The FRM Part I

Formula Guide: Financial Market and Products

2015

iPlan Education, 2015

Hedging with Futures and Options

Basis (Spread) = St - Fo
Here,

St = Spot price of the underlying asset (Current market price if you pay now in cash)
Fo = Current market price of the Future Contract

Introduction (Future, Options and Other Derivatives)

Call option payoff: Ct = max (0, St-X)

Profit of Call: Ct-Co

Put option payoff: Pt = max (0, X-St)

Profit of Put: Pt-Po

Here,

Ct = Call option payoff

Pt = Put option payoff
Co= Premium paid for call option
Po= Premium paid for put option

St = Spot price of underlying at maturity

X = Strike price of option contract

*Payoff means the amount option buyer/seller receives at the time of maturity. Net profit will
be calculated after deducting option premium cost.

Payoff for Forward Contract: St-K

St = Spot price of underlying at maturity
K = Delivery price of underlying asset set as per the contract at the time of
initiating the contract.

iPlan Education, 2015

Hedging Strategies Using Futures

Hedge Ratio: s,f

s,f = Correlation between spot and future contract price

s = Standard deviation of the spot price

f= Standard deviation of the future contract price

Cov s,f
Beta: =
2

Cov s,f
Correlation:

Hedging with stock index future:

Number of contracts = portfolio

Value of index future contracts = index future contract price x contract lot size

Adjusting the portfolio Beta:

Number of contracts = (* - )

P = Portfolio Value
I= Value of the index future contracts

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Interest Rates

Discrete Compounding: FV = A [1 + /]
Here,

A = Initial Investment
R= Annual Rate of Return
m= Number of times compounded per year for t years
t= Number of years

Continuous Compunding: FV = Aert

2 2 1 1 1
Forward Rate: Rforward = = 2 + 2 1
2 1 2 1

Forward Rate Agreement:

Cash Flow (When Receiving) Rk = P(Rk R)(T2-T1)

Cash Flow (When Paying) Rk = P(R- Rk)(T2-T1)

P = Notional Principal
Rk = Annualized rate on P, on compounding period T1-T2
R = Annualized actual rate (Which we get) on compounding period T1-T2
Ti = Time expressed in years

Determination of Forward and Futures Prices

Forward Contract Price: F0 = Sert

Forward Contract Price with carriage cost: F0 = (S-U)ert

Forward Contract Price when underlying pays dividend : F0 = Se(r-q) t

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 F0 = Forward Price
S = Spot Price of underlying
e = Value of Exponential, Normally 2.718
U = Carriage Cost
r = Annualized rate of return / Risk free return
q = Dividend rate

Interest Rate Futures

# of days from last coupon to the settlement date

Accrued Interest = Coupon
# of days in coupon period

Day Count Conventions:

U.S. Treasury bonds use actual/actual days

U.S. Corporate and municipal bonds use 30/360 days
U.S. Money market instrument (Treasury bills) use actual/360 days

Calculating Cash Price of bond:

Cash Price = Quoted Price + Accrued Interest

Calculating Annual rate on T-Bill:

360
T-Bill Discount rate = 100 Y
n

Treasury Bond Futures:

Cash Received by the short = (QFP CF) + AI

Finding Cheapest to deliver bond:

Quoted bond price (QFP CF)

Here,

QFP = Quoted future price (recent settlement price)

CF = Conversion factor for the bond delivered
AI = Accrued interest since the last coupon date (on the bond delivered)

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 Eurodallar Future Price:

$10,000 [100-(0.25)(100-z)]

Convexity Adjustment:

Actual Forward rate = forward rate implied by futures (0.5 2 t1 t2)

Duration Based hedge ratio:

P Dp
N=
F Df

Here,

N = Number of contracts to hedge

P = Value of portfolio
Dp = Duration of Portfolio
Df = Duration of future contracts

Swaps

Forward Rate between T1 and T2:

2 2 1 1
Rforward =
2 1

1
= 2 + 2 1
2 1

iPlan Education, 2015

Properties of Stock Options

Put Call Parity Relationship:

p + S = c + Xe-rt =

Put-Call Parity:

S= c-p + Xe-rt

P= c-S + Xe-rt

c = S+p - Xe-rt

Xe-rt = S + p-c

Here,

S = Spot price or current stock price

X = Strike price of the option contract
t = Time till expiry of the contract
r = Risk free rate
c = Call option premium / Value of European call option
p= Put option premium / Value of European put option
C= Value of American call option
P = Value of American put option

Lower and Upper Bound for American and European Options:

Option Minimum Value Maximum Value

European call c max (0, S - Xe-rt) S
American call C max (0, S - Xe-rt) S
European put p max (0, Xe-rt - s) Xe-rt
American put P max (0, - X - S) X

iPlan Education, 2015

Trading Strategies Involving Options

Bull Call Spread: Profit = max (0, SE XL) max (0, SE XH) - CL + CH

Bear Put Spread: Profit = max (0, XH SE) max (0, XL SE) - PH + PL

Butterfly Spread with call:

Profit: max (0, SE XL) 2 max (0, SE XM) + max (0, SE XH)- CL + 2CM-CH

Straddle: Profit = max (0, SE X) + max (0, X SE) - C P

Strangle: Profit = max (0, SE XH) + max (0, XL SE) - C P

Here,

SE = Spot price at the time of Expiry / Exercising the call

XL = Lower Strike Price
XH = Higher Strike Price
CL = Lower Call Premium/Price
CH = Higher Call Premium / Price
PL = Lower Put Premium/Price
PH = Higher Put Premium/Price

Commodity Forwards and Futures

Commodity Forward:

Pricing with a lease payment: F0 = Se(r l)t

Pricing with storage/warehousing cost : F0 = Se(r + w)t

Pricing with convenience Yield: F0 = Se(r c)t

Here,

F0 = Forward Rate
S = Spot Price of underlying
e = Value of Exponential (2.718)
r = Short term risk free rate
l = Lease rate
w = storage cost rate
c = Convenience yield

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Foreign Exchange Risk

Interest Rate Parity:

(1+ )
Forward Price = Spot
(1+)

Forward Price = Se( )

Exact Method: (1 +r) = (1+Real r) [ 1 + Ei]

Here,

Rd = Annualized domestic interest rate

Rf = Annualized foreign interest rate
r = Annualized nominal interest rate
Real r = Annualized real interest rate
Ei = Annualized Expected rate of inflation
T = Time till maturity

Corporate bonds

The original-issue discount (OID) = face value offering price

Dollar Default Rate:

( ) ( # )

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Mortgages and Mortgage-Backed Securities

Single monthly mortality rate: SMM = 1 (1 CPR)1/2

Option Cost = Zero- Volatility spread OAS

Here,

SMM = Single monthly mortality rate

OAS = Option Adjusted Spread

iPlan Education, 2015