Chapter 1 - Introduction

 Derivative securities
 Futures contracts
 Forward contracts
 Futures and forward markets
 Comparison of futures and forward contracts
 Options contracts
 Options markets
 Comparison of futures and options
 Types of traders
 Applications

 Derivative securities
Securities whose values are derived from the values of other underlying assets
Futures and forward contracts
Options
Swaps
Others

 Futures contracts
An agreement between two parties to either buy or sell an asset at a certain time in the
future for a certain price

For example, in March a trader buys a June futures contract on corn at 600 cents (or $6)
per bushel
If ST > $6 (gain)
March: A trader buys a June: The trader must
June futures contract on buy 5,000 bushels of If ST = $6 (no gain/loss)
corn at 600 cents/bushel corn for $30,000
If ST < $6 (lose)

Profit/loss diagram
Profit Profit

0 ST 0 ST
K=$6 K=$6

Long position (buy a futures contract) Short position (sell a futures contract)

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K = delivery price = $6/bushel and ST = the spot price at maturity (can be greater than,
equal to, or less than $6/bushel)

If ST is greater than K, the person with a long position gains (ST - K) and the person with a
short position loses (K - ST) - zero sum game (someone’s gain is someone else’s loss)

If ST is less than K, the person with a long position loses (ST - K) and the person with a
short position gains (K - ST) - zero sum game

If ST is equal to K, there is no gain or loss on both sides - zero sum game

Corn: underlying asset - commodity (commodity futures contract)

Buy a futures contract: long position - promise to buy
600 cents/bushel: futures price/delivery price
5,000 bushels: contract size - standardized
June: delivery month
Spot price: actual price in the market for immediate delivery

More examples
(1) Long futures positions: agree to buy or call for delivery
On February 1, you buy a June gold futures contract at 1,300: you agree to buy (or call
for delivery) 100 ounces of gold in June at 1,300 dollars per troy ounce

Contract details
1,300 dollars per ounce - futures price of gold on February 1 for June delivery, also called
delivery price (Note: the futures price of gold on February 2 for June delivery may be
different)
100 ounces - contract size
June - delivery month
Underlying asset: gold - commodity (commodity futures contract)
Position: long position
Actual market price of gold - spot price which can be different from the futures price

(2) Short futures positions: agree to sell or promise to deliver

On February 1, you sell a June Yen futures contract at 1.1250: you agree to sell (or
promise to deliver) 12,500,000 Yen in June at $1.1250 per 100 Yen ($1 for 88.8889 Yen)

Contract details
$1.1250 per 100 Yen - futures price (exchange rate), also called delivery price
12,500,000 Yen - contract size
June - delivery month
Underlying asset: foreign currency - financial asset (financial futures contract)
Position: short position
Actual market exchange rate - spot exchange rate which can be different from the futures
exchange rate

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 Futures contracts can be written on different assets (underling assets):
Commodities - commodity futures, for example, grains, livestock, meat, metals, and oil
Financial assets - financial futures, for example, stock indices, bonds, currencies
Others

Technical details (covered in later chapters)

Margin requirements
Daily settlement procedures - marking to market
Bid-offer spreads
Clearinghouses
Delivery

 Forward contracts
A forward contract is similar to a futures contract in that it is an agreement between two
parties to either buy or sell an asset at a certain time in the future for a certain price. But
forward contracts are less formal, traded only in OTC markets, and contract sizes are not
standardized.

 Futures and forward markets

(1) Exchange-traded markets
Chicago Board of Trade (CBOT): futures contracts
Chicago Mercantile Exchange (CME): futures contracts

Open-outcry system: traders physically meet on the floor of the exchange and use a
complicated set of hand signals to trade

Electronic trading: increasingly replacing the open-outcry system to match buyers and
sellers

(2) Over-the-counter (OTC) markets

Telephone- and computer-linked network of dealers

Flexibility - tailor your needs

Credit risk - the risk that your contract will not be honored

 Comparison of futures and forward contracts

Exchange Standardized Marking Delivery Delivery Default
trading contract size to market time risk
Yes or cash Some
Forward No No No settlement One date credit risk
Usually Range of Virtually
Futures Yes Yes Yes closed out dates no risk

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 Options contracts
Rights to buy or sell an asset by a certain date for a certain price

American options vs. European options

American options can be exercised at any time before the expiration date
European options can only be exercised on the maturity date

Keeping other things the same, which type of options should be worth more and why?
Answer: American options because they can be exercised at any time before expiration

Two types of options: call options vs. put options

A call option gives the right to buy an asset for a certain price by a certain date
For example, you buy an IBM June 190 call option for $3.00
Option type: call option - the right to buy
The underlying asset - IBM stock
Exercise (strike) price - $190 per share
Expiration date - the third Friday in June
Contract size: 100 shares
Option premium (price of the option): $300.00

A put option gives the right to sell an asset for a certain price by a certain date
For example, you buy a GE June 24 put option for $2.00
Option type: put option - the right to sell
The underlying asset - GE stock
Exercise (strike) price - $24 per share
Expiration date - the third Friday in June
Contract size: 100 shares
Option premium: $200.00

Four types of positions: buy a call, sell (write) a call, buy a put, and sell (write) a put

(1) (2) (3) (4)

(1) Buy a call (2) Sell a call (3) Buy a put (4) Sell a put

Options can be written on different assets:

Stocks - stock options
Stock indices - index options
Currencies - currency options
Futures - futures options
Others

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 Options markets
Exchange traded markets
(1) Chicago Board Options Exchange (CBOE): options

(2) Over-the-counter (OTC) markets

 Comparison of futures and options

Rights (options) vs. obligations (futures)
Initial outlay (buying options requires an initial outlay while buying futures doesn’t)

Both need a margin account (futures are subject to marking to market daily)
Both use leverage

 Types of traders
(1) Hedgers: use options and futures markets to reduce price uncertainty (risk) in the
future

For example, a farmer can sell corn futures contracts to lock in a price and an investor
can buy a put option to protect a potential downward movement of a particular stock

More details: a company can use forward contracts for hedging currency risk
Import Co. purchased goods from a British supplier in June and needs to pay 10 million
British pounds in September. A local financial institution offers forward contracts for
British pounds. The quotes are shown below:

Bid Offer
Spot 1.6382 1.6386
1-month forward 1.6380 1.6385
3-month forward 1.6378 1.6384
6-month forward 1.6376 1.6383

How should Import Co. hedge the exchange rate risk?

Answer: Import Co. should buy 10 million British pounds in the three-month forward
market to lock in the exchange rate of 1.6384 (or 16.384 million dollars for 10 million
pounds for September delivery)

When you sell pounds to the financial institution you get the bid price
When you buy pounds from the financial institution you pay the offer price
The difference between bid and offer is called bid-offer spread which is the profit for the
institution

Hedging using options – Example 1.2 on page 13

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(2) Speculators: bet on price movement

For example, you buy gold futures contracts because you bet that the price of gold will go
up in the future, or you buy a put option on Intel if you bet that Intel stock price will drop

More details: a trader uses options for speculation (leverage effect)

A trader with $2,000 to invest bets that the price of ORCL will increase in the near future
and has the following quotes:
Current stock price: $20.00
ORCL June call option with exercise price of $22.50 sells for $1.00

Alternative 1: buy 100 shares of ORCL

Alternative 2: buy 20 ORCL June call options with exercise price of $22.50

Possible outcomes:
If ORCL stock price rises to $27
Alternative 1: profit of $700 = 100*(27 - 20)
Alternative 2: profit of $7,000 = 20*100(27 - 22.5 - 1)

If ORCL stock price falls to $17

Alternative 1: loss of $300 = 100*(17 - 20)
Alternative 2: loss of $2,000 (the options are worthless)

If ORCL stock price rises to $23.5

Alternative 1: profit of $350 = 100*(23.5 - 20)
Alternative 2: break-even (23.5 - 22.5 - 1)

(3) Arbitrageurs: look for risk-free profits by taking the advantage of mispricing in two or
more markets simultaneously

Conditions for arbitrage:

Zero net cost
No risk
Positive profit

Example: use stocks and exchange rates for arbitrage

A stock is traded on both NYSE and London Stock Exchange. The following quotes are
obtained at a particular time:

Stock price at NYSE: $20/share

Stock price at London Stock Exchange: 13 pounds/share
Spot exchange rate: 1 pound = $1.60

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 Detailed arbitrage process:
Borrow $2,000 to buy 100 shares at NYSE
Sell the shares at London Stock Exchange for 1,300 pounds
Covert the sale proceeds from pounds to dollars at the spot exchange rate to receive
$2,080 = 1,300*1.60
Repay the loan of $2,000
Arbitrage profit: 2,080 – 2,000 = $80 (ignoring transaction costs)

Example 1.3 on page 17

(4) Dangers: start from hedgers or arbitrageurs and consciously or unconsciously become
speculators

 Applications
Market completeness - any and all identifiable payoffs can be obtained by trading the
derivative securities available in the market (Financial Engineering)

Risk management - reduce risk or hedging

Trading efficiency - increase market efficiency

Price discovery - futures price is the best expected spot price in the future

Speculation - bet on prices

 Assignments
Quiz (required)
Practice Questions: 1.11, 1.12, 1.13, 1.14, 1.20 and 1.21

7
 Chapter 2 - Mechanics of Futures Markets

 Specification of a futures contract

 Convergence of futures price to spot price
 Operation of margins
 Quotes and prices
 Delivery
 Types of orders
 Regulation
 Accounting and taxes

 Specification of futures contracts

Opening a futures position vs. closing a futures position

Opening a futures position can be either a long position or a short position

(i.e., the opening position can be either to buy or to sell a futures contract)
Closing a futures position involves entering an opposite trade to the original one

The underlying asset or commodity: must be clearly specified

The contract size: standardized

Corn and wheat: 5,000 bushels per contract
Live cattle: 40,000 pounds per contract
Cotton: 50,000 pounds per contract
Gold: 100 troy ounces per contract
DJIA: $10*index
Mini DJIA: $5*index
S&P 500: $250*index
Mini S&P 500: $50*index

Delivery month: set by the exchange

Delivery place: specified by the exchange

Daily price limits: usually specified by the exchange, it is the restriction on the day-to-
day price change of an underlying commodity. For example, the price of corn can change
by no more than 10 cents per bushel from one day to the next and the price of wheat can
change by no more than 20 cents per bushel from the preceding closing price

Position limits: the maximum number of contracts that a speculator may hold
For example, less than 1,000 contracts total with no more than 300 contracts in any one
delivery month for random-length lumber contract in CME

Tick: the minimum price fluctuation, for example, ¼ cent per bushel for wheat

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 Convergence of futures price to spot price
As the delivery period approaches, the futures price converges to the spot price of the
underlying asset (no matter the futures price is higher or lower the spot price now)

Why? Show that the arbitrage opportunity exists if it doesn’t happen

If the futures price is above the spot price as the delivery period is reached
(1) Short a futures contract
(2) Buy the asset at the spot price
(3) Make the delivery

If the futures price is below the spot price as the delivery period is reached
(1) Buy a futures contract
(2) Short sell the asset and deposit the proceeds
(3) Take the delivery and return the asset

 Operation of margins
Margin account: an account maintained by an investor with a brokerage firm in which
borrowing is allowed

Initial margin: minimum initial deposit

Maintenance margin: the minimum actual margin that a brokerage firm will permit
investors to keep their margin accounts

Margin call: a demand on an investor by a brokerage firm to increase the equity in the
margin account

Variation margin: the extra fund needs to be deposited by an investor

Marking to market (daily settlement): the procedure that the margin account is adjusted to
reflect the gain or loss at the end of each trading day

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 Example: suppose an investor buys two gold futures contracts. The initial margin is
$2,000 per contract (or $4,000 for two contracts) and the maintenance margin is $1,500
per contract (or $3,000 for two contracts). The contract is entered into on June 5 at $850
and closed out on June 18 at $840.50. (Gold is trading around $1,300 per ounce now.)

Futures price Daily gain Cumulative Margin Margin call

Day (settlement) (loss) gain (loss) balance (variation margin)
850.00 4,000
June 5 848.00 (400) (400) 3,600
June 6 847.50 (100) (500) 3,500
June 9 848.50 200 (300) 3,700
June 10 846.00 (500) (800) 3,200
June 11 844.50 (300) (1,100) 2,900 Yes (1,100)
June 12 845.00 100 (1,000) 4,100
June 13 846.50 300 (700) 4,400
June 16 842.50 (800) (1,500) 3,600
June 17 838.00 (900) (2,400) 2,700 Yes (1,300)
June 18 840.50 500 (1,900) 4,500
Note: the investor earns interest on the balance in the margin account. The investor can
also use other assets, such as T-bills to serve as collateral (at a discount)

Clearinghouse: an intermediary to guarantee in futures transactions

 Quotes and prices

Opening price, highest and lowest prices, and settlement price – Table 2.2

Bid price vs. offer price

Bid price: the price an institution is prepared to buy

Offer price: the price an institution is prepared to sell

Settlement price: the average of the prices immediately before the closing bell and
marking to market is based on the settlement price

Open interest: the total number of contracts outstanding at a particular time

Open interest: an example

Given the following trading activities, what is the open interest at the end of each day?

Time Actions Open Interest

t=0 Trading opens for gold contract 0
t=1 Trader A buys 2 and trader B sells 2 gold contracts 2
t=2 Trader A sells 1 and trader C buys 1 gold contract 2
t=3 Trader D sells 2 and trader C buys 2 gold contracts 4

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 Delivery
Very few futures contracts lead to actual delivery and most of futures contracts are closed
out prior to the delivery month

If delivery takes place, the decision on when to deliver is made by the party with the short
position

Cash settlement: some financial futures, for example, stock index futures are cash settled
(No actual delivery)

 Types of orders
Market order: the best price currently available in the market

Limit order: specifies a price (limit price) and your order will be executed only at that
price or a more favorable price to you

More specifically, you will buy at or below a specified price (limit price) or you will sell
at or above a specified price (limit price)

For example, current price of gold = $1,300, you can specify to buy a futures contract on
gold if the futures price  $1,250 or you can specify to sell a futures contract on gold if
the futures price  $1,350

Stop (stop-loss) order: specifies a price (stop price) and your order will become a market
order if the stop price is reached

For example, current price of gold = $1,300, you can specify to sell a futures contract if
the futures price  $1,250 or you can specify to buy a futures contract if the futures price
 $1,350 (short term momentum)

The main difference between a limit order and a stop order:

With a limit order you buy when the price drops and you sell when the price rises
With a stop order you buy when the price rises and you sell when the price drops

Stop-limit order: a combination of a stop order and a limit order

For example, current price of gold = $1,300
A stop-limit order to sell at a stop price $1,250 with a limit price $1,200
A stop-limit order to buy at a stop price $1,350 with a limit price $1,400

Market-if-touched order: executed at the best available price after a specified price is
reached

For example, current price of gold = $1,300

A market-if-touched order to sell if price  $1,350

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 Day order: valid for the day

Open order (good-till-canceled): in effect until the end of trading in a particular contract

 Regulation
Futures markets are mainly regulated by the Commodity Futures Trading Commission
(CFTC). Other agencies, for example, National Futures Association (NFA), Securities
and Exchange Committee (SEC), the Federal Reserve Board, and U.S. Treasury
Department also step in from time to time.

The Commodities Futures Trading Commission (CFTC): to approve new contracts, set up
daily maximum price fluctuation, minimum price movements, and certain features of
delivery process

The National Futures Association (NFA): to prevent fraudulent and manipulative acts and
practices

Trading irregularities: corner the market - take a huge long futures position and also try
to exercise some control of the underlying commodity
Example: Hunt brothers’ price manipulation in the silver market in 1979-1980

Trading irregularities: front running - take the advantage of inside information

 Accounting and taxes

Changes in the market value of a futures contract are recognized when they occur unless
the contract is qualified as a hedge

For speculators, all paper gains or losses on futures contracts are treated as though they
were realized at the end of the tax year - marking to market at the end of the year

40% of any gains or losses are to be treated as short-term and

60% of any gains or losses are to be treated as long-term

For hedgers, all paper gains or losses are realized when the contracts are closed out

The 40% short-term and 60% long-term rule doesn’t apply for hedgers

 Assignments
Quiz (required)
Practice Questions: 2.11, 2.15, 2.16 and 2.23

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 Chapter 3 - Hedging Strategies Using Futures

 Hedging principles
 Arguments for and against hedging
 Basis risk
 Cross hedging
 Stock index futures
 Rolling hedging

 Hedging principles
Hedging: to reduce risk
Complete hedging: to eliminate all risk

Short hedges: use short positions in futures contracts to reduce or eliminate risk

For example, an oil producer can sell oil futures contracts to reduce oil price uncertainty
in the future

Long hedge: use long positions in futures contracts to reduce or eliminate risk

For example, a brewer buys wheat futures contracts to reduce future price uncertainty in
wheat

 Arguments for and against hedging

Hedging can reduce risk but it has a cost

(1) Firms don’t need to hedge because shareholders can hedge by themselves

(2) Hedging may cause profit margin to fluctuate

(3) Hedging may offset potential gains (or lead to a worse outcome)

 Basis risk
Hedging usually cannot be perfect for the following reasons:

The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract (e.g., stock index futures and your stock portfolio)

The hedger may be uncertain as to the exact date when the asset will be bought or sold

The hedge may require the futures contract to be closed out well before its expiration date

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Basis
Basis (b) = spot price (S) - futures price (F)

Basis risk
Let S1, F1, and b1 be the spot price, futures price, and basis at time t1 and
S2, F2, and b2 be the spot price, futures price, and basis at time t2, then
b1 = S1 - F1 at time t1 and b2 = S2 - F2 at time t2.

Consider a hedger who knows that the asset will be sold at time t2 and takes a short
position at time t1. The spot price at time t2 is S2 and the payoff on the futures position is
(F1 - F2) at time t2. The effective price is

S 2 + F1 - F2 = F1 + b2, where b2 refers to the basis risk

Basis risk in a short hedge

Suppose it is March 1 (t1). You expect to receive 50 million yen at the end of July (t2).
The September futures price (exchange rate) is currently 0.8900 dollar for 100 yen.

Hedging strategy:
(1) Sell four September yen futures contracts on March 1 (Since the contract size is 12.5
million yen 4 contracts will cover 50 million yen)
(2) Close out the contracts when yen arrives at the end of July

Basis risk: arises from the uncertainty as to the difference between the spot price and
September futures price of yen at the end of July (S2 - F2 = b2)

The outcome: at the end of July, suppose the spot price was 0.9150 and the September
futures price was 0.9180, then the basis b 2 = 0.9150 - 0.9180 = - 0.0030
Gain on futures contract F1 - F2 = 0.8900 - 0.9180 = -0.0280
Effective price F1 + b2 = 0.8900 - 0.0030 = 0.8870 or
Effective price S 2 + F1 - F2 = 0.9150 - 0.0280 = 0.8870

Detailed illustration:
Sell 4 Sept. Yen Receive 50 million Yen, exchange Delivery
futures contracts Yen to $ at S2, close Sept. contracts month

March 1 (t1) End of July (t2) September

(Know S1, F1, and b1) (Receive 50 million yen) (F1 = 0.8900, known in t1)
(Don’t know S2, F2, and b2) (Know S2, F2, and b2) (F2 = 0.9180, known in t2)
(Effective price = S 2 + F1 - F2)

Choice of contract for hedging:

(1) Same underlying asset (or closely related)
(2) Delivery month (usually a later delivery month)

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 Cross hedging
If the asset underlying the futures contract is the same as the asset whose price is being
hedged, the hedge ratio usually is 1.0. For example, if a farmer expects to harvest 10,000
bushels of corn, the farmer should sell 2 corn futures contracts.

Cross hedging: two different assets (but closely related)

Minimum variance hedge ratio: the ratio of the size of the position taken in futures
contract to the size of the exposure to minimize the variance of the hedged position

Define
S : Change in spot price, S
F : Change in futures price, F
 S : Standard deviation of S
 F : Standard deviation of F
 : Correlation coefficient between S and F

When the hedger is long the asset and short futures, the change in value of the hedged
position is S  hF

When the hedger is short the asset and long futures, the change in value of the hedged
position is hF  S

Taking variance of the hedged position, both positions yield

v   S2  h 2 F2  2h S  F

Taking the first order derivative of v with respect to h in order to minimize the risk
S
Minimum variance hedge ratio, h* =  , where  is the correlation coefficient
F
Note: h* is the estimated slope coefficient in a linear regression of F on S and  2 is
2
the R from the regression and it is called hedge effectiveness

Optional number of contracts is given by:

N* = h* QA/QF, where QA is the size of position being hedged, and QF is the size of
futures contract

For example, if an airline wants to purchase 2 million gallons of jet fuel and decides to
use heating oil futures to hedge, and if h* is 0.78 and the contract size for heating oil is
42,000 gallons, then the airline should buy 37 contracts to hedge (futures contracts on jet
fuel are not available in the market).

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 Stock index futures
Stock indices: price weighted vs. value weighted – Table 3.3

Price weighted indices: for example, DJIA

Value weighted indices: for example, S&P 500

For stock index futures, the optional number of contracts is given by:

N* =  VA/VF, where VA is the current value of the portfolio, VF is the current value of the
stocks underlying one futures contract, and  is the beta of the portfolio

For example, if you want to hedge a stock portfolio using the S&P 500 futures contract, if
P = $5,000,000,  = 1.5, S&P 500 index = 1,000, A = 250*1,000 = 250,000, then

N* = 1.5*5,000,000/250,000 = 30 contracts (short)

Changing beta of a portfolio from  to  * (  >  *)

N* = (  -  *)VA/VF

For example, if you want to reduce the portfolio beta from 1.5 to 0.75

N* = 15 contracts (short)

 Rolling hedging
Rolling the hedge forward multiple times (n times)

Short futures Close out future Close out futures Close out
contract 1 contract 1 and short contract 2 and short futures
futures contract 2 futures contract 3 contract n

Time 1 (t1) Time 2 (t2) Time 3 (t3) ------ Time T (tn)

 Assignments
Quiz (required)
Practice Questions: 3.12, 3.16 and 3.18

 Appendix: review of standard deviation, correlation, linear regression, and CAPM

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 Chapter 4 - Interest Rates

 Types of interest rates

 Measuring interest rates
 Zero rates
 Bond pricing
 Forward rates
 Forward rate agreements
 Term structure theories

 Interest rates
Treasury rates - risk-free rates
T-bill rates vs. T-bond rates

LIBOR (London Interbank Offer Rate): used between large international banks
LIBID (London Interbank Bid Rate): used between large international banks
LIBOR > LIBID

Repo rate: an investment dealer sells its securities to another company and agrees to buy
them back later at a slightly higher price - the percentage change in prices is the repo rate

 Measuring interest rates

Nominal rate vs. effective rate

Effective rate = (1  R ) m  1 , where R is the annual nominal rate and m is the number of
m
compounding within a year

If m goes to infinity, we have effective rate under continues compounding, eR - 1

In general, the FV of $A compounded continuously for n years at a nominal annual rate

of R is FV = AeRn

In the same way, the PV of $A discounted continuously at a nominal rate of R for n years
is PV = Ae-Rn

Relationship between continues compounding and compounding m times per year:

Rm
e RC  (1  ) m , where Rc is a rate of interest with continues compounding and Rm is
m
R
the equivalent rate with compounding m times per year, or RC  m * ln(1  m )
m
For example, for a 10% annual rate with semiannual compounding, the equivalent rate
with continuous compounding is Rc = 2*ln (1 + 0.1/2) = 9.758%

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 Zero rates
Zero rates: n-year zero-coupon interest rate is the rate of interest earned on an investment
that starts today and lasts for n years

 Bond pricing
When pricing a bond, you should use different zero rates to discount all expected future
cash flows (coupon payments and face value) to the present.

Determining Treasury zero rates using T-bond price quotes

Bond principal ($) Time to maturity (years) Annual coupon ($) Bond price (S)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6

For a 3 month T-bond, the price is 97.5 for $100 face value. With quarterly
compounding, the 3 month T-bond has a zero rate of 4*(2.5)/97.5 = 10.256%. Convert
that rate to continuous compounding

Rc = m*ln(1 + Rm/m) = 0.10127 = 10.127% (with m = 4 and Rm is 10.256%)

Similarly, we can obtain the 6 month and 1 year T-bond zero rates of 10.469% and
10.536% for continuous compounding.

To determine the 1.5 year zero-rate, we solve

4e-0.10469*0.5 + 4e-0.10536*1 + 104e-R*1.5 = 96 (semiannual coupon payments)

R = 10.681%

In a similar way, we can obtain the 2 year zero-rate of 10.808%

 Forward rates
Spot rate vs. forward rate
An n-year spot rate is the interest rate on an investment that starts today and lasts for n
years

A forward rate is an interest rate that is implied by the current spot rates for periods of
time in the future

In general, RF = (R2T2 – R1T1) / (T2 – T1)

For example, if T1 = 3, T2 = 4, R1 = 0.046 = 4.6%, and R2 = 0.05 = 5%, then RF = 6.2%

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 Forward rate agreements
A forward rate agreement (FRA) is an over-the-counter agreement designed to ensure
that a certain interest rate will apply to either borrowing or lending a certain principal
during a specified future period of time.

Example 4.2

 Term structure theories

Term structure of interest rates and yield curves

Term structure of interest rates: relationship between interest rates (yields) and time to
maturity

Yield curve: a graph showing the term structure of interest rates

Expectation theory: long-term interest rates should reflect expected futures short-term
interest rates

For example, if a 1-year T-bond yields 5% and a 2-year T-bond yields 5.5%, then the
1-year forward rate between year 1 and year 2 is expected to be 6%.

RF = (R2T2 – R1T1) / (T2 – T1) = (5.5%*2 – 5%*1) / (2 – 1) = 6%

If a yield curve is upward sloping, it indicates that the short term interest rates in the
future will rise.

Market segmentation theory: interest rates are determined by the demand and supply in
each of different markets (short-, medium-, and long-term markets, for example)

Liquidity preference theory: investors prefer to invest in short-term funds while firms
prefer to borrow for long periods - yield curves tend to be upward sloping

 Assignments
Quiz (required)
Practice Questions: 4.10, 4.11 and 4.14

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