Level II Derivatives

Access to all Level II derivatives articles until the next Level II exam date

Binomial trees are used in a variety of contexts in finance: Calculating probabilities for Bayes’ Formula type problems Calculating the value of options on stocks, commodities, and so on (you are here) Calculating the option-adjusted spread (OAS) for bonds Calculating the value of bonds with embedded options Calculating the value of floating-rate bonds Calculating the […]

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Equity swaps are just as easy to value as plain vanilla interest rate swaps; once again, as with all derivatives, the formula for the value is: \[Value\ =\ PV(what\ you\ will\ receive)\ –\ PV(what\ you\ will\ pay)\] If one leg is a fixed or floating rate, it is valued exactly as described for plain vanilla […]

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Remember that the price of a swap is the fixed rate on the swap.  An equity swap can take many forms: The equity side can pay the return on a single stock, on a portfolio of stocks, or on an equity index. The equity side can pay only the price appreciation on the stock, portfolio, […]

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Currency swaps are only slightly more difficult to value than plain vanilla interest rate swaps; once again, as with all derivatives, the formula for the value is: \[Value\ =\ PV(what\ you\ will\ receive)\ –\ PV(what\ you\ will\ pay)\] Because the swap is equivalent to two bonds (one long, one short, one in one currency, one […]

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Remember that the price of a swap is the fixed rate on the swap.  A currency swap can take one of three forms: Each side pays a fixed rate: one in one currency, the other in a different currency.  In this case, there are two prices for the currency swap: the two fixed rates (which […]

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Somewhat surprisingly, a plain vanilla interest rate swap is one of the easiest derivatives to value; once again, as with all derivatives, the formula for the value is: \[Value\ =\ PV(what\ you\ will\ receive)\ –\ PV(what\ you\ will\ pay)\] Because the swap is equivalent to two bonds (one long, one short, one fixed, one floating), […]

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The formula for computing the value to the long position of a currency forward is: \[V_t\ =\ \frac{S_t}{\left(1\ +\ r_{BC}\right)^{(T\ -\ t)}}\ -\ \frac{F_T}{\left(1\ +\ r_{PC}\right)^{(T\ -\ t)}}\] where: \(V_t\): value of the currency forward (to the PC payer / BC receiver) at time \(t\) (in \(\dfrac{PC}{BC}\)) \(T\): expiration of the forward contract \(S_t\): spot […]

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A currency forward contract is an agreement to exchange a given amount of one currency for a given amount of another currency at a future date.  The price of a currency forward is the exchange rate for the currencies at the expiration of the contract, and is related to the spot exchange rate by covered […]

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Recall that an FRA is essentially an agreement to enter into two loans (one long, one short) in the future: a fixed-rate loan and a floating-rate loan.  (The difference between an FRA and an actual agreement to enter into these two loans is that the FRA will be settled at the beginning of the loan […]

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The formulae for valuing all derivatives are essentially the same: \[Value\ =\ PV(what\ you\ will\ receive)\ –\ PV(what\ you\ will\ pay)\] First, the notation: \(V_t\): value of the forward (to the long) at time \(t\) \(T\): expiration of the forward contract \(S_t\): spot price at time \(t\) \(F_T\): forward price at time \(T\) \(r_f\): effective […]

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