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All posts for the month February, 2014

Triangular Arbitrage

Posted by Bill Campbell III, CFA on February 12, 2014
Posted in: Level II Economics.

Triangular arbitrage is nothing more than determining whether an arbitrage opportunity exists amongst three currencies with three exchange rates; the complicating factor is that the exchange rates each have a bid rate and an ask rate.  (Note: the arbitrage could, in fact, involve more than three currencies.  As the principles are the same, only three […]

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Valuing Derivatives

Posted by Bill Campbell III, CFA on February 11, 2014
Posted in: Free.

Valuing derivatives – forwards, futures, FRAs, and swaps – is much the same as pricing them.  The value of a derivative is the amount that one party would have to pay the other if the derivative were to expire today; it depends on the price of the underlying today compared to the price at the inception of the derivative.  Therefore, valuing a derivative generally means doing the same sort of calculation you did to price the derivative, then comparing today’s price to the original price.  Finally, bear in mind that the value to one party is the negative of the value to the other party.  I encourage you to practice valuation problems always from the same party’s point of view (e.g., always from long’s point of view in valuing a forward contract); if you have to calculate it from the other party’s point of view on the exam, do it the way you’ve practiced, then change the sign.

Here are links to articles on valuing derivatives:

Also note that the formulae used for valuing derivatives will vary depending on whether the risk-free interest rate is given as an effective rate or a nominal rate; for a refresher on nominal vs. effective interest rates, look here.

Valuing Plain Vanilla Interest Rate Swaps

Posted by Bill Campbell III, CFA on February 11, 2014
Posted in: Level II Derivatives.

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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Valuing Currency Forwards

Posted by Bill Campbell III, CFA on February 8, 2014
Posted in: Level II Derivatives.

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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Pricing Currency Forwards

Posted by Bill Campbell III, CFA on February 7, 2014
Posted in: Level II Derivatives.

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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Valuing FRAs

Posted by Bill Campbell III, CFA on February 7, 2014
Posted in: Level II Derivatives.

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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Valuing Forwards and Futures

Posted by Bill Campbell III, CFA on February 5, 2014
Posted in: Level II Derivatives.

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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CFA® Level II Derivatives Membership, CFA® Level II Membership

This will give you access to this and all other articles at that membership level.