Lecture 2

Interest Rates
Forward and Futures Pricing
Chapter 4 & 5 Hull, J. Options, futures and other derivatives. Pearson Education

2.1 Interest Rate

2.1a The interest rate applicable in a situation depends on the credit risk.
• The higher the credit risk, the higher the interest rate that is promised by the borrower.
• This is the risk that there will be a default by the borrower of funds, so that the interest and
principal are not paid to the lender as promised.
o Interest rates are often expressed in basis points. One basis point is 0.01% per annum.

2.1b Suppose that an amount A is invested for n years at an interest rate of R per annum. If the rate
is compounded once per annum, the terminal value of the investment is:
𝐴 ( 1 + 𝑅 )𝑛
• If the rate is compounded m times per annum, the terminal value of the investment is:
𝑅 𝑚𝑛
𝐴 (1 + )
𝑚
• The limit as the compounding frequency, m, tends to infinity is known as continuous
compounding. With continuous compounding, an amount A invested for n years at rate R
grows to:
𝐴𝑒 𝑅𝑛
• Where e is approximately 2.71828

Q1. Interest Rate

a. Consider an interest rate that is quoted as 10% per annum with semiannual compounding. With m
= 2 and Rm = 0.1. What would be the equivalent rate with continuous compounding?

b. Suppose that a lender quotes the interest rate on loans as 8% per annum with continuous
compounding, and that interest is actually paid quarterly. With m = 4 and Rc = 0.08, what would be
the equivalent rate with quarterly compounding?

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2.1c A bond’s yield (y) is the single discount rate that, when applied to all cash flows, gives a bond
price equal to its market price.
• Suppose that a 2-year (N) Treasury bond with a principal of $100 (F) provides coupons at the
rate of 6% (c) per annum semiannually.
• The market price (P) of the bond is $98.39.
• If y is the yield on the bond, expressed with continuous compounding, it must be true that:
𝑐𝐹𝑒 −𝑦×0.5 + 𝑐𝐹𝑒 −𝑦×1 + ⋯ + (𝑐𝐹 + 𝐹)𝑒 −𝑦×𝑁 = 𝑃
3𝑒 −𝑦×0.5 + 3𝑒 −𝑦×1 + 3𝑒 −𝑦×1.5 + 103𝑒 −𝑦×2 = 98.39
• This equation can be solved using an iterative procedure (i.e., by Excel) to give y = 6.76%.

Table 4.3 Data for bootstrap method

Bond Principal ($) Time to Maturity (Years) Annual Coupon* ($) Bond Price ($)
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
* Half and stated coupon is assumed to be paid every 6 months.

2.1d A popular approach to determine Treasury Zero rates is known as the bootstrap method.
• The continuously compounded 3-month rate: 100 = 97.5𝑒 𝑅×0.25 , so R = 10.127% per annum.
• The continuously compounded 6-month rate: 100 = 94.9𝑒 𝑅×0.5 , so R = 10.469%.
• The continuously compounded 1-year rate: 100 = 90.0𝑒 𝑅×1.0 , so R = 10.536%.
• The continuously compounded 1.5-year rate:
o 8(0.5)𝑒 −0.10469×0.5 + 8(0.5)𝑒 −0.10536×1 + [100 + 8(4)]𝑒 −𝑅×1.5 = 96, so R = 10.681%.
• A chart showing the zero rate as a function of maturity is known as the zero curve.

Q2. Treasury Zero rates

What would be the 2-year zero rate?

OFOD Figure 4.1 Zero rates given by the bootstrap method.

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Table 4.5 Calculation of forward rates.
Year (n) Zero rate for an n-year investment Forward rate for nth year
(% per annum) (% per annum)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.3 6.5

2.1e Forward interest rates are the future rates of interest implied by current zero rates for periods
of time in the future.
• The forward interest rate for year 2 can be calculated from the 1-year zero interest rate and the
2-year zero interest rate.
o 𝑒 𝑅𝑛−1(𝑛−1) 𝑒 𝑅𝐹 = 𝑒 𝑅𝑛(𝑛)
o 𝑒 0.03(1) 𝑒 𝑅𝐹 = 𝑒 0.04(2) , so RF = 0.05.
o Return of investing in a 2-year bond for two years: 𝑒 0.04(2) − 1 = 𝑒 0.08 − 1 = 8.33%
o Return of investing in a 1-year bond for the next two years: 𝑒 0.03(1) 𝑒 0.05(1) − 1 = 8.33%

Q3. Forward Interest Rates

What would be the 3-year forward rate?

2.1f When interest rates are continuously compounded and rates in successive time periods are
combined, the overall equivalent rate is simply the average rate during the whole period.
• 3% for the first year and 5% for the second year average to 4% over the 2 years.
• 𝑅𝐹 = 𝑅𝑛−1 + (𝑅𝑛 − 𝑅𝑛−1 )(𝑛)
• 5% = 3% + (4% − 3%)(2)

2.1g If a financial institution decides to make a lending for the second year at the current forward rate:
• It can borrow $100 at 3% for 1 year and invest the money at 4% for 2 years now.
o A cash outflow of 100𝑒 0.03(1) = $103.05 at the end of year 1.
o An inflow of 100𝑒 0.04(2) = $108.33 at the end of year 2.
• The inflow equals to invest at 5% forward rate at the end of year 1 = 103.05𝑒 0.05 = $108.33.

Q4. Locking in the Forward Interest Rates

What if a financial institution decides to make a borrowing for the third year at the current forward
rate?

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2.2 Forward Rate Agreement
2.2a A forward rate agreement (FRA) is a transaction designed to fix the interest rate that will apply
to either borrowing or lending a certain principal during a specified future period of time.
• The usual assumption underlying the contract is that the borrowing or lending would normally
be done at SOFR.
• If the agreed fixed rate is greater than the actual SOFR rate for the period, the borrower pays
the lender the difference between the two applied to the principal.
o If the reverse is true, the lender pays the borrower the difference applied to the principal.

2.2b Suppose that a company enters into an FRA that is designed to ensure it will receive a fixed rate
of 4% on a principal of $100 million for a 3-month period starting in 3 years.
• The FRA is an exchange where SOFR is paid and 4% is received for the 3-month period.
• If 3-month SOFR proves to be 4.5% for the 3-month period, the cash flow to the lender will be:
o 100,000,000 × (0.04 − 0.045) × 0.25 = −$125,000 at the 3.25 year point
• This is equivalent to a cash flow:
125,000
o − 1+0.045×0.25 = −$123,609 at the 3-year point

2.2c Consider an FRA where company X is agreeing to lend money to company Y for the period of
time between T1 and T2. Define:
• RK: The fixed rate of interest agreed to in the FRA
• RF: The forward SOFR interest rate for the period between times T1 and T2, calculated today
• RM: The actual SOFR interest rate observed in the market at time T1 for the period between
times T1 and T2
• L: The principal underlying the contract

2.2d We will depart from our usual assumption of continuous compounding and assume that the rates
RK, RF, and RM are all measured with a compounding frequency reflecting the length of the period to
which they apply.
• This means that if 𝑇2 − 𝑇1 = 0.5, they are expressed with semiannual compounding.
• Company X would earn RM from the SOFR loan, while the FRA means that it will earn RK.
o The extra interest rate that it earns as a result of entering into the FRA is RK – RM.
• The extra interest rate therefore leads to a cash flow to company X at time T2:
o 𝐿(𝑅𝐾 − 𝑅𝑀 )(𝑇2 − 𝑇1 )
𝐿(𝑅𝐾 −𝑅𝑀 )(𝑇2−𝑇1 )
o Payoff at time 𝑇1 : 1+𝑅 (𝑇 −𝑇 )
𝑀 2 1
• Similarly there is a cash flow to company Y at time T 2:
o 𝐿(𝑅𝑀 − 𝑅𝐾 )(𝑇2 − 𝑇1 )
𝐿(𝑅𝑀 −𝑅𝐾 )(𝑇2−𝑇1 )
o Payoff at time 𝑇1 : 1+𝑅 (𝑇 −𝑇 )
𝑀 2 1

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2.2e The market value of a derivative at a particular time is referred to as its mark-to-market (MTM)
value.
1. Calculate the payoff on the assumption that forward rates are realized (that is, on the
assumption that RM = RF).
2. Discount this payoff at the risk-free rate over the two periods (R2).
3. The value of an FRA where RK is received:
o 𝑉𝐹𝑅𝐴 = 𝐿(𝑅𝐾 − 𝑅𝐹 )(𝑇2 − 𝑇1 )𝑒 −𝑅2 𝑇2
4. The value of an FRA where RK is paid:
o 𝑉𝐹𝑅𝐴 = 𝐿(𝑅𝐹 − 𝑅𝐾 )(𝑇2 − 𝑇1 )𝑒 −𝑅2 𝑇2

2.2f Suppose that the forward SOFR rate for the period between time 1.5 years and time 2 years in
the future is 5% (with semiannual compounding)
• Some time ago a company entered into an FRA where it will receive 5.8% (with semi-annual
compounding) and pay SOFR on a principal of $100 million for the period.
• The 2-year risk-free rate is 4% (with continuous compounding).
• The value of the FRA = 100,000,000 × (0.058 − 0.050) × 0.5𝑒 −0.04×2 = $369,200

2.3 Duration
2.3a The duration of a bond is a measure of how long on average the holder of the bond has to wait
before receiving cash payments.
• A zero-coupon bond that lasts n years has a duration of n years.
o However, a coupon-bearing bond lasting n years has a duration of less than n years,
because the holder receives some of the cash payments prior to year n.
• Suppose that a bond provides the holder with cash flows c i at time ti (1 ≤ i ≤ n). The bond price
B and bond yield y (continuously compounded) are related by
o 𝐵 = ∑𝑛𝑖=1 𝑐𝑖 𝑒 −𝑦𝑡𝑖
• The duration of the bond, D, is defined as
∑𝑛
𝑖=1 𝑡𝑖 𝑐𝑖 𝑒
−𝑦𝑡𝑖
𝑐𝑖 𝑒 −𝑦𝑡𝑖
o 𝐷= = ∑𝑛𝑖=1 𝑡𝑖 [ ]
𝐵 𝐵

2.3b When a small change ∆y in the yield is considered, it is approximately true that
𝑑𝐵
• ∆𝐵 = 𝑑𝑦 ∆𝑦 = − ∑𝑛𝑖=1 𝑡𝑖 𝑐𝑖 𝑒 −𝑦𝑡𝑖 ∆𝑦 = −𝐵𝐷∆𝑦
∆𝐵
• = −𝐷∆𝑦
𝐵
• It is an approximate relationship between percentage changes in a bond price and changes in
its yield.

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2.3c Consider a 3-year 10% coupon bond with a face value of $100. Suppose that the yield on the
bond is 12% per annum with continuous compounding.
• Table 4.6 Calculation of duration.
Time (years) Cash flow ($) Present value Weight Time × weight
0.5 5 4.709 0.050 0.025
1.0 5 4.435 0.047 0.047
1.5 5 4.176 0.044 0.066
2.0 5 3.933 0.042 0.083
2.5 5 3.704 0.039 0.098
3.0 105 73.256 0.778 2.333
Total: 130 94.213 1.000 2.653

• When the yield on the bond increases by 10 basis points (10 × 0.01), ∆y = +0.001.
• The duration relationship predicts that ∆𝐵 = −94.213 × 2.653 × 0.001 = −$0.250.
o The expected bond price would be: 94.213 − 0.250 =$93.963
• When the bond yield increases by 10 basis points to 12.1%, the bond price is $93.963:
o = 5𝑒 −0.121×0.5 + 5𝑒 −0.121×1 + 5𝑒 −0.121×1.5 + 5𝑒 −0.121×2 + 5𝑒 −0.121×2.5 + 105𝑒 −0.121×3

𝐵𝐷∆𝑦
2.3d If y is expressed with a compounding frequency of m times per year, then ∆B = 1+𝑦/𝑚
𝐷
• Bond’s modified duration (D*) defined by D∗ = 1+𝑦/𝑚
• The modified duration relationship can be simplified to ∆B = −B𝐷∗ ∆y

2.3e The bond has a price of 94.213 and a duration of 2.653 with semiannual compounding of
12.3673%.
2.653
• The modified duration: 𝐷∗ = 1+0.123673/2 = 2.4985
• The modified duration relationship: ∆B = −94.213 × 2.4985 × ∆y = −235.39 × ∆y
• When the yield increases by 10 basis points, ∆B = −235.39 × 0.001 = −0.235, so B = $93.978.
• How accurate is this?
o If the bond is discounted by 12.4673%, the bond price = $93.978.

2.3f The duration of a bond portfolio can be defined as a weighted average of the durations of the
individual bonds in the portfolio, with the weights being proportional to the bond prices.
• There is an implicit assumption that the yields of all bonds will change by the same amount.
• Another assumption is that there is a parallel shift in the zero-coupon yield curve.
o Therefore, it is still exposed to shifts that are either large or nonparallel.

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2.3g Convexity measures the curvature and can be used to improve the price-yield relationship.
• When interest rate shocks are much larger, duration becomes a less accurate predictor of how
much the prices of bonds will change.
o This is the result of a bond’s price–interest rate relationship exhibiting a property called
convexity rather than linearity.
o For large yield changes, duration would underestimate the changes in bond price.
• The reason is that the relationship between bond price and yield is not linear.
1 𝑑2 𝐵 ∑𝑛 2 −𝑦𝑡𝑖
𝑖=1 𝑑𝑖 𝑡𝑖 𝑒
o C = 𝐵 𝑑𝑦 2 = 𝐵
• From Taylor series expansions, we obtain
𝑑𝐵 1 𝑑2 𝐵
o ∆B = 𝑑𝑦 ∆𝑦 + 2 𝑑𝑦 2 ∆𝑦 2
∆𝐵 1
o 𝐵 = −D∆𝑦 + 2 𝐶(∆𝑦)2
• A financial institution can make itself immune to relatively large parallel shifts in the zero curve.
o However, it is still exposed to nonparallel shifts.

2.4 Determination of Futures Price

2.4a We will assume that the following are all true in determining the futures price:
1. The market participants are subject to no transaction costs when they trade.
2. The market participants are subject to the same tax rate on all net trading profits.
3. The market participants can borrow money at the same risk-free rate of interest as they can
lend money.
4. The market participants take advantage of arbitrage opportunities as they occur.
5. All that we require is that the above assumptions are at least approximately true for a few key
market participants such as large derivatives dealers.

2.4b The following notation will be used throughout this course:

• T: Time until delivery date in a forward or futures contract (in years)
• S0: Price of the asset underlying the forward or futures contract today
• F0: Forward or futures price today
• r: The rate at which money is borrowed or lent when there is no credit risk, so that the money
is certain to be repaid.

2.4c The value of a forward contract on an investment asset with price S 0 that provides no income:
• 𝐹0 = 𝑆0 𝑒 𝑟𝑇
• If 𝐹0 > 𝑆0 𝑒 𝑟𝑇 , arbitrageurs can buy the asset and short forward contracts on the asset.
• If 𝐹0 < 𝑆0 𝑒 𝑟𝑇 , arbitrageurs can short the asset and enter into long forward contracts on it.
• If S0 = 40, r = 0.05, and T = 0.25, 𝐹0 = 40𝑒 0.05×0.25 = $40.5

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Q5. Forward Price
Consider a 4-month forward contract to buy a zero-coupon bond that will mature 1 year from today.
The current price of the bond is $930. We assume that the 4-month risk-free rate of interest
(continuously compounded) is 6% per annum. What would be the forward price?

2.4d We now consider the situation where the asset underlying a forward contract provides a known
yield.
• Define q as the average yield per annum on an asset during the life of a forward contract with
continuous compounding.
• 𝐹0 = 𝑆0 𝑒 (𝑟−𝑞)𝑇
• If S0 = 25, r = 0.10, T = 0.5, and the yield is 4% per annum with semiannual compounding.
0.04
o 𝑒 𝑟 = (1 + 2 )2 . This is 3.96% per annum with continuous compounding.
o 𝐹0 = 25𝑒 (0.10−0.0396)×0.5 = $25.77

2.4e We define f to be the value of forward contract today and K is the delivery price for a contract
that was negotiated some time ago.
• At the beginning of the life of the forward contract, the delivery price, K, is set equal to the
forward price at that time and the value of the contract, f, is 0.
o As time passes, K stays the same.
o As the forward price changes, the value of the contract becomes either positive or negative.
• For long position: 𝑓 = (𝐹0 − 𝐾)𝑒 −𝑟𝑇
o For asset that provides no income: As 𝐹0 = 𝑆0 𝑒 𝑟𝑇 , so 𝑓 = 𝑆0 − 𝐾𝑒 −𝑟𝑇 .
o For asset that provides income: As 𝐹0 = 𝑆0 𝑒 (𝑟−𝑞)𝑇 , so 𝑓 = 𝑆0 𝑒 −𝑞𝑇 − 𝐾𝑒 −𝑟𝑇 .
• For short position: 𝑓 = (𝐾 − 𝐹0 )𝑒 −𝑟𝑇
o For asset that provides no income: As 𝐹0 = 𝑆0 𝑒 𝑟𝑇 , so 𝑓 = 𝐾𝑒 −𝑟𝑇 − 𝑆0 .
o For asset that provides income: As 𝐹0 = 𝑆0 𝑒 (𝑟−𝑞)𝑇 , so 𝑓 = 𝐾𝑒 −𝑟𝑇 − 𝑆0 𝑒 −𝑞𝑇 .
• If S0 = 25, r = 0.10, T = 0.5, and K = 24:
o 𝐹0 = 25𝑒 0.1×0.5 = $26.28
o The value of the long position: 𝑓 = (26.28 − 24)𝑒 −0.1×0.5 = $2.17

2.4f Consider forward and futures foreign currency contracts from the perspective of a US investor.
• The underlying asset is one unit of the foreign currency.
• S0 is the current spot price in US dollars of one unit of the foreign currency
• F0 as the forward or futures price in US dollars of one unit of the foreign currency.
• For major exchange rates other than the British pound, euro, Australian dollar, and New
Zealand dollar, a spot or forward exchange rate is normally quoted as the number of units of
the currency that are equivalent to one US dollar

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2.4g A foreign currency has the property that the holder of the currency can earn interest at the risk-
free interest rate prevailing in the foreign country.
• rf is the value of the foreign risk-free interest rate when money is invested for time T.
• r is the risk-free rate when money is invested for this period of time in US dollars.
• 𝐹0 = 𝑆0 𝑒 (𝑟−𝑟𝑓)𝑇
• This is the well-known interest rate parity relationship from international finance.

Table 5.4 Futures quotes for a selection of CME Group contracts on May 14, 2013.

• For the Australian dollar, British pound, and Canadian dollar, short-term interest rates were
higher than in the United States.
o This explains why the futures prices of these currencies decrease with maturity.
• The September settlement price for the Australian dollar is about 0.6% lower than the June
settlement price.
o The futures prices are decreasing at about 2.4% per year with maturity.
o This is an estimate of the amount by which short-term Australian interest rates exceeded
short-term US interest rates on May 14.

Q6. Futures on Currency

a. Suppose that the 2-year interest rates in Australia and the United States are 3% and 1%,
respectively, and the spot exchange rate is 0.9800 USD per AUD. What should the 2-year forward
exchange rate be?

b. What if the 2-year forward exchange rate is 0.9300?

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2.4h Commodities that are consumption assets rather than investment assets usually provide no
income, but can be subject to significant storage costs.
• Storage costs can be treated as negative income.
• If the storage costs (net of income) incurred at any time are proportional to the price of the
commodity, they can be treated as negative yield.
o 𝐹0 = 𝑆0 𝑒 (𝑟+𝑢)𝑇
o where u denotes the storage costs per annum as a proportion of the spot price net of any
yield earned on the asset.
.
2.4i Users of a consumption commodity may feel that ownership of the physical commodity provides
benefits that are not obtained by holders of futures contracts.
• Ownership of the physical asset enables a manufacturer to keep a production process running
and perhaps profit from temporary local shortages.
o A futures contract does not do the same.
• The benefits from holding the physical asset are sometimes referred to as the convenience
yield provided by the commodity.
o 𝐹0 = 𝑆0 𝑒 (𝑟+𝑢−𝑦)𝑇
• The greater the possibility that shortages will occur, the higher the convenience yield.

2.4j The relationship between futures prices and spot prices can be summarized in terms of the cost
of carry, c.
• This measures the storage cost plus the interest that is paid to finance the asset less the
income earned on the asset.
• For a non-dividend-paying stock, the cost of carry is r.
o For a dividend-paying stock, the cost of carry is r – q.
• For a currency, the cost of carry is r – rf.
• For assets that convenience yield is zero: 𝐹0 = 𝑆0 𝑒 𝑐𝑇
o For assets that convenience yield is positive: 𝐹0 = 𝑆0 𝑒 (𝑐−𝑦)𝑇
• We can infer the market’s average opinion about what the spot price of an asset will be at a
certain future time from the futures prices.

2.4k Backwardation and Contango

• When the futures price is below the expected future spot price, the situation is known as
backwardation.
o 𝐹0 < 𝐹𝐹𝑎𝑖𝑟
o It could provide arbitrage opportunities to investors if the transaction cost is low.
o The difference between the forward price and the spot price is less than the cost of carry.
• When the futures price is above the expected future spot price, the situation is known as
contango.
o 𝐹0 > 𝐹𝐹𝑎𝑖𝑟
• It should be noted that sometimes these terms are used to refer to whether the futures price is
below or above the current spot price, rather than the expected future spot price.
o Definition of backwardation in industry: 𝐹0 < 𝑆0
o Definition of contango in industry: 𝐹0 > 𝑆0

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2.5 Suggested Questions
OFOD Chapter 4 Q34.
The following table gives the prices of bonds
Bond Principal ($) Time to Maturity (yrs) Annual Coupon ($)* Bond Price ($)
100 0.5 0.0 98
100 1.0 0.0 95
100 1.5 6.2 101
100 2.0 8.0 104
*Half the stated coupon is paid every six months

a. Calculate zero rates for maturities of 6 months, 12 months, 18 months, and 24 months.
Maturity (yrs) Zero Rate (%) Forward Rate (%)
0.5
1.0
1.5
2.0

b. What are the forward rates for the periods: 6 months to 12 months, 12 months to 18 months, 18
months to 24 months?

OFOD Chapter 4 Q35.

Portfolio A consists of a one-year zero-coupon bond with a face value of $2,000 and a 10-year zero-
coupon bond with a face value of $6,000. Portfolio B consists of a 5.95-year zero-coupon bond with a
face value of $5,000. The current yield on all bonds is 10% per annum.

a. Do both portfolio have the same duration?

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b. Would the percentage changes in the values of the two portfolios for a 0.1% per annum increase
in yields are the same?

c. What are the percentage changes in the values of the two portfolios for a 5% per annum increase
in yields?

OFOD Chapter 5 Q31.

A bank offers a corporate client a choice between borrowing cash at 11% per annum and borrowing
gold at 2% per annum. (If gold is borrowed, interest must be repaid in gold. Thus, 100 ounces
borrowed today would require 102 ounces to be repaid in one year.) The risk-free interest rate is
9.25% per annum, and storage costs are 0.5% per annum. The interest rates on the two loans are
expressed with annual compounding. The risk-free interest rate and storage costs are expressed with
continuous compounding. Suppose that the price of gold is $1000 per ounce and the corporate client
wants to borrow $1,000,000.
a. Discuss whether the rate of interest on the gold loan is too high or too low in relation to the rate of
interest on the cash loan.

b. What is the correct rate of interest?

END OF LECTURE 2

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 Solution
*A small difference (1%) between your answer and the solution is possible due to rounding errors in calculation.

Q1. Interest Rate

a.
0.1
• 2 ln (1 + ) = 9.758%
2
b.
• 4 ×(𝑒 0.08/4 − 1) = 8.08%

Q2. Treasury Zero rates

• 6𝑒 −0.10469×0.5 + 6𝑒 −0.10536×1 + 6𝑒 −0.10681×1.5 + 106𝑒 −𝑅×2.0 = 101.6, so R = 10.808%.

Q3. Forward Interest Rates

• 𝑒 0.04(2) 𝑒 𝑅𝐹 = 𝑒 0.046(3), so RF = 0.058.

Q4. Locking in the Forward Interest Rates

• It can borrow $100 at 4.6% for 3 year and invest the money at 4% for 2 years now.
• A cash inflow of 100𝑒 0.04(2) = $108.33 at the end of year 2.
• An outflow of 100𝑒 0.046(3) = $114.80 at the end of year 3.
• The outflow equals to borrow at 5.8% forward rate at the end of year 2 = 108.33𝑒 0.058 =
$114.80.

Q5. Forward Price

• 𝐹0 = 930𝑒 0.06×(4/12) = $948.79

Q6. Futures on Currency

a.
• 𝐹0 = 0.9800𝑒 (0.01−0.03)×2 = 0.9416
b.
• An arbitrageur can borrow 1,000 AUD at 3% per annum for 2 years, convert to 980 USD and
invest the USD at 1% (both rates are continuously compounded).
o The 980 USD that are invested at 1% grow to 980𝑒 0.01×2 = 999.80 USD in 2 years.
o After 2 years, the principal and interest on the 1,000 AUD 1000𝑒 0.03×2 = 1,061.84.
• Enter into a forward contract to buy 1,061.84 AUD for 1,061.84 × 0.93 = 987.51 𝑈𝑆𝐷.
o This strategy gives rise to a riskless profit of 999.80 − 987.51 = 12.29 𝑈𝑆𝐷.

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OFOD Chapter 4 Q34.
a.
• The zero rate for a maturity of six months, expressed with continuous compounding is
100−98 2
o (1 + 98 )2 = 𝑒 𝑟 , r = 2 ln (1 + 98) = 4.0405%
• The zero rate for a maturity of one year, expressed with continuous compounding is
100−95
o (1 + 95 ) = 𝑒 𝑟 , r = 5.1293%
• The 1.5-year rate is R where
6.2%
o 100 × 2 𝑒 −0.040405×0.5 + 3.1𝑒 −0.051293×1 + 103.1𝑒 −𝑅×1.5 = 101,R = 5.4429%
• The 2.0-year rate is R where
8%
o 100 × 2 𝑒 −0.040405×0.5 + 4𝑒 −0.051293×1 + 4𝑒 −0.054429×1.5 + 104𝑒 −𝑅×2 = 104,R = 5.8085%
Maturity (yrs) Zero Rate (%) Forward Rate (%)
0.5 4.0405 4.0405
1.0 5.1293 6.2181
1.5 5.4429 6.0700
2.0 5.8085 6.9054
b.
• Forward Rate (0-6 months): 4.0405%
(5.1293×1.0−4.0405×0.5)
• Forward Rate (6-12 months): = 6.2181%
0.5
(5.4429×1.5−5.1293×1.0)
• Forward Rate (12-18 months): = 6.0700%
0.5
(5.8085×2.0−5.4429×1.5)
• Forward Rate (18-24 months): = 6.9054%
0.5

OFOD Chapter 4 Q35.

a.
• Yes
1×2000𝑒 −0.1×1 +10×6000×𝑒 −0.1×10
• The duration of Portfolio A is = 5.95.
2000𝑒 −0.1×1 +6000𝑒 −0.1×10
• The duration of Portfolio B is 5.95.
b.
• The value of Portfolio A is 2000𝑒 −0.1 + 6000𝑒 −0.1×10 = 4016.95
o When yields increase by 10 basis points: 2000𝑒 −0.101 + 6000𝑒 −0.101×10 = 3993.18
4016.95−3993.18
o The percentage decrease in value is = 0.59%
4016.95
• The value of Portfolio 5000𝑒 −0.1×5.95 = 2757.81
o When yields increase by 10 basis points: 5000𝑒 −0.101×5.95 = 2741.45
2757.81−2741.45
o The percentage decrease in value is = 0.59%
2757.81
• The percentage changes in the values of the two portfolios for a 10 basis point increase in
yields are therefore the same.

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c.
• The value of Portfolio A is 2000𝑒 −0.1 + 6000𝑒 −0.1×10 = 4016.95
o When yields increase by 5%: 2000𝑒 −0.15 + 6000𝑒 −0.15×10 = 3060.20
4016.95−3060.20
o The percentage decrease in value is = 23.82%
4016.95
• The value of Portfolio B is 5000𝑒 −0.1×5.95
= 2757.81
o When yields increase by 5%: 5000𝑒 −0.15×5.95 = 2048.15
2757.81−2048.15
o The percentage decrease in value is = 25.73%
2757.81
• Since the percentage decline in value of Portfolio A is less than that of Portfolio B, Portfolio A
has a greater convexity.

OFOD Chapter 5 Q31.

a.
• The client has a choice between borrowing $1,000,000 in the usual way and borrowing 1,000
ounces of gold.
• If it borrows $1,000,000 in the usual way, an amount equal to 1,000,000 × 1.11 = $1,110,000
must be repaid.
• If it borrows 1,000 ounces of gold it must repay 1,020 ounces.
(0.0925+0.005)×1
• 𝑟 = 0.0925 and 𝑢 = 0.005, so that the forward price is 1000𝑒 = 1102.41.
• By buying 1,020 ounces of gold in the forward market the corporate client can ensure that the
repayment of the gold loan costs 1020 × 1102.41 = $1,124,460.
• Clearly the cash loan is the better deal (1,124,460 > 1,110,000).
• This argument shows that the rate of interest on the gold loan is too high.
b.
• Suppose that R is the rate of interest on the gold loan. The client must repay 1,000(1 + 𝑅)
ounces of gold. When forward contracts are used the cost of this is 1,000(1 + 𝑅) × 1102.41.
• This equals the $1,110,000 required on the cash loan when 𝑅 = 0.688%.
• The rate of interest on the gold loan is too high by about 1.31%.
• However, this might be simply a reflection of the higher administrative costs incurred with a
gold loan.
• It is interesting to note that this is not an artificial question. Many banks are prepared to make
gold loans.

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