not set by
oCil, nut is determined by market forces'
The premiums for share options are quoted on a cents
o"idnut" basis. To calculate the full premium payable
ioi a sianoiro size option contract, multiply the quoted
pi"*iu* by 1,000' the number of shares per contract'
To
The oremiums for index options are quoted in points'
the full premium payable for an index option'
"Jt.ut"t*
multiplv the premium by the index multipller' hor
a irremium oi 30 points, with an index multiplier
"*u*p1",dt0, reptes"nts a total premium cost of AUD
;iAU'D
$300 Per contract.
.iL,
07./08-/99 IoF oF
Terms of use I Privacv Ftatement I Last reviewed:
ABN 98 008 624 691
O Australian Stocx
excnangelihiied
PAGI
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Page 8
Derivatives
Are index options on the ASX
2.
considered to be European or American

options? What does this imply?
ASX Index options are European. This indicates you can only exercise
them at the expiry date.
J.
what is the benefit_ of trading index options? what benefits, if any, do index
options have over share options?
- Leverage, protection of a share portfolio, low trading costs,
can trade all
stocks of an index with one trade
4.
what is the difference between holding a short cail and a long put position?
Dôes one of these positions result in anlbtgation
on trr" pu.t of the holder?
rf you have taken a SIToRT position, you are obligatei to exchange either
goods/money if the taker exercises the option. noi a short
call oi shares,
this would indicate you needing to eichange shares in return for a
specified amount of cash. The holder of the long put can chose
to either
exchange his/her shares for cash. A long poritioo may not entail
an
obligation but it does cost up-front money in the form of a-premiam.
5.
What is an efficient market and why is it important for derivatives markets?

Without an efficient market, derivative instruments cannot be correcly
priced.
6,
what types of transaction costs

Broker commission rates
Bid-ask spread
Clearing house fee
are you faced
with when trading options?
Exchange fee
7.
If you wanted to physically trade an option here in Australia how would you
go about it? Work out which brokers and what transaction
costs they would
charse.
A question like this may well appear in the exam and so its worth students
researching this question. Usually brokers charge a
fixed fee -$50 to
cover all costs.
8.
what is the main taxation ruling that governs options taxation processes?
There is no specific taxation ruring that appties to options. rlowevero

ITAA1997 covers general taxation matters relating to options.
9.
How is the treatment of the options premium different for a writer and a taker
of an option? Is there any difference between calls and puts in this regard?
Writers receive the premium and therefore it is treated as assessable for

tax purposes' For takers it is a cost and therefore deductible.
There is no
difference between puts and calls in this matter.
Page 9
Derivatives
Topic 2 Activities
1.
Get hold of a recent copy of fr'rc Financial Review. Chose at random a stock
that offers both a call and put option on it.
a) Work out whether the lower and upper boundary copditions of the call
and put options are being maintained.
b) Determine whether Put-Call parity holds. If it doesn't, explain
possible reasons for it not holding.
Students to discuss in class. At least on student should demonstrate
his/her calculations. There should be no arbitrage opportunities. If there
are it could be because no account was made for:
- dividend payments
- incorrect risk-free rate used
- bid/ask spread very wide (allow for deviation from the 'fair value' by 57 cents either way.
2.
A friend of yours tells you she holds
3.
:
A friend of yours tells you he holds an American put option that is very deepin-the-money. He tells you he's going to exercise it now and cash in on his
winnings. Is this a wise move to make?
Possibly, as the limit a stock price can drop to is $0, if it is close to this you
may as well cash in now, given that there is always a chance a white
knight rescues the company.
4.
You notice two call options on the market that are costing the same. However,
the expiration dates are different. If everything else is the same, how can this
an American call option that is very

deep-in-the-money. She tells you she's going to exercise it now and cash in
on her winnings. Is this a wise move to make?
No, she should sell it. Sell now you get S-PV(X), rather than exercise now
which leads to S-X.
be the case?
If
the calls are very deep out of the money, time value of the options
be small and option value essentially zero.
5.
will
Your friend is about to offer an American call option on the market. However,
she decides to be a little different and set no maturity date for the option.
What would be the maximum and minimum value you would pay for this
option?
The call becomes a stock!
6.
Will an option's time value be gteatest when the stock price is
near the
exercise price, when the option is deep-in-the-money, or deep out-of-themoney?
At-the-money. This is when there is most uncertainty about the final

value of the option at expiration.
Page 10
Derivatives
The following diagram shows the value of a put option at expiration:
Option
Exercise price of both Options
Value
-4
76
80
Stock Price ($)
Ignoring transaction costs, which of the following statements about the value
of the put option at expiration is TRUE?
A: The value of the short position in the put is $4 if the stock price is $76.
B: The value of the long position in the put is -$4 if the stock price is $76.
c: The long put has value when the stock price is below the $80 exercise
prrce.
D: The value of the short position in the put is zero for stock prices equalling
or exceeding $76.
Source: 2002CFALevel
1 samole exam
Previous Exam Question
Which of the following statements about the value of a call option at

expiration is FALSE?
A: The short position in the same call option can result in a loss if the stock
price exceeds the exercise price.
B: The value of the long position equals zero or the stock price minus the
exercise price, whichever is higher.
C: The value of the long position equals zero or the exercise price minus
the stock price, whichever is higher.
D: The short position in the same call option has a zero value for all stock
prices equal to or less than the exercise price.
8.
ource
:'ii"::l'J
J.'#6H1,1T
Is it possible to have two calls (or puts) similar in all respects, except the
9.
exercise price, having the same market price?
lf
both options were deep out-of-the-money, they might have prices of zero. As in the previous question,
tr,r..o options arc expectecl to expire out-of-the-moniy.
the
Page 11
Derivatives
10.
having a value less than Max [0, So

X(1+r)t1, identify the transactions you should execute to create an arbitrage
profit.
If you observed a European call option
The call is underpriced, so buy the cal1, seli short the stock" and buy risk-free bonds with face value oi'X
Tire cash received from the stock is greater than the cost of the call and bonds. Thus, there is a positivt'
cash florv up front. The payoffs from the portiblio at expiration are as {bllows:
If
sr<X.
- Sr
X
(from the stock)

(frorn the bonds)
the total, X - S,, is positive
tf
sr>X
S, - X
Sr
X
-
(fi'oia the cail)

(from the stock)
ifrom the bonds)
the total is zero.
fhe portfolio generates a positive cash flow up front and there is no cash outflow at expLatian.
Page 12
Derivatives
Topic 3 Activities
l.
How does the binomial model account of volatility in the stock?

The u and d factors measure the spread of price movement from one
period to the next. This is a measure of volatility.
z.
when would you account for early exercise of an option? How do you do it
within a binomial framework?
When:
i) it is an Americ an option and
X
ii) it's a call paying dividends
iii) its a put
How:
At every node, the price of an option is calculated from its present value
of future prices. This is then compared to the value if it were exercised
today. If the latter is larger, then this is the value of the option and you
would exercise it.
3.
see if you can apply the binomial model to your selected share option you
used for the previous topic. use a binomial software package to check your
option price after
- 1 iterations
- 10 iterations
- 50 iterations
- 100 iterations
How many iterations are necessary before adding another 10 iterations does
not change the option price by more than 0.01?
For student discussion in class
4.
A stock has a 15 percent change of moving either up or down per period and is
currently priced at $25. using a one period binomial model, and assuming
that the risk-free rate is 10 percent, complete the following.

Determine the possibie stock prices at the end of the first period.
?
b' Calculate the intrinsic values at expiration of a European call option with
an exercise price of$25.
c. Find the value of the option today.
d' Construct a hedge by combining a position in stock with a position in the
call' Show that the retum on the hedge is the risk-free rate regardless of
the outcome, assuming that the call sells for the value you obtained in c.
e. Determine the rate of return from a riskless hedge if the call is selling for
$3.50 when the hedge is initiated.
Source: Chance, An Introduction to Derivatives and Risk Management, 5thEd.
Page 13
7-
Derivatives
: 28,?s
25{ 1. 1s)
25{0.85} = ?l-25
i!{ax{0,28.?-1- ?5i = l"7i

Max{0,21"25 -- 15):0
tJ
:{1.10-0.85)/(l.ls -
0"85)
-8313,
- p :.1667
i.8il3)3.75+(.1667)0 * a e1
L_=--_!.O-
ilO
h = {3.15 *.0.CI)l(28.75
V will then be
- 2l.25}
= 0 50
500(25)
* 1.000(2.84):9,660
500(25i
500{28.75)
vd =- 500i21.75)
==
V,
Rn
1'000(3'50) = 9'000
be 10'61:
V" (and Vi wil! stili
Ar expiration'
Sa buy 500 shares artci sell 1.000 calls
Rd
= (10'625/9'000)
- 1 *'18
- 1.000(3.75) - 10.625
- I .000(0.0) : 1ii.625
{10,63519,660)
Î*
-10
an option is lower than what the value is from using the

binomial model what would You do?
If it's a call, sell n shares and buy the call as it is underpriced. This leads
If the market price for
5.
to an arbitrage profit (riskless profit above the risk-free rate)
6.
stock index is currently trading at 50'00. The annual index standard

deviation is 20 percent. Paul Tripp, CFA, wants to value two-year index
options using the binomial model. To correctly value the options, he needs the
formulas in Exhibit 1. The annual risk-free interest rate is 6 percent. Assume
no dividends are paid on any of the underlying securities in the index.
Exhibit
[.J
1.
eo6
Wbere:
=l.212l4
o,,=ffi
=!U
rvhere e'^'
=Lo6l84
U:lp movement factor

D: down movement factor
rT,, : probfuility of an upward price movement
Exhibit 2.
Discount Factors
5.00% 6.00%
Period
Period
Period
A:
B:
C:
7.Q00/o
1 0.95123 0.94176 0.93239

2 0.90484 0.88692 0'86936
3 0.86071 0.83527 0.81058
C"^tt*"t a two-period binomial
lattice for the stock index'

Calculate the value of a European index call option with an exercise
price of 60.00.
Calculate the value of a European index put option with an exercise
price of 60.00.
Source: 2000 CFA Level2
samPle exam
Page 14
Derivatives
A. over two periods, the stock
price must follow one of four patterns: up-up, up-down, dcwndown' or down-up. Ts construct a Z-period stock price latiice for a2-yearr oprion, each period
consists of 365 days, for a total of 730 days.
u =eo&
U =1.2214
D= |
D=:
u
t.22t4
whereD=0.glg7
The binomial paramctrs are:

IT - + percentage increase in a period if the stock price
rises = 1.2214
D= + percentage decrease in a period if tha stock price falls = 0.818?
ft= + Risk-free rate = 1.06 I 84
,'rr{ro*$so.oo\
,oo.no
Period 0
Period
//$so.oo
-_-*rr.r,
Period 2
Period 1:
Up:
Down:
$50x1.2214=$61.0?
$50 x 0.8187 = $40.94
Period 2:
Up:
Down:
up,
Down:
$61.0? x 1.2214=574.59
$61.0? x 0.818? = $50.00
$40-94 xl.2214 =$50.00
$40.94 x 0.8187 = $33.52
B. For each terminal
stock price, a call option has a specific value. Because the company does
not pay any dividend, 6 = 0 . With a stock paying a dividend, the dividend yield rvould be
subtracted from the risk-free rate.
The probability of an upward stock price movement in any period is:
t__
7T..
i^
0.6038 = 1.06184-0.8187
eU-6rL!
. =- U-D-
t.2214 -0.8181
l^
I
The probability of a downward stock price movement in any period is:
I -0.6038 =0.3962
t-
The value of a call option at expiration must be:
where:
L-
max (0,S
S=
- X)
curent price of stock index
X = exercise price of
the call option
l*
Ir-
L:
Page 15
Derivatives
$14.59
$8.30
<--/
-"
$4.12 <
$o.oo
$o'oo
/4,0.00
-\
Period
Period
,/
<---.-
--'$0.00
Period 2
Period 2:
Up-UpUp-Down:
Down-Up:
- X) = max (0, $?4.59 - $60.00) = rnax (0, $14'59) = $14'59

- X) = max (0, $50.00 - $60'00) = max (0, -$i0'00) = $0'00
max (0,s - X) = max (0, $50.00 - $60.00) = max (0, -$10.00) = $0.00
Down-Down: max (0,S * X) = max (0, $33.52 - $60.00) = max (0, -$26'48) = $0'ffi
Period 1:
max (0,S
max (0,S
$ 0.00 x 0.3962
$ 0.00 x 0.6038
$ 0.00 x 0.3962
a upward stock movement) = $8'81

(probability of a downward stock movement) = $9'g'g
(probability of a upward stock movement) = $0'00
(probability of a downward stock movement) = $0'00
With
factor of 0.941?6, the value of the call in period
Sf +-SS
x 0.6038 (probability of
a discount
i is:
($0.00x0.941?6)+($s.slx0.941?6)+($0'00x0'941?6)+($0'00x0'941?6)=$8'30
Period 0:
$8.30 x 0,6038 (probability of a upward stock movement) = $5.01

$0.0O x 0.3962 (probability of a downward stock movement) = $0.00
With
a discount
factor of 0.94176, the value of the call in period 0 is:
($5.0i x 0.94176) + ($0.00 x 0.941?6)'= $4.72

Alternatively:
C = (fluuCuu+ llupCue + I-IouCou + flpeCpp) / R2
C = (0.6038 x 0.6038 x 14.59 +0.6038 x0'3962 xO.ffi + 0.3962x0'6038 x 0'00
+ 0.3962 x0.3962 x 0.00) / (1.061b4)'?
C = $4.72
C. Thc put-call ParitY formula is:

P1
=c1
-St+Xe-(r't)
where:
c = call option price = $4.72
S = current stock.or index price - $50'00
X = exercise price = $60.00
e-r(r-() - discount factor = 0.88692
T = time to expiration in Periods = 2
t = current time = 0
r = risk-free rate = 0.06
p=
$4.72- $50.00 + ($60 x 0.88692)
p = $7'94
Page 16
Derivatives
Topic 4 Activities
1.
r+
b'l ttFl
2.
what are the two primary components that make up a stochastic process?
Pt : Pt-r + et
implying a deterministic component and
random/stochastic component
write down the formula for a Markov process. If stocks follow a Markov
process, what does this imply for technical trading rules?
As above. If stock prices follow a Markov process then any trading rule
wiII be ineffective as markets will be weak form efficient.
J.
4.
Why can we calculate retums using logs?

rn the mid to long run, prices are log-normally distributed. Furthermore,
the use of logs can be derived from rto's Lemma showing returns are
ln(PtlPt-r)
Explain what risk-neutral valuation is?
You don't care about risk when you make a decsion as to where you place
your money. only returns are important. As B-s implies risk-neutral
pricing it means that volatility is not a 'bad' thing to have. In fact with
options extra volatility is good!
of
5.
all the variables in the Black-Schores model, which one do you think
is the
most critical?
Sigma - volatilify. Options are very sensitive to volatility changes plus
it is
the only variable that cannot be direcdy observed - therefore it is
susceptible to being miscalculated.
6.
What difficulties are there in ensuring an option position is risk free to stock
price changes?
very difficult to maintain in reality as it requires constant, continuous
delta-hedging. Even if stock prices don't change, as time changes
continuously delta values will also change, and therefore so will yJur
delta-neutral position.
$"
1$'A'
8.
when looking at an option quoted in the market, you notice that the implied
volatility of the option is much higher than the historical volatility you ^hurr"
just calculated. what can you do to profit from this information?
This could indicate that the option is overpriced. you should short the
calVput and go long/short/ in the stock.
Is it reasonable to expect differences in implied volatility between options
the only difference is the expiration dates?
Yes, implied volatilify is sensitive to expiration dates. If you think of
must be as the time span for the option life is different

different potential stock price movements.
if
it, it
covering
Page 17
Derivatives
if
Is it reasonable to expect differences in implied volatility between
the only difference is the exercise price?
There should not be, but in reality there is. It is known as the volatilify
skew. very hard to explain and is an indicator that the B-s model is not
explaining everything that occurs in options pricing'
g.
option you
Go back to the previous topic and re-calculate the price for the call
compare?
examined when valuing it using the Binomial model. How does it
to four
correct
is
model
How many iterations are required before the binomiai
decimal places?
Using the AMP X:$7.75 call priced at32.82 cents below'
so = 8.00, x =7.75, r" = 0.04813, o =0.3628, and T --81365 =0.0219
tu{KqdT
Binomial:
10 iterations
50 iterations
100 iterations
200 iterations
32.62 cents
32.79 cents
32.80 cents
32.82 cents
AMP Share at $8.00
11.
Series Ex
Bid
Ask
.30
.47
.38
.57
Price
Apr 03
Jun 03
7.75
8.00
Last
Sale
Vol
000's
Open
lnt
.28
.56
390
37
869
B8B
Implied
Delta
Return
Volatility
36.28
33.97
Annual %
.77
.57
bank bill
Above is the quoted price for AMP call options on April, 16 2003' The
reference rate is 4.8L3%.
a.
Calculate the theoretical B-S value for the AMP June call option with a
$8.00 exercise Price.
dz =0.1374-0.3:,g7J0Jg45 = -0.0124
S^ =8.00. X =8.00, r- =0.04813, o =0.3397, andT =7|l 365=0.1945
Af(0.13741= 0.5546
(0.048 n + A3e7t t 2N.re45
rfr(s.q.ol
= 0.137 4
n1 -
s.+
c = g.00(0.5546) -
g.00e-0
0a813(0 re45)
(0.4950) = $0.5137
Page 18
Derivatives
b.
Assume now that a dividend of 20 cents is to be paid on May

Work out the new value of the option.
Substitute 5:8.00 with S' :8.00 - PV(Dig : 8.00 - 0.20e(0'0481x1e/36s):
8.00 - 0.1995 : 7.8005
5th.
d1
d2
N(dr)
N(dt
Call:40.97 cents
lrt
&ffi
'Ak6
Explain what the terms below mean in the context of option hedging and the
values they can have.
a. Delta
change in call price for a small change in the stock price. Tends
towards one as expiration approaches if the call if in the money. Else
it converges to zero.
b.
Gamma
change in delta for a small change in the stock price. Gamma is large
when the option is at the money, close to zero when deep in/out of the
money.
c.
Rho
change
in option price for a change in the interest rate.
relationship is nearly linear and fairly weak.

d.
The
Vega
change in option price for a small change in volatility. very sensitive.

Relationship nearly linear when options are at the money.
Theta
change in option price for a change in time. Theta will be negative,

indicating option prices fall as time to expiration approaches.
Page 19
Derivatives
gained
Also, use the AMP June call to demonstrate the information that can be
from examining these terms for option pricing if your stock price changes by
$1 in two daYs.
Using the AMP X:8.00 oPtion:
""'"T:il
Price
0.513:
Delta
0.554(
Gamma
0.329',,
Theta
-1.4062
Vega
1.3942
Rho
0.763i
Assuming $1 price rise is not a large cbiangeo two things happen - the
TIIETA and the DELTA change.
A $1 increase in the price of the stock, changes the option price by 0'5546
($1 x 0.5546).
:((21365)
Two days closer to expiration changes the option price by -0.008
x -1.4064).
:
The combined effect is $0.5137 + $0.5546 - 0'0008 $1'0675
As the option was at the moneyo delta is high leading to high option price
changes. As expiration is not closeo the impact of THETA will be small.
13.
14,
In the lecture you were told that the April cali option tabulated in question 11
asking
above was worth 32.82 cents. If the market price for the call is at its
this
from
price (:g cents), design a portfolio that will lead to a riskless profit
information?
The delta is 0.77 (from the table). Therefore, as the option is currently
overpriced, write 1,000 calls and buy 11000(0'77):770 shares'
For your riskless strategy above, what will happen to the value of the portfolio
if the stock price changes to $8.50? Calculate the profit or loss of the strategy
above (Assume the call price adjusted back to its fair value)
:
The new value of the call will roughly equal to 0,3282 + 0.50(0'77)
: $333'2 to
0.3282 + 0.3850 :03132. This is a loss of 1,000(0.7132-0.3800)
your portfolio
You make $0.50 on each share you own, leading to a profit of 770 x
$38s.
Net profit: $385 - $333.2
0'5:
: $51.8 (approximation)
Page 20
Derivatives
You are an options advisor who has been asked

by a client to recommend how
she can profit from an expectation that
over the next few months there will be
a substantial number of unexpected
earnings announcemerts from reporting
companies in their quarterly reviews. provide your
client with advice on how
best to profit from this expectation, while minimising
risk.
15.
Devise an option portfolio that is delta,

theta, rho and gamma neutrar _
exposing only the risk component associated
with voratility. rrora a roog
position in this portfolio, wait titl earnings
announcements are released
and hopefully the unexpected results wili
translate into increased stock
price volatility which leads to higher
option prices!
16,
Describe how you can explain how some

of the greer<s impact
option prices by
referring to the B I ack- s choles p arti al di f ferentiai
"d;i;
Examines change in call prices

for large changes in stochprice
d2c
dt
---=- = fC
as2
AS
(S') and volatilitv
Time decay. Change in

call price for a change in
time
Theta
Change
garnma and vega
in call price for a
change in stock price
small
delta
You hold a portfolio that is currently delta neutral.

It has a gamma of -5000
and a vega of-8000.
There are two traded options
Gamma
Option A
0.5
Option B
0.8
in the market
Vega
2.0
1.2
Delta
0.6
0.5
a) what would
you need to do to make the portforio

both vega and delta
neutral? What will be the new value of gamma?
Go long in 41000 Option A contracts.
Then short the assets of the portfolio by 2,400
units.
The new gamma value for the portfolio would
ne _jOOO.
b)
what would you_need to do if you had to make the originar

portforio both
gamma, vega and delta neutral?
-5000+0.5w1
-8000+2.0w1
wl :400
w2:6000
*0.8w2:0
*1.2w2:0
Go long on 400 option A contracts and 6000

option B contracts.
The new Delta will now be 400(0.6) + 6000(0

.5):3,240. Therefore, for
delta-neutrality you wourd arso have to ,nori'i,eqo
units of the
portfolio asset.
Page21
Derivatives
Topic 5 Activities
an insurance policy' What
insurance policy?
would the exercise price beiepresented as in a standard
need to be paid
The exercise price would be the EXCESS that would
The higher the
before the insurance provider contributes to the cover'
you receive'
EXCESS, the lower the premiums, but the less cover
very much like
Examples include car and house insurance. They operate
the exercise Price on a Put'
1.
It is said that aprotective put is very much like
2.
call before
what are the advantages and disadvantages of closing out a held
the exPiration date.
remains
Main benefit is that the option will be valued more, if everything
flowever'
value.
time
unchanged, than at expiration due to having more
if the:a",1 price goes
money
more
you lose o,rt oo the chince of making
in your favour.
3.
TRUE?
which of the following statements about "short selling" is

A:Ashortpositio.'-uybehedgedbywritingcalloptions.
B:Ashortpositio,,'.'uybehedgedbypurchasingcalloptions.
price
C: Short se1ers may be suilect- io margin calls if the stock
D:
4.
{tn>a- J -t(ue- 've-rc c.rS V"=l'q.fit^fu

-J
increases.
before the ex-dividend
Stocks that pay large dividends should be sold short
large price decline in a
date and Uo"gitt a{erward to take advantage of the
short time period'
Source: 2002 cFA Level 1 sample exam
at-the-money American
The current price of an asset is 75. A three-month,
what value of the asset
call option on the asset has a current value of 5. At
willacoveredcallwriterbreakevenatexpiration?
A: 70.
B: 75.
C: 80.
D: 85.
Source: 2002 CFALevel
1 samPle exam
Page22
L_
I
t_
Derivatives
t-
5.
Below is a trickv
mink before you attempt it!

,60. Call options on the stock
LI
and put options have an
l
tL-
will
expire in three months. Th"

There are no transaction costs
using the proceeds from the short sale of any
These options
ffil
security.
A: A synthetic
Treasury bill can be constructed by investing in a combination

of the securities identified above.
i. Identify the three transactions needed to construct a synthetic Treasury
I
I
bi11.
,-
ii.
LI
bill's annualised yield {basic

but remember that the yield given is for 3 months)
calculate the synthetic Treasury

percentage return
B: An arbitrage strategy
can be constructed with 75 actual and 100 synthetic

Treasury bills, producing a face amount of $750,000.
i. State the arbitrage strategy.
ii. Calculate the immediate incoming net cash flow.
(Notes: contract multiplier : 100 for put options, call options and stocks;
face value for treasury bills is $10,000)
c:
Determine the net cash flow of the arbitrage strategy at the six-month
expiration date if the stock price at expiration is $80. (Ignore any cash
flows stemming from the original arbitrage profit.)
Source: CFA Level 3 sample exam
Page 23
Derivatives
Topicr
Portfolio Management
Minutes:
t2
Reading References:
"Option Payoffs and Option Strategies," Ch.l1, Futures, Options & Swaps,2nd edition, Robert
W. Kolb (Blackwell, 1997)
Purpose:
To test the candidate's understanding of when and how to exploit mispricing of puts and calls
relative to each other.
LOS: The candidate should be able to

"Option Payoffs and Option Strategiesl'tsession 13)
determine whether an arbitrage opportunity exists, given a put price, a call price, the stock
price, and the price of a bond;
. construct and evaluate the appropriate trade when an arbitrage opportunity exists given a put
price, a caI price, the underlying asset price, and the price of a bond;
. create a synthetic securiry from three of the following four instruments: a calL, a put, ths
underlying asset, aird a bond
'.
Guideline Answer:
A.
i.
The transactions needed to construct the synthetic T-bill would be to long the stock, long
the put, and short the call.
ii.
Assuming the T-bill yield was quotd on a bond equivalent basis,

bill's annualized yield can be calculated on the same basis:
$?7.50 + $4.00
t($75.00
B.
$7.75
the synthetic Treasury
= $?3.?5 initial investment and $75 ending value
$73.7s) / $73.751 x 4 = 6.78%
i.
The strategy would be to shod ?5 actual T-bilis and to long 100 synthetic T-bills.
ii.
Assuming the actual T-bill was quoted on

a l.25Vo quarterly return.
bond equivalent basis, the actual T-bill gives
Immediately, the short actual T-bill position pays:

$750,000
| l.Ol25=
$?40,741
III Guideline Answers

Afternoon Section - Page l0
2000 Level
Prge24
Derivatives
At the time of creation, the long posirion in the synthetic T-Bill would be:
Long stock -$??5,0ffi
Long put
-$ +oooo
Short call
$ 77.500
-$737,500
Therefore the net cash flow is:
$740'741
C.
- $737,500 = $3,241
The approach to calculating net cash flow gives the same result whether the calculation is
done for three months or six months.
At the thee-month expiration, the value of the long slnrhetic position is:
E=P+S-C
where E = exercise price, p = put price, S = stock price, C = call price.
Atexpiration, E =
F+S*C
= $0+$80-$5
= $75 per share or $?,50O per conlract
Total cash flow of the long synthetic position = 100 conrracts x $7,500
= $750,000
Total cash flow of thE short ?reasury bili position = ?5 actual Treasury bills x $10,000
= $?50,O00
Net cash flow = $750,000
$750,000
$0
$0 cash flow at three months would be worth $0 at six months.
Alternatively, if the stock price at expiration is $80:

Long stock position
= $ S0
Short call position = $?5 - $80 = -$ 5
Long put position
= $0
Short Treasury bill position = *$ 75
Net position
$0
2000 Level Itr Cuideline Answers

Afternoon Section - Page I I
Page 25
Derivatives
6.
Ken Webster manages a $100 million equity portfolio benchmarked to the

s&P 500 index. over the past two years, the S&p 500 index has appreciated
60 percent. webster believes the market is overvalued when measured by
several traditional fundamental/economic indicators. He is concerned about
maintaining the excellent gains the portfolio has experienced in the past two
years but recognizes that the S&P index could still move above its current 668
level. webster is considering the following option collar strategy:
Protection for the portfolio can be attained by purchasing an s&p 500

index put with a strike price of 665 fiust out of the money).
The put can be financed by selling two 675 calls (farther out of the money,
for every put purchased).
Because the combined delta of the two calls is less
1 (that is, 2 x 0.36
: 0.72), the options will not lose more than thethan
underlying portfolio
advances.
The information in the following table describes the two options used to create
the collar.
OPTIONS TO CREATE THE COLLAR

Characteristics
Option price
Option implied volatility
Option's delta
Contracts needed for collar
Notes:
Ignore transaction costs
S&P 500 historical 30-day volatility
Time to option expiration: 30 days
675 Call
665 Put
$4.30
$8.05
14.00%
0.44
rr.00%
0.36
602
301
= 12.00%
Describe the potential returns of the combined portfolio (the underlying

portfolio plus the option collar) if after 30 days the S&p 500 index rras
trj
risen approximately 5 percent to 701.00, (2) remained at 66g (no change),
and (3) declined by approximately 5 percent to 635.
b. Discuss the effect on the hedge ratio (delta) of each option as the s&p 500
approaches the level for each of the potential outcomes listed in part a.
Evaluate the pricing of each of the following in relation to the volatility
data provided: (1) the put, (2) the call, and (3) the collar.
CFA Examination Level II
a.
Derivatives
CFA Examination ill (1997')

The suggested strategy is essentially a zero-premium collar, which is
constructed by selling a call option with enough premiums to fund the
purchase of the put option. In this case, at-the-money protection
(provided by the put) is more expensive than the out-of-money call.
Therefore, the strategy requires the sale of two calls to finance one put.
The call is not struck (sold) at the money because the fund manager, Ken
Webstero does not want to incur the opportunity cost for a 1 .05 percent
rise above the S &P 500 Index's current 668 level.
$4-ll-60
ffi-manager would expose the portfolio to iqcurring losses (from the
calls) ## twlcc fhe rate of the underlying portfdtiois appreciation.rThe
portfolio would experience full market participation within the 005-ezs
range (plus the premium received from selling the collar). The strategy
will
h*s ry,eeiatedfbbyolrd 675 dt expiration
date a
if the' ,ndex has declined below 655 at expiration.l
Potential Returns
Index rises to 701. This rise would cause a substantial loss to the
combined portfolio. An increase above the 675 call's strike price
would require an increase above 1.05 percent (668 to 675) in the
S&P 500, at which time the call would be in the money. Because
two calls were sold for every put bought in the collar, the collar
would lose at twice the rate of the underlying portion of the
portfolio against which it was written for any appreciation of the
S&P 500 above 675. (The portfolio would realize a slight
increment in return because of the premium [per collar tradedl
generated by the collar [2 x 4.30 - 8.05 = 0.55 per collarl.)
a.i.
a.ii. No
change. The combined portfolio would experience only a

slight gain as a result of the premium (per collar traded)
generated by the collar (2 x 4,30 - 8.05 = 0.55 per contract). Both
the put and the call would expire worthless. Therefore, the
change in the portfolio would mirror the S&P 500 at 668.
@;e
a.iii. rndex declines to 635. This decline would cause a slight loss tot
he combined portfolio because of the unhedged portion (668 to
675); then, the put hedge would take effect. Below.f!ftf5' fhe put
option guards againsi losses on a oo"-for-orrffiri*a{irre
portfolio would realue a slight increment in return because of
the premium [per collar traded] generated by the collar
- 8.05:0.55 per collarl.)
12
x 4.30
Page 27
Derivatives
b.
Effect of Scenarios on Delta

b.i. Index rises to 701. The initial delta of the out-of-the-money
calls was 0.36. As the call option got into the money and time
expired, the delta of each call would approach 1.0. As the put
option went out of the money and time expired, the delta of
each put would approach zero.
b.ii. No change.
The delta of both the put and call would approach

zero as they both went out of the money and time was
expiring.
b.iii. Index declines to 635. The initial delta of the out-of-themoney put was -0.44, As the put option got into the money
and time expired, the delta of each put would approach 1.0.
As the call option went out of the money and time expired, the
delta of each call would approach zero.
c.
Pricing
Compared with the historical volatility of the market (12 percent), the
calls (Part ii) are priced relatively cheaper (11 percent) and the puts
(part l) are priced relatively more expensive (14 percent). The
suggestion is that the collar (Part iii) is relatively expensive.
Page 28
Derivatives
I
J
l
l
-l
does an
option Pricing Model relt us About

Option Prices?
/ .lzirs-f I
i \^\K
r. /I
v\lt
Read the accompanying article (next page) and answer the

questions:
i
i
following
Identify factors that are not part of the B-S pricing model but still would affect
option prices.
-l
what
Transaction costs, supply and demand for options, Taxes, Margin

requirementso Differences in contract specifications between options
Outline reasons why the B-S model may be wrong.

Cannot calculate with certainty the correct volatility rate for stocks
The assumptions of the B-S model not realistic. Eg,
- Investors are not homogeneous
- Doesn't account for the above listed factors
- Doesn't explain why options with different exercise prices have different
implied volatility rates
- Doesn't explain why puts and calls on the same stock have different
implied volatility
consistently underestimates the value of deep out-of-the-money options
Prices may not behaviour as Brownian motion (as outlined by the general
weiner process and Ito process which underlies the B-s pricing model).
Stock price distributions seems to have fat-tails (excess kurtosis)
probably due ,.,tg market volatility not remaining constanf for the life,,of.
theoption. fiefit**i>hc + f&,tr.lan efirf,,rtJ ,-){
lr,f,l,kt* pt,sj
' Lil* ou,

cl4rhifr\r, t
Explain how the B-S model may calculate the correct value for an option but still
be different from the market price.
- two cases in point:
Deep out-of-the-money options tend to affract investors for the potential
high gains that can be made with relative low costs involved (the option
premiums will be very low) - just as with purchasing lottery tickets. This
is a human perception factor relating to how people view risk and return which is not always as rationale as the equations make out that we are.
- Sometimes the markets find it too difficult to properly calculate true
values for certain options, such as American and. Embedded options due
to the computing time and effort involved.
Page29
Derivatives
@tls$
Cunrent lssue$: Opti0n$
=
=
Pricing Model Tell Us

What Does an Option
' Option
Prices?
by Stephen Figlewski, prcfessor of Fi- "That depends. Are you buying
iorrr,' Stern Schoal of Business,'New or selling them?"
The story is told of a Seeker of
Knowl-
the
them
u.rJ*",. to a question that has

him for a long time. In his travels he
hears of tr.rro wise men lvho are said by
many to be very knowledgeable and
experienced in such matters.
The first, a famous guru, lives at the
top of a mountain, high above the
hustle and bustle of everyday life. After a strenuous clirnb, the Seeker is
able to pose his question: "What is a
call option worth?"
The guru ans"ers immediately, "It
is not hard to prove that
price above the theoretical value an:

will have infinite demand at any pncr
,IlT:ilii::xr.llT,'?i,ll';,iH:::"il*:',:1i:l';T::ii:lT":1i:,==
the words, and equations, of the
first
guru, but he is quickly intermpted

troubled with: "I don't care about all of that
edge who sets off in search of
About
is the reasoning behind the first guru
answer'
.=
But in trying to apply a theoretic- =,E
stuff. Tell him to make me a bid, Then valuation model to the real world, i!,, E
we can talk about what a call option is immediately clear that none of tf - E
really worth."
odel assumptions actually .hold.
Somewhat confused and not at all The arbitrage strategy, lvhich is risi ,f
=
sure the wise men's answers have less and costless in theory, is neithe: E
brought htT lty closer to enlighten- in practice. There is risk because ti'.: E
ment, the Seeker goes away to medi- poritiot can't be rebalanced contin- ff
tate further on his question'
ously when markets are closed, an: ff
and Pricing
there are costs because even less ff
than-continuous rebalancing can lea: I

to large transaction costs. Even ti. I
Models
theoretical optionvalue,itself is unce: I
two
different
very
offers
This parable
tain, because it depends-on the voi:
question.
basic
same
the
C = SN tdl - Xe-,rN Id - o{t1, uns*Lrc to
tility of the stock, which cannot !- |I
reflects
them
between
distinction
The
where S is the stock price, X the strike the not often recognized difference be- known exactly' Unlimited arbitra; I
price, T time to expiration, r the risk- twen theories of option valuation and does not dominate the market' il
ln actualmarkets, oPtion prices, li' I
iree interest rate, rvolatility, N[.] de- option pricirzg.
notes the cumulative normal distribu- The Btack-Scholes model and others prices for everything else, are det' I
tion and
like it are theories that try to derive the mined by supply and demand. T: I
aalue of an option so that it is consis- lncludes supply t"o,"l;TflJ:.--f,
d.: (log(srX) + (r +
Valuation Models
ttz)T)tl.Vi.
::l:Jfi"f:Jff":t#-:i*lInq
ffi#3:ntiXll;,i"1"" oprionsothis has to be modiried

in practice to take into ac- ment in which a dynamic riskless ar- pariicipation in stock price moveme: =
E
"
count dividends, the value of early bitrage strategy with the stock and the on the upside, limit risk on the do.'
=
exercise and a few other technical de- option is possible, and find the value side, and allow inveslors l: contrt a.
si:
tails (see the appendix)."
oi the opiior, as a component of the large amount of stock with
investment. Call writers supply - ,E
This answer seerns pretfy exact, if a arbitrage portfolio.
=
In this ideal market, if the option's options to the market because it '
bit complicated. The Seeker thanks the
=
price should differ from the model way to generate in,come when t-'=
guru warmly and goes on his way.
sha::
rise
E
not
will
The second wise man lives in the value, an arbitrageur can trade it exPect stock price
middle of a city, surrounded by a againstthecorrectnumberof sharesof in the near future.
Option demand arrd supply are '
continuous swirl of noise and activity. siock to produce a position that is
=
Once the Seeker is able to get his riskless over the next instant of time. influenced by the market envi:
attention, he poses the question again: Continuous rebalancing keeps the ment, rt'hich encompasses taxes, tl' =
"What is a call option worth?"
hedged position riskless until the op- acfion costs, margin treatment ot :
Again the answer is immediate: tion"expiration date. But its return will ferent securities, delivery featurt, f=
be higher than the risk-free interest option contracts, constraints on -
or course,
somewhat
:ffiiJ*:TlHl:Tli:
Lt*'l:
$::r,T:l::n#f.i**'
$u'
contracts, and r
Brcwn, loel Hasbrouck, Mark Rubinisteh there are no corrstraints on the size of related futures
that affec:' E
and Wiltiam Silber for comments on an their positions, arbitrageurs will offer other things. Anything
but is : =
decisions
hading
vestors'
at
any
of
options
number
,lnii*itud
ur,
earlier draft of this p,aper.
FINANCIAL ANALYSTS TOURNAL / SEPTEMBER-OCrOBER 1e8e n
12
Deriyatives
tends to push the market
lyay from the model value. As
nd wise man indicated, a
ca-ll
is wcrth exactly the price
at
it can be kaded in the market,

does not depend on just the
might ask: l{ithout unlimarbitrage betr+'een the option and
risk. Moreover, ii is dear that, given

the cost and uncertainty of the trade,
arbitrageurs wi-ll not take unlimited
positions, e1'n at prices r:utside these
wide bounds. This makes for something less than impenetrable barriers"
. We are left with distressingly little in
the lvay of a response to the skeptic's
question.
ying stock as a foundation,
can a theoretical valuation model
us anything about actual market

possible answr is that, under
conditions, the equilibriun oF
price is the Black-Scholes value
when there is no arbitrage, ber,r'hen investors evaluate the opas if it were any other asset, that is
t its pa-Voff pattern is worth.l Unnately, one of the necessary conions for this result is that all invesbe identical, which is no rnsre true
real markets than the continuous
itrage assumptions it replaces
An argument that is on stronger
nd, but has weaker implications,
'that as long as the arbitrage is posble, it will be done in spite of transn costs and risk whenever the
profit is large enough to csmnsate for thern. This leads to arbibounds around the model value.
lf ithi.n these bounds, there is no arbitrage and market price can move
feely, but if the price skays too far
irom the model value, arbitrage hecomes profitable and rcill tend to push
:::ce back into the bounded range.
Horv much information the riiodel
a::ually gives us about what the mar!,:i price u'ill be depends on ho.w wide
;,: arbitrage bounds are. This is not
:;s',' to determine, because the trans:-on costs and risk for the arbitrage
r-: a function of r,.'hich random path
:: = stock price follor+.s. ln a recent
:::er, I simulated a large number of
::,:e paths and discovered that the
.::i;rage bounds are disturbingly
:''.ie. even for routine cases.z For ex.::.rle, the price of a one-month, at:.i-inoney call rvith a Black-scholes
' : . re of 52.05 could be anywhere frorn
S- :1 to 52.35 without giving an arbi::i:eur el1en a 50/50 chance of cover:.: ;csfs. or any compensation for
: :::r-.otes appear at end of
arhicie.
Real Options Using

Tf$lg,
Model Prices
The probiems associated with applving a theoretical option valuation
model to the real tvorld have obr.!
ously not prevented virtuall-v every
serious option trader from doing just
that. But they use the model in ways
that are more consistent rt'ith the second rvise man's approach than with
the model's theoretical underpinnings.
Fe*" investors use the model mainiv
for finding mispriced ophons that can

be arbitraged against the underlying
stock, A major reason for this is that
no one feels confident they know ihe
true volatility. Esrimaring volatility
from a sample of past prices is a routine exercise, but you can't be sure the
future will be exactly like the past.
Based on historical volatilitr, for example, the price change that occurred on
October 19, 1987 rvas essentially
impossible.3
Option traders normally pay more

attention to the implied volatility that
sets the racdel option value equal to
the market price. This is easv to compute and, in principle, gles a direct
reading of the market's volatilitl' estimate. But ii has the disadvantage that
you ha1'e to _ag-sur!e_--thq.-,g1arkg1[. is.
pricing the option according to the
model, rvhich rules out using implied
volafilih, to detect mispricing.
Another problem is that, because
volatility is the one inptrt to the model
thai can't be directly* observed. implied volatili$ actually sen'es as a free
parameter. It impounds expected volatiliW nnd nerything e/se that affects
option supply and demand but is nat
in the rnodel" If a change in the tax law
makes writing options less attractive,
for instance, the price effect will shorv
up in implied volatility. Any time the
market prices options differently from
a given model, for any reason, the
FL\ANCIAL A\'.41\5TS
implied volatility derived from that

model is not going t0 be the market,s
frue volatility esfimate.
Generally, implied voiatilities d.ifer
across slrike prices in a regtrlar way,
even though it is logically inconsistent
for a stock tryt have more than one
v alatrlity
Tput-o f-t he-mo ney op tio ns
hpically have higher implied volatilities than at and in-the-money options,
puts are often priced on different valatilities than calls, and ttge pattems
vary from time to nmer/ffis is evidence that the market difes not price
options strictly according to the
rnodel, or at least not according to the
particular model that produces the di{fering implied volatilities.
Traders don't care much abcut these
problems. In fact. they seldom think
about ihe technical details of the computerized models they use, or even
about rvhether they are pncing Euro,
pean or American options. Instead,
they tend to take whatever theoretical
model happens to be available on the
computer and (eat the implied volatili$ it produces lbi-a,qarticular option
a$,q kind of index of h$.v the option is
currently beisg;.p*cd in the market
relative to other options and relative to
how it was priced at other times.
It is perfecily normal, for example,
for an ophion trader to reason, ',yesterday the ccmputer said these XyZ
options were trading on a volatilify of
20 per cent, but this morning the options market is a little soft, so l,ll use
19.5 tod,ay and 21.5 {or the outof-the-money puts that always are a
iittle richer."
These volatilirl* "estimates" are then
plugged into the computer's model,
and bids and offers are based on the
theoretical values that it produces. The
idea behind this procedure is not that
the trader thinks 19.5 is the best available estimate of XYZ's volatility until
option expiration, but ihat it is a reasonable way to summarize the current
state of supply and demand for XYZ
options and that conditions will probablv remain fairly stable for a whileuntil thev change.
For many option traders, having exactly the right model and volatilify
may not be of such great importance,
because r.r'hat they really care about is
the delta, which tells how to hedse an
.
/ SEn-EMBER-OCTOBER 1989
'OURNAL
-i j.3
Derivatives
option, and delta is much less sensitive to these things than theoretical
value. Also, markeFmakers and active
traders frequently hedge options
against each other, rather than against
the stock, so the effects of changing
volatility and other model inaccuracies
on the different options partly offset
each other. In ofher words, *F-.,nut tto, ,
rnatter so much if your model misprices an option as long as the option.
vnll conti,nr.re to be mispriced in ttre
same wqy when lhe stock price,
changes, or as long as it is hedged by
other options that are similar$ mirs-
in$y
complex alternative rnodels tb pirical examination of those

explain the phenomenon, :
has not led to widespread reje
Tinkering with a model to try to them, suggests that, at least fc:
make it fit market prices better con- maturity, exchange-traded oph :r:
fuses valuation and pricing. What afi tracts, the models work acc:
arbitrage-based option model says is t well.
that buy,ing the option at its fair value " But some situations wa::
and following the arbitrage strategy I greater degree of skepticism i:;
until expiration will rtum the risk- trs. There are problems of tr^,
free rate of interest., If empirical tests The model can be wrong, sc
show that this would happen in prac-. theoretical value is not the tru:
trce, qss.uqtiyg you could buy the op- value, or the model may give
tion for its model value and had no " rect value, but the market p::l
transaction costs, then the valuatbn option differently.
formula is correct.*How those optiory
In the first category we inc
might be priced in the market h6s uations in which the model ar
priced.
Still, when a stock has a large price nothing to do with whether the model tions are violated (to a large:
|
than normal). This is true fc:
{nove/ implied volatilities also typi- aatrues them correctly!
What
model-testers
have
in mind, of maturity options, where par:
cally change, meaning that the actual
change in the ophion's price is not course, is that the theoretical valuation such as volatility and intere,
what was predicted by the original model should also be the market,s (which one can treat as beini
delta. The skeptic might wonder if we pricing equation. As we have seen, iin , constant over a month) ca.
can even be sure that the apparent the real world an arbitrage-based vaL: widely and unpredictably over
stabilify of implied volatility under uation model produces a band around periods. We can have confider:
normal circumstances isn't partly due the' theorbfiCal'Option value,i withinry valuation model only to the exte
to a kind of self-fulfilling prophecy, which the excess profit that could be" \A'e are confident of our forecas=
what with so many option traders us- made is smaller than the cost to set up' parameters out to option exp:
ing the model to change their bids and tLre arbitrage tradd. In this context, the which may be many years in :r
model only says that the price should ture.
otfers as the stock price moves.
be
within the bounds.t It is perfectly
We can also expect inaccuraci*
l4lhile it was conceived as an arbiconsistent
with
the
model
for
the
maring
from errors in modeling st
trage-based valuation theory, rthe
ket
price
to
be
always
at
the
lower
prices
as geometric brownian r:,
Black-Scholes rnodel is actually used
bound
or
the
upper
bound,
or
followThere
is considerable evidenc:
by option traders as a pricing equaing
any
kind
of
pattern
in
between.
actual
price
changes have "fat t=
tion, to predict how the option price
The
finding
of
',bias,,
a
consistent
fn
that
is,
there
is a greater probat:
w|!l,,Sl-1enge ;when the underlying stock
market
prices
does
not
indicate
a
rejbca
large
change in a short inten'i
rnoves. But baders treat the model
almost as if it lvere a rule of thumb, tion of the modbl, unless the bias is the model assumes, leading tc
rather than a formula that gives the large enough that pricqs lie well out- ing problems and undervalua:r
side the arbitrage bounfus. And those short-maturity options. There .
true option value with confidence.
bounds may be very wide.
growing evidence that over boi;
and short horizons, there is somr
Testing Models with Real
Is the Skeptic Right?
randomness in stock price move
Option Prices
A true skeptic might argue that this
There is certainly reason to dc
In a sense, the mirror image of an discussion has shown fwo things. arbitrage-based model's valuat:
option trader evaluating market prices First, option valuation models dorr'g an option on an underlying ass=
using the model is the academic theo- give correct fair valges because the is not traded, even though th.
rist "testing" a model on market data. continuous arbitrage can't be done in routinely apply the Black-Schoi
The standard procedure is to compute practice. r5econd,",F'?,,en if modefS rdla mula to all manner of cases in .
theoretical values for a set of actual give correct values, option prices in the arbitrage is irnpossible,
or .
options and compare them with mar- the market would not equal those val- tially so. For example,
it is an
ket prices. Small random differences ues because of all of the other factors tant theoretical insight
that lim
can be explained as "noise," but sys- affecting supply and den{and.
ability in trankruptcy makes the,.
tematic deviations are viewed as eviI would not go so far, although I of a firm with outstanding debt s
dence of problems with the model.
think some skepticism is a healthy, to a call option to buy the firm's:
The common finding that deep-out- and risk-averse, attifude in this case. A from the bondholders by payrr:
of-the-money options seem to be model does not have to be exactly debt. But the firm as a whole is:
priced higher in the market than' right for it to be of use. The general asset that can be traded indepen:
Black-Scholes would suggest has acceptance of option models in the real from its securities, so there ls r.
given rise to any number of increas- world, and the fact that extensive em- investors could arbitrage
the
-
:_
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER.OCTOBER 1989 tr 14
Derivatives
asset, such as a unique piece of propstv/ causes difficutty lvhen there is no

wav to form a hedge portfi:lio that ran
jle reUalanced. There are clearly many

f**r in rvhich one must be sieptical
about deriving an option's value from
i ltre
seccnd categorv of problems

irertains lvhen the model gives the
-. r';e value of an opfion, but the market
$pn."r it differentlv. The more difficult
je-rd costly the arbikage trade is to do.
Fre greater the scope is for factors not
foi'ered in the model to move the
Frarket price away from its theoretical
:',:lue. Several situations harre proved
difficult for arbitrage*::.rticularlv.
E-:,:SeO
models.
". Cut-of-ilrc-tn{iny aptions: people par_

:-r-rlarly like the combination of a large
;::ential payoff and limited rlsk arici

s=:: rviiling to pay a premium
for it.
,.iat is why they buy lottery tickets at
::.es_that embody an expected loss.
f j:-ot-the-monev
;options offer a sirn; "; payoff pattern, At the same fime,
-:'--. ',r.riters cf those options are ex-f :,,,-ed to substanial risk hecause it is
'--::C to hedge against large price
::::nges. lÎlry
-r,-:-of-the-moneyshould we fiof expect
options to seil flr a
;:.-::rtum over fair value?
.:-',;ericet! optians: The possibilifv of
6 :::.'. exercise makes American option,
" .-::: iL, r.alue
theoretically, especiallv
:*::use the early-exercise pravision is
, _:'i.:.-'m exercised optimally according
,' :.-.t theorv. f his is an erlormous
::- :lem with mortgage-backed securi::: trecause of the homeclwner,s r.)p_
f
tion to prepay the mortgage lcan, but for computing option values;
further_
all American opticns share it to some more, the harder ihe
arbitrage is to do,
extent. We should not be surprised if the less con.fidence these investors
can
the market pricrs American options have that the moclel is going to
give
differently from their model values be- either the truer4ption value
or the
cause of the uncertainty.
market pnce. f{edging options r+,ith
Emfudtled aptions: Valuation models
options, rathei thaffiffiTIFiiriHerlv_
treat a security rvith embedded option
iirff{dck, can provicle some defense
features, such as a callable bond or a against inaccurate
valatility estimates
security with default risk, as if it were and mod'
simply the sum of a straight security
In general, investars
are nOt
and the opticn. But the market doei ffueg as snarket-making
arbitrageurs
not generally price things this way_ should be less cotcern*d
with Glua_
For example, when coupon strippers tion models than
with using options to
unbundle government bonds. or produce overall payoff patterns
that
when mcrtgage pass-throughs are re- suit their market expectations
and risk
packaged into CMOs, the sum of the preferences. When they
think the mar_
parts sells for more than the original ket might drop sharpltL it makes
sense
whole. Whv should we expect" ihe for them to buy put options, er.en
if
market to pric ernbedded options as if they have to pay rncrre than ,'far{'
they could be traded separately rt'hen
value.
this is nct true of other securities?
Times of crisis: The period around the
Footnotes
crash of October 1987 showed that in
1. See M. Rrrbinstein, ,'The Valuation
times of financial crisis, arbitrase beof Uncertain Income Streams ancl
comes even harder to do and Jption
the Pricing of Opticns,,, BeIl fourna!
prices can be subject to tremeridous
of Econombs and Management Scietzrc,
pressures. At such fimes, rve should
Aufumn 1976, ar Nl[. J. Brennan,
not experl to be able to explain market
'The Pricing of Ccntingent Claims
prices n'ell with ur, utbifr"ge-based
in Discrete Time Models," Th l$urvaluation model.
nal ot' Finance, lv{arch 1979.
2. S. Figlewski, "Options Arbitrage in
Whete Do We Go From Here?
lmperfect Markets," The [ournal of
If what is really u'anted is a model to
Financt, forthcoming I 989.
explain hor*- the market prices cp- 3. And including that
day,s price
tions, it doesn't make sense for acl_
change in volatility estimates after
demics and builders of optian models
the er..ent meant that ii dominateei
to restrict their attention entirelv to
the calculaiian. There lyas then a
elaborating arbitrage-based valuaiion
spurious sharp fall in estimated volmodels in an ideal market. They
abilitv months later, on the day Ocshould at least examine broader
tober 19 dropped out of the data
classes of theories that include factors
sample.
such as expectations, risk aversion and 4. See, for example,
E. Fama and K.
market "imperfections" that do not
French, "Permanent and Tempoenter arbitrage-based valuation modrary- Cornponents of Stock Prices,"
els but do affect option dernand and
lournal of P<liiticnt Ennouy, Apri
supply in the real world.
i988, orJ. Paterba and L. Surnmers,
For those who would use theoretical
"lr4ean Reversion in Stock prices,,,
models tr: trade actual options, it is
lournnl of Financinl Econornics, Octclsafer tcr use models for hedging than
ber 1988.
FINANCINL ANALYSTS JOURNAL I SEPTEMBER.OC-TOBER 1989

tr 15
Derivatives
Topic 6 Activities
1.
what is the benefit of holding a spread position over single long (or short)
option positions?
a
Spreads limit risks that single positions in calls/puts yield. For example,
Ilowever'
bu11 spread limits the downside potential if the stock decreases.
this is done at a cost of also timiting upside potential'
Z.
Determine the maximum and minimum profits and the breakeven stock piice
at expiration for a put bull strategy.
Buy put with Xr, and sell Put with Xz.
Profit Equation: ft: Max (0, Xr-Sr) - Pr - Max(O,X2-Sr) + Pz
SrcXr<)fu fi :Xr-Sr-Pr-Xz+Sr+Pz :Xr'Xz-(Pr - Pz)
Above expression must be overall negative as the difference in exercise
prices is less than the difference in premiums'
Xr<Sr<Xz t[:
Xr<Xz<Sr 6:
- Pt - Xz*Sr
- P1 * Pz
Pz
Solving for 51:
Xr<St<Xz fi: - Pt -Xz*Sr * Pz

Sr*:&+(Pr-Pz)
3.
Why does a strap indicate you have a more bullish outlook on the economy
than if you were to have taken a straddle position?
A strap involves purchasing more calls than puts. If the market goes up
you piofit quicker, but the downside is that you have more to lose if the
market decreases in value.
4.
The current price of an asset is 100. An out-of-the-money American put

option with an exercise price of 90 is purchased along with the asset. If the
breakeven point for this hedge is at an asset price of 114 at expiration, then the
value of the American put at the time of purchase must have been:
A:
B:4
C: 10
D: 14.
Source: 2002CFALevel I samPle exam
Page 34
Derivatives
5.
Donna Donie, CFA, has a client who believes the cofllmon stock price of TRT
Materials (currently $58 per share) could move substantially in either direction
in reaction to an expected court decision involving the company. The client
currently owns no TRT shares, but asks Donie for advice about implementing
a strategy to capitalise on the possible stock price movement. Donie gathers
the TRT option pricing data shown in Exhibit 1.
Exhibit
TRT Materials Option Pricing Data

Characteristic
Price
Strike Price
Time to Expiration
Call Option
Put Option
$5
oou
$4
$55
90 days from now
90 days from now
A:
Recommend whether Donie should choose a long strangle strategy or a

short strangle strategy to achieve the client's objective. Justifu your
recommendations with one reason.
B:
Indicate, at expiration for the appropriate strangle strategy in Part A, the:

i. Maximum possible loss per share
ii. Maximum possible gain per share
iii. Breakeven stock price(s)
Calculate the approximate change in price for the call option in Exhibit 1 if
TRT's stock price immediately increases to $59 and the,current delta is
0.6250.
D: Define gamma and state whether gamma for the put option in Exhibit 1
would decrease, stay the same, or increase if TRT's stock price
immediately decreases to $57.
Source: 2002 CFALevel2 samole exam
Guideline Answer:
A.
Donie should choose the long strangle strategy.
A long strangle option strategy consists of buying
a put and a call
with the sanre expiration

date and the same uaderlying asset. In a sn-angle strategy, the call has an exercise price above
the stock price and the put has an exercise price below the stock price. An investor who buys
(goes long) a strangle expects that the price of the underlying asset (TRT in this case) will
either move substantially below the exercise price on the put or above the exercise price on
the call. With respect to TRT, the long strangle investor buys both the put and call options for
a totai cost of $9.00, and will experience iarge profits if the stock price moves rnore than
$9.00 above the call exercise price or $9.00 below the put exercise price. This strategy would
enable Donie's client to profrt from a large move in the stock price, either up or down, in
reaction to the exDected court decision.
4
E
Page 35
Derivatives
B. i.
ii.
The maximum possible lcss per share is $9.00, which is the total cost ofthe two optians
$5.00 + S4.00.
The maxirnum possible gain is unlimited, if the stock price moves outside the breakeven
range
iii.
ofpric*s.
The breakeven prices are $46.00 and $69.00. The put will just cover costs if the stock
price finishes $9.00 below the put exercise price {$55.00 - $9.00 = $46.00), and the call
willjust cover costs if the stock price finishes $9.00 above the call exercise price ($60.00
+ $9.00 = $69.00).
The following diagram provides support for the answers above.
Long strangle
12
10
A8
g6
A4
09
do
E-2
F4
*
-10
35 40 45 50 55 60 65 70 75
80
Stock Price{$}
C. The delta for a call option is ahvays positive, so the value of the call option in Exhibit 13-1
will increase if the stock price increases. Specifically, if the stock price increases by $1.00,
the price of the catl will increase by approximately $0.63:
APrice*x:0.6250 x $1.00) = $0.625 increase
D. Gamma
is the second derivative of the option price with respect to the stock price and
nreasures'how delta changes with changes in the underlying stock price.
The gamma for the put option in Exhibit 13-1 would increase if the stock price decreases to
$57.00. Gamma is relatively small when an option is out-of-the-money but becomes larger as
the option approaches near-the-money, which is the case as the underlying asset value moves
down toward the put option's $55 exercise price.
Page 36
Derivatives
6.
Linda Morgan is evaluating option strategies that will allow her to profit from
large moves in a stock's price, either up or down. she believes that a
combination of a long put and a long call option with the same expiration and
exercise price (straddle) would meet her objective. price information on
APEX stock and options is presented in Exhibit 1.
Exhibit
1.
APEX stock: $50
call option with
an exercise price of $50 expiring December 1999: $4
Put option with an exercise price of $50 expiring December 1999: $3
No transaction costs or taxes exist

A: Draw a net profit-and-1oss diagram at expiraiion for the straddle, using the
information in Exhibit 1. Calculate and label the maximum loss and
breakeven points of the position.
Morgan is considering a lower-cost strategy that would allow her to profit

from large changes in the stock's price.
Exhibit
2.
APEX stock: $50
call option with
an exercise price
of $55 expiring December 1999: $2.50
Put option with an exercise price of $45 expiring December 1999: $2.00
No transaction costs or taxes exist

Draw a net profit-and-loss diagram at expiration for the straddle, using the
information in Exhibit
2.
calculate and label the maximum loss and
breakeven points of the position.

Source: 1999 CFA Level2 sample exam
Page 37
Derivatives
Guideline Answer
A.
The maximum loss at expiration for the straddle buyer takes place at the exercise price and is
$7. This is the total cost to purchase the long call and the long put that are combined to create
the straddle. If the stock price exceeds the exercise price, the straddle owner wiil exercise the
call; if the stock price is less than the exercise price, the straddle owner will exercise the put.
The maximum ioss is shown in the graph for Question 3-A and is computed as follows:
MAX t0, Sr-X) -C, + MAX {0, X- S'r}',* Pt

Cr+ Pr =MAX i0, $50-$50) - $4 + MAX {0, $50 *$501 - 93
Cr + Pr = MAX {0, $0} - $4 + MAX {0, $0} - $3
C1+
P1 =
Cr+Pr=(r$4)+(-$3)
Cr+Pr=-$7
Profits will be realized for the straddle if the stock price moves above $57 or below $43 (the
breakeven points). The breakeven points for the straddle buyer are the exercise price of the
options plus and minus the cost of the straddle. Stock prices, at expiration, that are lower than
$43.00 or higher than $57.00 will produce a gain for this position. These are shown as the
intersection between the payoffprofit and the zero profit line in the graph for Question 3-A.
The breakeven points are those stock prices that result in zero pro{it:
Ca+P1 =MAX {0, Sr-X} -C1 + MAX t0, X- Sr} -P,

Cr+ Pr = MAX i0, $43 -$501 -$4 + MAX {0, $50 - $43}
Ca + Pa = MAX {0, -$7} - $4 + MAX {0, $7} - $3
-$:
Page 38
Derivatives
cr+Pr={*$4)+$7+(-$:)
Cr+Pr = MAX {0, Sr- X} - C, + MAX {0, X- Sr} - P,
Ca + F1= MAX {0, $57 - $50} - $4 + MAX {0, $50 - $511 Cr * Pr = MAX {0, $7} - $+ + MAX {0, -$7i - $S
53
C1+P1=+$7-$4-$3
C1+F1=$$
(See
B.
graph on next page)
The alternative option combination, consisting of buying a put and a call with the same
expiration dates and the same underlying stock but dilferent strike prices, is called a strangle. In
a strangie, the cali has an exercise price above the current stock price and the put has an exercise
price below the current stock price.
The maximum loss at expiration is $4.50, the cost of the two options (1.e., the long call and the
long put). The maximum loss is computed as follorvs:
Cr(Sr,
Cr(Sr,
Cr(Sr,
Cr(Sr,
CdSr,
Xi, T) + P{S1,
Xr, T) +PdSr,
Xi, T) * Pa{Sa,
Xr, T) + PdSr,
Xr, Ti + PdSr,
MAX i0, Sr- Xr} - C, * MAX {0, Xz- Sr} -P,

Xz, T) = MAX {0, $50- $SS} - $Z.SO + MAX {0, $45 -$50} -$2.00
Xz,'T) = MAX {0,- $5} - $2.S0 + h[A.X {0,-$5} - $2.00
Xz, Ti = .- $2.50 - $?.00
Xz, T) =
Xz, T)
=-
$4.50
The breakeven points for the position are $40.50 and $59.50. The total cost for the two options
is $4.50. The breakeven points are calculated by taking the put option strike minus the combined
option premiurn ($+S * $4.50 = $40.50), and taking the call option strike plus the combined
option premiums ($55 + $4.50 = $59.50). These are shown as the t*'o intersecticns between the
payoff profile and the zero profit
graph for Question 3-8.
.4.s
\ {s_ *ou }
tl;j?i-
Cr(Sr,Xr, T) +Pr(Sr, Xz,T)=MAX{{0, Sr-Xr} -C,*MAX {0, Xu -Sr} -P,

= MAX {0, $40.50-$55} - $2.s0 + MAX t0, $55 - $40.50} - S2.00
= MAX t0, *$5) - $2.50 + MA.X {0, $4.50i - $2.00
=-$2.50+$4.50-$2.00
=$0
= MAX {0, $59.50 - $55i - $e.SO + MAX i0, $55 - $59.50}
= MAX i0, $4.501 - $2.50 + MAX {0, - $4.50} - $2.00
= $4.50 - $2.50 - $2.00
$2.00
=$0
Stock prices, at expiration, that are iower than $40.50 or higher than $59.50 ''.vill produce a gain
for this position.
(See
graph on next page)
Page 39
Derivatives
Graph for Question 3'A
Straddle
25
2Q
'r5
q10
Ev
9o
B-
-5
-10
40 45 50 55
60
Stock Prlce {$}
Graph for Question 3-B
Strangle
25
2A
6
-:15
o
810
ton
a -3
-tu
2A 25 30 35 40 45 50 55 60 65 7A 75
80
Stock Frice {$}
Ii Guideline Answers
Morning Section - Page 10
1999 Level
Page 40
Derivatives
Case Study
- LTCM
In this tutorial, there is a quiz you should complete that accompanies the video which
is shown in the lecture. Also, there are two articles written by different authors
focusing on the events that 1ed to the collapse of Long Term Capital Management.
The demise of LTCM was the largest financial collapse that has occurred in the world
from a private company. LTCM was a hedge fund, gambling heavily on swap spreads
and utilising the principles of the Black-Scholes differential equation to minimise risk
by taking large positions in derivatives around the world. Specifically, this was
accomplished by VAR analysis (Value-At-Risk) and hedging using the Greeks that
we have covered in the lectures to iimit exposure to interest rate movements, time
decay, stock price changes and volatility. Nevertheless, as you will read, it was not
enough to save the company.
Video Quiz
Two offsetting risky positions do what? yv\Ar<4-1".r<aCl"?
Eliminate risk
(otz'q-' g'r<f
rf
'
Academics don't think traders can make money because ....

Stock price behaviour is random - stochastic, follows a random walk
Who was the first person that theoretically showed risk could be eliminated?
Louis Bataleir - actually, I think I'm spelling the name incorrectly - was a
PhD student in early 1900s in France. Itio one took any notice of him
How did Academics in the 1930s design a portfolio to test whether traders could
'beat the market'?
Throw darts on a wall hanging wall street journal pages listing stocks
What was the problem with the option pricing models in the 1950s and 1960s?
Inputs unobservable - like risk aversion
What are the variables required as inputs into the B-S model?
Risk-'(measured by volatilify), intgpst rateo tirne-"io expiry, stocX'price,
exersjre"price '9*\v1
gfiiirimq
'Tte+o_
Kl,trr ve"p t F
"
Who developed continuous time mathematics?
Ito
What was the problem with dynamic hedging?

Too long to calculate, needs updating eontinuously
Page
4l
Derivatives
Which academics founded

Scholes and Merton
what was the second years' return to investment for the hedge fund?
hedge found in the 1990s?
430
What was the name of the hedge fund set up by academics?

Long-Term Capiral Management LTCM
What 2 events led to the collapse of the hedge fund?

Russia defaulting on its debt (1998)
Thai property market collapse, Asian Financial crisis (1997)
What was the total amount of liabilities and monetary assets of the hedge fund in
1
998?
1 trillion dollars liabilitY

3 billion dollars in assets
.
(-
Why did the hedge tund fail?

Over-reliance on mathematical modelling
Unexpected events not accounted for in the model
Stocks did not follow a normal distribution
J..',
rcg*+
pcg-rs^r<=:r*<v"u{ .'^f,- c
nQC f Clvl r.rP;<-els1e_.
y'r\G.
<yc.dg.,
Page 42
Derivatives
Search Ha rvard l.l a g azi n e :
HAffiR*
:.
i*f+F-%_@r
I Ca>rrlr
.rf*+nEB.aE
[I+me ErckIs*us
Books: When Genius

Failed and Inventing
T'h**r*wg*r
e$RnrNT l$3Ue
Money
a
Books. etc.
Risk
Off the Shelf

Chapter & Verse
Ooen Book: A Life in the
Twentieth Centurv
without Reward
When an investment madel melted down
by James K. Glassman
Contents
DEFANTMEHTS
|
.
.
| eH-e..
The Browser
New Enqland Reoional
Edition
.
.
a
.
The Alumni
The Colleqe pumo
Treasure
Crimson Classifieds
On,October 14, 1997,

Robert C. Merton {now
McArthur University
Professor at the Business
and Myron Schotes
-_Schoot)
werb awarded the Nobet
Prize in Economic
Science. They had
devised a method for
pricing options, which are
{inahciat contracts that
were designed to reduce
lltustration by christopher Bing
risk, but that often produced disastrous losses for investors.
on
the day the prize was announced, Roger Lowenstein writes
in
when Genius Failed, "Merton, who was teaching a ctass at
Harvard, got a three-minute ovation from his students. He
humbly warned, however, 'rt's wrong to betieve that you can
etiminate risk just because you can measure it.,,'
That admonition was prophetic. A littte tess than a year later,

Long-Term capitat Management (LTCM), the ftashy Greenwich,
connecticut, firm that both Merton and schotes had joined five
years eartier--putting their options theories into practice--was
hit with losses so severe the Federat Reserve Bank of New york
was forced to ca[ an unprecedented emergency meeting
of
Wat[ Street's top powerbrokers, who ponied up
bittion
53.65
to
prevent a wortdwide financial catastrophe. what went
wrong is
the subject not only of a competting and entertaining book by
Page 43
Derivatives
Lowenstejn, a former reporter for the wall street Journal and

of
author of an excettent biography of warren Buffett, but atso
Dunbar,
the far less accessible lnventine lfionev by Nicholas
who earned a master's in earth and ptanetary sciences at
Harvard and is now a financiat editor in London'
"Finance is often poeticaLty just," writes Lowenstein' "lt
punishes the reckiess with speciaL fervor." That fact makes the
story of LTCM particutarl'y juicy. lt goes like this: Young man
joins
from South Chicago works as caddy, gets graduate degree,
watt Street firm, is pushed out after a scandat, then starts his
own firm, earns bil'tions, gets caught in a market downdraft'
att,
nearly p|'unges wortd economy into chaos, toses practicatly
rebuitds. And there's even a morat'
John Meriwether joined Satomon
Brothers in 1974, an ambitious young
man with a business degree from the
University of Chicago. He eventuatly

became head of the investment banks
arbitrage dePartment, where he
concentrated on making moneY off
smatt anomaties between the prices of
different assets, maintY bonds.
Meriwether became a legend on Wat[
Street and tater starred in Liar's Poker,
the bestsetter by Michaet Lewis that
Robert C. Merton
features him daring Satomon's CEO,
Harvard University
John Gutfreund, to ptay a singte hand
News Office
of poker for $tO mittion. Lowenstein
was never
sees the Lewis story as apocryphat' Meriwether
recktess. He was, 'in fact, the "priest of the catcutated
gambte....cautious to a fautt." He knew he needed an edge to
iucceed in bond trading, and he found one:
Whynothiretraderswhoweresmarter?Traderswhowould
treat markets as an intettectuat disciptine, as opposed to the
folkl,oric, unscientific Neanderthats who traded from their
who
betties. Academia was teeming with nerdy mathematicians
hadbeenpubtishingunintet|'igibledissertationsonmarketsfor
years. ...That would be his edge'
So,
making
in 1983, Meriwether hired Eric Rosenfetd' who was
Business
a year as an assistant professor at the Harvard
530,000
Schoot.HehiredaHarvardcotteagueofRosenfetd.snamed
witriu* Krasker--ptus Gregory Hawkins and Lawrence Hitibrand,
with Ph.D.s from MlT, and others' The strategy worked'
Meriwether'sarbitragegroupbecameimmenselyprofitabte,
In 1989'
and many of the academics became immensety rich'
Page 44
Derivatives
for example, Hilibrand took home 523 mittion. But in 1991,

things fett apart. A bond trader named paul Mozer, who was
working for Meriwether as head of the government-bond desk,
confessed to his boss that he had submitted false bids to the
U.5. Treasury in bond auctions. Neither Aderiwether nor
Gutfreund took Mozer's revelations seriousty enough, and a
scandal ensued that cost alt three their jobs.
But the scandal also presented Meriwether with an
opportunity. The next year, with the hetp of Merri[ Lynch &
company, he began raising more than 51 biltion to start his own
firm, enticing Hilibrand, Rosenfetd, and others to join him. He
even bagged David Mullins, vice chairman of the Federat
Reserve Board and a former professor at Harvard Business
School, and sealed his coup by recruiting two of the biggest
names in financial economics: Merton, who was teaching at
Harvard, and Schates, who had studied at the University of
Chicago under Eugene Fama and Nobet laureate Merton MiU.er
'44, devetopers of the "efficient market hypothesis"--the idea
that prices today are "correct" because they reflect ail known
information and that their movements in the future are
essentially unknown, a "random walk." But, like many
random-watkers, Schotes believed, paradoxicalty, that he could
beat the market.
And, of course, beating the market was the game that
ff :l i:: 11, ::'
W;';.:$T
ce
nt
ra'ie d
exampte, that Ford and General Motors are essentiaLty the

same--in their profitabitity, riskiness, and prospects, Assume
that both earned $2 per share last year. But also assume that
today, Ford's price in the stock market is 5ZO and GM's is S30.
Something is screwy here in the relationship between Ford and
GM. 5o an investor might buy a share of Ford stock and sell
short a share of GM. {ln setl.ing short, you borrow the share
from another investor, setting it immediatel,y for cash and
promising to return the share later. Your hope is that the price
of the share witt falt, so you can buy it back more cheapty.)
With this trade, you expect that the natural, Logicat state of
affairs will soon come to pass--that the prices of Ford and GM
wittWm$fou reatty don't care if the market rises or
fatts--or whether Ford stands still and GM drops, or Ford rises
white GM stands stitt. Att that counts is the convergence--Ford's
price in comparison with GM's.
c.c-rrr.v1Te
(1v'Vc
The fotk at LTCM focused their trades mainly on bonds, which

have a purity that stocks tack. When the computer models
devetoped by the academics signaled an anomaly between
different kinds of bonds, the traders woutd swing into action,
Page 45
rre_
Derivatives
get back to
making bets that the retationship would eventuatty
might
normal__as it usualty did. For instance, the computers
6
yietding
find that a plain-vanilta 10-year Treasury bond was
percent at the same time that a certain sliced-and-diced
"spread"'the
mortgage security was yielding 9 percent' That
modJ *igftt say, 'is too targe: the proper, historicat
points. 5o
retationsliip might be a difference of two percentage
thefirmwoutdspecutatethattheratesontheT-bondwoutd
such
rise and/or the rates on the mortgage security woutd fattarb'itrage plays were not very risky, but, since the spreads
between the prices of ttre bonds were typicatly tiny, LTCM
"w6iitd have to muttipty its bet many, many time3 by
borrowing'i#order to make a tot of money. Such financial
leverage boosts profits, but it atso threatens to boost losses.
of
Moreover, there was a particular danger in this sort
into the
miltion
puts,
say, 51
investing. When a normal investor
stockofacompany,onlytofindthatitisnotmeetingits
manager
earnings projections, or a product has faited, or a key
But
outbaits
is leaving, the investor reatizes the mistake and
LTCMs pitncipats had no mistakes to reaiize. Their computers
recognized a situation of mispricing that would certainly be
corrected. As Lowenstein writes in the very first sentence of
his first chapter: "lf there was one article of faith that John
your
Meriwether discovered at Salomon Brothers, it was to ride
if you have
tosses untit they turned into gains." In other words,
interest
the
enough capitat to stay in the game' to make
your
payments on your borrowings and even to increase
potition, then, in the end, you will win the bet'
Nicho|.asDunbarusesthegamb|'ingexploitsofGiacomo
Casanova in 1754 to expl'ain the phenomenon' Casanova'
ptaying faro (a game simitar to routette) in the casinos of
venice, used a technique cal.led the "martingale." Assume you
are betting on red. Begin with a bet of 51. lf btack comes up
lf you
and you [oie, then doulle the wager to 52 the next time.
bet, with
tose again, doubte the bet again. Finatl.y, on the fifth
paid 516 (and get your
516 aLstake, suppose you win. You are
the preceding four
$16 bet back), and your totat bets over
g8
g2 + g4 +
= 515). 5o you watk away
iounds come'to Sf S-151 +
a 51 winner'
Theat|'ureofthemartingaleasabettingsystemliesin'its
you w'itl wjn:eY'qltually, as long as you have

you
ei,rqueh Eapitit to keep doubting your sta!*e' U-nfortunately'
mlghi;utt go bankrupt before that happgns' For example' in
the untikety event that the 26 btack cards in the pack appeared
gotd
in a row, casanova woutd have needed to stake 67 mittion
coins to win just one.
rul9.1ni$e,,lhat
Page 46
Derivatives
{l am wetl acquainted with the dangers of the martingale

myself, having tried a version of it at roulette in Las Vegas.
Betting on black, I lost eight times in a row. Even though I
began with a bet of just S20, my get-ahead bet the next round
woutd have had to be 55,'120. I fotded.)
it, the "smatl print of martingates" says that you

affiffi.Btf*if e;ifefit cti{yJf yo,u llavd-'unlirnite ita,t. LTCM
As Dunbar puts
had a lot of money: but its resources weren't infinite. In Aprit

1998, after four years of success, the firm's ovrn capital base
totatted 54.9 bittion. In fact, Meriwether decided that LCTr!1
had too much capital and forced his institut'ional investors,
against their vigorous protests, to take back 52.7 bittion. The
timing could not have been worse. Just a few months later,
LCTM was stuck with some shockingty poor trades--hurt
especiatty by the Russian debt default--and Meriwether had to
scramble for cash to hold his positions. But firms tike UBS, the
huge Swiss bank, wh'ich had been begging to become an
investor earlier, now turned him down. In August atone, LTCM
tost 45 percent of its vatue and was bleeding to death at the
;3je of 5500 mitljon a week. One disastrous trade waq$:i'risl{
ffi$tragtl"tbet that the telecommunications company Tellabs
woutd successfutly comptete a takeover of its rival Ciena.
Instead, the deal crumbled, and LTCM tost 5200 mittion. By
September 22, when Wittiam McDonough, president of the New
York Fed, calted together Watt Street's barons (among them:
Dav'id Komansky of Merrill, Jon Corzine of Goldman Sachs,
Thomas Labrecque of Chase Manahattan, James Cayne of Bear
Stearns, and Sandy Weill, who was about to merge his own
empire with Citicorp), LTCM had debt totatling about 5100
bittion with just 5773 mittion of its own equity teft. ln the end,
a bailout was arranged--a fascinating story totd we{t by
Lowenstein and glossed over by Dunbar, whose main interest is
the intricacies of derivatives trading--and a rotling disaster was
averted. Without the extraordinary infusion, LTCM's defautts
coutd easily have caused other institutions to defautt, and on
and on.
:ul6. a/-6'-{@&
The firm's principals saw their own investment in the fund

plummet from 51.8 bittion to 527 miltion. "Larry Hilibrand, the
most cocksure of traders, who had previousty been worth ctose
to hatf a biltion doltars, awoke to discover that he was broke,"
writes Lowenstein. In fact, he was 524 mittion in debt.
Rosenfetd, the former assistant professor at Harvard,
"auctioned off casetoads of the wine cottection he had once so
tovingly assembled." But the partners, while no tonger
superrich, weren't reduced to penury. They kept their homes
and lived to fight another day. In November 1999, JWM
Page 47
Derivatives
Partners {a firm that inctuded Meriwether, Hilibrand,
Rosenfeld,andothersfromLCTM}begancirculatinga
document for "Retative opportunity vatue Fund ll"--where
leveragewouldbekept,itwaspromised,tojustl5toland
fund had
disciptTne wouLd be tighter. within a month, the
"was
running
and
off
raised 5250 mittion, and Meriwether
again,"showingthat,indeed,therearethird'aswettas
second, acts to American lives'
DespiteMeriwether.ssurv.ivat-.andperhapsfuture
prosperity-.theLong.TermCapitatManagementstoryisa
tragedy'Someverysmartandtalentedpeopte,including
Merton and Scholes, gave their time and brainpower to an
more
enterpr.ise that tost bil,tions of doltars and produced little
however,
here,
lesson
than heartache. There is an important
anditisnotsirnptythatthegods,asusual,punishPromethean
hubris.
Afewyearsago,Icametotheconclusionthattherearetwo
many
kinds of investors: outsmarters and partakers. Although
they
outsrnarters acknowtedge the efficiency of the market,
thinktheycanbeatit.Fewcan.one,certainly,isWarren
Buffett, who becarne chief executive officer of Satomon after
the Treasury bond scandat' He wrote in 1988: $@'bserving that
went
the nrarket was frequently efficient, [certain economists]
0rrteconcrudeincorrecttythatthemarketwasa|ways
,gfficient.;Thedifferencebetweenthepropositionsisnightand
to
day..'Yet, but the temptation to try to beat the market h'hs
appty--fdr
r.are{y
Uq tem,p;red with disciptine that outsmarters
**"*pt*,aregimeforcuttinglossesandanaversjontd
to boitow
lever,iggi; ln,rny,financial writing, I tell. investors not
rnoney to invest in the stock market--ever:
Partakersaremerelyalongfortheride.Theybuystocks,
and
especiatly, to share in the success of individual businesses
in generat economic growth. The record here is wonderful:
500
Since 1926 abasket of stocks such as the Standard & Poor's
lndex,hasreturned,includingbothdividendsandprice
appreciation'anannuataverageofl2percent.|maginea
casinowherethehouseadvantageisone.eighthofattthecash
that's bet and where you are the house'
in 1998, the firm
Despite LTCMs fabutous record before its fatt
haddoneontystighttybetterthaninvestorswhohadputtheir
the 5&P
money into pubtii index mutual funds that mimicked
500.AndLong-TermCapitatManagementisnottheonly
high-profiteinvestmentpooltofattonhardtirnes.The
top
ceiebrated George soros.has dismissed three of the
managersofhisrreagefundsafterpoorperformance,and
Page 48
Derivatives
Risk Management Lessons from

Long-Term Capital Management
Ph,ili,ppe Jarion
:
;
I
Current version: Jarma;ry 2000
Prrblisired
itt
European Financial lulanagement 6 (Septeniber 2000): 27740A.
f
F
E
E
This paper has q'on the Besi Paper Award for 2000 in the EFh,{ Journal
*
E
E
E
Thanks are due to Neil Pearson and Neal Stoughton for useful cornments.
E
Correspondence can be addressed to:

E
Philippe Jorion.
Graduate Schocrl of ivlanagement,
Univeasity of California at lrv'ine.
&
Irvine, CA 92697-3125.
(949) 824-52,{5, FAX: (949) 824-8469,
Bmail: pjorion@uci.edu
E
02000 P. 'iorion
EE
E
I
L
Fl
f:t

'r
t_
Page 49
Derivatives
Risk Management Lessons foom

Long-Term Capital Vlanagement
ABSTRACT
The 1gg8 failgre of Long-Te,rm Capitat Nlanagement (LTCN{) is said to have
nearly blown up the world.'s financial system. For such a near-catastrophic event,
the finance profession has precious little inforrnation to drarv from, By piecing
together plhlicly available inforrnation, this paper drarvs risk management lessons
from ITCM.
LTCI\,I's strategies are analyzed. in terms sf the furrd's Vahie ab Risk (VAR)
and the a.molnt of capital necessary to support its risk profile- Tbe paper shows
ihat LTCIv{ had severely underestimated its risk due to its reliance on short[e.rrn ]ristory anrl risk concenfration. LTCI\'I also provides a good exampie of ris]i
rnanagement taken to the extreme. IJsing the same covariance matrix to measru'e
risk and to optirnize positions inevitably leads to biases in the measurelrent of
risk. This approach also induces the strategy to
tal<e positions
that appear to
generate .,arbitrage" profits based on recent history but also tepresent Lrets on
extrerne events, like selling options. Overall, LTCN{'s strategy erylloitecl hhe
intrinsic weal<nesses of its risk marlagelnent system.
JEL Classification Nurnbers: G-11, G-13, G-14, G-23
Page 50
Derivatives
Risk Management Lessons from

Long-Term Capital Managernent
"Had the fathre of LTCII{ triggered, the sei,z'i,ng u,p of markets, substanti,al darnage
could, haue been'infi;icted on lnany market parti,ci,pants, includi,ng sorne not directly
'i.nuolued with the fir"m, and coukL haue potenti,ally impai,red, the economi,es of ma,nu
nat'ions, i,ncluding aur oulrl."
Chairman Alan Greenspan (1993)
The 1998 failure of Long-Term Capital fuIanagement (LTCL,,I) is said to have nearly blou'n
up the rvorld's fi.nancial systenr. Indeed the ftind's woes threatened to create major losses for
its \4rall Street lenders. LTCM rvas so big that the Federai Reserve Bank of New York took
the unprececlented step to tacilitate a bailout of the private hedge fund, out of fear that a
forced liquidation might ravage world markets.
For such a near-catastrophic event, the finance profession has precious little information
to draw lessons from this failure. No doubt this is due to the secrecy of the hedge ftrnd,
which never revealed information about its positions, even to its own investors.
As LTCNI is now in the process of rehabilitating itself, it is slowly disclosing infolmation
about its risk management practices. By piecing together publicly ar-ailable informatiorr,
this paper attempts to draw lessons from the LTC\'I failure.r
This issue is important as LTCN'I's failure has been widely ascribed to its use of Value
at Risk (VAR).2 If so, the disturbing implication is that the statistical risk-management
methods spreading throughout ti:e finar:cial industry are rvoefully inadequate.
This paper ls sfructtred a.s follows. Section 1 first presents an over:view of the LTCIvI
saga. As the funcl was highly leveraged, the key issue was the choice of the appropriate
capital base. LTCM failed because it dJd not have enough equity capital to ride out the
tru'bulence of 1998. Section 2 rer.iews how Vaiue at Risk can be used to asse.ss the capital
base needed to support a leveraged portfolio. Tiris leads into the risk rnanageilent practices
of LTC\,,I, rvhich are analyzed in Section 3. In effect, LTCNI r.ised the tools of portfolio
optimization to structrue its portfolio, leveraging it by a factor of 25 to bake advantage of
so-called "arbitrage" trades.
This application, however, is ftaught with danger. VAR has been primarily cleveiopecl to
measure and control risks. Optimizing a portfolio risk/return profile and using the reisulting
lThis paper expands oil press reporNs based on inter*views ancl preserrtations of the principals that appearecl
in tlre W(\II Strcet Jownal, the Neu York Times, und Deri.âtiues Strvtegy (1999). The first systematic Leview
of LifClr,f's dorvnfali rvas by Dunbar (fgg8).
zSee for irxtance Llrc Econornzisl,
Nor.ember 14, tggS "Rislr N{anagement: Too Clevel by Half."
Page 51
Derivatives
P.Jorjon-Rj
sk Managentent Lessons from WCM
\AR to measure rish leacls to serious optimization
biases, which are illustrated
in section 4'
LTCIvI was singularly unidirectionai'

Section 5 also shows that the nature of the bets taken by
Finaliy, the last section plovides some concluding comments"
How LTCM Lost its CaPital

to etpect sw'ings as h'i'gh as
"So,,rces say Lang Temn' Capital has wamted' inuestors
B0% and, as lou as -2A% i'n a g'iuen year'"
Business Wbek, AugusL 29, 1994
can be traced to a highly profThe seeds of Long-Term capital l\'Ianagement (LTCM)

by John luerirvether'3 I'TCM was
itatrle bond.-arbitrage grollp at salomon Brothers ran
1991 salomon bond scandal'a
found.ed by i\,Ieriwether in 1994, who left after the
wlto had been part of
Ivleriwether took with him a grolrp of traders and acarlenrics,
of dollals in profits' Together,
Salomon,s bond-arbitrage group that had racked up billions
had been using at salomon"
they set 1p a ',hedge" fund using simila.r principles to those they
lirnited partnership, operated
F.ormally, Loug-Term Capital Nlanagement L.P., a Delarvare
organizecl as a cayman
the fund, Long-Texm capital Portfolio L.P. (LTCP), which wa's
Island partnershiP'
that can take long ancl short
A, hed,ge fund is a private investment partnership fund
invesbors' As sudt, hedge funcls
posiLions irr rario*s rnarkets ancl is accessible only bo large
is sornervhat of a urisnorrrel' if
are not regulated by the SEC. Of coul'se, the term "hedge"
and can be quite risky'
not rnisleacling, since these investment vehicles are le'i''eraged
The core strategy of LTclr,l czur be described as "reiative-valtte", ol- "convergence'
prices alllong closely reiated
arbitrage' trades, trying to take advantage of small differences in
yielclilg 6'1% versus 6'0%
securities. Compare, for instance, an off-the-run Tteaslrry bold
some compensation for
for the more recently issued on-the-rtur. The yield spread represents
a,ncl short Nhe on-the-nrn
liquidii,y risk. over a year, a tra<le that is long the off-the-nrn
invesfed. The key is that eventually the
woulcl be expectecl to retuni 10bp for every clollar
strategy was usecl in a varieby of rnarkets'
two bond.s rmrst converge to bhe same value. This
vivic.ilydescrilleclirrzr.color{tlldescriptionofWa1lStr.eet,tr'jar's
Poker, by lr{ichael Lervis'
t'corner" the primary

apaul \{oze.-, a Sal'mon boncl trader who reportecl to il"lerirvetlrer,. had tried to
Bank
excess of the firrr's limit' \\rhen the Feclelal Reserve
Trea.sur.y auction mo.k"i by submittirrg t'idsin
from
ban
salomon
to
threatelred
it
infraction,
the
of
learned that it had not been adequately informed
started
Investors
to a 'tun" on saloctou'
pariicipating in the primary T,'.*,r.y rnarket-.These nervs led
with
$150 biltion in assets financed by only $4
leveragerl,
rvas
highly
Salomr:n
As
dcbt.
firn,s
to dunrp the
After Salomon's top management
doubt'
rvas
in
survival
n'ery
frlff*,r Jt equity and $16 billion of ciebt, its
allowing Salofrort to survive the
rer''ersed,
was
tire
ban
chairma.rr,
as
over
took
resigned and Warren Buffett
to srrpe|r'ise traclers properly'
failecl
he
that
crisis. Nleriwether was fined $b0,000 by the sEC anrid allegations
Page 52
Derivatives
P.Jorion-Risk Manaeemenf .Lessons ftom LTCM
lorrg swap-government spreads, long mortgage-backed securities \rsLls short gol-ernment,

long high-yieiding verslls short lorv-yielding European bonds, Japanese convertible boncl ar-
bitrage, equity pairs (stocks with different share classes) and so on. The firm also clabbled in
non-arbitrage strategies, such as short positions in equity options, bets on takeover stocks,
emerging market debt, and even catastiophe bonds.s Most of the time, these trades shoulcl
be profitable-barring default or market disruption.
The problem with such strategies is that they generate tiny profits, so that.leverage has
to be used to create attractir.e returns. To controi risk, the target ceiling risk level rvas set
to the volatility of an unleweraged position in {J.S. equities (and t}re fund rvas eiclvertizecl to
investors a; such). In essence, positions wele obtained by an optimization with a constraint
on volatiJity (rvith presrrmably some additional constraints such as the liqrridity ancl concen-
tration of positions). Thrrs, leverage had to be quite large, umrsually so, as LTCI\{ enclecl 1p
with four times the asset size of the next largest hedge fund.
Initially, the new ventute was erninently profitabie. Capital grew from $1 billion to more
t'han $7 billion by 199?. The firm was charging lofty fees consisting of an annual charge of
2% of capital plus 25% of profi.ts. By comparison, other hedge funds charge a 1% fixecl fee
and 20Yo of profits; the typical mutua.l fund fee is about t.4l%. By lgg7, total fees haci
grown to about $t.5 billion. LTCM's 16 partners had ir:r,'ested roughly $1.g billiol of their
own morley in the fund.
&'Iuch has been said aborrt LTCNI's positions in the press. LTCi\,I's balance sheet rvas
abont $125 billion. This represents the total ussets of the fund, rnost of it borrowecl.6 Cornpared to equity of about $5 billion only, this represents an txtonishing leverage ratir; of
25-bo-1.
Even more astonishing rvas the off-balance-sheet position, including swaps, options, anci
other deri"'atives, that added up to a notional pri,nci,pal amount of $1.2b trillion.T N{any of
these trades, ho'wever, r.vere Oft'setting each other, so
that this notiorral arnount is r;racticallv

rva^s the total risk of the funcl.
LTCNI was able to leverage its balance sheet through sale-repnrchase ;r,greements (repos)
n'ith commercial aurd investrnent banks. Under "r'epo" agreements, the frind solcl some of its
assets in exchange {or cash and a promise to repurc}rase them track at a flxed price on sor}e
future date. Normaliy, brokers reqrrire collaterai thal; is worth slightly more than the cash
mean\ngless. \Mrnt rnattered
5
Instdtutional ht ue.stor. Deceruber 1998.
oAccording to the President's \['orking
Group report (1999), t]re fund liacl 60,000 tracies on its [:ooks.
?As of December 1997,
total swap positions amounted to $697 billion, futures to $471 billion, with options
and other O'IC derivative"s accounting for the rest. To give an idea of the size of these positio.*s, the BIS
reports a total srvap market of $29 trillion on the sane date. Hence, LTCN.{'s srvap positions accounted for
2.4% of. the global srvap market. The fulures positions accounte<l for 6Vo of the $7.8 trillio' total. Orilv six
banks had a notional derivati'r..es atnoLurt above $1 trillion at the time.
Page 53
Derivatives
P.Jodon-Risk Mattag:ement Lessons from I'TCM
to provid'e a bufier against decreases in the

icaned. bv an amount known as a haircut, clesigned
unusually good financing conditions'

coilaieral value.E LTCIvi, howevet, rvas able to obtain
by its lenders' This must have
rvitlr next-t o-zero haircuts, as it was widely viewed as "safe"
picture of the extent of LTcNI's
been clue bo bhe fact that no countelpady had a complete
operations.
that their crrrrent

The srvaps were subject to tivo-way marking-to-market, which mealls
these loans were
market vaiue was always close to zero. But even rvhen "fully collateralized",
same time as tire collaterai lost vahre'
exposed to the risk that, LTCM coutd default at the
default' In any
\\iall Street thrrs seerns to have ignored lis potenti'al etposure to an LTclvI
positions with term financing (e'g' six
event, tjTClvI was able to protect its shorFterm Iepo
LTC\'I also securecl a $900 million
montirs) fi.om wall street that carried no initial margin.
credit line from Chase ivianhattan and other banks'e
iiquidity squeeze' LTCIVI
on the a-sset side, LTCN,{ was also "bulletproofing" against a
in the fund for a minimum of three yeam'
had initialiy required investors to keep their motrey
in the hedge fund industry'
The purpose of this "lockup" clause, rvhicir was very unusual
LTCM also secured
was to avoid forced saies in case of poor performance.l0
with after'-fees retulns
This strategy workecl excellently for LTCM in 1995 and 1996,
piaced large bets on conveLgence of Elropean
abo.,.e 40%, trs shorn'n in Figrge 1.11 The flrrd
paid off handsomely' Convergence
interest rates wibirin the European L.{onetary system that
catrre i'to being ou January 1st'
had occrurecl i' Eruope, a-s the common Curlency' the Euro,
substantially.
1gg9.12 By 1997, ilrost spreacls had narrowed
since 1986-13 As the figure indicates'
Figur.e 2 shows the evolution of reler.ant yield spreads
since 1986 and considerably lo$'er
credit spreads were almost as narrorv as they had ever been
t'hat convelgence trades had
than bhe average over the periocl 1986-93. But this also meant
reLTCN1faltere<l,|herewerenohaircutson.Irea^suries;haircuts
market debt, 10%' Tbe total hair-cut for LTcM's

for nortgage-backecl .""rrritiu* rvele 3%; for dollar emerging
only $500 million.
$110 billjon in borrowing rvas reported to be around
repaid
sNew york Ti*nr, O".tob", 23, 1ggg. LTC\.,I usea $iOO niillion from ttrat creclit line, rvhich wns
rr,lth the proceeds from the rescue funds'

roThis risk is very .eal for liedge funds. Incieed, sixty pcrcent of iredge firnds
<1o
not survir''c three years
because iuvestots remo\ie their funds'

lrReturns are derivcd ftom Wall Street Jovnt'alreports'
political rea-sons, which

l?Note that there rvas a probability that the common curreilcy woulcl ilot occur for
the t.re risks of t'he
represent
not
rtid
ih" hirtori"aldata
rvould have made rhese trades *'pr-ofitable. So,
As
eiiminated in Europe' risk has not totally disappeared'
strategy. E.r"r. ,row, a" .*r"rl.y ,i"Lh* bee[
defauit
of
risk
the
i" ti,r*tr". their cleficit by printing rnoney'
Er-rr.opean governrnents ]r.-r,ve losi theiL ability
partially into credit lisl<, rvhich is in fact harcler to
transformed
been
hn"s
iras incr.eased. Thus cur..reilcy risk
uttfitru
maturity l0-yea'r yields, \''Ioody's

the
JP lvlorgan go'ernueilt l:oud
from
are
yielcls
BAA yielcis, and fixeJ mortgage yielcls. The non-dollar
u.s. bond series are takeir from the Fecleral
Reserve's constant
indices.
Page 54
Derivatives
P.
Jorion-R isk
N{ anagement Lesso rrc
become less profitable.
In
frorn Lll CM
1997, the fund's
retrirn was down to 17% only.
FIGURE 1 LTCiVI's Returns

60%
(percent, after lees)
--l
I
401"
20%
I
-l
0%
oi
-20"/o
I
I
I
-40%
ffiLTGM
fund
i
I
I
-607"
-8 0olo
.100%
FIGURE 2 Bond Yield Spreads

3.s
LTCM starts operations
----}I
l-3
I
2
;\i
'.
t-3
1
I
U,5
yield spread (left scale)

i
-BAA-Treasury
MBs-Treasury yield spread (left scale)
I
-- - - Italian-German yield spread (right scale)
I
86
87
88
89 90
91
92
93
94
95
96
97
98
This performance, in fact, was below that of U.S. stocks rvhich gained 33%. The leverage
of the frrnd had also decreased from 25 to 18 drre to the asset growth. To achieve the 210%
Leturns it had become accnstomed to, the firm had to assurne greater leverage.
Page 55
Derivatives
P.Jorion-Risk Managernent Lessons from
mCM
billion of capitai to investors in 1997 while keeping total assets

at $130 billion, expiaining that "invesbment opportunities were not large and attractive
enough.,' By s6rinking the capital base to $+.7 billion, the levelage ratio went bacl< up to
2g, ampiifying retrrns to investors that rernained in the fund, as shown in Figure 3- Sorne
investors who were forced out rvere reported to be ripset that the partners did not reduce
So, UICi\.I returned $2.7
their own equity.
FIGURE 3 LTCM Leverage and Asset Growth

Assets ($b
60 +ve:as+
ec-94
ec-95
ec-96
ec-97
Unfortunately this also increased. the risks. TYoubles began in N'Iay and June of i998'
A downtlrn in the rnortgage-backed securities ma,r'ket led to a 16 percent loss in LTC\'l's
capital, which dropped from $4.7 to $4.0 billion, thereby increasing leverage from 28 to 31.
Then came August 17. Russia announced that its was "testtuctutitrg" its bond
payrnents-de facto defaulting on its <tebt. This bombshell led to a reassassment of credit
and sovereign risks across all financial markets. Credit spreads, risk prenila, anci liqtridity
on Arrgust 21
spreads j*mped up sharply. Stock markets dived. LTCN'I lost $550 rnillion
basis 1:oint's evely
alone. swap spreacls, rvhich usuaily ltevel mor,ed by tlore than a couple of
had rnovcd b1' 2i basis poirrts.
By August, the funci iracl iost 52% of its December 31 value. With assets stili at $126
biilion, tire leverage ratio had increasecl frorn 28 to 55-to-1. LTCNI badl;' neecled new capital'
In his September 2 lebter to investors, N,Ieriwether revealed the extenb of the losses and rvrote
lhat, ',Since it i,s pru,d,ent to ra,ise additional ca,pi,tal, th,e Fund i,s offering you the opporht'n,i,ty
da1,,
Page 56
Derivatives
P.Jorion-Risk Management -Lessons ftom WCIvt
to inuest on speci'al terms related, to LTCM fees. If you haae an ,interest ,in inaesting, please
contact... " There were no takers, though.
The portfolio's losses acceleratecl. On September' 21, the fuld lost alother
$b50 million,
mostly due to increased volatility in equity malkets. Bear Stear-ns, LTCi\4,s prime
broker,
faced a large margin call frorn a losing LTCfuI T-bond futures position.la
It ilren requireci
increased collateral, which depleted the funds's iiquid resources.
Counterparties feared that
LTCIVI could not meet further margin cails, in which case they would
har,'e to liq'idate their
repo collateral.
A liquidation of the fund would have forced dealers to sell off tens of billions of dollars
of
securities and to cover their numerolls derivatives trades with LTCNI. Because
lenders hacl
reqrdred next-to-zero haircuts, there was a potential for losses to accrue while
the collateral
rvas being liquidated. In addition, as the fund was orgarrized in the Cayman
Isiancts, there nas
uncertainty as to whether the lenders could have been allowecl to liquiclate their coliateral.
In contrast; such liqlridation is explicitly allowed under the U.S. Bankruptcy Code. As it
q"as beiieved that the fund could have sougbt
bankruptcy protection lnder Cayman law,
LTCM's lenders could have beeu exposed to major losses on their. collateral.
One of the
policy recommendations of the Fresident's Working Group report (1ggg)
was to clear up
this uncertainty.
The potential effect on financial markets *,as such that. the New york
Fecleral Resen e
felt compelled to act. On Septernber 23, it organized a bailout of LifCM, encouraging

14
banks to invest $3.6 billion in return for a g0 percent stake in the firm.
These fresh funds came just in time to avoici melLdor,vn. By September 28,
the f1nrl,s
valtte had clropped io $400 million only. If Arrgust x,as bad, September
rvas even
'vorse,
r.vitlr a loss of 83%. Inr,'estors had lost a r,,.,hopping g2% of their year_to_clate
investment. Of
the S4.4 billion lost, $1.9 billion belongecl to the partners, $700 millio' to {Jnio'
Bank of
Srvitzerland, and $1-8 billion 1;o other investors. orit of the $4.4 biilion
lost, a goocl $B billio'
came from the trvo main type.s of bets, interest rate swaps ancJ eqpity
volatility.ls
LTCM is no'w operating undel the control of the 14-member consortium, formally
hnown
as Oversight Partlers I LLC. Helpecl try recovering financial markets, the portfolio
gailecl
13% to Decerrber 1998. The portfolio was llnwolrnd over the following months.
By the enci
of 1999, all of the ruolrey had been p:ricl back to investors ancl John \,Ieriwether haci sbartecl
a ne$/ hedge fund.
prime broker provirles centralized custodial, clearing, record-keeping,
and financing for tire heclge f'ncl.

]'],4'
ssee
Lewis (1999). He reports that LTCN'I had sold 3--Co 4-year u.3. uria Europ*an
Ju*, opbiols ar the
<"ncl of 1997, q'hen rolatility stood at 20 percent. LTCIVI *ou
ol-o lcporiecl to ha,r'e voiatility positions o. thc
CAC 40 Frencir stock index that correspoucled to 30 percent of the open interest
(New york Tirues, Oct 23,
1998).
Page 57
Derivatives
forward and futures

What are the similarities and differences between
1.
contracts?
Major Differences:
Forward markets have default risk
Forward contracts are non-standardised'
Major Similarities:
Contractsondeliveryofgoodsatspecifiedpriceinfuturepointintime
House in a futures exchange'

Explain the function and role of the clearing
Intermediary between buyer and seller
Eliminate default risk
Record lvho own what contracts
Manage margin accounts
2.
and why are they used?

What are daily price limits and circuit breakers,
J.
Dailypricetimitslimitfuturespricemovementsonadailybasis-usedto
helps the cII make
It also
control markets experiencing excess votatility'
the day are not too large'
sure variation mariins at the end of
4.
the trading day that lead to

Circuit Breakers are Price movements during
swept away by bullish/bearish
trading halts, so that the market is not
short-term sentiment'
can be terminated. List and
There are three ways in which futures contracts
explain each method'
Offsetting Trade
Cash Settlement - for financial futures
DeliverY - for non-financials
Derivatives
5.
In futures trading, the minimum level to which an equity position may fall
before requiring additional margin is the:
A: initial margin.
B: variation margin.
C: cash flow margin.
D: maintenance margin.
Source: 2002 CFA Level 1 sample exam
6.
A silver
futures contract requires the seller to deliver 5,000 Troy ounces of

silver. An investor sells one July silver futures contract at a price of $8 per
ounce, posting a 82,025 initial margin. If the required maintenance margin is
$1,500, the price per ounce at which the investor would first receive a
maintenance margin call is closest to' $2025 - X: $1500
A: $5.92.
B: $7.89.
C: $8.11.
D: $10.80.
X: 5525
$525 / 5000 ounces: $0.105 or $0.1

$8 + $0.1 I $8.1 I per ounce
A seller loses when the orice rises
Source: 2002 CFALevel
7.
per ounce
1 samole exam
When comparing futures and forward contracts, it has been said that futures
are more liquid but forwards are more flexible. Explain what this statement
means and comment on how differences in contract liquidity and design
flexibility might influence an investor's preference in choosing one instrument
over the other.
It is generally true that
futures contracts are traded on exchanges

whereas forward contracts are done directly with a financial institution.
Consequentlyo there is a liquid market for most exchange traded futures
whereas there is no guarantee of closing out a forward position quickly or
cheaply. The liquidity of futures comes at a priceo though. Because the
futures contracts are exchange traded, they are standardized with set
delivery dates and contract sizes.
If
;i
having a delivery date or contract size that is not easily accommodated

by exchange traded contracts is important to a future/forward end user
then the forward may be more appealing. If liquidity is an important
factor then the user may prefer the futures contract.
Another consideration is the mark-to-market property of futures. If a
firm is hedging an exposure that is not marked-to-marketo it may prefer
to not have any intervening cash flowso hence it will prefer forwards.
Page 59
Derivatives
We have futures contracts on Treasury bonds, but we do not have futures

contracts on individual corporate bonds. We have cattle and hog futures but no
chicken futures. Explain why the market has developed in this manner. What
do you think are the most important characteristics for the success of a new
8.
futures contract concept?
There are many different reasons some futures contracts succeed and
some fail, but the most important is demand. If people need a particular
contract to expose themselves to or hedge a price risk, then the contract
will succeed. Most people use Treasury bond futures to gain exposure to
or hedge general long-term interest rate risk. The only additional
advantage of futures on corporate bonds would be that the investors
could gain exposure to changes in the credit spread. Apparently there is
little demand for this, either because investors do not want to hedge or
gain exposure to this risk or because the underlying market is not liquid
enough to support futures. Either way, the lack of futures is motivated by
a lack of demand in the asset or futures contract. The lack of chicken
contracts most likely derives from a similar lack of demand. It could be
that chicken prices are highly correlated with other existing contract
priceso so investors do not need the additional chicken contract. Perhaps
there are too many different types of chickens to have a single contract
that would attract enough trading volume.
9.
You own an equally weighted portfolio of 50 different stocks worth about

$5,000,000. The stocks are from several different industries, and the portfolio
is reasonably well diversified. Which do you think would provide you with the
best overall hedge: a single position in an index futures or 50 different
positions in futures contracts on the individual stocks? What are the most
important factors to consider in making this decision?
is most tikely that a singte position in an index futures market would be
the best hedge. There are several reasons for this. The most important is
cost. Since there are no exchange traded futures for individual stocks,
entering 50 different positions would have to be done through an over-
It
the-counter derivative dealer. This typicatly would mean higher

transaction costs to cover the fees from setting up the one-off deal, the
lower liquidity of individual stocks, and the increased commissions for the
dealer. Another disadvantage is the liquidity of the position. Index options
are very liquid and can be closed out quickly with little trading cost.
Closing the 50 different positions would entail paying many of the startup costs twice. Finally, it is easy to short an index future but rather hard
and more expensive to short the underlying stocks which the OTC dealer
would have to do to hedge the position in the 50 different stocks. The only
advantage to the 50 different positions is that they would provide a nearly
perfect hedge, whereas there would be some basis risk in the index futures
position. Since the portfolio is well diversified, this should not be a major
problem.
Derivatiyes
10.
CFA Examination Level III

The Franklin Medical Research Foundation is to be established
with a gift
from Mr. John Franklin in memory of his deceased wife. The foundation,s
grant-making_ and investment policy issues have been
finalized. n""rtpt of the
expected $45 million Franklin cash gift will not occur for
90 days, yet the
committee believes current stock and bond prices are unusu
ally
attiactrve and
wishes to take advantage of this perceived opporrunity. tgr;t{dy1^
a' Briefly describe two strategies that utiliii derivative fi;"ialT;truments
and could be implemented to take advantage of the
committee,s market
expectations.
b' Evaluate whether or not it is appropriate for the foundation to undertake
a
derivatives-based hedge to bridge
expected
90-day
time
gap,
_th"
considering both positive and negative factors.
CFA Examination III (1993)

(a).Derivatives can be used in an attempt to bridge the
90-day time gap in
the following three ways:
r*rtttSlt -? tt\na.tft d-eutrer.ctg-
La-Ct- tr,.nttrr_.-Jtr:ptL\es{.egA=
(1) The foundation could buv Qong) ."ilr on an equiiv indei
s&P 500 Index and on Treasury bonds, noteso or bills. This straregy Fo rcrr*ter\.
the foundation to make an immediate cash outlay for the
:_"_19,1:luire
"premiums" on the calls. If the foundation were to buy
calls on tire entire
$45 million, the cost of these calls could be substantial, particularly
if
their strike prices were close to current stock and bond p.i*.,
(i.e., the
calls were close to being..in the money"). tfOi*_tgr-
i.n1.:1:
6everr1furn oUcl-{g
ilF,;#,ffiF'*qh*l#,"eYt
'*Ef'1,rffffi"ffi;m
-vor
writing
on Treasury bondso notes,
bilrs. By
puts, the foundation ;;il
receive an immediate cash inflow equal to m. 66premiums,
on the puts
(less brokerage commissions). rf stock and bond prices
rise as the
committee expects, the puts would expire worthless,
and the foundation Lpsry
w_ould keep the premiums, thus hedging part
or a[ of the market incr
If the prices falt, howev"., th. foundation lqses the difference b.*.JAt;
= *H**
strike price and the current market price, Iess the value
of the pr.*i,rfr'." rn-lXr,,ryl
)?
-? dtL.f
= prelu,tsarn_1a6iii&-'?A
(3). The foundation could buy Gdng) equity and fixed-income
futures.
This is probably the most practical way ror the foundation
to rreoge its
expected gift. Futures are available on the s&p 500
Index uol o,
Treasury bonds, notes, and bills. No cash outlay would be required.
Instead, the foundation could use some of its current portfolio
as a good
faith deposit or "margin' to take the long positions. The market value of
the futures contracts will in general, mirior changes in the underlying
market values of the s&p 500 rndex and rreasuries. Although
no
immediate cash outlay is required, any gains (losses)
in the value of the
contracts will be added (subtracted) from the margin
deposit daily.
Hence, if markets advance as the committee expects,
the balances in the
foundation's futures account should reflect the market increase.
-'[i
C*;J=_
B"-rt\sk,-2 torl3t>n frafi-r,rc.l -2 !a^V (or,J reelJ. hQ3t

l
\et*e-l,
Vrx+ n'âcqdrl ./t=?s,u\r,h e,n+-s: \.F v.".a,tref e.Ufg "
Page 61
a
Derivatives
There are both positive and negative factors to be considered in

gift'
il.agittg the 90-day g"p b.fot. the expected receipt of the Franklin
(b).
Positive factors
fh4fb-'F
Fq.fi
@Eatron
;,qqvrttnefiL
pdui ffOY\'
to.-tl
(1). The foundation could establish itq pgpition in stock and bond markets
derivatives toda-v, and benefit in any subsequent increase$ - in
"ri"g
in the 90 day
m,r[*t values in the S3.p lnOex and Treasury instruments
p"tioa. In effect, the foundation would have a $lthettc position in those
markets beginning todaY.
(2).The..eostofestablishingthes5'ntheticpositionisrelativelylow'
cost is
aepenaing oo th. derivative strategy u sed. If calls are used, the
the
on
losses
the
timited to ttre premiums p aid. If futures are used,
cq}l
lost if the
futures contracts would be similar to the amounts that would be
strategy
riskiest
the
puts
is
foundation invested the gift today. Wfit-tng the
but here again
because there is an open--ended loss if the markel flsglines'
and stock and
the losses would be similar if the foundation invested today
bond markets declined.
.l|frafq.,1
^vT)a,frJQ1"44
@,\Padtw
tf,r,
Vu.lo1bq
7ar!-tue4s.
4sif.r{
-ttrcl.htCp-
1S;. D&siVatlve
markets sor the types of contracts under consideration
herg}4re liquid.
Negative factors
(1). The Franklin gift could be delayed or not received at all. This would
its
create a situation-in which the foundation would have to unwind
on market movements in
fosition and could experience losses, depending
.aF Fos;Jfon
ihe onderlying assets. p,ffig1r.
ffi
aF
e+rl*.-q1t.
"316;trg!^
bond
and
stock
that
(2). The committee might be wrong in its expectation
,s,Eeec-r*a*uryif :Ti":#HTffi
lose part or all of the premium on the calls and have
would TJT"iil',:hTJ,il1i"J,lfriH:::1"."ffi*1"#;
YTIO?
r4.($<tLt2e/r) in" foundation
of loss of
es< 4
-(os*4
&fri'&4l,
\\nnt{t
t
Y\t-eat\rsoflt
?@Jt*
nn
futures contiacts and the"puts wriffen. The risk
the firfirres
on fhe
capital is a serious concern. (Given that the current investment is
p.i*orily bonds and cash, the foundation may not be knowledgeable
enough to forecast stock prices over the next 90 days')
,ôooo
losses
L/.jrtt\re,*.
(3). Because there is a limited choice of option and futures derivative

wish to
contract compared to the universe that the committee might
a1o
invest in, there could be a mismatch between the specific 9-t1i-tie1
size
in
available
bonds the foundation wishes to invest in and the contracts
i;r-izi"rilion. unless the 90-day period exactly matches thea 90-day
period before expiration dates on the contracts, there may be timing
c laqld"-A- fa vtebln
cd r*{@O.F Eeer
nrismatch
tt " {a3r\e
potentially high. For example, if the
"
(4). The cost of the deriilfives is

market in general shares the committee's optimistic outlook, the
premiums pu-id for. calls would be expensive and the premiums received
on puts would be lean. The opportunity cost on all derivative strategies
bnth-tn'\o
ci-tlg Q oq* pc-rB
a
=
Derivatives
discussed would be large
or both markets.
if the commiffee is wrong on the outlook for one
(5). There may exist regulatory restrictions on the use of derivatives bv

endowment funds.
,\ d(9$nf\ei^d
t(\.q \t4cp()/d\,qt\Fltz
Evaluation
The negative factors appear to outweigh the positive factors if the ougook
for the qrarket is neutrall therefore, the committee's decision on using
derivatives to bridge the gap for 90 days will have to be related to the
strength of its conviction that stock and bond prices will rise in that
period. The certainty of receiving the gift in 90 days is also a factor. The
committee should certainly beware that there is a cost to establish the
derivative positions, especially if its expectations do not work out. The
committee *igttt want to consider a partial hedge of the $45 million.
cerhairrr'\S if <e+ r"Fs eeeJq_ft\;S: @aê*{qtvo&ti p4r@sts <'R eeFqrcr_tsr/L,\n1 pJ;hlCng,7

-J \
11. CFA Examination Level II
\rtoqr.l
Robert Chen, CFA, is reviewing the characteristics of derivative securities and

their use in portfolios. Chen is considering the addition of either a short
position in stock index futures or a long position in stock index options to an
existing well-diversified portfolio of equity securities. Contrast the way in
which each of these two alternatives would affect the risk and return of the
resulting combined portfolios.
CFA Examination II (1991)

Because Chen is considering adding either short index futures
or long
index options (a form of protective put) to an existing well-diversified

equity portfolio, he evidently intends to create a hedged position for the
existing portfolio. Both the short futures and the long options positions
will reduce the risk of the resulting combined portfolios, but in different
ways.
Assuming that the short futures contract is perfectly negatively correlated

with the existing equity portfolio, and that the size of the futures position
is sufficient to hedge the risk of the entire equity portfolio, any movement
up or down in the level of stock market prices will result in offsetting
gains and losses in the combined portfolio's two segments (the equity
portfolio itself and the short futures position). Thus, Chen is effectively
removing the portfolio from exposure to market movements by
eliminating all systematic (market) risk (unsystematic (specific) risk has
already been minimized because the equity portfolio is a well-diversified
one). Once the equity portfolio has been perfectly hedgedo no risk
remains, and Chen can expect to receive the risk-free rate of return on the
combined portfolio. If the hedge is less than perfect, some risk and some
potential for return beyond the risk-free rate are present, but only in
proportion to the completeness of the hedge.
lf
on the other hand, Chen hedges the portfolio by purchasing stock index
puts, he will be placing a floor price on the equify portfolio. If the market
declines and the index value drops below the strike price of the puts, the
Page 63
Derivatives
portfolio'
value of the puts increases, offsetting the loss in-the equity
put options will
conversely, if the stock market rises, the value of the
decline,andtheymayexpireworthlesslhowever,thepotentialreturnto
by the cost of-the
the combined portforio i. unlimited and reduced only
puts.Aswiththeshortfutures,ifthelongoptionshedgeislessthan
proportion to
in
perfect, downside risk remains in the combined portfolio
the amount not covered bY the Puts'
Insummary,eithershortfuturesorlongoptions_(puts)canbeusedto
options (put)
reduce or eliminate risk in the equlty portfolio. Use of the
realized (less
strategy, however, permits unlimiied potential returns to be
effectively
the cost of the options) while use of the short futures strategy
potential r-eturns
guarantees the iisk-free rate but reduces or eliminates
each offers a
above that level. Neither strategy dominates the other;
Arbitrage
different risk/return profile aoo involves different costs'
ensuresthat,onarisk-adiustedbasisrneitherapproachissuperior'
t2.
what priority basis?

How are orders entered into SYCOM matched? under
matchedby price
Electronically entered by registered traders. Orders are
and then time PrioritY,
13.
What is SPAN margining and how does it generally function?

measures
SPAN stands for standard portfolio analysis of risk and
under 12
potential loss over a one day period with 997o confidence
from
obtained
risk
different risk scenarios. The scanning risk (highest
margin for a futures
these scenarios) is then used to determine the initial
contract Position.
14.
what is the difference between full and local participants on the
SFE?
themselves' They
financial backing
are required to have an AFSL. They also require more
to list as a full member.
FULL participants can trade for other clients as well
15.
as
what legal documentation exists for oTc futures/forwards?
have a "Master
The International Swaps and Derivatives Association
of the world to utilised
Agreement,, that is the accepted standard in most
*L.o
signing an OTC forward contract'
Prge 64
Derivatives
Topic I Activities
1. '
What is the value of a futures contract at the time of purchase? Why is it this
value? How does this differ from the value of the spot price?
The value is zero. After purchasing it, and apart from a small initial +
maintenance margino the contract requires no initial outlay. If you tried
to sell it before the price of the contract has changed you would receive
nothing for it. Therefore it has no value. However, with the spot market,
purchasing the spot entitles you to the good/service, which has value and
can be re-sold to earn money.
2.
When and under what conditions
will forward and futures
contracts be
identical in price.
r
o
o
o
'iir.
At expiration
One day prior to expiration - marked to market has no effect
At any time if interest rates are constant
At any time if interest rates move in a known manner
(The above two are due to the fact that it eliminates the uncertainty of
marking to market)
If interest rates and futures prices are uncorrelated - no benefit/loss in
the long run exists from marking-to-market.
3.
You find out today that high-grade crude oil has a spot price of $5.5 per barrel
and the corresponding futures contract price is $6.6 with an expiration date in
three months time. If you know there is no risk premium in the futures
market, why is the futures price higher than the spot price?
The futures price represents market expectations that the price of crude
oil will rise bv $1.1 over the next three months.
4.
The index on a futures contract is currently priced at $150. The futures

contract has a life of 180 days, and during that time the stocks will pay
dividends of $1 in 30 days, $0.85 in 90 days, and $0.50 in 120 days. The
current risk free rate is 10% percent.
a. Find the price of the futures contract assuming no arbitrage opportunities
are present. Use discrete compounding.
b.
Find the value of 0, the cost of carry in dollars.
a. Dt:
1(1.10)1s0/36s
1.04 +0.87+0.51
+ 0.s5(1.10)e0/36s + 0.50(1.10)60/36s
:2.42
Futures : 150(1.10)180/36s -2.42: 154.8

Above is only a rough approximation!
b.
theta: 154.8 - 150 :4.8

This is the future interest forgone minus the future value of
fo(T)
So*0, then
the
dividends.
Page 65
::
Derivatives
=
.=:
Joan Tam, CFA, believes she has identified an arbitrage opportunity for a
commodity as indicated by the information given in Exhibit 1.
5.
Exhibit
:
::
1.
Spot price for commodity

Futures price for commodity expiring in 1 year
Interest rate for one year
20
2s
8.00%
$1
$1
=
=
=
Describe the transaction necessary to take advantage of this specific
arbitrage opportunity.
B: Calculate the arbitrage profit.
C: Describe nuo muket imperfections that could limit Tam's ability to
implement this arbitrage strategy.
Source: 2000 CFALevel 2 sample exam
==
===
=
=
=
Guideline Answer:
A. The arbitrage
strategy that would take advantage of the arbitrage opportunity is a Reverse

Cash and Carry. A Reverse Cash and Carry opportunity results from the following
relationship not holding true:
Fs,12 Ss
(l+
C)
g
If
the futures price is less than the spot price plus the cost of carrying the goods to the futures
delivery date, an arbitrage in the form of a Reverse Cash and Carry exists. A trader would be
able to sell the asset short, use the proceeds to lend at the prevailing interest rate, and buy the
asset for future delivery. At the future delivery, the trader would then collect the proceeds
from the loan with interest, accept delivery of the asset, and cover the short position of the
=
=
-=
=
g
:
=
=
=
:
=
commodity.
B.
Sell the spot commodity short

Buy the commodity futures expiring in
Contract to lend $120 at 8Vo for I vear
Total cash flow
+$120.00
0.00
-$120.00
'!r,
,iil"''
l\/
.,. |
,i\-'
;t*l
t\\'
)'
\,t,{,
1rdr"'
I
',
i/
))
, rr'
,o 'l'
lt:
J,
',f.;
\\,;
', i,$
,\n\
Lr
.i; i!
\\'
3rril;
I
'
I i-
'
1i t'
',
\,\
,,,u"".
\i"
,i,
\O
Page 66
=
Derivatiyes
Closine Transaction One Year {rom Now

Accept delivery on expiring futures
Cover short commodity position
Collect on loan of $120
Total arbitrase nrofit
C.
-$125.00
0-00
+$129.60
+$4,60
Tam rnust cogsider at least four market imperfections that could limit her ability to
is arbitrate strategy-
First, the trader rnust pay a fee to have an order executed. This fee
and vanous exchange fees. Second, in every market, there is a bid-ask
spread. Market makers on the flocr of the exchange must try to sell at a higher price (ask
price) than the price at which they are willing to buy (bid price). With the inclusion of
transaction costs, the same arbitrage opportunity that is profitable without transactions costs
may not be after transactiofl costs. Rather tlran having a specific no-arbitrage price in rvhich
traders can profit, there is now a band of no-arbitrage futures prices, bounded by the
ifludes comnr:ssions
applicable transaclion
,)
costs.
lre.LA_ULfi\.
Unegual Borowing and Irnding Rates: In perfect markets, all traders can borrorv and lend at
the risk-free rate" This is not true in real markets. Generaily, traders face a borrowing rate
that exceeds the lending rate. As in the case of transaction costs, there is no ionger a single
no-arbitrage price but rather a lransaction that has boundaries established by the differential
between the borrowing and lending rates.
\
)
^)
3)
n\
K>l
I
ing: ln perfect markets traders can sell assets short and use the
sale. In actual markets, however, there are serious impediments to
selling. First, for some goods, there is virrually no opportunity for sirort selling. This
K particulariy true for many physical goods. Second, even rvhen short seiling is permitted,
restrictions limit the use of funds from the short sale. Often these restrictions mean that the
shon seller does not have the use oi all the proceeds from the short sale. This particuiarly is
important in the reverse cash and carry, rvhere the short sale is employed in the transaction.
Short selling restrictions lo*,er the boundary of the reverse cash ard car4r. If an investor can
only use a portion of ihe short sale proceeds, that condition rvill depress lhe lorver boundary,
having little effect on th futures pnce.
lê l.p-t t-trrt-$s from the short
Limitations on Storage: The storability of a commodity is important in the futures pricing of

some commodities. While some goods siore well, others do not. Perishable cornmodities are
said 1o have infinite storage costs. This limitation to storage means that a cash-and carry
strategy cannot link futures and cash prices. Therefore rvhen the cash and carry or reverse
cash and carry strategy are executed, the inability to store a commodity indefinitely can cause
the no arbitrage bounds to be altered lo refiect the actual limitations to storage.
Supnlv Shortage: The supply of commodities such as gold is large relative to its
consumption, hence the market for gold wiii closely approximale its full carry market. The
supply of some industrial metals is small relative to consumption and those markets are not
full carrv nrarkeis"
Seqsonal Factors:
Highly seasonal production or consumption factors can cause distortions in
normal price relationships.
Tam must also realize that these imperfections differ widely across markets and have
different effects on different traders, and that their potential effect on her ability to implement
a given arbitrage strategy depends on her unique circumstances.
Page 67
=
=
Derivatives
(This is a tricky question, requiring your knowledge of bond prieing)

Industrial Products Corp. [PC), a publicly held company, is considering going
private. It is extremelylmportant to IPC's management that the pension fund's
present
surplus level be preserved pending completion of buyout financing'
-For
the next three months (until September 1, 1990), management's goal is to
sustain no loss of value in the pension Snd portfolio. Today (June 1, 1990),
this value is $300 million. Of this total, {ff$SO millionis ffiffds-t i".equities in
the form of an fr-&F..,500 Index fiXrd, producing an atltlual dividendrylold o.f 4
government bond issue,
gercent;ithe balance is invested in a single
Since the "no-loss
ffi01/2005.
of
iavitrg a coupon of 8 percerit and a maturity
strategy" has only a three-month time horizon, management does not wish to
sell any of the present security holdings'
6.
ffi.
I 'tiot,g
Assume that sufficient cash is available to satisfy margin requirements,

transaction costs, and so on, and that the following market conditions exist as
I okt b r- -B r',rent ?L-\ '
of!ilffi6.t
s.,
Thes&p 500 Index is at 1[e.35O levd, with a yreid or+.0 percent.
I'
atilffiS'
selling
are
12005
6
due
. Thqb,S. govemment'S.O percent bondd
o U.S. Treasury bills due on 911190 are priced to vietd@-bonj;fgrJlre
':t<-Ft< '
period (i.e' 6 percent annually)'
.{:9go:
9o
the Tollowr
follo
Available investmen mstruments are Ine
Expiration
Current Contract
Price
S&P 500Index future
9tU90
$355.00
$175,000
Future on U.S. government
91U90
101.00
100,000
9lll90
JfU
91U90
8.00
7.00
350
35,000
35,000
9nt90
2.50
100
100,000
9lll90
4.50
100
100,000
Contract
8% bonds due 61112005
S&P 500 call oPtion

S&P 500 put option
U.S. government 8%
61112005
due
call option
U.S. government 8%o due

61112005 put option
a)
b)'
Strike Price
Contract Size
Assume that the management wishes to protect the portfolio against any
losses (ignoring the costs of purchasing options or futures contracts) but
wishes also to participate in any stock or bond market advances over the
next three months. Using the preceding instruments, design two strategies
to accomplish this goal, and calculate the number of contracts needed to
implement each strategY.
using the put-call parity relationship and the fair value formula for futures
of the two strategies designed in Part
lUottr follow), recommend which one
a should be implemented. Justify your choice'
Call Price Minus Security Price Plus Present Value of (Exercise

Price Plus Income on the Underlying Security)
Futures price : Underlying Security Price Plus (Treasury Bill Income Minus
Income on the underlying Security)
put price
cFA Examination Level IiI
Page 68
Derivatives

(a). Alternative I (Buv Puts)
. Buy S&P 500 put options with market exposure equal to equity holdings
to protect these holdings.
. Buy Government bond put options with market exposure equal to the
bond holdings to protect these holdings.
This could be done by (1) buying $150 million of S&P 500 put options. Since each
option is equivalent to $35,000 market exposure, this could be done by buying:
$150,000,00/($35,000/option) :4,286 S&P 500 put options
and (2) buying $150 million of Government bond put options. Since each option
is equivalent to $100,000 market exposure, this could be done by buying:
$150,000,000/($100,000/option) :1,500 Government bond put options
By buying 4'286 S&P 500 put options and 1,500 Government bond put options,
the portfolio is protected and upside participation is achieved.
i.
Lt
Ii
Alternative 2 (Sell Futures/Buy Calls)

o SelI S&P stock index futures equal to the equity exposure in the portfolio
and buy S&P 500 call options equal to the exposure.
o SeIl Government bond futures equal to the bond exposure in the portfolio
and buy bond call options equal to the exposure.
1-
This could be done by:

(1) Setling $150 million of S&P futures. Since each future
$1750000 of equity exposure, this could be done by selling:
$150,000,000/($175,000/future) : 857 S&P futures
is equivalent
to
Buying $150 miilion of S& P 500 catl options or 4.286 call options (see above
calculation).
ll'-
t_
(2) Selling $150 mitlion of Government bond futures contracts. Since each bond
future is equivalent to $100,000 of bond exposure, this could be done by selling:
$150,000,000/($100,000/future)
1,500 bond futures
Buying $150 million of Government bond call options or 1.500 call options
atrove calculation).
(see
By selling 857 S&P futures and 1,500 bond futures, and buying 4,286 S&P call
options and 1,500 bond options, the portfolio is protected from loss and upside
participation is achieved.
Page 69
Derivatives
(b).Giventheput-callparityrelationship'theputoptionsappearmisvalued
compared to the call oPtions'
be priced at:
Given the S&P 500 call price, the put should
Put : 8.00 - index price * present value of (strike * income)
: 8.00 - 350 + (.01) x (350)
: 8.00 - 350 + 1'015
:6.28
Giventhebondeallprice,thebondputoptionshouldbepricedat:
Put :
2.50 - bond price * present value of (strike

:2.50 - 100 + (.02) x (100)
* income)
:2.50-100+1.015
:2.99
ForboththeS&P500optionsandtheGovernmentbondoptions,theputoptions
of the calls'
appear overvalued compared to the prices
price for the s&P 500 future

The prices of the futures also appear high. A fair
would be:
S& P 500
future :
index price + (bill income - dividend income)
:350 + [(.01s -.01) x (3s0)l

:35L.75
A fair price for the bond future would be:
Bondfutureprice:bondprice+(billincome--bondincome)
100
:99.5
+ t(.015 - .02) x (100)l
and the put options are

From this analysis the futures are somewhat overvalued
relatively overpriced compared to the call options'
assets (the put options)'
Alternative 1 involves buying relatively expensive
(the futures contracts) and bu1'rng
Alternative 2 involves selling_ expensive assets
;"tt*ty t"*pensive assets (the catl options)'
,.seting futures and buying ca'

{ on".native 2 where protection is gained by
\\ options is recommended'
1
y"tr;,{c;'ttr.re=;"
*} flt t'= {_ i-(-u(K

-::-
--:..
I
"!
Page 70
Derivatives
Topic 9 Activities
Explain the relationship that basis risk has when taking long and short hedges.
Basis is the difference between the spot price and futures price. If the
basis strengthens it is indicating that the spot price is becoming
increasingly higher relative to the futures price. If you have taken a long
hedge - you are losing out as you would have gone long on the futures
contract and short on the spot. The opposite is true if you had taken a
short position.
2.
You are interested in taking a short futures contract on 1 ton of platinum, as

you hold that amount of the physical asset and are worried prices may go
down before you can sell it in 3 months time. If there are no futures contracts
in platinum what can you do? What considerations need to be made?
You can try and find someone willing to enter a forward position with
you. Otherwiser Vou can try and find a commodify futures contract that
is highly correlated with platinum prices.
Other considerations:
1) The worse the correlation, the worse your hedge becomes
2) Does the contract cover you for 1 ton?
3) Does the contract expire when you want it to?
3.
Under what conditions
will tailing the hedge be considered not worthwhile
pursuing?
If
the interest r:ate is very small, or that you are sure there will be no
interest rate changes during your hedging period, then the necessity to tail
the hedge is reduced.
Page 71
Derivatives
You are a portfolio manager holding the following Australian stocks on 1"
+.
October. The number of shares, and the betas are as follows:
Stock
Shares
Price
Beta
Goodday Inc.
Goodnight Ltd.
Hello Ltd.
The End Inc.
4000
$62.62s
s24.s
$47.875
r.2
1.05
0.95
$32.r2s
1.15
83 10
4300
7500
=
=
The portfolio is to be liquidated on 30 November. However, you believe that

the Australian market willrally during October and November and would like
to increase the beta to 1.3.
(a) Construct transactions that wiil increase the beta of the portfolio to 1.3
using one or more of these December futures contracts:
in Australian dollars and assume all futures contracts have

contract multiplier of $250 per index point.
are
(b) Identify two alternative methods (other than selling securities from the
portfolio or using futures) that replicates the feature strategy in Part a.
Contrast each of these methods with the futures strategy.
Answer
Volue of the Portfolio
+
+
+
4,000
x 62.625
Ihis ornounts to odditionol rnorket exposure of'
8,310x24.5
4,300 x 47.875
7,500 x
$900,895 x 0.204 =
32.125
gI
83,782.58
Eoch futures contract provides
= $900,89s
on exposure of:
373x$250=$93,250.
Market exposure of the portfolio
+
,+
+
So the nurnber
(,A00x62.625x 1.2)
(8,310x24.5 x 1.05)
(4,300x 47.875 x 0.95)
(7,500x32.125 x l./5i
$|
offutures controcas to be bought
83,782.s81$93,250
is..
1.97
which opproximotes to 2 controcts.
= $987,022.25
Portfolio 6216 = $987,022.251$900,895
Additionol beto required = 0.204
4.
1.096
(b) 1i) crffi$u ,roffifr'.\ io?ru**c*
positiort ustilg a cormbina,tiorrof catls
and puts.
(ii) Long a forward contract
(iii) Grate c vatiable equ,ity swap
rc,ti
aa
=
S&P 500 futures, which are currently trading at l5l

SPI 200 futures, which are currently trading at373 "
Goodday Inc. futures, which are currently trading a394.
All prices
Prge72
Derivatives
5.
It is possible to trade futures contracts based on the performance of the Taiwan

stock exchange in both Singapore and Taiwan. Data in 'Hedge Ratio.XLS' on
the course website contains the daily data for the Taiwan Stock Index and
Futures Index price traded in Taiwan, as well as the MSCI Taiwan index and
index futures price traded and quoted in the Stock Exchange of Singapore.
Calculate the minimum hedge ratio for both the Taiwan index futures contract
traded in Taiwan. as well as the Taiwan MSCI futures contract which is traded
in Singapore.
HINT: convert all figures to continuous returns (Ln(Ps / Pt-t), tlten use EXCEL
'tools'-'data analysis'-'regression'to answer the question. Alternatively,
you can use the 'covariance' and 'variance' functions in EXCEL.
Regression for Taiwan Stock Index Futures

SUMMARY OUTPUT
Regreqsion Sfafisfics
R
Square
Multiple
R
Adjusted R Square
Standard
Error
Observations
rrrr.grr..,e.r
-"al-
0.701407164
0.49197201
0.486624347
0.001675577
97
ANOVA
dfSSMSF
Regression
Residual
Total
Intercept
X Variable 1
1
95
96
0.000258288 0.000258 91.99757

0.000266718 2.81 E-06
0.000525006
Coefficients Standard
Error f Sfaf
P-value
0.60363
0.097592825 9.591536 1 .23E-15
.88595E-05 0.00017058 -0.52093

0.936065133
o.5ESS?3
Iledge ratio is 0.936. Measure of hedging effectiveness is 0.49 (49%).
Page73
Derivatives
Regression for Taiwan MSCI Stock Index Futures traded in Singapore

SUMMARY OUTPLru
Regression Statistics
Multiple R
0.670t04748
R Square
0.449440373
0.443240798
0.002r06536
Adjusted R Square
Standard Error
Observations
97
ANOVA
di
I
95
96
Regression
Residual
Total
0.000343579
0.000421562
0.00076s141
Coefficients StandardError
Intercept
X Variable
9.1 8349E-05
1
0.9488777
Iledge ratio is 0.949. M
0.107836467
of hedging effectiveness is 0.45 (45%).
Which contract is better to hedge Taiwan systematic risk?

It is better to hedge systematic risk using Taiwan's Index futures contract
as it has a higher measure of hedging effectiveness.
6.
Your friend has advised you to purchase stock in AMP shares. You therefore
decide you want to buy 10,000 shares. unfortunately, you will only have
money to pay for the stock in 3 months time, by which time you are afraid that
the stock market may rise further. Currently, the stock is worth $4 per share
and has a beta of 1.2. How can you hedge against this general stock market
rise using the 3-month ASX 200 futures index, if it is currently priced at 3000,
with a contract multiplier of $25?
Determine how successful your hedge was if the index futures price in three
months time is 3123 and AMP shares are $5.3.
Stock is worth (10,000)4 : $40,000; Futures price is 3000(25):75,000
You need to go long on : 40,000 / 75,0A0 fl.z :0.63999 - one futures
contract
In 3 months time:
Stock is worth (10,000)5.3 :453,000
Increased cost of stock is
: 53,000 - 401000 : $131000
New futures price is:3123*25 : $78,075

Profit on futures contract is 78,075-75,000=$3075
Net additional cost of stock: $13,000 - $3,075 : $9,925
This implies the hedge had only reduced the total cost of the stock by
-24o . This is because you have only hedged the rise in systematic
returns -whereas the stock increased in value bv 32.5oh
Page74
Derivatives
Case Study - Barings Bank Collapse

Attached are two articles relating to the Barings Bank Collapse, one comes from the
intemet and the web address is cited at the top right-hand corner of the pages. You
might wish to visit it for more information.
Answer the following questions:
1)
What is proprietary trading?

Trading on behalf of the bank itself, not for the banks clients
2)
What is cross-trading and how does it work?

Trades transacted on an exchange between two accounts within the same
bank.
3)
What is a switching strategy?

Arbitraging between the price of the same contract traded in two separate
exchanges. If the same asset is sold for different prices, go short on the
expensive item and long on the cheap version. Wait till convergence and
earn a no-risk profit.
4)
Why was the original strategy by Barings to switch considered low risk?
Read above.
5)
Why didn't anyone in the Osaka Exchange question how Leeson could hold
such large open positions in Nikkei 225 and JGB futures?
OSE thought Leeson held offseffing positions in SIMEX.
6)
Why, to arbitrage, Leeson would have to go long/short on twice as many

SIMEX Nikkei 225 futures when going short/long on OSE futures.
SIMEX contracts rvere on half the value of any OSE contract.
7)
What is the maximum profit and loss that can be made from a buy straddle?
Profit: potentially limitless - dependent on stock price
Loss: _(C + p)
8)
What is the maximum profit and loss that can be made from a short straddle?
profit: (C + p)
Loss : potentially limitless - dependent on stock price
g)
Why did Leeson go long on Japan futures even after the Kobe earthquake?
He was an idiot.

!
Page 75
Derivatives
Derivatives Debacles
Case Studies
of Large Losses in Derivatives Markets

Anatoli Kuprianov
all mistakes in the conduct af great enterprises is

powers. Plutarch, Lives: Fabitts.
Tb avoid
ntatz's
bej,ond
ecent years have witnessed numerous accounts of derivatives-related

losses on the part of established and reputabie firms. These episodes
have precipitated concern, and even alarm, over the reeent rapid growth
of derivatives markets and the dangers posed by the widespread use of such
instruments.
What lessons do these events hold for policymakers? Do they indicate the
need for stricter govemmenf supervision of derivatives markets, or for new laws
and regulations to limit the use of these instruments? A better understanding
of the events surrounding recent derivatives debacles can help to answer such
questions.
This article presents accounts of two of the costliest and most highly publicized derivatives-related losses to date. The episodes examined involve the
firms of Metallgesellschaft AG and Barings PLC. Each account begins with a
review of the events leacling to the derivatives-related loss in question, followed
by an analysis of the factors responsible for the debacle. Both incidents raise
a number of public policy questions: Can government intervention stop suclr
incidents from happening again? Is it appropriate for the government even to
try? And if so, what reforms are indicated? These issues are addressed at the end
of each case study, where the lessons and pulrlic policy concerns highlighted
by each episode are discussed.
Alex Mendoza assisted in the preparation of this article. Ned Prescott, John \\'alter, ancl John
Vy'einberg provided valuable cotnments on earlier drafts. Any remaining errors or omissions
are the responsibility of the author. The views expressed are those of the autlror and do not
necessarily represent those of the Fedeml Reserve Bank of Richmond or the Federal Reserve
System.
Federal Reserve Bank of Richmond Ecorrtnnic Quarterly Volume
8l/4 Fall
1995
Prge76
Derivatives
Federal Reserve Bank of Richmond Economic Quarterly
20
aimed at providing long-term, Iixed-price delivery contracts to customers-a

type of arran-qement common to many types of commercial activity. Systematic
attempts to discourage such arrangements would seem to be poor public policy.
Finally, MG's financial difficulties were not attributabrle solely to its use
of derivatives. As noted eiulier, the firm's troubles stemmed in part from the
heavy debt ioad it had accumuiaied in previous years. Moreover, MGRM's
oil marketing program was not the only source of its parent company's losses
during 1993. MG reportecl losses of DM 1.8 billion on its operations fsr the
fiscal year ended September 30, 1993, in addition to the DM 1.5 billion loss
auditors attributed to its hedging program as of the same date (Roth 1994a).
Simply stated, the MG debacle resulted from poor management. As a practical
matter, government policy cannot prevent firms such as Metallgesellschaft from
making mistakes. Nor should it attempt to do so,
3.
BARINGS
At the tirne of its demise in
February 1995, Barings PLC rvas the oldest

merchant bank in Creat Britain. Founded in 1762 by tlie sons of German
immi_srants, the bank had a long and distingirished history. Barings had helped
a fledgling United States of America arrange the firrancing of tire Louisiana
Purchase in 1803. It had also helped Britain finance the Napoleonic Wars, a
feat that prompted the British government to bestow five noble titles on the
Baring family'.
Although it r.vas once the largest merchant bank in Britain, Barings rvas
no longer the pou,erhouse it had been in the nineteenth century. With total
shareliolder equity of f440 million, it was far from the largest or most irnportant banking organization in Great Britain. Nonetheless, it continued to rank
among the nation's most prestigious institutions. Its clients included the Queen
of England and other members of the royal family.
Barings had long enjoyed a reputation as a conservatively run institution.
But that reputation was shattered on February 24, 1995, rvhen Peter Baring,
the bank's chairman, contacted the Bank of England to explain that a trader in
the firm's Singapore futures subsidiary had lost huge sums <if money speculating on Nikkei-225 stock index futures and options. In the days that follorved,
investigators found that the bank's total losses exceeded US$l billion, a sum
large enough to bankrupt the institution.
Barings had aimost failed once before in 1890 after losing millions in
loans to Argentina, but it rvas rescued on that occasion by a consortium led
by the Bank of England. A similar effort rvas mounted in Febnrary 1995, but
the attempt failed when no immediate buyer could be found and tlre Bank of
England refused to assume liability for Barings's losses, On the evening of
Sunday, February 26, the Bank of England took action to place Barings into
Page 77
Derivatives
A. Kuprianov: Derivatives Debacles
2L
administration, a legal proceeding resemblirrg Chapter 1l bankruptcy-court proceedings in the United States. The crisis brought about by Barings's insolvency
ended just over one week later when a large Dutch financial conglomerate, the
Internationale Nederlanden Groep (ING), assurned the assets and liabilities of
the failed merchant bank.
What has shocked most observers is that such a highly regarded institution
could fall victim to such a fate. The ensuing account examines the events
leading up to the failure of Barings, the factors responsible for the debacle,
and the repercussions of that event on world financial markets.le This account
is followed by an examination of the policy concerns arising from the episode
and the lessons these events hold for market participants and policymakers'
Unauthorized Trading Activities

199?, Barings sent Nicholas Leeson, a clerk fiam its London office, to
manage ttre back-office accounting and settlement operations at its Singapore
futures subsidiary. Baring Futures (Singapore), hereafter BFS, was established
to enable Barings to execute tlades on the Singapore Internatiortal Monetary
Exchange (SI}{EX). The subsidiary's profits were expected to come pr:itnartly
from brokerage commissions for trades executed on behalf of customers and
other Barings subsidiaries.2o
Soon after arriving in Singapore, Leeson asked permission to take the
SIMEX examinations that would pennit him to trade on the floor of the exchange. He passed the examinations and began trading later that year. Some
tinre durirrg late 1992 or early 1993, Leeson was named general manager and
head trader of BFS. Normally the functions of trading and settlements are
kept separate within an organization, as the head of settlements is expected
to provide independent verification of records of trading activity. But Leeson
was never relieved of his authority over the subsidiary's back-office operations
r,vhen his responsibilities were expanded to include trading'
In
llThis
accounr is based on the findings of a report by the Board ofBanking Supervision of

(1995) and on a number of press accounts dealing with tlre episode. Except
Englan{
the Bank of
where otherwise noted, all information on this episode was takcn fron'r the Board of Banking
Supervision's published inquiry'
20
Most ol BFS's business \\,as concentrated in executing trades fbr a limited nurnber of
financial tutures ald options corltracts. These were the Nikkei-2?5 contract, the lO-year Japzurese Govemmcnt Bon<J (JGB) contract, the tkee-nronth Euroyen contract, and options on those
contracts (known as futures options). The Niktei-225 contract is a futures contract whose valtte
is based on the Nikkei-z25 6tock index, an index of the aggregate value of lhe stocks of 225 of
the largest corporations in Japan. The JGB conuact is for the future delivery of ten-year Japanese
govemment bonds. The Euroyen contract is a futures contract whose value is determined by
ihung"a in the three-month Euroyen deposit rate. A futures option is a cqntract that gives the
buyei the right, bur not thc obligation, to buy or sell a futures conlract at a stipulated price on or
before some specified expiralion date.
Page 78
Derivatives
22
Leeson soon began to engage in proprietary trading-that is, trading for

the finn's own account. Barings's management understood that such trading
involved arbitrage in Nikkei-Z25 stock index futures and l0-year Japanese Gov*
ernrnent Bond (JGB) futures. Both contracts trade on SIMEX and the Osaka
Securities Exchange (OSE). At times price discrepancies can develop between
iire same contraet on different exchanges, ieaving room for an arbitrageur to
earn profits by buying the lower-priced contract on one exchange while selling
the higher-priced contract on the other. In theory this type of arbitrage involves
only perfectly hedged positions, and so it is commonly regarded as a low-risk
activity. Unbeknownst to the bank's management, however, Leeson soon smbarked upon a much riskier trading strategy. Rather than engaging in arbitrage,
as Barings management believed, he began placing bets on the clirection of
price movements on the Tokyo stock exchange.
Leeson's reported trading profits were spectacular. His earnings soon came
to account for a significant share of Barings total profits; the bank's senior
management regarded him as a star performer. After Barings failed, however,
investigators found that Leeson's reported profits had been fictitious from the
start. Because his duties included supervision of both trading and settlements
for the Singapore subsidiary, Leeson was able to manufacture lictitious reports
conceming his trading activities. He had set up a special account-account
number 88888-in July i992, and instructed his clerks to omit intbrmation on
that account from their reports to the London head office. By manipulating
information on his trading activity, Leeson was able to conceal his trading
losses and report large profits instead.
Figure 4 shorvs Leeson's trading losses from 1992 through the end of
February 1995. By the end of 1992-just a few months after he had begun
trading*Leeson had accumulated a hidden loss of s2 million. That figure
remained unchan-9ed until October 1993, when his losses began to rise sharply.
He lost another f2l million in 1993 and f,185 million in 1994. Total cumulat-ive
losses at the end of 1994 stood at f208 million. That amount was slightly larger
than the f205 million profit reporred by the Barings Group as a whole, before
accounting for taxes and for f,102 million in scheduled bonuses.
A major part of Leeson's trading strategy involved the sale of optiorrs on
Nikkei-Z25 futures conlracts. Figures 5a and 5b show the payoff at expiration
accruing to the seller of a call or put option, respectively. The seller of an
option earns a premium in return for accepting the obligation to buy or sell the
underlying item at a stipulated strike price, If tlre option expires "out-of-themoney," the option premium becomes the seller's profit. If prices turn out to
be more volatile than expected, however, an option seller's potential losses are
virlually unlimited.
some time in 1994, Leeson began selling large numbers of option straddles, a strategy that involved the sinultaneous sale of both calls ancl puts on
Nikkei-Z25 futures. Figure 5c shows the payoff at expiration to a sold option
Page 79
Derivatives
23
A. Kuprianov: Derivatives Debacles

Figure
Concealed Tfading Losses
619
600
.E +oo
ui
o@
'c
U
185
200
21
1992
1994
1993
004
Source: Bank of England' Bsard of Banking Supervision
Figure
Payoffs to selected options Tbading strategies
c. Sell Straddle
b. Sell Put
a. Sell CalI
.=
On
r
;U
On
LV
o-
Strike Price
Strik Price
Strike Price
Derivatives
'lA
L-
Federal Resene Bank of Richmond Economic Quarterly
straddle, Option prices reflect the market's expectation of the price volatility
of the underlying item. The seller of an option straddle earns a profit only if
the market proves less volatile than predicted by option prices. As is evident
in Figure 5c, Leeson's strategy amounted to a bet that the Japanese stock
market would neither fall nor increase by a great deal-any large movement in
Japanese stock prices would result in losses. By January l, 1995, Leeson was
short 37,925 Nikkei calls and 32,967 Nikkei puts. He also held a long position
of just over 1,000 contracts in Nikkei stock index futures, rvhich would gain
in value if the stock market were to rise.
Disaster struck on January 17 when news of a violent earthquake in Kobe,
Japan, sent the Japanese stock market into a tailspin. Over the next five days,
the Nikkei index fell over 1,500 points-[,gs5s11ts options positions sustained a
-o-uying
massive amounts of
loss of t68 miliion. As stock prices fell, he began
placed
a side bet on Japanese interest rates,
Nikkei stock index futures. He also
selling Japanese government bond futures by the thousands in the expectation
of rising interest rates.
This strategy seemed to \.vork for a short time. By February 6, the Japanese stock market had recovered by over 1,000 points, making it possible for
Leeson to recoup most of the losses resulting from the market's reaction to the
earthqualie. His cumulative losses on that date totaled 253 million, about 20
percent higher than they had been at the start of the year. But within days the
market began falling again-Leeson's losses began to multiply. He continued
to increase his exposure as the market kept falling. By February 23, Leeson
had bought over 61,000 Nikkei futures contracts, representing 49 percent of
trrtal open interest in the March 1995 Nikkei futures contract and 24 percent
of the open interest in the June contract. His positiort in Japanese goyernment
bond futures totaled just over 26,000 contracts sold, representing 88 percent
of the open interest in the June i995 contract. Leeson also took on positions
in Euroyen futures. He begeur 1995 with long positions in Euroyen contracts
(a bet that Japanese interest rates w'ould fall) but then switched to selling
the contracts, By February 23 he had accumulated a short position in
Euroyen futures equivalent to 5 percent of the open interest in the June 1995
contract and i percent of the open interest in both the Septentber and December
contracts.
Barings faced massive nrargin calls as Leeson's losses mounted. While
these urargin calls raised eyebrows at the bank's Londort and Tokyo offices,
they did not prompt an immediate inquiry into Leeson's activities. It was not
until February 6 that Barings's group treasurer, Tony Hawes, flerv to Singapore
to investigate irregularities with the accounts at BFS. Accompanying Harves
was Tony Railton, a settlements clerk from the London office.
While in Singapore, Hawes met with SIMEX officials, who had expressed
concern over Barings's extraordinarily large positions. Hawes assured them that
his firm was aware of these positions and stood ready to meet its obli*eations
Page 81
Derivatives
26
(Szala, Nusbaum, and Reerink 1995). It is not known whether the OSE suffered
any losses as a result of Barings's collapse.
Leeson was later detained by authorities at the airport in Frankfort, Cermany! and was extradited to Singapore the following November. In Singapore,
I-eeson pleaded guilty to charges of fraud and was sentenced to a 6'lz-year
prfuon term (Mark 1995).
Certain material facts regarding the entire incident are not yet known, as
Leeson refused to cooperate with British authorities unless extradited to Great
Britain. He later contested the findings of the Banking Board's inquiry, however.
A letter to the board from his solicitors states,
These conclusions are inaccurate in various respects. Indeed, in relation to certain of the matters they betray a fundamental misunderstanding of the actual
events. Unfortunately, given the uncertainty regarding Mr. Leeson's position
we are not able to provide you with a detailed response to y'f,ur letter.Z?
Page 83
,i
Derivatives
Not Just One Man - Barinqs
l. How Leeson Broke Barings

The activities of Nick Leeson on the Japanese and Singapore futures exchanges, which led
to the downfall of his employer, Barings, are well-documented. The main points are
recounted here to serve as a backdrop to the main topic of this chapter - the policies,
procedures and systems necessary for the prudent management of derivative activities.
_l
Barings collapsed because it could not meet the enormous trading obligations, which
Leeson established in the name of the bank. When it went into receivership on February 27
1995, Barings, via Leeson, had outstanding notional futures positions on Japanese equities
and interesfrates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$2
billion on Japanese government borld (JGB) and Euroven contracts. Leeson also sold 70,
892 Nkkeipg!and call options with a nominalvalue of $6.68 billion. The nominal size of
these positions is breathtaking; their enormity is all the more astounding when compared
with the banks reported capitalof about $615 million.
The size of the positions can also be underlined by the fact that in January and F_ebruary
19gS, Barings Tokyo and London transferred US$835 million to its Singapore office to
-l
enabie the latter the meet its margin obligations on the Singapore International Monetary
Exchanqe (SIMEX).
Reported activities {FantasY}

The build-up of the Nikkei positions took off after the Kobe earthquake of January 17. This
reflected in Figure 10.1 - the chart shows ihat Lesson's positions went in the opposite
t
a=
th; Nikkei - as the Japanese stock market fell, Leeson's position i1cr99s"ed.
earthquake, with the Nikkeitrading in a range of 19,000 to 19,500, Leeson
Kobe
eeioretne
had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange.
(itre eq-uiuulent number of contiacts on the Singapore Internatlonal Monetary Exchange is
days after the
bOOO U""uuse SIMEX contracts are half the size of the OSE.) A few
culminated in a high of
programme_which
buying
earthquake Leeson started an aggressive
7'
February'1
on
later
a
month
about
reached
19,094 contracts
direction to
ffo09 ensftrnJ{a
Nturei
?25 average t9
EOS
1g
400
Nrkhi
20
ln|)usand gorrirafls
19 !C,S
15
225 auer3B rs oca
t6 800
B.aJsrg'g net long
18 600
lutu/ca po$iliot!$
1B 40?
IE 2Sl
16 000
t7 Afn
t7 6m
t7 400
1S95
Nikkei225 Average'
Figure 10.1 Baring's Long-Positions aqeinst the
Exchanges
So-urce: Datastream and Osaka Securities
public knowledge since the osE publishes weekly

But Leeson's osaka position, which was
lf Lees6n was lono on the OSE' he had to
data, reflected only rruft oi nii sanctioned ttuJ"t.
why? Because i.e"on's officialtrading
be short twice the nuroL, oicontracts on sitr,1ex.
oiff6rences between the SIMEX and oSl
rice
temporary
f
strategy was to tat<e advantage of
required Lee,son to bu
Nikkei Z2S contracts. This arbitraqe, wfricn 6J'iin-gs "irr"-O expensivd
-i'1'19hing"
reversing the tradt
one'
more
the
the cheaper contract anC to sett simultaneously
activity has
of
arbitrage
Jaipp"uted' This kind
when the price difference had narrowed ot
Page 84
Derivatives
little market risk because positions are always matched.

But Leeson was not short on SIMEX, infacl he was long approximately ihe number of
contracts he was supposed lo be short. These were unauthorised trades wfrich he hid in an
account named Error Account 88888. He also used this account to execute all his
unauthorised trades in Japanese Government Bond and Eurovn luiures and Nikkei 225
options: together these trades were so large that they ultimately broke Barings. Table 10.1
gives a snapshot of Leeson's unauthorised trades versus the trades that he reported.
For the rest of the chaoter. contracts will be discussed or converted into SIMEX contract
sizes.
U
nreported oositicns {Fact!
The most striking point of Table 10.1 is the fact that Leeson sold 70,892 Nikkei 225 options
worth about $7 billion without the knowledge of Barings London. His activity peaked in
Novem[er and December 1994 when in those two months alone.
j*,lumber of contracts
F"i""lp*ttlm tt
terms of open
interest ofrelevant
nominal value in US$ amounts
contract?
iAcrualq
ji.lutures
49% of March
1995 contract and
24V,'
of June
1995
contract.
lssgzo
li9'1c
88?i' of
June
|
i contract.
S39S0 rniilion
5%o
I
Euroyen
601
S16.5 niillror-r
sliort t-;8-li
I
j^--,.
i)-r)t)
IllilllL)ll
i
i
1995
ofJune 199j
contract.
1?lo
of
lseptember 1995
i contract and 1olo of
j December 199-5
r-
of x,larch
1995 contract and

I
contract.
loptiont
l;;ii::
225
,\ll
catls
js::so nillioir
32967 puts
i 00 rnillitrn
lS3
|
those of the OSE and tire

Exoressed in terms of SIMEX contract sizes which are half the size of
size'
TSE. For Ewoyen, SIMEX and TIFFE conlracts are of similar
i. op"o i"t..rrt f,rg1rr., for each contract month of each listed contract. For the Nikkei 225. JGB
and December.
and i*oyeu contrics. the contract montis are lv{arch, June, September
they.x'ere part of Barings'
matchedbecause
r+ele
supposedly
positions
funrres
3. l*eson's reported
the Singapore
swirching activity. i.e. the number of contracts on either lhe Osaka Stock Exchange,
Exchange'
Stock
the
Tokyo
or
E.xchange
Internationai N4onetary
4, The acnral positions refer to those unauthorized trades held in error accowtt'8888''
l.
of the
Source: The Report of the Board of Banking Supervision Inquiry into tlte Circumstances
l9Q5
Office
Statinneru
Maieste's
Hpr
Cnmmnns
nf
the
Hnrrse
hv
Orrlered
Cnllanse nf Rriroq
Page 85
Derivatives
he sold 341 400 options. ln industry parlance, Leeson sold straddles. i.e. he sold put and cal
options with the same strikes and maturities. Leeson earned oremium income fr6m selling
well over 37,000 straddles over a fourteen month period. Such trades are very profitable
provided the Nikkei 225 is trading at the options' strike on expiry date since n6th tne puts
and calls would expire worthless. The seller then enjoys the full premium earned from sellin
the options- (see Fig 10.2 for a graphical presentation of the profit and loss profite of a
straddlg.) lf the Nikkei is trading near the options' strike on expiry, it could still be profitable
because the earned premium more than offsets the small loss experienced on either the ca
(if the Tokyo market had risen) or the put (if the Nikkei had fallen.).
Slrtto Frlo6 ol oglhns.

sry tB 5,SO
K*y:
b(6!(-ilBn
Figure 10.2 Payoff Profile of a Straddle.

The strike prices of most of Leeson's straddle positions ranged from 18,500 to 20,000. He
thus needed the Nikkei 225 to continue to trade in its pre-Kobe earthquake range of 19,000
20,000 if he was to make money on his opiion trades. The Kobe earthquake sh-attered
Leeson's options strategy. On the dayof the quake, January 17, the Nikkei225 was at
19,350. lt ended ihat week slightly lower at 18,950 so Leeson's straddle positions were
starting to look shaky. The call options Leeson had sold were beginning to look worthless br
the put options would become very valuable to their buyers if the Nikkei continued to decline
Leeson's losses on these puts were unlimited and totally dependent on the level of the
Nikkei at expiry, while the profits on the calls were limited to ihe premium earned.
This point is key to understanding Leeson's actions because prior to the Kobe earthquake,
his unauthorised book, i.e. account'88888&'showed a flat position in Nikkei 225 futures. Ye
on Friday 20 January, three days after the earthquake, Leeson bought 10,814 March 1995
contracts. No one is sure whether he bought these contracts because he thought the marke
had over-reacted to the Kobe shock or because he wanted to shore up the Nikkei to protect
the long oosition which arose from the option straddles. (Leeson did not hedqe his option
posltions prior to the earthquake and his Nikkei 225 futures purchases after the quake
cannot be construed as part of a belated hedging programme since he should have been
selling rather than buYing.)
When the Nikkei dropped 1000 points to 17,950 on Monday January 23, 1995, Leeson foun
himself showing losses on his two-day old long futures position and facing unlimited damag
from selling put options. There was no turning back. Leeson, tried single-handedly to revers
the negative post-Kobe sentiment that swamped the Japanese stock market. an 27
January, account '88888' showed a long position of 27 ,158 March 1995 contracts. Over the
next three weeks, Leeson doubled this long position to reach a high on 22nd February of
55.206 March 1995 contracts and 5640 June'1995 contracts.
Page 86
Derivatives
The large falls in Japanese equities, post-earthquake, also made the market more volatile.
This did not help Leeson's-short option pasition either - a seller of options wants volatilitv lo
decline so that the value of the options decrease. With volatility on the rise, Leesorts-Jfrirt
options would have shown losses even if the Tokyo stock market had not plunged.
Leegon engaged in unauthorised activities almost as soon as he started trading in Singapor
in 1992. He took proprietary positions on SIMEX on both futures and options contracts. (ii;s
mandate from London allowed him to take positions only if ihey were part of 'switching'and
to execute client orders- He was never allowed to sell options.) Leeson lost money from his
unauthorised trades almost from day one. Yet he was perceived in London as thewonder
!9y and t-urbo-arbitrageur who single-handedly contributed to half of Barings Singapore's
1993 profits and half of the entire firm's 1994 profits. The wide gap between fact-and fantas
is illustrated in table 10.2 which not only shows the magnitude of Leeson's recent losses bur
the fact that he always lost mcney. In i994 aione, Leeson losi Baiings US$296 miliion; his
bos-ses thought he made them US$46 million, so they proposed paying him a bonus of
us$720,000.
l+cBp
s.B3
Actual
(million)
Cumulative
actuall
-GBP 2I
-GBP 23
(millicn)
ll
:an 199.1to 31 Dec
i 1994
-cBP 208
+GBP 28.529
1 Jair 1995
1
qq5
18.567
-GBP 619
1. The cunrulative achral represnts Leeson's cumuiative losses carrird fonvard.

Source: Report of tbe Board of Bani<ing Superuision Ilquiry into the Circunutances of the
Collapse of Barings, Ordered by the House of Cornmons, Her Majesry's Stationery Office,
l 995.
The cross-trade
How was Leeson able to deceive everyone around him? How was he able to post profits on
his 'switching' activity when he was actuaily losing? How was he able io show a flat book
vrhen he was iaking huge long positions on ihe Nikkei and short oositions on Japanese
interest r-etes? The Bcard of Banking Superuision (BcBS) of the Bank of England which
conducted an invesiigation into the collapse of Barings believes that "the vehicle used to
effect this deception was the cross trade."1 A cross trade is a transaction executed on ihe
floor of an Exchange by jusi one Member who is both buyer and seller. lf a Member has
maiching buy and sell orders from ir,vo different customer accounts for the same contract
and at the same price, he is allowed to cross the transaction (execute ihe deal) by matching
both his client accounts. Holvever he can only do this after he has declared the bid and oife
price in the glJ and no other member has taken it up. Under SIMEX rules, the Member musi
declare the prices three times. A cross-trade must be executed at market'price. Leeson
entered into a significant volume of cross transactions between account'88888' and accour
'S2000' (Barings Securities Japan - Nikkei and JGB Arbitrage), account'98007' (Barings
London - JGB Arbitrage) and account'98008' iBarings London - Euroyen Arbitrage).
After executing these cross{rades, Leeson would instruct the settlements staff to break
down the total number of contracts into several different trades, and to change the trade
prices thereon to cause profits to be credited to 'switching' accounts referred to above and
losses to be charged to account'88888'. Thus while the cross trades on the Exchange
appeared on the face of it to be genuine and within the rules of the Exchange, the books an
records of BFS, maintained in the Contac system, a settlement system used extensively by
SIMEX members, reflected pairs of transactions adding up to the same number of lots at
prices bearing no relation to those executed on the floor. Alternatively, Leeson would enter
Page 87
Derivatives
into cross trades of smaller size than lhe above but when these were entered into the
dontuc system he would arrange for the price to be amended, again enabling profit to be
credited io the'switching' account and losses to be charged to account'88888"
profit on
Table 10.3 below is an example of how Leeson manipulated his books to show a
activitY.
switching
Baring's
lltt
'
llJanuary
LJ
â
January
3o0o
17810
18815
17810
18147
25
r;F" F-WWF[i"*
26715
(7re70) (73332)
91 528
January
16276
18210
148193
149560
FF-
l'
W4s
i. f f.,i. table is Figure 5.2 of Report of the Board of Banking Supervision Inquiry into the
House of Common, Her Majesly's
Circ,rmstances of-the Collapse of Barings, Ordered by the
Stationery Office, 1995.
traded on the floor of SIMEX for the
2. This colunur reptesents the size of Nikkei 225 cross-trades
accQunt'92000''
in
clates shown, witlrthe other side being
contac system reflected.a

The BoBS report notes "ln each instance, the entries in the
transacted on the floor'
those
to
prices
different
number of spurious contract arnounts at
of giving the.impression
effect
the
had
This
tiaded.
originally
ioi
reconciling to the total
that these had taken place at
"ir"
'92000&'
in
account
trad--es
the
ref,orted
of
a
review
from
Barings Securities Japan into
dilferent times during tire day. This was necessary to deceive
of authorised arbitrage
result
a
in.account'92000'was
proiituOlf
ity
reported
believing the
in account'92000&' at
profits
reported
inflate
to
was
effbct of tfiit *uniprf"tion
losses from the
substantial
incurring
was
also
which
".ii"iiy,in"
the expense of account'88S8S',,
trades on slMEX,
to
crossing
ln
addition
unauthorised trading positions taken by Leeson.
betweenaccount'eaas8a'andtheswitchingaccounts,Leesona|soenteredfictiiioustrades
of the Exchange' The effecl
crossed on the floor
between lhese accounts which were never
permitted oy sltrf eJ<], was again to credit the
of these [off-market truJu.., *nicn were.not
,switching, accounrs *itn Jiont. *hilst charging account '88888'with losses."
its
that Barings was counterparty to many of
The bottom line of all these cross-trades was
lay
not
did
doing
so
in
and
other,
the
to
and sold
own trades. Leeson Oought from one hand
the
and
SIMEX
it'* not arbitraging between were buried in
off any of the firm's *"rfiut risk. Barings *u.
iuustantial)f,os-itions' which
very
open"(and
Japanese exchanges;"Gr.i"g
,88888',. lt was the profit and loss statement of this account which correctly
account
Leeson' Details of this account were
represented tne revenue earneo (or not earned) by
in London, an omission which
offices
or risk control
never transmitted to il;1;Jt
and bondholders'
shareholders
Barings
for
ultimately had catastropni"
"oni"quences
executed bv Leeson' lt is the

Fioure 10,32, below, shows the number of cross-trades
Nikkei trades of account'92000'
the
all
,"pr"""ntt
line which
diFerence between the solid
i8ggg8' and the broken tine which reflects the position Leeson
not crossed into accouni
Page 88
Derivatives
reported to Barings management. The figure graphically illustrates the chasm between
reported and actual positions. For example, Barings minagement thought the 1rm had a
'short'position of 30,112 contracts on STMEX on24 FebruJr$ in fact it ias long Al,gZe
contracts after ignoring the trades crossed with account,ggggg'.
a0 oco
ft{00
10offi
EO
50
Ig Fb
-10 000
-30 000
-3S 000
-40 000
l{il.
"-''
Po*ltbn ignodng lr#sf, cro8sid rYi$r acount tsBB$B'
Figure 10.3 Graph to show the Nikkei Position of Account '92000'. Reproduced by
permission from the Report of the Board of Banking Supervision Inquiry into the
Circumstances of the Collapse of Barings.
Footnotes:
1, 2) Report of the Banking Supervision Inquiry into the Circumstances of the Collapse of
Barings, Ordered by the House of Commons, July 1995, Her Majesty's Stationery Office,
London
See a/so: Leveraqe, Maturitv, Risk Manaqement, Variation Marqin
Case Stt:dies " Not Just One lr,,lan - Barinqs
Page 89
Derivatives
Topic L0 Activities
why do you assume that there is a
1.
zefo cost
of carry when pricing futures
options?
the value of the

Although you could argue that futures contracts embed
but not the obligation'
cost of carry, with options - a taker has the right,
options holder'
the
for
to buy the futures - th"re is no cost of carry
spot rate is
what is the lower bound of a European foreign cufrency call if the
interest rate is 6'20/o, the
$2.25,the domestic interest rate is s.5%, the foreign
option expires in three months, and the exercise price is s2.20?
2.
C 2 Max [0,S(1+P)-r - X(l+r)-r]

^ ^C 2 Max to,z:sOo 621-o'zs - 2'20(1'05fl-o'zs,
C 2 Max 10,2.216 -2'17081
C 2 Max [0,0.4571
3.
why
What techniques should

are path-dependent options so hard to calculate?
Provide an example of a pathbe employed to value path-dependent options?

dePendent oPtion in Your answer'
They are
You calculate patn-aependent options using binomial models'
leads
because of non-recombining paths within the trees
hard to calculaie
to excessive compution time and effort. Number of possible final
outcomes are 2n, not (n.1) in the case of recombining trees.
Talk about Lookback options or Asian options or Barrier options
as
examples of path-dependent options'
at 3301' The ASX 200 is at

The current December sPI200 futures contract is
3305.4. The current 30-day bank bill rs at 4'492oh'
contracts
a) If there are 45 days remaining untii December 2001 futures
for the December
expire, determine whether put-&ll paritlis.maintained
price closest to the
call & put options on SpI zbo futures with the exercise
current SPI 200 Price.
4.
cnl-loPTloNs
:i:1n;l*il,,.s:.,. :,gi
*T'ffiiWl,
177
e6c
'80
r13
?co
iq
02 3500.0
'.!i.Sc 1:5
lllQ 20
i$i '.2
:ii
;l$ i
6so ft: -id 19q
S 3St
11.2
8?N
.5.9
':
:#.H,,i,o 'Gii$Sm"*'',''i
SH 200 llS25
:r5
Ior 01
3lC0
SPl2dll,
23.0
?0.0
11 0
0* 01 29C0.0 218.0
oic 01 31C0.0
o.c 01 3U5.0 25.!
1
Hfrsfis $3 S3 $i
r n f*g i3; ll3
H: ffi #3 'i3: leo
r 02 3650.0
I't
,'.rl$ s+ 'S
",0
l#! rolo :ojc

H
1{i3 9ll sso
or r:so.o {?.-o 48q ô
iii 3i
tr
':.t*i
PUT OPTIONS
140.0
^1;
364
6s5
*l :i: ll:il ll1

*t
;.i *l ilil ': H
i:o ,*i fi 13ffi li 'Hi
,Bo jll
r3s
'3ll
X:
il; ;'6
30.3
31.0
106 9
68,0
90.0
D* 01 3150.0
,Ali
1;fl
roo
$m 't
103
160
0r< 01 3200.0 4?.8

D.c 01 3?50.0 59.3
Ooc fl 3?75.0 69 3
Occ fl 3QS0 --&:5
Dcc
01 3350.0
xr @ 2S.0 19 3
rn Gl 2S.0 29.3
r.r e 2950.0 35.8
ra @ s500 53.1
xr e 31000 10164.35
r{ 01 3225.0
Irr @ 3$00 131.5
Jn 02 H00 60
92 3
tin 02 30f0.0
39.0
?3
:g.o
26.0
32.0
39 0
1t^
lql
,1
^3-i "i;
rii
+rc
ti.i:
i!:o
fi;
?6,
fi;
'4.:
iic
iii
ji?
So 3sn 38
iqi
lq
s8d
E.U
9?:
!0.0
$o
135.00
. 1
98.8
16.8
.ii
-2. a
;i;
i',
!l :oo 2;3:
4?.50 i3 ?I
:{9 . 3
8"2
6 lci
1ql
1ql
19i
qq
t!
;flH 'g; f:
r17
.180.c0
.?02.50
-6?.50
r:x
1J
Li
30
!,
35;
aa :9II 2I 1x
lib
48.0
58.5 i'r rTfi * T
9{-0
9{-0
J
47.5C
{68
.5.1
.5.8
.l
itir
56.7
81-0
the Possible reasons whY
li i$,$ # tr
I
{.0
.5.3
it
might not be.
,'E
iil ;{ i## i
bl.!
6e.0
''.,.|
Page 90
108
156
Derivatives
P:
C + (X-f)e-'t
73.3e (using settlement price)
73.3 :74.3 - 0.99448
:74.3c + (330 - 3301X0.99448)
Put-Call parity seems to be maintained

Reasons why it might not include:
o Dividend yield not accounted for
c Bis-Ask spread
o Miscellaneous transaction costs
5.
Wrong risk-free rate
Pamela Itsuji, a currency trader for a Japanese bank, is evaluating the price of
a six-month Japanese yerVU.S. dollar cuffency futures contract. She gathers
the currency and interest rate data shown in Exhibit 1.
Exhibit
Japanese Yen/U.S.
Dollar Spot Currency Exchange Rate: Y124.300i$1.000
Six-month Japanese Interest Rate: 0.10%

Six-month U.S. Interest Rate: 3.80%
A:
calculate the theoretical price for a six-month Japanese yenlU.S. dollar

cuffency futures contract, using the data in Exhibit 1 and Japanese yen as
the local currency. Show your calculations.
Itsuji is aiso reviewing the price of a three-month Japanese yen/u.S. dollar

culTency futures contract, using the currency and interest rate date shown in
Exhibit 2. Because the three-month Japanese interesl rate has increased to
0.50 percent, Itsuji recognises that an arbitrage opportunity exists and decides
to borrou'$1 million U.S. dollars to purchase Japanese yen.
Exhibit
Japanese Yen/U.S.
Dollar Spot currency Exchange Rate: +i24.300/$1.000
New Tluee-month Japanese Interest Rate: 0.50%

Three-month U.S. Interest Rate: 3.50%
Three-month Currency Futures Contract Value : +123 .2605l$ 1 .0000
B:
Calculate the yen arbitrage profit from Itsuji's strategy, using the data in
Exhibit 2. Show your calculations.
Source: 2002 CFA Level 2 exam
Page 91
Derivatives
Guideline Answer:
A.
The theoretical futures contract price is*122.0645, calculated as follows:
. x (l + interest ratein the local market)*rydi"epoiod

Futures price = sPot Pnce
'
(1+ interest iatein the foreign marketf-F-dinePeriod
: y124.30000 x (1 + 0.0010)o't 1 (1 + 0.0380)0'5
= *124.30000 x (1.00049988 i 1.01882285)
- +122.06453
B. The yen arbitrage profit is*129,928.0t,
calculated as follows:
Borrow $1,000,000 for 3 months @350%

n.(
x
Repay principal * interest: $IO0O,O00 1.0350't5: $1,008,63?.45
:*124,300,000
Exchange the $1,000,000 borrowed @ +124.30/ $1.00
Invest the*124,300,000 for 3 months at 0-5ff/o
:1124,455,084'52
Receive principal * interest = 124,300,000 x 1.0050'25
Sell 3-month futures to pay offUS$ denominated loan
payoff (in y) $t,0b9,637.45 x +123.2605 i $1.00
+124,325,155.91
of the us$ loan

Yen arbitrage profit = Proceeds from yen investment - repayrnenl (t-n Y)
: *129,928'61
= *124,455,084.52 -ry124,325,155.91
'
Page 92
Derivatives
There are curency futures contracts that allow for the exchange of Mexican
of Swiss
francs and u.S. dollars. If I am an investor based in zuich, explain how I
could use these contracts to convert the payoff to a peso-denominated asset
back into francs in two months.
6.
pesos and U.S. dollars, while other contracts allow for the exchange
First, enter into a forward position agreeing to exchange pesos for dollars
in two months. Then, enter into another forward contract agreeing to
exchange those dollars for Swiss francs, also in two months.
You are a coffee dealer anticipating the purchase of 82,000 pounds of coffee
in three months. You are concerned that the price of coffee will rise, so you
take a long position in coffee futures. Each contract covers 37,500 pounds, and
so, rounding to the nearest contract, you decide to go long in two contracts.
The futures price at the time you initiate your hedge is 55.95 cents per pound.
Three months later, the actual spot price of coffee turns out to be 58.56 cents
per pound and the futures price is 59.20 cents per pound.
a. Determine the effective price at which you purchased your coffee. How do
you account for the difference in amounts for the spot and hedge
7.
b.
positions?
Describe the nature of the basis risk in this long hedge.
(a)
You bu,v the coffee at 58.56 cents per pound. This will cost 75,000 x
($.5856) : $43,920. Your futures profit will be 75,000 x ($ .592 - $ .5S9q :
82,437.50. This reduces the effective price at which you buy the coffee to
$43,920-s2,437.50 : $41,482.50. This is an effective price per pound of
$41,482.50/75,000 : $ .5531. So you paid 55.31 cents per pound.
Buying fivo contracts for 75,000 pounds at 55.95 cents/pound leaves 71000
pounds unhedged and therefore purchased in the spot market for 5g.56
cent/lb. The effective price per pound is therefore
7,000 x 58.56)/82,000
56.17
cents/pound.
(75,000
x 55.95 +
(gtqntResl6t
The difference in price betn'een spot and future is probablv due to

delivery costs. 1.t<5rr ônu,rqe,ttcrq- cp& taqstS dbcr..q66
(b)
I'qtô.n+ttt
vtsF_
'
t)tvecaA v"adqg&rse.ooo t4rt
There are a couple of types of basis'risk. First the anticipated amount is

not exactly hedgable because of the contract size. This.means you will
either have to over-hedge or under-hedge. Also you may not know the.
exact amount that you will really need at the future date. If you are really
going to purchase the coffee somewhere else and were only using the
futures to hedge (i.e. close your position before delivery) then you will be
e.xposed to changes in the relative prices between the market you
purchase in and the futures market.
rnrq,rh-t
3)
,/
onq
?SrobO"
6{\FRre!(ftqb
*4a& e>rv\^q.q.9se,g* r\n c{iF4l.

[ocq,ttons staou-(ct V<.*
\cean56el\ l.tn prr\ C-A-_ <srtfne;rAif
ard,'ty.=f;e.
Page 93
Derivatives
8.
CFA Examination Level III

trust holds $100 million in
The world Ecosystem consortium (wEC) pension
interest rate risk, you, as an
l,ong-term U.S. Treasury bonds. To reduce
the trust diversify by investing
independent advisor to tire WEC, suggest that
(bunds) for six months' You point
$30 million in Cerman gorr"*.nt bonds
a fixed^number of contracts)
out that u fr^"d-".rrrer"f rut r."t hedge (shorting
the $30 million in bunds
could be used by WEi's pension trust to protect
against exchange rate losses over the six months'
for the WEC
Explain how a fixed-currency futures hedge could be constructed
exchange rate
trust Uy shorting cuTency futot"t contracts to protect against
that wEC's investment
losses. Describe one characteristic of this hedge
committee might deem undesirable'

spot rate to calculate
If wEC invests in Bundso they can use the current
million' We can assume
how many bonds they wiil receive today for $30
primarily by-a
motivated
wEC is satisfied withthe Bund interest rate and
Even if they could
desire to diversify and reduce interest rate risk'
will holdo however'
guarantee the Deutschemark value of the bonds they
contract sets
it *ootd still face exchange rate risk. A currency futures
a prior agreement'
the"yrate for future exchange of marks for dollars. With
six
like a futures contract, wnc can guarantee their exchange rate
months hence.
rate rises and

Short futures positions will incur losses as the exchange
of the Bunds will change
gaios as the .""nurr!" rate falls. The dollar value
WEC buy just
in the opposite Oir-""tioo. A perfect hedge would havemarks
they will
enough futures (face value in marks) io cover the
repatriate.
Undesirable Characteristics
hedge does not preserve the entire $30

almost surely
million. The futures settlement rate for six months hence is
but probably
hedge
can
wEC
less favorable than the exchange rate today.
part of the
will lock in a loss, even without transaction costs. This loss is
Even a perfect n-.d f"t,t*s
opportunitycostotn.agiog.forgoingthechanceofexchangerategains
in ieturn for preventing exchange rate losses'
Fixedeurrencyhedgesarerarelyperfectbecalrle^Germanmarkfutures
1251000 DM) and may not be
contracts are for a irxed amount (currently
purchased today. A typical
an integer multiple of the number of maiks
fixedfuturesneageiseitherslightlyoverorunderhedged.
be paid daily' If
currency futures positions require margin. Losses must
the futures'
wEC does not tiquidate gains on the Bunds to fund losses on
theymayneedextracashsometimeduringthesixmonths.
the Bunds mature

Fixed currency hedging also presents problems when
will not know exactly how
beyond the six *or,th holding period. wEC
Page94
Derivatives
many marks it will need to repatriate six months hence. Iledging by

shorting a fixed number of contracts is rarely done unless the foreign
investment is a pure discount security.
Page 95
Derivatives
Topic
1"1
1.
You are a fund manager for net-wealth clients. One of your clients expects
short-term interest rates to remain low over the coming year and expects
Activities
equities to offer a significantly higher return. The investor wants to shift some
funds from cash to equities. The investor currently holds a portfolio of money
market assets.
(a) Detail 3 possible solutions available to the client to achieve her aims,
alongwith the advantages/disadvantages associated with each method.
One of these solutions should be a swao contract.
1) Liquidate the money market portfolio and purchase a portfolio of

stocks.
This solution is subject to execution costs and administrative costs which

have a negative impact on returns.
2) Go short on money market futures contracts and long on stock index
contracts.
This solution will be cheaper but the client may not be able to perfectly
hedge her exposure in the money market (problems associated with
quantity / time risk, etc.)
3) Enter into a one-year equity swap where the counterparty agrees to
pay the investor the total return to the stock index in exchange for an
agreed upon money market return (variable interest rate).
This solves all the above options, but as swaps are OTC the client is
exposed to default risk and the problem of locating a counterparty willing
to engage in the swap.
The client decides to enter into a one-year equity swap where the counterparty
agrees to pay the investor the total retum to the stock index in exchange for
dollar-denominated Libor on a quarterly basis. The Exhibit below summarizes
the mechanics of the swap assuming that on settlement date the stock index is
at 640, dividends are 3.30 index points each quarter, and current 90-day Libor
is 3.25% and the notional amount of the contract is $ 1,000,000. Each quarter
contains 91 days.
Page 96
Derivatives
Exhihit4
Shnrap
TIME
LIBOR
Settlement
3.25Vs
Rese#l
Reset#Z
Reset#3
Maturity
i
3.70:
3.10 ",
3.25
3.15
Data
S&P
5OO
640
645
650
640
670
(b) Fill in the missing values from the cash flow schedule below:
Exhihit 5
Cash Flow Schedule
Time
Notional
1,000,000
#i
#2
#3
maturity
Libor
8,215
Index
7,812
Diuidend
5,156
Net
4.753
5,140
5.125
5,109
Total
Irrcremental Return
An example of calculation of payments is given below:

Calculation of payments :
Investor Receives: (Return * Notional Amount) * Accrued Dividends
Investor Pays: Libor * 91/360 * Notional Amount
On the first reset date the investor receives $4,753:
*
[((645-640) 1640 1,000,000) : 7,812 + 5,156 : 12,968. Net payment to
investor : 120968-8 1215 : 417531
The entire cash flow schedule is given below:
Cash Flow Schedule
Time
Nohonal
#1
1,000,000
#2
1,004,?53
#3
1,00e,556
matLnity 990,983
Total
Incremental Return
Libor
8.2i5
8.128
8,166
8,015
Index
1.812
?,788
(15,531)
46,452
Dividend Net
5,156
4,753
5,140
4.802
(18,572 )
5,125
5,109
43.546
34.529
3.45o/o
Page 97
Derivatives
(c) What is the total incremental return for the above swap?
The total return to the equity index consists of $43,546 in incremental

return above Libor - a 3,45oh return. This is the same amount if the
investor was able to purchase the index directly without incurring
transactions costs.
(d) Swaps can be viewed as an amalgamation of a number of alternate

financial instruments. What type of portfolio of financial instruments is
the above swap replicating? What benefits are there from using the swap
over the alternative?
This type of equity swap is the economic equivalent of financing a long

position in the S&P 500 Index at a spread to Libor. The advantage of
using the swap isl no transactions costs, no sales or dividend withholding
tax and no tracking error or basis risk versus the index.
2.
Two parties enter a three-year, plain vanilla interest rate swap agreement to
exchange the LIBOR rate for a 10 percent fixed rate on $10 million. LIBOR
is 11 percent now, 12 percent at the end of the first year, and 9 percent at the
end of the second year. If payrnents are in arrears, which of the following
characterises the net cash flow to be received by the fixed-rate payer?
A: $100,000 at the end of year 2.
B: $100,000 at the end of year 3.
C: $2000000 at the end of year 2.
D: $200,000 at the end of year 3.
Source: 2002 CFA Level
1 sample exam
Because the payments are in arrearso the end-of-year payments depend on
the interest rate at the beginning of the year (or prior year end). The
payment at the end of yenr 2 is based on the lLoh tnterest rate at the end
of year 1. If the floating rate is higher than the fixed rate, the fixed rate
payer receives the interest rate differential times the principal amount,
or:
$L0,000,000 x (0.12
0.10)
$200,000
Page 98
Derivatives
3.
Fran Arseneault manages investment assets and liabilities for Allied

Corporation. Allied's portfolio currently has the following characteristics:
.
.
$300 million of the assets must be invested short term. These assets
currently earn a six-month LIBOR rate of five percent.
$300 million in debt is outstanding; $tOO million is seven-year term fixed
at a 6.5 percent rate and $200 million is short term at the six-month
LIBOR rate.
A:
Describe Arseneault's asset/liability exposure to declining interest rates.
Allied
has been unable to issue additional variable rate debt at reasonable fees.
Hogan Stanfield Investment Bank stands ready to swap intermediate term 6.5
percent fixed and six-month LIBOR.
B:
Diagram an appropriate interest rate swap using boxes. Label all boxes.
Draw and label affows to specify the rates, the payer and receiver for all
fixed and floating rates, and the notional amount(s) involved. Your
diagram must identify the fixed-rate bonds and variable-rate assets.
After the swap is executed, LIBOR immediately decreases substantially and

remains at the lower level until the swap contract expires.
C: Determine the effect of the LIBOR decline on Allied's
asset and
liability
positions. Explain why this effect occurs.

Source: 2000 CFALevel3 samole exam
Guideline Anslver:
A. A mismatch problem arises because Arseneault has more variable assets ($300 million) under
management than variable liabilities ($200 million)" The $300 rniilion in assets has a smaller
duration than an equivalent $300 million in liabilities that are split between $200 million
variabie and $100 million fixed rate. Consequently, Arseneault is exposed to interest rate
risk. Should rates go down, the value of the liabilities will increase more rapidly than the
value ofthe assets.
B. Allied will receive fixed rate and pay floating rate to the investrnent bank, which will pay
fixed rate and receive floating rate. The notional amount will be $100 million, the differenee
between the $300 million in variable rate assets and the $200 million in variable rate
liabilities. The diagram shows Allied paying LIBOR to Hogan Stanfield and receiving6.5To
fixed. The diagram also shows Allied paying 6.5Vo to $100 million in fixed rate bond
liabilities and receivine LIBOR from the variable rate assets.
t;
Page 99
Derivatives
LIBOR
.>
($100m notional)
Allied
Hogan Stanfield
6.5?o flxed
($100m notional)
I
6.sqo
fixed
Fixed rate
bonds
{$ 100 million)
C.
The asset and liability values

during the ternr af the swap.
1,.*..
Variable rate
assets
($ 100 millioni
will remain equal, because
ttre portfclio
will be immun':';
Page 10t
Derivatives
4.
Ashton Bishop is the debt manager for World Telephone, which needs 3.33
billion Euro financing for its operations. Bishop is considering the choice
between issuance of debt denominated in:
. Euros (), or
. U.S. dollars, accompanied by a combined interest rate and currency swap.
A: Explain one nsk World would assume by
entering into the combined
interest rate and culrency swap.
Bishop believes that issuing the U.S. dollar debt and entering into the swap
can lower world's cost of debt by 45 basis points. Immediately after
selling the debt issue, world would swap the U.S. dollar payments for
Euro payments throughout the maturity of the debt. she assumes a
constant currency exchange rate throughout the tenor of the swap.
Exhibit 1 gives details for the two alternative debt issues. Exhibit
provides current information about spot currency exchange rates and the 3year tenor Euro/U.S. Dollar cuffency and interest rate swap.
Exhibit
Characteristic
Par Value
Term to Maturity
Fixed Interest Rate
Interest Payment
Exhibit
Euro Currency Debt
U.S. Dollar Currency Debt
3.33 billion
3 years
3 billion
3 years
6.25o/o
7.75
Annual
Annual
Spot currency exchange rate

3-year tenor Euro/U.S. Dollar fixed interest rates
B:
c:
$0.90 per Euro
s.8% /7t30%g
Show the notional principal and interest payment cash flows
of the
combined interest rate and cuffency swap.
State whether or not world would reduce its borrowing cost by issuing the
debt denominated in u.s. dollars, accompanied by the combined interest
rate and cutrency swap. Justifu your response with one reason.
Source: 1999 CFA Level2 sample exam
Page 101
Derivatives
Guideline Answer;
A. World would assume both csunterparty risk and currency risk'

principal
default on payment of
counterparty risk is the risk thar Bishop,s counterparty wiu
or interest cash flows in the swap"
all cash flows' If the US$
Currency risk is the currency exposure risk associated with
funding of the coupon payments;
appreciates (Euro depreciatesl, tiere would be a loss on
worth lrss at the swap's maturity'
however, if the us$ depreciates, then the dolars wilr be
14,
3.33 billioa
Interest PaYment
l{orld
193.14 milliont
193.14
million
Receives
Notional
Principal
$ 3 billion
3.33 billion
Interest PaYment
$ 219 millionz
S 219
miiiion
6 .rt rr l.tLllllvu
'b L 17 -illlnn
1 tg:.t+ million = 3'33 billion x 5'87o

t Ztg million = g 3 billion x7.3%
$
c.
Euro market'
because what Bishop saves in the
cost,
borrolving
its
reduce
not
worrd would
.rne in;rest rate on the Euro puy i1a3 of her swap is 5'80
she loses in the dollar market.
an interesl savtng
she would Pay on her duro debt issue'
percent
6.25
the
than
lower
percent,
7'?5
?'30 percent in U'S' doilars to pay on her
of 45 bps. But Bishop is only receiving
curenc)
shortfall of 45 bps. Given a constant
pefcent u.s. debt interest payment, *Tn,*r"ri
percent
-.
exactly offsets the savings from paying 5'80
exchange ,*,*, ,irir-+s tpu'.r,ottr.ri
deut
dollar
U'S'
rhe
seiting
tu"inlt uy
is no inter".,
versus the 6.25 percent. Tbus there
"ort
issue and entering into the swap alrangemenl
Page 102
Derivatives
Tax Treatment for Swaps

The tax treatment of swaps, as with other derivatives is not governed in Australia by
any single tax ruling. It is also a complicated matter as taxation of these contracts and
instruments can largely depend upon the individual's circumstances and purpose for
using them. Over the next few pages the
full income tax ruling of
IT26182 and
IT26150 are printed specifically relate to swaps. The tax rulings refer to the ISDA
Master agreement for swap contracts. You are not expected to know the contents
these rulings inside out,
of
but rather have a general understanding of the tax
implications that stem from taking a derivatives position, whether it be for hedging or
speculation.
To ensure you feel confident in having covered the material sufficiently, the checklist
below should help gauge your level of understanding. Tutorial questions are also
provided for class.
CHECKLIST
o
o
.
o
Understand what party of a swap cash flow is assessable for tax and what can
be deductible.
Know the means by which swap receipts and payments can be brought to
account for taxing.
Understand what characteristics of a contract make it bona fide and the
difference this has on the treatment of the swap for taxation purposes.
Taxation implications for accelerated and deferred swap arrangements
Tutorial Questions
t.
Define the main criteria for determining whether a swap contract is bona fide
or not?
uses swap to hedge exposure to an interest rate fluctuation on an

loan
underlying
-if taxpayer
taxpayer is acting as an intermediary (usually implying it is a financial

institution)
-if the taxpayer operates a swap book (does not have any underlying loans in
respect to the swaps as it is a financial institution profiting from its services)
-if
Page 103
Derivatives
2.
What
is the tax treatment for non bona fide
interest accelerated swap
contracts? Why do you think this is the case?
for tax purposes. Thereforer some

of the accelerated payments are treated as outgoing of non-deductible principle.
The reason this is done is because otherwise there would be a major incentive to
enter into accelerated swaps for tax purposes.
-If not bona fide, they can be treated
3.
as loans
Explain the four methods used to tax swap receipts and payments. Using
numerical examples, show how each method functions.
Commencement of payment period

Example: if swap contract entered into now with first payment in one
month time with receiver to get $1000 and pay $300, then this would be brought
to immediate account as income and deduction. Essentially, there is a one period
lead time over each PaYment.
Straight line accrual basis
At the end of each payment period

Example: if swap contract entered into now with first payment in one
month time with receiver to get $1000 and pay $300, then this would be brought
to account as income and deduction at the end of next month. Essentially, there
is a one period lag time over each payment.
Marked-to-market basis
Example: at the end of each tax year (andior payment period) losses are
matched against profits to determine whether there is a net loss or gain for each
tax period. In the above case, $700 net profit needs to be declared.
4.
If
What type of tax basis should be used if the swap contract is bona fide?
swap is bona fide then straight line accrual basis should be used.
Page 104

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Optionsr, Futures and

Answers to Class Activities

A lot of work has gone into these questions.

Under NO conditions are

Some questions can

If you are unsure of how to answer a question,

few days before you tutor so you are prepared.

The Universitv of Adelaide

What is the contract size for its share options derivatives?

What is the contract expiry date for index options?

What is the contract expiry date for share options?

iv) What is the longest expiry length for an option?

The University of Adelaide

From the ASX website

market sector covered by the particular index'

movements in the underlying index.

ASX approved indices (currently the S&P/ASX

third Thursday of the month, unless otherwise

Last trading day

Trading wili cease at 12 noon on expiry

a specified number of dollars per point e'g'

ihe exercise price of the option multiplied by the

The UniversitY of Adelaide

index options are cash settled.

lndex options are cash settled.

Options are currently available over the following ASX indices:

S&PTM/ASX 200TM Index - code XJO

Benefits of index options:

The Universitv of Adelaide

trrysi*yg:i/8 l.ihtip:/7*$yw. asx.corL

The ability to trade all the stocks in an index with

just one trade - investing in index options approximates

Leverage - index options, like ordinary options, provide

Protection for a share portfolio - when you buy shares

Low trading 6osts - since the amount of capital outlaid

'pdf documents require Adobe Acrobat Reader

Terms of use I Pnvacy Statement I Last reviewed: 31107142

The University of Adelaide

$ry'si\..vg:/ls 64rftp://wTrw.asx. com. aur'rnarketsr'I4/optionleatures

In order to make it easier for investors to trade into and

the underlying securities

The only other variable is the premium, which is the

market price of the option.

The companies over which options are listed are

An option contract size is standardised at 1,000

In the case of index options, the contract value is fixed at

AUD $10 per index point). The size of the contract is

equal to the index level multlplied by the dollar value per

This is the price at which you may buy or sell the

OCH lists a range of exercise prices for all options listed

exercise prices available for options with a given expiry

asx. corn au/markeJsn4lOptionFearu l.ss-

The Expiry Day is the day on which all.unexercised

There are also longer term option contracts listed over

$300 Per contract.

The UniversitY of Adelaide

Are index options on the ASX

considered to be European or American

What is an efficient market and why is it important for derivatives markets?

what types of transaction costs

are you faced

with when trading options?

There is no specific taxation ruring that appties to options. rlowevero

trrysiyg:i/8 l.ihtip:/7$yw. asx.corL