Level II Derivatives

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

If you haven’t read the article on option strategies in general, that’s a good place to start, then return here. In particular, if you haven’t read the warning about calculating profit that appears at the end of that article, you should go read it now; the way I’m calculating the profit here is correct, but […]

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Interest rate caps and floors are, essentially, collections of interest rate options: each option has a positive payoff when it expires in the money and a zero payoff when it expires out of the money.  The individual options are called, respectively, caplets and floorlets. Note that caps and floors are commonly based on LIBOR or […]

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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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