Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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interest rate swap rates. From these prices, the equivalent zero couponbond yields of the different maturities are calculated. This process is knownas "stripping" the yield curve.How could we know what the level of the rates should be in a few yearstime? We need to have some reference interest rates to start with. In mostbig countries, the government would issue some debt instruments to borrowmoney from the public. These instruments have fixed coupons and have awide range of maturities. As expected, the US government is the biggestissuer of debt instruments, and the Treasury bills and bonds have maturitesranging from one week to thirty years. Other governments usually issueinstruments of shorter maturities. The Hong Kong Monetary Authority(HKMA) has recently issued some bonds with maturity in ten years, whichgive indication of the interest rates up to ten years. From these bond yields,the market would establish the rates of the different traded instruments,usually at a "spread" above the bond yields.THEORIES OF TERM STRUCTURE OF INTEREST RATESMost of you would have come across time deposit accounts. The big banksusually offer fixed term deposits from one week up to one year and offerdifferent interest rates for different fixed periods. After deregulation, theseinterest rates are affected by the market rates, so this is very close to theactual yield curve. (In reality, the deposit rates offered by banks are slightlyhigher than the Hong Kong dollar yield curve. This reflects the credit riskof the banks.) It is common knowledge that in most circumstances thelonger the fixed period, the higher the interest rate. In fact, historically,yield curves are mostly upward sloping, which means that long-term interestrates are higher than short-term interest rates. People have been trying toexplain this phenomenon and come up with three popular theories:Unbiased Expectations TheoryThis theory proposes that the forward rate represents the averageopinion of the expected future spot rate (or short-term interest rate)for the period in question. For example, if today's one-year interestPricing of a Forward Contract and the Yield Curve
ate is 6% and it is expected that this one-year interest rate will rise to8% in one year's time, then this situation would be reflected in today'stwo-year rate. There should be no difference between a) we invest themoney for a fixed one-year period and re-invest this amount with interestfor another year; and b) invest the money for a fixed two-year period.Given the interest rates above, the two-year rate today could becalculated by:(I + r) x (I + r) = (I + 0.06) x (I + 0.08)which gives r = 6.995%. In other words, this theory suggests that, iftoday's two-year rate is 6.995%, it implies that the marketplace (thatis, the general opinion of the investors) believes that the one-year ratewould rise to 8% in one year's time.Market Segmentation TheoryUnder the theory, different investors and borrowers are supposed tobe restricted by law, preference, or custom to certain maturities andthey do not switch maturities. There need be no relationship betweenshort-, medium-, and long-term interest rates. The short-term interestrate is determined by supply and demand in the short-term bondmarket, the medium-term interest rate is determined by supply anddemand in the medium-term bond market, and so on. However, thistheory is not as popular as the other two theories as it does notdirectly explain why yield curves are upward sloping more often thendownward sloping.Liquidity Preference TheoryIn some ways this is the most appealing theory. It argues that forwardrates should always be higher than expected future short-term interestrates. The basic assumption is that, as an investor, you would probablylike to put money in a short-term fixed period account (if the interestrate offered is the same as that of a longer-term fixed account) becauseit would not tie up the money for too long in case you need it.Pricing of a Forward Contract and the Yield Curve
Page 2 and 3: THE UNIVERSITY OF HONG KONGLIBRARIE
Page 4 and 5: VI- . .7 « i8^p ! ««^^OOSHSlVCJ
Page 6 and 7: Ever since derivatives took centre-
Page 8 and 9: denominator, value at risk, which c
Page 10 and 11: the kind of information that superv
Page 12 and 13: This book is a team effort of the H
Page 14 and 15: While most market participants defi
Page 16 and 17: of this investment is 6.32 percent
Page 18 and 19: Mathematically, the relation betwee
Page 20 and 21: $10,000. (For simplification of pre
Page 22 and 23: Hong Kong does go up and the HSI ri
Page 24 and 25: 3OF ATHEPRICING OF A FORWARD CONTRA
Page 26 and 27: COST OF CARRYIn the above example,
Page 30 and 31: Borrowers, on the other hand, usual
Page 32 and 33: Again we use our method of having t
Page 34 and 35: ates, the forward rate for the peri
Page 36 and 37: 5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
Page 76 and 77: If the stock price of A continues t
Page 78 and 79:
OF AN11In the previous two chapters
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at-the-money option approaches its
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12Mortgage-backed securities (MBS)
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NEGATIVE CONVEXITYFor MBS, there is
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MULTI-CLASSIn 1983, Freddie Mac int
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13What is a hedge? According to the
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management to enter into swap and o
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transaction. For this criterion to
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CREDIT DEFAULT SWAPThe simplest for
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APPLICATION OF CREDIT DERIVATIVESYo
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in the US. Equally innovative, cred
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THE VARIANCE-COVARIANCE METHODThe t
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"cell" would have a cash flow expos
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Daily profit and loss ranked in asc
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of the market factor. Through this
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3. Most value at risk models use hi
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16ANDIn Chapter 5, we talked about
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price) of 9,000. For this transacti
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and the June 3-month futures rate i
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needs to take the necessary busines
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ief, the policies and procedures sh
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The derivatives industry can be com
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ANDONOFINTRODUCTION1. The Monetary
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MANAGEMENT AND CORPORATE5. As the B
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ensure that there is sufficient awa
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15. Branches of foreign banks which
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20. Where the institution considers
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RISK MEASUREMENT25. Having identifi
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) the tendency of the relevant mark
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38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
Page 170 and 171:
This book is due for return or rene
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Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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