Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
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THE YIELD CURVEIn the above sections, you have seen the pric<strong>in</strong>g of simple forward contractsrelat<strong>in</strong>g to physical assets. The same pr<strong>in</strong>ciple can be applied to the pric<strong>in</strong>gof equity related forwards. However, the pric<strong>in</strong>g of <strong>in</strong>terest rate andforeign exchange related contracts is slightly more complicated. Before wemove on to <strong>in</strong>terest rate related derivatives, it is important to understandsome basics about the markets. The most important concept is the yieldcurve. Many people work<strong>in</strong>g <strong>in</strong> <strong>in</strong>vestment banks are paid "telephonenumber-like"salaries just for guess<strong>in</strong>g and play<strong>in</strong>g <strong>with</strong> the "shapes" of theyield curves and putt<strong>in</strong>g <strong>in</strong> trades <strong>in</strong> order to benefit from the movementsof these curves, so you would appreciate the importance of this.For a simple def<strong>in</strong>ition of a yield curve, though it is arguable, most peoplewould use one of the follow<strong>in</strong>g: it is a plot of I) yield of governmentsecurities or 2) annual compounded <strong>in</strong>terest rate (zero coupon yield, or theyield of a zero coupon bond) aga<strong>in</strong>st time. For most currencies, you willsee <strong>in</strong>terest rates for maturities of five years or more. An example is given<strong>in</strong> the graph below.An example yield curve8.5% T4 5 6Time (years)10This graph is sometimes referred to as the "Term Structure of Interest Rates".In many markets, zero coupon rates of less than one year <strong>in</strong> maturity arequoted <strong>by</strong> different banks and brokers. However, rates for longer thanone.y ear maturity are not quoted. They are usually obta<strong>in</strong>ed from theprices of other traded <strong>in</strong>struments, for example <strong>in</strong>terest rate futures andPric<strong>in</strong>g of a Forward Contract and the Yield Curve