FIN4110: Options and Futures

Zongbo Huang
CUHK(SZ)
Commodity Swaps
Commodity Swaps

• Suppose you are a producer of methanol who purchases natural

gas as an input. You plan to purchase 10,000 MMBtu’s of natural
gas every three months for one year starting on October 1
(assume Oct 1 is 3 months from now). Natural gas prices can be
highly volatile so you would like to lock in the prices for the
coming year. Assume the risk free rate is 3.35%.
• You have two ways to hedge the uncertainty:
• Buy a strip of futures contracts.
• Buy a swap.

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Buy a Strip of Futures Contracts

• The producer could enter into a series of futures contracts, one

for every month he plans to purchase natural gas.

DATE Futures Price

Oct 3.142
Jan 3.809
Apr 3.482
July 3.581

• These four contracts allow the producer to lock in a purchase

price for the coming year. What is the total cost locked in?

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Buy a Swap

• The producer could enter into an arrangement where he pays a

fixed price for gas every three months over the next year. This is
referred to as a swap.
• What should be the fixed price (ignoring credit risk)?

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Swap Settlement

• The swap could be settled through physical delivery of the

natural gas or the contract could be cash settled.
• If the contract is cash settled, a cash payment equal to the
difference between the spot price and the swap price is made.
• Example:
• If the spot price in October is $3.20, what is the payoff to the
producer?
• What if the spot price in October is $3.80?

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Hedging Swap Positions

• The risk of variable natural gas prices has been transferred from
the producer to the counter party. How does the counter party
hedge the risk associated with the swap?
• The natural way to hedge would be for the counter party to buy
a strip of futures to lock in a price for the natural gas he
committed to deliver.

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Market Value of the Swap

• When the producer and the counter party enter into the swap,
the swap is priced so that the market value of the swap is zero.
• Suppose that on December 1, futures curve becomes

DATE Futures Price

Jan 3.550
Apr 3.300
July 3.410

• If the producer wants to get out of his swap position, what

needs to be done?

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Currency Swaps
Currency Swaps

• Suppose a European firm has decided to issue debt in dollars

because the CFO thinks the dollar denominated debt market is
more liquid. The bond is a $10 million dollar 4 year 3.35%
coupon bond. The firm’s revenues are in euros so the firm faces
some exchange rate risk. Assume the continuously compounded
dollar denominated interest rate is ln(1.0335)=3.3%, the euro
denominated interest rate is ln(1.043)=4.21% and the current
exchange rate is $.92/euro (which could be restated as
1.087euros/$).
• Because the firm’s revenues are in euros and the coupon
payments are in dollars, the firm faces some exchange rate risk,
i.e., the firm doesn’t know the euro cost of covering its coupon
and principle payments. How to hedge?

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• The firm can enter into a series of currency forwards, one for
each of the four years. What is the Euro cost locked in?
• The firm could enter into a swap where the firm makes a fixed
set of euro payments.
• Let C denote the euro coupon payments and P be the principal
payment made by the European firm.
• What euro coupon and principle payments should the firm be
required to make?

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Interest Rate Futures and Swaps
Zero Coupon Bonds

• Define Pij as the price in period i for $100 received in period j.

• Coupon paying bonds can be thought of as portfolios of zero
coupon bonds.
• Example: A 2 year bond with a 6% annual coupon and face value
equal to 100 can be thought of as a portfolio containing
1. 0.06 of a 1 year zero
2. 1.06 of a 2 year zero
Price of the 2 year coupon paying bond should be

BondPrice = .06P01 + 1.06P02.

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• The prices of zero coupon bonds can be inferred from prices of
coupon bonds.
• Example: we observe the following coupon bond prices
1. 1 year 5% coupon bond: 100
2. 2 year 6% coupon bond: 100
3. 3 year 4% coupon bond: 98
What are the prices of 1-year, 2-year, 3-year zero coupon bonds?

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• If you invest in a zero you pay P0i today and receive $100 in
period i. The rate of return on that position should be the
riskfree rate over that period, that is,
100
= er(0,t)t
P0t

Note that r(0, t) is the annualized continuously compounded

risk free rate over the period 0 to t.
• Therefore the price of the zero bond is

P0t = 100e−r(0,t)t

or equivalently
1
r(0, t) = ln(100/P0,t )
t

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Forward Prices

• The forward prices can be computed from the zeros using a cash
and carry.
• Let F0,i,j = forward price in period 0 for a future on a zero which
matures in period j with delivery in period i.
• Suppose I want to price a forward contract on a 3 year zero bond
with delivery in two years (i.e I want F0,2,5 ).

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• Consider the following portfolio:
today delivery
buy spot (a 5-year zero) −P05
sell a forward F0,2,5
Total −P05 F0,2,5

• This is a riskless transaction so the rate of return should be

equal to the two year T-Bill rate:
F0,2,5 P05
= er(0,2)×2 ⇒ F0,2,5 = 100
P05 P02

• In general,
P0j
F0,i,j = 100
P0i

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LIBOR Rates

• LIBOR rates (London Interbank Offer Rates) are for US dollar

deposits in banks not subject to US banking regulations, and are
determined by a survey of large international banks in London.
• The LIBOR rates are quoted on an add in yield basis using a
360-day year.
• For example, if the 3 month LIBOR rate is 8%, then the interest
on $1,000,000 is

(.08) × (90/360) × ($1M) = $20, 000

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Eurodollar Futures Contracts

• Quantity: $1million/contract
• Contracts are cash settled based on the 3 month LIBOR rate (this
is the fixed rate on US dollar deposits in banks not subject to US
banking regulations.
• The expiration futures price (i.e. the settlement price) =
100 × (1 − rLIBOR )
• At expiration the payoff to the long is:

[100(1 − rLIBOR ) − F] × 2500

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• Example: Suppose on 2-28-04,a firm would like to lock in a 3
month lending rate starting in June on $1 M. The Eurodollar
futures price for June delivery was 97.74.
• If they buy a the long Euro 3 month future, they can lock in a 3
month lending rate of 100-97.74 =2.26%.
• Suppose the spot LIBOR rate in June is 2.10%.
• If the firm enters into the long futures position, the firm receives

[100(1 − .021) − 97.74] × 2500 = 400.

• From the 3-month lending, they receive interest equal to

(0.021) × 1/4 × 1, 000, 000 = 5, 250.

• So the net payment is $5650 which results in a 2.26% return.

• What if the spot LIBOR rate in June is 2.35%?

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Interest Rate Swap

• Suppose A and B enter into a plain vanilla swap. Let A be the

floating rate payer and let B be the fixed rate payer. B pays A
cash flows equal to the interest at a pre-specified fixed rate on a
notational principal for a pre-specified period. A pays B cash
flows equal to the interest at a floating rate on the same
notational principal for the same number of periods.
• Define:
• N = notational principal
• rfixed = fixed rate
• rfloat = floating rate
• n = number of payment periods per year
• Each period:
• Fixed rate payer receives a net payment equal to
N × (1/n) × (rfloat − rfixed )
• Floating rate payer receives a net payment equal to:
N × (1/n) × (rfixed − rfloat )
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• Example: Suppose A and B enter into a swap on 9/22/03 with
payments made twice a year (that is, n=2) beginning in 6 months.
The notational principal is $10 million. The fixed rate is 10.5%,
the floating rate is the 6 month LIBOR rate and the payments are
exchanged every six months for 3 years. (Interest payments are
typically made in arrears but we will ignore that for now.)

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 month LIBOR rate and the payments are exchanged every six months for 3
years. (Interest payments are typically made in arrears but we will ignore
that for now.)

• The cashflow
The cash flow
for afor a possible
possible setrates
set of LIBOR of isLIBOR rates is given below.
given below.

Date LIBOR Fixed Floating Net Net Payment

Payment Payment Payment to to the
(B Pays) (A Pays) the Fixed Floating
Rate Payer Rate Payer
3/22/04 .094 525,000 470,000 -55,000 55,000

9/22/04 .097 525,000 485,000 -40,000 40,000

3/22/05 .10 525,000 500,000 -25,000 25,000

9/22/05 .108 525,000 540,000 15,000 -15,000

3/22/06 .11 525,000 550,000 50,000 -50,000

9/22/06 .10 525,000 525,000 0 0

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Why Use Interest Rate Swaps?

• B might be interested in this type of swap if he wanted to hedge

an existing floating rate loan.
• Suppose B has a floating rate loan of $N. Every six months B
makes a floating rate payment equal to
N × 1/2 × rfloat .
What swap position should he take to eliminate the exposure to
the floating rate?
• If he is the fixed rate payer in the swap, he will receive
N × 1/2 × (rfloat − rfixed )
Therefore his net payment (loan payment less swap revenue) is:
(N × 1/2 × rfloat ) − N × 1/2 × (rfloat − rfixed ) = N × 1/2 × rfixed
• Switching a fixed rate loan to a floating rate loan is done in a
analogous way.
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Swap Pricing

• The swap can be priced (i.e the appropriate fixed rate for the
swap can be determined) by using the futures prices.
• Suppose there is a Euro dollar swap (i.e., floating rate is LIBOR)
which makes payments every 3 months.
• The floating rate payer’s net revenue from the swap every 3
months is:
(1M) × (90/360) × (rfixed − rLIBOR )

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• To hedge this position (that is, remove the exposure to the
floating rate) the floating rate payer can take a short position in
a strip of 3 month Euro dollar futures.
• The net revenue from the strip of short futures every 3 months is:

2500 × [F0,t,t+1 − 100(1 − rLIBOR )].

• Every 3 months the total revenue from the two positions is:

(1M) × (90/360) × (rfixed − rLIBOR )

+2500 × [F0,t,t+1 − 100(1 − rLIBOR )]
= 2500 × [F0,t,t+1 − 100(1 − rfixed )]

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• This position produces a certain cash flow every 3 months. The
initial cost of the position is zero. Since there is no risk and no
capital required for the position (the strip and futures and the
swap are both ”free”), the rate of return on the position should
be zero.
• This implies that the present value of the net cash flows should
be zero or else there is an arbitrage opportunity. This implies
that the fixed rate on the swap must be such that:
n
∑
2500 × [F0,t,t+1 − 100(1 − rfixed )]e−r(0,t)×t/4 = 0.
t=1

• Rearranging terms, we get:

∑n
(100 − F0,t,t+1 )e−r(0,t)×t/4
rfixed = t=1 ∑n
100 t=1 e−r(0,t)×t/4

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