Convention used in different derivatives

CFA Level II Derivatives
#1

Guys, I get confused of whether we should use add-on yield and compounding yield.

From Schweser book 4 p.124, we are told that for Currencies, bond/stocks related derivatives, we should use days/365 and also compounding yield. That mean when we calculate FX forward, we should use S0 x [(1+ra)/(1+rb)]^(day/365).

However, in the formula sheet in Economic Chapter, Kaplan said the formula is S0 x [(1+ra(days/360)]/[1+rb(days/360)]

Also in some mock exam, when we are calculating Bond option, I saw the answer simply multiple interest by (day/360). What is the actual method we should use in the exam if it doesn’t specify? Much Thanks !!!

#2

from my experience, when LIBOR, HIBOR or EURIBOR (basically all the IBORs) are mentioned, use 360 days and simple interest rather than compounding (so a 90-day LIBOR of 2% means an effective rate of 2% x 90/360 = 0.5% rather than 1.0290/360-1 = 0.496% )

for everything else, use 365 and annual compounding, unless the question says the rates are in continuous compounding form or we’re dealing with equity index forwards, BSM model or expected loss on risky bonds

I’d be happy if someone can correct me

#3

You got it, Edbert.