Contents

1 todo 3
2 Global Summary 3
2.1 ToI Summary (AKA checklist of problem types to be prepared
for, and ability to recognize quickly) . . . . . . . . . . . . . . . . 4
2.1.1 Cashows . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.1.1 Bonds . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.2 Multiparty Cashow Exchange . . . . . . . . . . . . . . . 4
2.1.3 Some Yield Calculations for Short Time Interval . . . . . 4
2.1.4 What Happens if Interest Rates Vary?! . . . . . . . . . . 4
2.1.4.1 Measures of a Cashows Sensitivity to Changes
in Interest Rate . . . . . . . . . . . . . . . . . . 4
2.1.4.2 Linear Combinations of Cashows . . . . . . . . 4
2.2 Conceptual Aids . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.3 Some Approximations to Look Forward To . . . . . . . . . . . . 6
3 Interest, Cashows, Annuities 7
3.1 Overview of Formulas . . . . . . . . . . . . . . . . . . . . . . . . 7
3.2 Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.3 Linearly Varying Annuities . . . . . . . . . . . . . . . . . . . . . 8
3.4 Some Common Pairs of Accumulation Functions and Forces of
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
4 Rate of Return of an Investment 8
4.1 Interest Measurement of a Fund: Dollar-Weighted Interest Rate . 8
4.2 Allocating Investment Income: Portfolio and Investment Year
Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
5 Loan Amorts., Sinking Funds, Bonds 9
5.1 Loan Payment Breakdown . . . . . . . . . . . . . . . . . . . . . . 10
5.2 Bond Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
5.3 Amortization of Premium or Discount . . . . . . . . . . . . . . . 12
5.4 Valuation of Bonds Between Coupons Payment Dates . . . . . . 13
5.5 Approximation Methods of Bonds Yield Rates . . . . . . . . . . 14
5.6 Callable Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
5.6.1 Discussion of Correlations between Changes in Price, Call,
Term, Yield . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1
6 Stocks and Money Market Instruments 17
6.1 Short Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
7 Measures of Interest Rate Sensitivity 18
7.1 The Term Structure of Interest Rates and Yield Curves . . . . . 18
7.2 Comparing Equated time, Durations, Convexity . . . . . . . . . . 18
7.3 Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
7.4 Full Immunization . . . . . . . . . . . . . . . . . . . . . . . . . . 20
7.5 Dedication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
8 Derivatives Markets 21
8.1 Mine Own Notation . . . . . . . . . . . . . . . . . . . . . . . . . 21
8.2 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2
1 todo
amorts w/ varying annuities
clarify callable bonds
study serial bonds?
for dollar-weighted, try to get uent with the strange tables they use, Assets,
Sales, Net, Salaries, Other, etc.
2 Global Summary
The main two lines of Exam FM, are in ToI (Theory of Interest) and DM
(Derivatives Markets).
The main line of ToI as I see it is three things. First annual compound
interest. Second, annuity formulas. Third, if earlier material looked at global
values of cashows, the sections on loans and bonds look at local values, inves-
tigating in detail the interest and payment step in any given period. This is
amortization. We may consider bonds a generalization of loans, where ending
balance is closer to original loan than zero.
The right and left arms of ToI could be said to be mirror images, on the one-
hand, the eect of cashow on interest, on the other hand, the eect of interest
on cash ow. (See chapters Rate of Return of Investment and Measures of
Interest Rate Sensitivity.)
The topics of DM are summed up nicely in my notation. Nu said.
Of course this is a brief, and the spine and arms need to be eshed out by
the diligent student.
3
2.1 ToI Summary (AKA checklist of problem types to be
prepared for, and ability to recognize quickly)
2.1.1 Cashows
Cashows Annuities Loans & Bonds Amortization.
Factors to consider: periods comparison date.
Periods: (if annuity then payment period) interest period. Usually interest
is compound, ie smooth, so let the discontinuous payment take precedence for
period.
Comparison date: (if annuity then due/immmediate) (PV, FV, etc., ...)
2.1.1.1 Bonds
The payments may vary. Know amortization. May have to value between
coupon dates. Questions regarding callable bonds may get tricky.
2.1.2 Multiparty Cashow Exchange
Multiparty Cashow Exchange Mid-Cashow Purchase & Reinvestment.
Reinvestment Level Reinvestments.
If purchases are made at convenient times, and any reinvestments are level,
can probably get a lot of mileage out of a ow chart of the various parties.
Otherwise, need a owchart where each party is lined up with timelines.
2.1.3 Some Yield Calculations for Short Time Interval
Time-weighted and dollar-weighted rate of return are usually applied for
cashows over short lengths of time.
2.1.4 What Happens if Interest Rates Vary?!
Ination, (Portfolios = (Port., IYM, i
y
1
)), Term Structure of Interest Rate
(Spot Rates versus Forward Rates)
2.1.4.1 Measures of a Cashows Sensitivity to Changes in Interest
Rate
Duration (like center of mass, and relatable to volatility), Volatility (rst
derivative), Convexity (second derivative)
2.1.4.2 Linear Combinations of Cashows
Matching liabilities, or setting price and derivative equal, hoping second
derivative of assets exceeds that of liabilitites.
4
2.2 Conceptual Aids
We have to solve for interest rates for many cashows, emphasis should be
placed on identifying ownership of a cashow. (For instance, investor, annuity,
reinvestment fund).
Transfer of loans or bonds can also benet by identifying dierent parties
cashows.
Things to put on front of scratch paper: Put-call parity, months and num-
berings for dollar-weighted rate of return, bond equations?
5
2.3 Some Approximations to Look Forward To
(Edit: note that most approximations are less needed, since calculators han-
dle a lot these in fact more easily) There are many approximations to know:
1. the time to double (Law of 72)
2. the time of equivalent payment (Method of Equated Time)
3. the interest for payments over a single interval (re: Dollar-Weighted In-
terest Rate)
4. linearization of bond amortization (Straight Line Method)
5. valuation of bonds between coupon dates (Practical Method and Semi-
Theoretical Method)
6. a bonds yield rate (theres two, second one is Bond Salesmans Method)
6
3 Interest, Cashows, Annuities
3.1 Overview of Formulas

t
=
a

(t)
a(t)
,
a(s, t) = e

t
s
rdr
,
(s, t) = a(t, s),
A(t) = A(s)a(s, t),
a(r, t) = a(r, s)a(s, t),
a(s, t) =
a(r, t)
a(r, s)
Solving for unknown interest rate of NPV (i) = 0 is typically a polynomial
problem, amenable to the table in multiview, or the IRR function in nancial
calculator.
Solving for unknown time (note: general cashow; in annuities, this is a
dierent question) uses logs in exact answer. The rule of 72 is relevant here. We
can ask for an equivalent cashow, where all deposits are made at a single time.
We can calculate exact time, a nasty beast, or the average term-to-maturity,
from the method of equated time.
t

=
ln
_
s1
t
1
++sn
tn
s1++sn
_
ln
,
t

t =
s
1
t
1
+ +s
n
t
n
s
1
+ +s
n
.
For annuities, solving for term seems straightforward, unless it shows up
more than once, in which case, multiviews table or a nancial calculator may
work well. Solving for i is generally tricky, and should be done using one of the
calculators.
a
ni
=
1
n
i
It may be useful to imagine annuities and cashows as generally similar to
convolution or inner product, V (s) = c
t
, a(s, t). For instance s may correspond
with either present value or future vale. We might have cashow (0, 1, 1, 1), and
dot that with (x
3
, x
2
, x, 1), where x = 1 +i.
3.2 Annuities
Currently testing a conjectured nmemonic, numerator is generator of pay-
ments, denominator is type of payouts, for instance (m)-thly payments requires
7
nominal interest rate skimming. (Notice big dierence is payments of
1
m
.)
3.3 Linearly Varying Annuities
Just remember the most general formula in terms of P and Q, easiest to
implement with MultiView. And dont forget to know version for future value.
3.4 Some Common Pairs of Accumulation Functions and
Forces of Interest
a(t) = (1 +i)
t
=
t
= ln (1 +i).

t
= = a(t) = e
t
, i = e

1.
a(t) = 1 +it =
t
=
1
(1/i) +t
.

t
= ct = a(t) = e
1
2
ct
2
.
a(t) = (1 dt)
1
=
t
=
1
(1/d) t
.
4 Rate of Return of an Investment
Given a cashow, what should we say is the apparent interest rate (this was
treated more simply in the rst chapter). This is the topic of this chapter (also
the practice of complicated portfolio interest rate schedules).
4.1 Interest Measurement of a Fund: Dollar-Weighted In-
terest Rate
First, we consider the balance, with successively coarser approximations:
(The rst approximation is simple interest, quite reasonable since t is assumed
less than one. Note k solves an exact equation; in other contexts, it is

t of the
method of equated time. A problem may ask for some other reasonable k value
to be used. In the last approximation, we consider the reasonable and well-used
approximation k =
1
2
.)
B = A(1 +i) +

c
t
(1 +i)
1t
A(1 +i) +

c
t
(1 + (1 t)i)
= A(1 +i) +

c
t
(1 + (1 k)i)
A(1 +i) +

c
t
_
1 +
1
2
i
_
.
8
Why bother writing these? So that one can easily see what has been done,
what approximations have been made, and since after all, these formulas as
written are easy to recall, and simple to solve for eective interest i.
Recall that we use notation C =

c
t
. Also, we mentioned above, but we
explicitly state, the exact equality above was for k satisies k =

tc
t
/C.
Approximations may relay on comparison of size of c
t
to A.
4.2 Allocating Investment Income: Portfolio and Invest-
ment Year Methods
The tables for IYM are commonly read left to right till we get to the last
column, then read down. There is a subtlety in t = m versus t > m, where m
is often 5.
5 Loan Amorts., Sinking Funds, Bonds
I combine these in one section, because I think a common viewpoint can be
taken in contrast to previous chapters. In both the loans chapter and bonds
chapter, we have the same essential features. We take a cashow, and do things
like calculate the balance after so many years, investigate the steps taken before
loggin the next years values, such as loan payment or coupon. We also consider
values between integer numbers of periods.
Perhaps a striking dierence, the loan payment is intended to head in some
respects uniformly to zero. In stark contrast, bonds are more to the tune of
paying out coupons worth approximately the interest due, so that redemption
might be in the ball park of original price.
If we recall interest reinvested at a dierent rate from the rate of return
of an investment chapter, we learned it behooved us to explicitly identify pos-
session of dierent cashows. We will see a similar problem type here, where
the ownership of debts or bonds are sold to a third party, and this can be more
dicult without these dierentiating observations.
We will encounter two more approximations in the section on bonds, namely,
valuation of bonds between coupon dates, and nding the yield rate.
9
5.1 Loan Payment Breakdown
Very straightforward to compare payments in two dierent periods,
P
t
P
s
=
X
nt+1
X
ns+1
= (1 +i)
ts
.
Its often also not dicult to get TVM to ll in missing data.
If we cannot nd a slick algebraic relation, we might note that there are
three degrees of freedom, for instance i, n, L, and so we might expect TVM to
assist in nding complete data, for instance nding one of the balances should
get us well on our way. To orient oneself in the problem, one might identify the
three relations in the problem setup.
Notice that balance is always worth the prospect of remaining payments (t
payments have been made):
B
t
= B
p
t
= Xa
nti
= X
1
nt
i
.
Notice that the interest for this period will be
I
t
= iB
t1
= X(1
n(t1)
)
= X(1
nt+1
).
Since the payment R
t
= X, then we quickly note that the principal repaid is
P
t
= R
t
I
t
= X X(1
nt+1
)
= X
nt+1
.
In the interest of fast recall of any quantity, lets nd some other sensible ways
to get these quantities.
I
t
= iB
t1
= iXa
nt+1i
= X(1
nt+1
).
(Think leftover interval is n t plus 1.)
P
t
= B
t
B
t1
= X
nt+1
.
10
(Think dierence between remaining payments is the value now of a payment
for this period.) A sum of principal repayments is a geometric annuity with
equal growth and interest rates, so the value at beginning of sequence is the
frequency times the rst value (or we can take dierence in balances?). A sum
of interests, we should consider the annuity on the payments, and take the
complement.
Perhaps a best formula for sum principal repayments, is the following

t=k
P
t
=

t=k
B
t1
B
t
= (B
k1
B
k
) + (B
k
B
k+1
) + + (B
1
B

)
= B
k1
B

=
L
a
n
(a
nk+1
a
n
).
Look out for use of last principal repayment is same as previous balance.
5.2 Bond Formulas
Fr = Cg = Gi, K = C
n
i
P = Fra
ni
+C
n
i
(basic formula)
= C + (Fr Ci)a
ni
(premium/discount formula)
= G+ (C G)
n
i
(base amount formula)
= K +
g
i
(C K) (Makeham formula)
Premium/discount formula is useful for amortizations. Makeham Formula is
useful for serial bonds (since the term has been eliminated).
11
5.3 Amortization of Premium or Discount
Amortization:
R
t
= Fr
I
t
= iB
t1
P
t
= rF iB
t
B
t
= (1 +i)B
t1
Fr
Another form that seems helpful for amortization is
P = C +C(g i)a
n
.
We claim balance is
B
t
= C +C(g i)a
nt
.
We prove by induction,
R
t
= Cg,
I
t
= iB
t1
= i[C +C(g i)a
nt+1
]
= iC +C(g i)(1
nt+1
)
= iC +C(g i) +C(g i)(
nt+1
)
= Cg C(g i)
nt+1
P
t
= R
t
I
t
= Cg I
t
= C(g i)
nt+1
,
B
t
= B
t1
P
t
= C +C(g i)[a
nt

nt+1
]
= C +C(g i)a
nt
.
Since P C, we might use the straight line method,
B
t
= P(1
t
n
) +C
t
n
= P +
C P
n
t,
B
t
= B
t1
P
t
,
P
t
=
P C
n
,
I
t
= Fr P
t
12
5.4 Valuation of Bonds Between Coupons Payment Dates
a
t+k
= a
t
+
t+k
_
(1 +i)
k
1
i
_
.
a
t+k
(1 +i)
t+k
= a
t
(1 +i)
t+k
+
(1 +i)
k
1
i
= s
t+k
= s
t
(1 +i)
k
+
(1 +i)
k
1
i
.
B
m
t+k
= P(1 +i)
t+k
Frs
t+k
B
f
t+k
= B
t
(1 +i)
k
= P(1 +i)
t+k
Frs
t
(1 +i)
k
B
m
t+k
= B
f
t+k
Fr
_
(1 +i)
k
1
i
_
.
The accrued interest/coupon Fr
k
= Fr
_
(1+i)
k
1
i

is valid for 0 k < 1. At

k = 1, it would imply we are a step before the coupon is actually paid o. That
the names coupon and interets are appropriate are questionable.
The exact value for at price given above is called the theoretical method.
If we approximate the coupon, using
(1+i)
k
1
i

1+ik1
i
= k, we have Fr
k

kFr. (A mnemonic might be that Fr is analogous to annual interest, so kFr is
analogous to the simple interest approximation.) This is further justied by the
idea that P C, a steady balance. If we also make a straight line approximation
for market/book value, its called the practical method. That is,
B
m
t+k
= B
f
t+k
Fr
k
= B
t
(1 +i)
k
Fr
k
B
t
(1 +ki) kFr
= B
t
+kiB
t
kFr
= B
t
+k[B
t+1
+Fr Bt] kFr
= (1 k)B
t
+kB
t+1
.
The semi-theoretical method is heavily used. The accrued coupon/interest is
approximated, then the market price is calculated based on exact book value at
integral t, exactly minus the accrued, which is the approximated. That is,
B
f
t+k
= B
t
(1 +i)
k
Fr
k
= kFr
B
t+k
= B
t
(1 +i)
k
kFr.
13
5.5 Approximation Methods of Bonds Yield Rates
1
a
n,i
= i
_
1 (1 +i)
n
_
1
= i
_
1
_
1 ni +
n(n + 1)
2
i
2

__
1
= i
_
ni
n(n + 1)
2
i
2
+
_
1
=
1
n
_
1
n + 1
2
i +
_
1
=
1
n
_
1 +
n + 1
2
i +
_

1
n
_
1 +
n + 1
2
i
_
P = C +C(g i)a
n,i
g i =
P C
C

1
a
n
= k
1
a
n

k
n
_
1 +
n + 1
2
i
_
g
k
n
i
_
1 +
k(n + 1)
2n
_
i
g
k
n
1 +
k(n+1)
2n

g
k
n
1 +
1
2
k
14
5.6 Callable Bonds
5.6.1 Discussion of Correlations between Changes in Price, Call,
Term, Yield
Simple mnemonic, if P < C, exercise immediately, this gives maximum yield
of innity. If you buy at discount, exercise as soon as possible.
When you buy at premium, interest and term are positively correlated.
When you buy at discount, interest and term are negatively correlated. (For
given
PC
C
; note this last is positively and negatively correlated with P and C
respectively.)
So to guarantee a minimum yield, use the earliest date, cuz itll only get
better.
Lets start with a loan. If interest rate increases, value of annuity drops. If
term increases, value increases. In other words,
a
ni
=
1 (1 +i)
n
i
is positively correlated with term, and negatively correlated with interest.
Lets now consider for bonds. And it will depend on if price is above or
below call, i.e., bought at premium or discount, respectively. Lets rst note
that
K = C
n
=
C
(1 +i)
n
,
the present value of the call, is negatively correlated with both interest and
term. Then I would gather that price would be negatively correlated with
interest. Correlation with term could depend, so lets investigate: We have
P = Fra
ni
+C
n
= C + (Fr Ci)a
ni
.
Then, lets assume F = C, and recall that value of annuity a
ni
is positively
correlated with term. So if i decreases,...
Too many things changing. Lets focus on what question we most want to
handle. A common concept of consideration, is for a given price, call-value, and
coupon, will a bond yield increase or decrease depending on an adjustment in
term. In other words, what is the behavior of
i
(P,C,Fr)
(n).
15
0.079990
0.079995
0.080000
0.080005
0.080010
x
0
5
10
15
20
y
0.0001
0.00005
0.0000
0.00005
0.0001
Comput ed by WolframAlpha
0.079990 0.079995 0.080000 0.080005 0.080010
0
5
10
15
20
x
y
Comput ed by WolframAlpha
These are visuals for
P C
C
= (.08 i)
1 (1 +i)
n
i
.
We can now use the visuals to more easily consider questions about calling a
bond early or late, with minimum or maximum yield rates, and varying prices
or calls, thus limiting the trickiness of curve-ball questions on exams.
One might simply memorize the orientation of tangent planes for the two
cases, i > r and i < r.
16
6 Stocks and Money Market Instruments
6.1 Short Sales
I overlooked the following equation, perhaps the most surprising one. The
price you sell for short is held till later with no interest.
M(1 +j)
n
= M(1 +i)
n
+S
0
S
n

d
t
(1 +i)
nt
.
To help recall the equation, lets derive it. Only an initial investment of M
is made. On the one hand, this grows by (market-maker?) at i. We receive the
dormant S
0
. We cover the short at S
n
. We are held responsible for the lack
of dividends, d
t
. Alternatively, we could have invested in the ambient market,
which should yield j.
17
7 Measures of Interest Rate Sensitivity
7.1 The Term Structure of Interest Rates and Yield Curves
Could potentially be dicult to remember that spot rates are for a long
interval.
Spot rates are rates as a function of time, which instruct us how to nd
present value of contribution, i.e., c
t
(1 +i
t
)
t
. In contrast, forward rates tell us
how to evaluate money for intervals in the future, for instance f
6
3
is the interest
expected as we pull money from t = 6 back to t = 3. In other words, we can
write i
t
= f
t
0
. And just as (1 +i
1
)(1 +f
3
1
)
2
= (1 +i
3
)
3
, we have in general
(1 +i
n
)
n
(1 +f
n+k
n
)
k
= (1 +i
n+k
)
n+k
.
May need to consider all permutations of dierent bond lengths.
7.2 Comparing Equated time, Durations, Convexity
(Note that interest rate sensitivity will limit itself to future payments, since
there is no risk in the past.)
We compare various formulas resembling center of mass, at an attempt to
compare them in contrast. (We use (1 +i)
x
1 ix.)
(s
1
+ +s
n
)
t

= s
1

t1
+ +s
n

tn
(s
1
+ +s
n
)(1 i

t) = s
1
(1 it
1
) + +s
n
(1 it
n
)
Solving each equation separately for their respective t

and

t, we have
t

=
ln
_
s1
t
1
++sn
tn
s1++sn
_
ln
,

t =
s
1
t
1
+ +s
n
t
n
s
1
+ +s
n
.
A helpful nmeunonic for remembering which is which, the nasty one gives
the exact location of an equivalent payment, and is gratefully approximated.
These may be named term-to-maturity and average term-to-maturity.
How are we to contrast duration? Lets start by writing

d =

t
t
R
t

t
R
t
.
It appears the times are weighted not by the value at payment, but by the
present value of each payment. Thus emphasis is being pulled away from later
payments. Or anyways, its a realer value, in the sense that you can take the
values at a comparison date (t = 0 say), and decide where to put them all
18
so that the value is still the same. So while average term-to-maturity is an
approximation to the exact placement of all payments, duration is something
else, it is... Im gonna leave it there.
Then we have modied duration, or volatility, where we dene P(i) =

t
R
t
(present-vale of all future payments), and (we also list convexity here
for comparison)
=
P

(i)
P(i)
=

d,
c =
P

(i)
P(i)
.
Both volatility and convexity of portfolios can be treated wholly, or sepa-
rately, then weighted by portfolio segment.
7.3 Duration
Duration for an annuity:

d =

tR
t

R
t

t
=
(Ia)
n
a
n
Duration for a perpetuity:

d =
1

= (1 +i)
_

(i)
P(i)
_
= (1 +i)
_

1/i
2
1/i
_
=
1 +i
i
.
When duration becomes tricky to calculate, try approximating modied du-
ration (or volatility), using TVM values, and storing them in MultiView, using
=
P

(i)
P(i)

P(i+10
n
)P(i)
10
n
P(i)
= 10
n
_
1
P(i + 10
n
)
P(i)
_
.
For instance, calculating duration of a bond becomes rather straightforward and
ecient. Remember to let period of payment (coupon) take precedence.
19
7.4 Full Immunization
Where Redington immunization or convexity check for local minimum for
P(i), full immunization refers to a global minimum for P(i). We have a theorem
on the matter, but we also have a set of commonly used formulas. First the
theorem:
We are given a cash ow of A, L
k
, B at times k a, k, k +b. Then we have
full immunization if
1. present values of assets liabilities are equal (in practice, we compare at
time k),
2. modied durations of assets and liabilities are equal,
3. A happens before L
k
happens before B.
The rst two guarantee that the given P(i) has a root and critical point at
the given i. They all work together to ensure P(i

) > P(i) for i

= i.
Lets look at some associated equations (essentially from the proof) that
well typically need.
We have six variables L
k
, , a, b, A, B, ie, the liability, force of interest, times
of assets, and values of assets.
Then two equations, easiest to remember the rst one as present value, and
the second as simply as its derivative,
Ae
a
+Be

= L
k
Aae
a
Bbe

= 0
Given four of the variables, we can solve for the remaining two.
Not sure what is meant by For a portfolio with multiple liabilities, repeat
the above process for each liability outow.
7.5 Dedication
For dedication, we are given a liability sequence, and securities each with
their own sequences. We must nd a linear combination which gives net zero
contribution at each payment. More or less a change of basis problem, where
we must rst nd the sequence for each security.
20
8 Derivatives Markets
8.1 Mine Own Notation
Call:
C (0, K)
0 (0, 1)
Call:
_
C (0, S
T
K)
0 0
_
Put:
_
P (K, 0)
0 (1, 0)
_
Put:
_
P (K S
T
, 0)
0 0
_
Floor (Long and Put):
_
S
0
P (K, S
T
)
0 0
_
Cap (Short and Call):
_
S
0
C (K, S
T
)
0 0
_
Writing a covered call (Long and Written Call):
_
C S
0
(S
T
, K)
0 0
_
Writing a covered put (Short and Written Put):
_
S
0
+P (K, S
T
)
0 0
_
Put-Call Parity:
_
P (K S
T
, 0)
0 0
_
+
_
C (0, K S
T
)
0 0
_
+
_
0 S
T
F
0,T
0 0
_
=
_
C P K F
0,T
0 0
_
Bear spread (Sell call, buy call (or...)):
(C
1
; (0, S
T
K
1
, S
T
K
1
))+(C
2
; (0, 0, K
2
S
T
)) = (C
2
C
1
; (0, S
T
K
1
, K
2
K
1
))
Bull spread (Buy call, sell call (or...)):
(C
1
; (0, K
1
S
T
, K
1
S
T
))+(C
2
; (0, 0, S
T
K
2
)) = (C
2
C
1
; (0, K
1
S
T
, K
1
K
2
))
21
Ratio spread (eg buy m calls at C
1
, sell n calls at C
2
) is when we have dierent
slopes, suggesting how to construct any shape with calls and puts.
Collars (buy a put, sell a call):
_
P
1
(K
1
S
T
, 0, 0)
0 0
_
+
_
C
2
(0, 0, K
2
S
T
)
0 0
_
=
_
C
2
P
1
(K
1
S
T
, 0, K
2
S
T
)
0 0
_
Collared stock (Collar and Long) (looks like bull, but cash ow is dierent):
_
S
0
+C
2
P
1
(K
1
, S
T
, K
2
)
0 0
_
Straddle (Call and Put at same K):
_
C P (K S
T
, S
T
K)
0 0
_
=
_
C P |S
T
K|
0 0
_
Buttery Spreads (Put minus Straddle plus Call):
_
P
1
(K
1
S
T
, 0, 0, 0)
0 0
_
+
_
C
2
+P
2
(S
T
K
2
, S
T
K
2
, K
2
S
T
, K
2
S
T
)
0 0
_
+
_
C
3
(0, 0, 0, S
T
K
3
)
0 0
_
=
_
P
1
+C
2
+P
2
C
2
(K
1
K
2
, S
T
K
2
, K
2
S
T
, K
2
K
3
)
0 0
_
Asymmetric Buttery Spreads:

_
C
1
(0, K
1
, K
1
, K
1
)
0 (0, 1, 1, 1)
_
+
_
C
2
(0, 0, K
2
, K
2
)
0 0(0, 0, 1, 1)
_
+
_
C
3
(0, 0, 0, K
3
)
0 (0, 0, 0, 1)
_
=
_
C
1
+C
2
C
3
(0, K
1
, K
2
K
1
, K
2
K
1
K
3
)
0 (0, , 1, 1 +)
_
But if we add stock on the last condition (S
T
> K
3
), then the right arm of the
buttery spread wont be at. Thus we want 1 + = 0, giving the often
mentioned but seldom justied = 1 in the third call. Thus we consider

_
C
1
(0, K
1
, K
1
, K
1
)
0 (0, 1, 1, 1)
_
+
_
C
2
(0, 0, K
2
, K
2
)
0 0(0, 0, 1, 1)
_
+ (1 )
_
C
3
(0, 0, 0, K
3
)
0 (0, 0, 0, 1)
_
=
_
C
2
C
3
+(C
3
C
1
) (0, K
1
, K
2
K
1
, K
2
K
3
+(K
3
K
2
)
0 (0, , 1, 0)
_
22
So at time T, we sell or buy 1 stocks, depending on S
T
. Thus we have
cash-settled asymmetric buttery spread,
_
C
2
C
3
+(C
3
C
1
) (0, (S
T
K
1
), K
2
K
1
(1 )S
T
, K
2
K
3
+(K
3
K
2
)
0 0
_
Another restriction can be added by requiring that the payo is zero for S
T
>
K
3
. Then
=
K
3
K
2
K
3
K
1
.
So nally, our asymmetric buttery spread is
_
C
2
C
3
+(C
3
C
1
) (0, (S
T
K
1
), K
2
K
1
(1 )S
T
, 0
0 0
_
23
8.2 Swaps
For a given asset f
0
(t
i
), a strip of values, we may replace with a xed value
R to be made at times t
i
. So that they have the same value, we use the swap
formula
n

i=1
P(0, t
i
)R =
n

i=1
P(0, t
i
)f
0
(t
i
).
The strip f
0
(t
i
) can be commodity forwards (F
0,ti
), currency forwards on foreign
annuities (R

F
0,ti
), or interest rates (r
0
(t
i1
, t
i
)). Additionally, we may weight
on notional amounts Q
ti
, that is,
n

i=1
Q
ti
P(0, t
i
)R =
n

i=1
Q
ti
P(0, t
i
)f
0
(t
i
).
Notice that these formulas do not involve spot rates. Also, the value of a swap
agreement is eected by the ambient forward prices and rates. If in a time
later the forward prices and rates have changed, the change in value of the swap
agreement is adjusted by the value

i=1
P(0, t
i
)f
0
(t
i
) P(, t
i
)f

(t
i
)

,
which the sign of depends on which party in the swap agreement it is. If just
the forward prices f
0
(t
i
) change, then this is also the change in swap prices. If
just the rates change, then, in Mcdonald, it is pointed out as a motivation to
hedge interest rates as well (since the above is a hedge for swaps). This value
eects exiting a swap. If the value and exit is negotiated with the original swap
counterparty, we avoid credit risk. Otherwise, we may oset the swap with
whoever oers the best price.
We may associate the exchange of S
ti
and commodity between buyer and
seller; S
ti
and R between buyer and dealer/market-maker; R and F
0,ti
between
dealer and forwards market.
24