Risk Management Irene San José Martínez

1. Futures Contracts:
Pricing Futures (on stocks)
(using “risk-free arbitrage strategy”) Or, “Cash-and-carry Arbitrage”

Gives an equation which determines the: [“Correct/ Theoretical/Fair/ no-arbitrage”]

futures price F: F = S (1+rT)

Arbitrageurs in Futures Market

➢ Arbitrageurs, are traders who try and make money from mispriced futures contracts

➢ What makes them different from speculators, is that the trades initiated by arbitrageurs
are (almost) risk-free.

➢ So when the trades are initiated, the arbitrageur knows for certain, what profit she will
make (in the future).

➢ We illustrate the above by assuming the quoted futures price Fq =102 is different from
the “fair” futures price , where the “fair” (no-arbitrage) futures price is given by the
formula F = S( 1+ r T) = $101

Cash-and-Carry Arbitrage (Overpriced futures contract)

➢ Stock price(AT&T), S = $100

➢ Risk-free rate, r = 4% p.a (0.04) (simple interest)

➢ Time to maturity (delivery) for Futures contract is 3 months T=3/12 years

➢ Quoted Futures Price Fq = $102 (for maturity and delivery in 3m, T=1/4 year )

➢ We believe, correct (no-arbitrage/fair) futures price is given by the formula

F = S (1+rT) = $101.

➢ Note that F = $101 is not quoted by any futures trader

➢ Today, the futures contract is overpriced at Fq = $102 ( > S (1+rT) = $101 )

Cash-and-Carry Arbitrage (Overpriced futures contract)

Strategy Today (“no risk” , ie. you know for certain you will make a profit)

➢ Sell futures contract (in Chicago) at Fq = $102 (receive nothing today)

➢ Borrow $100 from bank and buy the stock @ S=100, today (on NYSE)

➢ Now: “Carry the stock” to T

3-Months Time ( T = 1/4 )

➢ Bank Loan Outstanding = $100( 1 + 0.04 / 4) = $101

➢ Deliver stock (to Chicago) and receive from futures contract = $102

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Riskless profit = $1

Economics: Supply and Demand (Simplified)

Lots of arbitrageurs are selling futures contracts in Chicago, this leads to a fall in Fq to Fq =
$101 (say) , at which point Fq = F= S (1+rT), which is the “fair” futures price.

Cash and Carry Arbitrage Technical Terms

➢ Borrowing $100 to purchase the stock today, is equivalent to having the stock at a
known “cost” of $101, in 3-months time – which you can then “deliver” when your short
futures contract matures and receive Fq = $102 in 3 months time.

➢ “stock+bank loan” is called the “Synthetic Future” or “Replication portfolio”

➢ Cost of creating this “replication portfolio” at T is equal to S ( 1 + r.T ) = $101

➢ The “correct” futures price must equal S ( 1 + r.T ), otherwise riskless (arbitrage) profits
can be made, hence at all times we should observe all traders quote a futures price:

F = S ( 1 + r .T ) = $101

Futures Price = Spot price (S = $100) + $-cost of carry (= S rT = $1)

Arbitrage at Maturity: FT = ST
➢ At maturity of the futures contract we must have FT = ST

➢ otherwise riskless arbitrage profits could be made, at T

➢ Consider a Futures contract on “AT&T stock”

Arbitrage at Maturity: FT = ST
➢ Suppose on maturity date, T of futures contract (e.g. 25th September)

FT = 100 (Chicago) > ST =98 (NYSE)

➢ Then buy ‘low’ at ST =98 on NYSE , and at same time T, sell one future contract (on
AT&T) at FT = 100 (in Chicago).

➢ Deliver the AT&T stock (electronically) to the CH in Chicago to settle the futures contract

➢ CH will credit your “margin account” by FT =$100. You have made a riskless profit of $2
(= FT - ST )

➢ Above will quickly result in FT = ST = 99 (say). (Supply and Demand!!!)

Relationship between Spot and Futures Prices

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3-month Futures Prices Different Interest Rate Conventions

Implied Repo Rate

An arbitrage opportunity using futures can also be expressed in terms of the “implied repo
rate” (=“return on the futures arbitrage strategy”) and the actual cost of borrowing (=
actual repo rate)

If the “implied repo rate” does not equal the actual interest cost of borrowing (ie. the
”actual repo rate”) then a (risk-free) arbitrage opportunity is possible.

The concept can be applied to any futures contract (e.g. the spot asset could be a stock,
stock index, oil, gold, T-Bill etc)

Pedagogically, it is easiest to think of the spot/cash market asset as a stock.

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Speculation with futures

Speculators  Buy futures at a low price today and hope to sell (close out) at a high price
later – or vice versa. This is a “ risky trade” ( ‘naked/open’ position)

Buy Low – Sell High

Sell High – Buy Low

➢ Speculation with futures, is really speculation about future movements in the price of
the underlying asset S.

➢ If you think S will increase (fall) in the future, then a “futures speculator” should today,
buy (sell) futures contracts (today).

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➢ If your forecast is correct

(incorrect) you will close out your
futures contracts at a profit (loss).

➢ Because you only pay a small

“initial margin” when entering the
futures contract the percentage
return on your futures position
(relative to this initial “margin
payment”) can be “very large”
percentage gain (or loss).

➢ Hence futures contract are said to

provide “leverage” for speculators.

Hedging using Stock Index

Futures NF = - [ Vp / ($250 x F0) ] x beta
What is Beta?  Beta is a measure of the response of the return on your stock portfolio to
a change in the “market return” (i.e Rm = % change in S&P500 index)

Hedging Market Risk

It is 15th Jan today.

➢ Pension fund (M/s Midas) has experienced capital gain over last 10 months on a
‘diversified $2m equity portfolio (“specific risk” has been eliminated by diversification) –
performance will be assessed in 2 months time (15th March) by trustees.

➢ M/s Midas believes the market will be more volatile (risky) than usual over the next 2
months (say).

➢ Wants to ‘protect’(hedge) the portfolio over next 2 months (15th Jan to 15th March),
from this volatility.

➢ In particular, M/s Midas fears a general fall in all equity prices.

What does M/s Midas do to hedge ?

➢ Short the futures – removes the “systematic (market)” risk

➢ How many futures contracts does she short ?

➢ Today, you sell 80 (short) futures contracts on the S&P500.

➢ This means that the change in value of your stocks plus any profit / loss on the futures
position (after closing out in 2 months time) will be close to zero.

➢ You can use any futures which matures after 15th March (2 month hedge period)

➢ Hence on 15th Jan you could short 80 March-contracts, or 80 June contracts

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➢ It is usual to use “nearby contracts” (ie.

March) as these are usually the most liquid
with low bid-ask spreads. When closing out
on 15th March, basis risk will be small, as
the March contract, will mature close to
15th March - say around 25th March)

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Eurodollar Interest Rate Futures: Hedging bank loan / bank deposit

Short-term interest rate futures IRF contracts are used to:

1. “Lock in” future loan or deposit rates (ie. Hedge)

2. Speculate on future movements in interest rates (eg. $-LIBOR)

3. Change the duration of a bond portfolio

4. Estimate the term structure (i.e. Given quoted IRF prices F, we extract (LIBOR) forward
rates (= f % pa) and then from these we extract spot rates, y ) – not done here.

Eurodollar IRF (Traded on CME)

■ Eurodollar Futures:

“Underlying asset” in contract is a 90-day (3-month fixed term) LIBORT Eurodollar deposit,
beginning at the maturity date of the futures T, & ending at T+90 days.

■ There is no “delivery” of the underlying asset at T – contract is cash settled

■ Futures Contract size VF = $1m per contract (“notional value of one futures”).

■ Duration of 90-day futures is DF = 0.25 years (ie. 90/360 is day count convention)

■ Today’s Quoted Futures “price, F0,T ” is called the “IMM index” (Chicago)

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2. Options: Call and Puts

Call and Put Contracts (Structured Product: Guaranteed Bond ( = stock +
put)
Call Options
➢ Introduction ➢ Payoffs, Delivery vs Cash Settlement

➢ Long Call Option: Speculation ➢ Long Call Option: Insurance

➢ Sell (write, short) European Call

European Call Option

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Today is 1st Jan

➢ Today you buy (go long) a (European) “March-80” call option on AT&T stock.

Today (1st Jan) you have to pay a call option (price) premium C = $3 say.

➢ This gives you the right (but not the obligation) to buy (ie. “take delivery”)

the “underlying asset ” in Chicago, (eg. one AT&T stock)

➢ on the maturity date T of the option contract (eg, T =28th March, say) at a (strike) price
K=$80, agreed today (on 1st Jan).

➢So, you can choose at T, whether or not to “exercise the call option” and take delivery of the
stock or to “do nothing” and “throw away” the option (ie. not exercise)

Types of Option
➢ European Option can only be exercised on the maturity date

➢ American Option can be exercised at any time (before and at maturity).

Options on Futures Contracts (“Futures Options”)

➢ Note that many of the most actively traded options have a “futures contract” (and not the
“cash market asset”) as the “underlying asset”.

Examples.

Options on S&P500 futures contract (not options on the S&P500 (stock) index)

Options on crude oil futures contract (not options on crude oil)

Closing Out (“Offset”)

Long Call Option

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Speculation with Long Call Option

➢ Buy a call if you think stock prices will rise, so that ST > K+C.

➢You will make a profit at T

➢ Maximum amount you can lose is C

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Long Call provides “insurance”

Motivation: Long call option, K=80

➢ Pension fund intends to buy stocks in the future and is worried that stock prices will rise.

➢ Today Pension fund buys a call with K=80

Uses of Long Call Option: “Insurance”

A long call provides “Insurance” which can be described as:

a). Buying a call option sets a maximum price , K =80

pension fund will pay for delivery of the stock (in Chicago) at T (28th March). (if we
ignore the call premium).

b) But a long call, also allows pension fund to take advantage of low stock prices (on
the NYSE) should they occur.

➢ For this ‘flexibility’ the pension fund pays the call premium of C = $3 (today).

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Sell (write, short) European Call (K=80)

Today (1st Jan) M/s Short sells a March-80 call and receives C = $3 premium

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Seller (Writer) of European Call: Delivery

Ms Short (if she has not closed out the written call by T)

➢ Has an obligation to deliver the stock to Mr Long in Chicago, at T

➢ for which she receives the strike price K

➢ if “Mr Long” decides to exercise the option by “taking delivery”

➢ (ie, when ST >K)

➢The Options Clearing Corporation (OCC) in Chicago randomly assigns a writer (“Ms Short”) to
deliver the underlying asset, to “Mr Long” (one day before expiry/maturity).

Sell (write, short) European Call: Margin Payment

M/s Short sells (writes) a call option (1st Jan) and she “receives” the call premium C =3
However on 1st Jan:

The writer, M/s Short has to “post” an “initial margin” payment with her (Chicago) broker. This
is a “good faith deposit” to ensure M/s Short does not default on the option contract in the
future ( if ST > K).

“Initial margin” is about 15% of current value of the 100 stocks in the option contract (15% x
100 S0 ) plus a “deposit” equal to the option premium received from the sale of the call (=100
x C) .

The initial margin can usually be paid in cash, T-bills or other securities.

There may also be “variation margin” payments in the future, if M/s Short’swritten option
position begins to lose value (ie. if the stock price increases)

Seller (Writer) of European C

➢ Paradoxically the writer of a (European) option, Ms Short does not have any ‘choice’, at
maturity.

But before maturity (eg. 15th Feb)

➢ Ms Short has the ‘choice’ to close out her position, by buying (back) a March-80 call option
from Mr X (at whatever is the market price of the call on 15th Feb).

Then Ms Short is “out of the market” and no delivery of the underlying stock at T (on 28th
March) is required from her

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Put Options
Definition plus Delivery & Cash Settlement

Buy (Long) European Put Option

1 st Jan

➢ Buyer (Mr Long) of the March-70 put option (on AT&T stock)

➢ has the choice of “delivering” and selling (in Chicago)

➢ the underlying AT&T stock

➢ on the maturity date (T = 28th March) of the put contract

➢ at a (strike) price K (=70 say), which is fixed today

➢ For this privilege, Mr Long pays the put option premium (price),P = 2 on 1st Jan

➢ Note: Put options can also be “cash settled”

Buy (long)European Put Option: K=$70 Delivery and Cash Settle

At maturity T=28th March, Mr Long can (in Chicago)

either:

➢ 1) deliver a stock (in Chicago) and receive K = 70

or

➢ 2) “Cash settle” and receive: cash payoff at T =

max {K- ST , 0}

ST = stock price at maturity of the option

Speculation: Buy (Long)

European Put

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Speculation with a long put

➢ Expect S to fall in the future, then buy a put today (at a cost of P=$2).

➢ If stock price falls so that ST is (well) below K, you make a profit

➢ If S rises (above K) , the put is not exercised but the most you lose is the put premium,

P = $2.

“Insurance” using a Long Put Hold stock and buy European Put:
1 st Jan

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➢ Pension fund (L&G) already holds stocks currently worth S0 =70 and fears a

➢ fall in S by T=28th March, when it intends to sell its stocks, to pay out

pensions to its new retirees.

➢ Today, L&G pension fund buys an ATM put (K=S0 = 70, T= 3 months) .

➢ For L&G how does holding (both) Stock + Put provide “insurance” ?

➢ This is also known as a “protective put” strategy

1 st Jan: L&G already holds stocks and is long a put

T=28th March: ST < K

➢ L&G has “locked in” a minimum price (K=70) L&G will receive (at T = 28th

➢ March) when L&G exercises the put by “delivering” the stocks it already

➢ holds , (together with the put contract), in Chicago.

T=28th March: ST > K

➢ If ST > K, L&G does not exercise the put option but it can sell its stocks

➢ for a high price ST (on the NYSE).

➢ “Stock+Put” guarantees a minimum price of K=70

➢ The “insurance” is that L&G is guaranteed a minimum selling price of K=70

➢ The cost of this insurance is the put premium, P=2.

➢ “Stock+Put” also allows L&G pension fund to sell its stocks at a high price in the future, at ST
on the NYSE, should this occur on T= 28th March.

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Write/Sell/Short a European Put

Option Strategies (eg. Bull spread, Bear Spread, Straddle).

Spread Tardes
Long Straddle (Volatility Bet)
Long straddle is a bet on the stock price
moving a large amount in either direction

➢ Long straddle = Buy one call and one put

➢ on same underlying (eg. AT&T stock)

➢ with same strike, K and time to maturity,

T=1 year say

➢ Assume calls and put are at-the-money,

ATM (so S0 = K =100 )

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Nick Lesson’s Short Straddle

Speculation: (Long) Bull Spread with Calls

➢ Long bull spread is a “directional bet” (on the underlying stock price).

➢ You buy call options (@ K1 =102) to gamble on the stock price increasing (ie. If ST >> K1 )
and the long call also sets a lower limit to your downside losses.

➢ But you also choose to “cap” your upside potential by selling a call @ K2 =110 (> K1 ) .

Implied Volatility and

“trading volatility”
Implied Volatility

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➢ Implied volatility is the (option) market’s forecast of stock return volatility,  , over life
of option – if we assume B-S formula is correct.

Black-Scholes (Merton) Two key assumptions of B-S:

1) Stock returns (contin comp, log returns) are (niid) normally distributed

2) Volatility (over life of option, 0 to T) is assumed to be constant

Theoretical (Black-Scholes) price, CBS = f (S, K, r, T, 

Quoted market price: Cq = $10 (say)

Implied Volatility Calculation

Volatility Smile
➢ Today, options with 10 different strike prices K (but same maturity date T) are available.
➢ Today you can calculate 10 values of imp using the10 (different ) quoted options’
prices (on say USD/GBP exchange rate) and the B-S equation.

➢ According to assumptions of B-S model , all these ten values of imp should be constant
and (hence) equal (for all 10 values of K).

But they are not!

➢ Hence there is something wrong with B-S assumptions and the BS formula.

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3. Pricing (MCS) & Hedging using “the Greeks”

Delta Hedging & The Greeks (gamma and vega hedging)
DELTA

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Examples: Delta of (one) stock

Delta of a stock

Delta of (one) “long” stock is +1

Delta of (one) “short” stock is -1

Examples: If you buy 100 stocks you have a delta of +100

If you “short-sell” 100 stocks you have a delta of -100

Portfolio DELTA

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Dynamic Delta-Hedge

Initial Position: Hedge Written Call at t=0

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Dynamic Delta-Hedge
Rule for dynamic delta-hedge of one written call by MS sales desk

- As the stock price changes, each day, so does the call premium and the call’s-delta (via
Black-Scholes)

- As delta changes MS needs to “rebalance” that is, adjust the number of stocks each day,
to hedge the (one) written call by MS.

Dynamic Delta Hedging

How do we view the hedge from MS sales desk perspective?

1) Look at the outcome for MS hedge position at time t (< T) before maturity

- After closing out all MS positions in calls, stocks and paying back any bank debt then MS
net position, should be close to zero, at any time t , before maturity

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Delta Hedging: Rebalancing, when Stock Price Rises

Delta Hedging: Rebalancing

Note: In the above diagram, YOU cannot calculate(determine):

- “Deltas” (These are calculated from Black-Scholes)

- Debt levels D1 and DT (ie. Outstanding MS Bank Loan with Citibank) These are calculated
by me from “daily simulations” of the stock price (which is stochastic

GAMMA

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Portfolio
Gamma
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Delta-Gamma Approximation

Gamma Hedge

VEGA

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Sensitivity of Option price to change in Volatility

Vega: For Single Call

Vega: For Portfolio of Calls

Vega- Hedge (Vega-Neutral Portfolio)

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Hedging Practical Issues

How frequently do you delta-hedge or gamma-hedge a portfolio of call and put options
on AT&T stock ?

Depends on:

- the size of portfolio-delta and portfolio gamma

- and how much (over 1- day say) you think the stock price will change.

The more frequently you rebalance your delta and gamma-hedged positions the smaller is
the hedging error.

But this may involve high transactions costs (i.e. large bid-ask spreads, commissions and
“price impact” of large sales or purchases), when rebalancing by buying or selling options
and stocks

Option sales desks of banks, usually sell more (ATM) options (to pension funds and
insurance companies) than they buy, & end up with large net negative gamma and vega.

Hence banks need to purchase ‘other’ options (on the same underlying) to hedge these
two risks – this may be expensive (in terms of bid-ask spreads and commissions).

If the options happen to move ‘in’ or ‘out’ of money, gamma and vega get smaller (see
“bell curve” diagrams, earlier) and then there is less need to hedge these “two Greeks”. 
But you may still need to delta hedge (eg. daily).

All your hedge positions have to be continuously rebalanced as “the Greeks” change over
time, change with different values for the underlying S and the market’s view of volatility.

But you don’t always have to hedge all the “Greek risks” – depends how “large” they are
and on how much risk you are prepared to tolerate.

4. Value at Risk VaR

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Variance-Covariance method VCV (Single Index Model, Foreign

Assets, Bonds)
Variance-Covariance method VCV
Common methodologies used to measure “market risk”
Also known as ‘delta-normal’ approach

Used for stocks, bonds, foreign exchange, futures where portfolio return is
(approximately) linear in individual returns and returns are assumed to be niid

Practical Issues
Portfolio of Stocks

- Too many covariances /correlations to forecast [= n(n-1)/2 ] = 1225 for n=50

- For each country’s stock returns, use “single index model” SIM

Foreign Assets held by US Resident

- Need VaR in “home currency”, USD

- Treat stocks held in foreign country (e.g Germany) as equal $ amounts held in “foreign
stocks ” + “spot FX risk” , - that is, as “two assets”

Portfolio of Bonds

- Many different coupons paid at many different times

1) Use the duration approximation (easiest) – for parallel shifts in yield curve

2) Consider each bond as a series of “zero coupon bonds” (“zeros”) – for non parallel
shifts in the yield curve

Single Index Model

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Portfolio of Stocks

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VaR: Foreign Assets

Sources of risk for US resident holding portfolio of German stocks

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VaR: Bonds
1. VaR : Zero-Coupon Bond

2. VaR: Coupon Bond (Assume Parallel Shift)

3. VaR: Coupon Bond (Assume Non-Parallel Shift)

1. VaR : Zero-Coupon Bond

2. VaR: Coupon Bond

(Assume Parallel Shift)

3. VaR: Coupon Bond (Assume Non-Parallel Shift)

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VaR using MCS & Historical Simulation, HS.

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Variance Reduction Methods for use in MCS

1. Antithetics
Variance reduction methods seek to reduce “estimation error”, for any given number of
simulations, m.

 Computational time in MCS is in generating random draws for εt = (ε1, ε2 , …. ε252 ) , for
say 252 trading days

 “Antithetics” takes these 252 random values and uses them with the signs changed ,
that is we also use - (ε1, ε2 , …. ε252 ).

 Note we have not simulated a further 252 values of εt , we have just changed the signs
of the original 252 generated random values

 This gives us 2 simulation paths for stock price and 2 possible call premia C+ and C- .

 Then we calculate our first “antithetic estimate” of the call premium :

Repeat, MCS for “m-runs” and the best “antithetic estimate” of the call premium is:

 Using the 252 random values of εt and their negative values -εt , we obtain ”two call
premia for price of one”

 and the two call premia are negatively correlated,

 thus reducing the variability in estimates of the “antithetic call premium”.

 Hence, we obtain more accuracy for any given number of simulations (=m)
(compared with the standard MCS method).

2. Control Variate Method

 Control variate technique adjusts the “MCS price” of a complex option (eg. a Asian
option) by the error in pricing a simpler option (eg. a plain vanilla option)

 We want to price a “complex” call option-A , using MCS.

 eg. Asian call option, where payoff depends on max( Sav – K, 0)

 A plain vanilla European call option-B has a (closed form) “correct”

Black-Scholes price fBBS = 10 (say)

 MCS (m-simulations) option-B has an estimated price fBMCS = 9 (say)

 MCS error in pricing the vanilla option is (fBBS - fBMCS) = 1

 MCS is an underestimate of the correct Black-Scholes (European) price

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 Suppose MCS estimate of the Asian call option-A (with m-simulations) is

fAMCS = 7 (say)

 “New” improved control variate estimate for the Asian option is:

 MCS of the vanilla option is an underestimate (fBBS - fBMCS) = 1 so

 MCS estimate of the Asian option-A , fAMCS =7 is adjusted upwards by 1

VaR: Historical Simulation Method

This method useful when there is non-normality in returns data (eg. “fat tail” distribution for
stock prices or distribution of changes in options prices).

This is a non parametric method since we do not estimate any variances or covariances or
assume normality.

We merely use the raw historical data on returns, which “contain”

- the correlations between the (daily) returns on the different assets

- the ‘own volatility’ for each asset return

- and whatever distribution the historical data embodies ( [Link]’s t distribution, mixture
of normals etc).

- Hence our HS-VaR forecasts implicitly include all these “features” of the historical data

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5. Swaps and other Fixed-Income Derivatives

Forward Rate Agreements, FRAs (Hedging bank loan or bank deposit)
Some Issues
➢ When discussing forward (interest) rates:

➢ “Bond Text Books” use “annual” or “semi-annual” compound rates

➢ (eg. Fabozzi).

➢ “Derivatives Text Books” use “continuously compounded” rates (eg. J. Hull)

➢ “Real World” uses “simple” LIBOR interest rates & day count conventions

➢ I will try and chart our way through this – as best I can.

➢ When we get to the FRA itself, you will see it’s pretty straightforward and uses “simple
LIBOR interest” and LIBOR day count conventions.

➢ (The main source of complexity, is linking together all these different interest rate
conventions – which is NOT our focus!!!)

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Interest rate swaps – hedging interest rate risk, pricing the swap,
valuation of swap..
❑ Swaps are privately arranged contracts (OTC) where two parties agree to exchange cash
flows in the future based on a pre-arranged formula

❑ Swap dealers are usually large banks (eg. JPMorgan, Goldmans, Citibank) who act as market
makers & provide swaps for corporates (e.g. Apple, British Airways)

❑ Now it is more usual that a “Clearing House” ensures contracts are honored (by requiring
margin payments/collateral).

❑ Largest markets are for interest rate swaps (IRS) , but other swaps (eg. currency swaps,
energy swaps) are also actively traded.

Most common types : “plain vanilla” or “fixed-for-floating rate” swaps

➢ Payments are based on “notional principal”, $Q

➢ Only interest payments are exchanged

Reasons for using interest rate swaps

➢ To remove existing interest rate risk

➢ To reduce the (overall) cost of borrowing – “comparative advantage”

Using a Swap to remove interest rate risk

Interest Rate Swaps can be used to remove interest rate risk

Example:

➢ Microsoft currently has floating rate loan, principal Q= $100m with Citibank, to run for a
further 5 years on which it pays a floating interest rate (LIBOR +0.5% pa), with interest rate
resets, each year (h =“tenor”).

➢ This is risky as LIBOR may increase in the future

➢ If Microsoft takes out an interest rate swap (IRS) with Merrills, to receive LIBOR and pay a
fixed interest rate (= swap rate, sp = 6% pa)

➢ then

➢ Bank Loan + IRS means Microsoft now effectively has a fixed rate loan

➢ (see below)

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Pricing an “at market” Swap: Calculating the (“at market”) swap rate , sp
Note: “At market” means the floating cash flows are determined by LIBOR (not LIBOR+spread)

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Using Duration To calculate the (approx.) Change in Value of the Fixed-Leg of the
swap
➢ Using “duration” gives an approximate value for dVFix ,

➢ when there is a small parallel shift in the yield curve

➢ (ie. when all spot yields change by the same amount).

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