Study Session 17
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. What would you like to do?
Exchange Traded Derivative?
Standardized and backed by a clearinghouse.
Benefit of derivatives?
- -Provide price information
- -Allow risk to be managed and shifted among market particpants
- -Reduce transaction costs.
Two arbitrage arguments?
- 1. Law of one price. Two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price.
- 2.Two secuities wher uncerteranin return can be combined in aportfolio with a certain payoff. If porftolio consisting of A and B has a certain payoff, the portfolio should yield the risk-free rate. If this condition is violated, then putting 2 securities together would mean that you get a return higher than the risk free frate. IN this case you could borrow Risk Free and invest in A&B porftolio, and make unlimited no risk gain.
bilateral contract obligating one party to buy and the other to sell a specific quanitty of an assets on a specific date in the future.
Are partys in a forward contract exposed to default (counterparty risk)
What are the payment types for forward contracts?
Cash settlement and deliverable forward contract. Deliverable meanse you actually exchange the underlying security while cash means you just settle up the net in cash.
What's the best way of exiting/terminating the position of a forward contract?
To take on theother side with the same party, which reduces your counterparty/default risk. If you take it on with a different party, there is ap otential that the other party defaults and you are stuck having to pay the entire contract of the first transaction
How does an equity forward contract work? How is a forward contract on a stock index different from a regular stock equity forward?Are dividends usually included in equity forward contracts?
It is where the underlying asset is a single stock, proftolio or index. For example if I want to sell 1 million shares of IBM 90 days from now for 100$ and I like the current rate, I would enter in a forward contract to sell that much. If the shares appreciate, I'm still getting the 1 million $.
An equity forward is based on a notional amount and will likely settle in cash.
Typically, dividends are not included, however it depends on the wy the contract was customized.
Forward contracts on zero-coupon and coupon bonds
A forward contract covering a 10 mil face value of T-bills that will have 100 days to maturity at contract settlement is priced at 1.96 on a discount yield basis. Compute the dollar amoun the long must pay at settlement for the T-Bills?
Forward contracts must settle before the bond matures.
1-.00544*10Million = 9,945,560
When market interest rates increase, discount rates increase, and prices go down. Therefore, if you are long a contract, you will lose money bc you should be able to buy the bond at a lower price. Opposite of a FRA.
What is Euribor and Euro dollar deposits?
Euro-dollar deposits are deposits in large banks outside the US denominated in dollars Quoted at LIBOR. Euribor is lending rate of Euro's for banks oustide of Europe. Difference in rates btwn the two is due to different currencies
What is a FRA?What is the formula for making payments in a FRA?
Consider a FRA that Expires/settles in 30 days. Bzased on notional principal of 1 million and is based on a 90 DAY LIBOR. Specifies a forward rate of 5%. Actual 90 Day LIBOR at expiration (30 days from now is 6%. compute cash settlement at expiration.
A FRA is a forward contract to borrow/lend money at a certain day in the future. A long in a FRA means you are borrowing money at a certain rate in the future. A short in a FRA means you are lending money at a certain rate in the future. If interest rates go up, a long makes money bc the rate at which you agrred to borrow is lower than the current rates.
Formula is 2 parts First: (notional Principal)*(Floating-forward)*(Days/360). This gets the interest amount gained if you could borrow at the day of the settlement date. However, typically you get paid until the end of the denominated loan period. Therefore you must divide this interest rate by 1+(.06)(Days/360)
Answer to Question : (.06-.05)*(90/360)*1 Million = 2,500$. This 2500 in interest savings would not come until end of 90 Day Loan period. Value at settlement is the present value of these savings. Use the discount rate of actual rate at settlement, not the contract rate of 5%.
2,500/1+(.06*(90/360))= 2463.05 which is what the short would pay the long and is the present value of the savingns at settlemtn.
On the equation, if floating rate happens to be less than the forward rate, the number is negative meaning the logn would pay. This hapens bc the current rate is less than the contract rate, and you lose money bc you could technically borrow at a lower rate with current rates than you can in the contract.
What does a 2 by 5 FRA Mean.
It means that you will have a FRA that settles in 60 days with a 90 Day LIBOR contract.
Currency Forward. GEMCO Expects to receive EUR 50 million three months from now and enters into a currency forward to exschange euros for dollaras at USD1.23 per euro. Market exchange rate at settlement is 1.25 USD what is amount of payment to be received or paid by GEMCO.
- BC Euro appreciated, we are going to lose money bc we locked in at a lower exchange rate.
- 1.23-1.25x 50 million = USD 1 million
How do futures differ from forwards?
Futures are standardized, traded over exchanges, are backed by clearinghouses, you must post a margin.Government regulates futures market
In regards to Futures, does the standardization of the contracts promote market liquidity?
Yes, bc everyone knows exactly what's being traded.
Initial margin? Maitenance amrgin?Variation Margin?
Initial margin is amount that is posted at begining. Maitenance margin is a point below the initial margin that when hit, funds must be added that equat the entire balance back to the initial margin. The variation margin is the amount that is added when the account falls below the maitenance margin.
What is the settlement price for a future? Is the margin in future acounts higher or lower as a percentage of the value of the underlying asset then regular security margins?
It is not simply the closing price of a stock, but it is the average of the prices of the trades during the last period of trading. This prevents manipulation of prices immediatley before clsoing.
Futures are leveraged much more so have a lower margin.
What is a limit move, limit up and locked limit?
If the price for a specific future increases past a certain daily trading limi, it is in limit up., If it is below it is limit down. if it is either a limit up or limit down, the stock has made a limit move. When trades can't take place bcause of a limiit move, the price is locked limit.
What are the 4 ways of terminating a futures contract?
- 1. Delivery
- 2. Cash Settle
- 3. Reverse or off setting
- 4. Exchange for physicals. This is where a trader with an opositie position to your own and yourself meet up and work otu and off the floor agreement. (ex-pit transaction). Sole exception to the federal law that requires all trades take place on the floor of the exchange. Must contact clearninghouse to tell them.
Determining the price of a T-Bill futures contract. Based on a 1 million $ face value, 90 day t0bill settle in cash. Price quote of 98.52 with annualized discoung of 1.48%
.0148 *(90/360)= (.0037-1)* 1 million = 996,300$ delivery price. These units have lost significance due to Eurodollar future contacts, which represent a more free market and global measure of short term interest rates .
Euro Dollar Futures?
Based on 90-day LIBOR, which is add-on-yield. Therefore, you take the 100-annualized Libor in percent. Quote of 97.6 would mean 100-97.6=2.4*(90/360). Effective 90 Day yield of .6%. KNOW THAT EURODOLLAR AND TBILL CONTRACTS ARE BOTH BASED ON 90 DAY CONTRACTS AND THAT A MOVEMENT OF .01 CORRESPONDS WITH A 25$ MOVEMENT IN THE PRICE
Treasury Bond contracts deliverable? Cheapest to deliver?
Yes, they are deliverable. Have face value of 100,000 quoted as a percent and fraction of 1% measured in 1/32nds of face value.
When deliveryging, the short has the option to deliver any of several bonds that will satisfy delivery terms. Valuable to short bc expiration, one particular T bond will be cheapest to deliver. Each bond is given a conersion factor, which is uesed to adjust the longs payment at delivery so that the more valuable bonds receive a higher payment.
Stock index future? Most popular index future? What is muliplier?
S&P 500 most popular. Value of contract is 250 times the level of the index stated in the contract. with index of 1000, value of contract is 250,000. One point corresponds with a 250$ move.
At maturity, which one is more European or American Option? Before the option has matured which one is priced more?
At maturity they are the same. Before has matured american option will always be priced mroe.
In the money & Out of money call/Put option in terms of S and X?
- In the money call option: S-X>0
- In the money put option: X-S>0
- Out of the money call option S-X<0
- Out of the money Put option X-S<0
What is the difference between exchange traded options and Long term equity anticipatory securities?OTC?
- Most exchange listed options are 2-4 month expiring options. LEAPS is for equity options with expiration dates greater than a year.
- Over the counter options is an active market for instituional buyers which is largely unregulated.
Interest Rate Options and FRA's? How do you replicate a Call FRA with interest rate options?
Pretty much to replicate a FRA, you Buy a call Option, and Short a put. Similar to FRA's bc there is no deliverable asset. If Rates go up, you would make money, and you would lose money if they go down in a FRA. BC an option has a set downside in a call for rates, you would have to have the Buying of the call to replicate the price going up when interest rates went up, and a short of the put to replicate the FRA losing money when interest rates went down.
Caps and floors Options on interest rates? Interest rate collar?
A cap is a series of interest rate call options that have expiration dates corresponding to when the loan's floating rate resets. It is used to protect a borrower in rising interest rates. The call option places a maximum on interest rates.
A floor protects the lender with a series of put options that have expiration dates corresponding to when the rates on the loan reset. This would give you $ when the rates go below a certain level. You have the strike rate at the floor rate.
- Interest rate collar is using both a floor and a cap to defray the costs. If I was a borrwer I want the rate to be capped at a certain level,. say 10%.
- In turn I would buy a a 10% Call Option, which would cap my rate at 10%. In order to defray the costs I would Sell a Put Option, at say 5%, so if the rate went below 5, I would have to pay. This means that at all times, the Interest rate would pretty much btwn 5 and 10%
Payoff vfor interest rate options, Assume you bought a 60-day call option on 90 day LIBOR with anotional principal of 1 million at strike rate of 5%. compute the payment you will receif if 90 day libor is 6% at contract expiration, and determine when payment will be received. When will the payment be made?
.06-.05 *90/360* 1 million = 2500$. You would receive this amount after the 90 Day LIBOR expired.
What is an options Intrinsic Value?
S-X or X-S
fWhat is time value?
Value that the option is that is over the intrinsic value. This has to do with the amount of time that the option potentially can be "in the money". Therefore the longer the option the more it is's time value will be, and usually the more it is
Upper and Lower bounds of a Euro and American Call Option
- Lower Bound of a European Call= Max(0,S- x/1+RFR^T)
- Lower Bound of a American Call=Max(0,S- x/1+RFR^T)-S
- Lower Bound of a European Put=Max(0, x/1+RFR^T)-S
- Lower Bound of a American Put=Max(0,X-S)
- Upper Bound of a American Call=Max(S)
- Upper Bound of a Euro Call=Max(S)
- Upper Bound of a American Put=Max(X)
- Upper Bound of a Euro Put=Max(X/(1+RFR)^t)
All else equal, How are call and put prices related to their excericies prices?
Longer time to expiration will increase an options value. what is the excpetion?
Put prices are directly related to movements in excercise price.
Call prices are inversely related to movements in excercise price.
Exception, we cannot state postiviley that the value of a LONGER EUROPEAN PUT WILL BE GREATER THAN THE VALUE OF A SHORTER TERM PUT. If volatility is high and discount rate low, extra time will be dominant factor and longer term put will be mroe valuable. Low volatility and high interst rates have the opposite effect and the value of longer in the money put options can be less than value of a shorter term put.
Put call parity?
What happens if there is apostive cash flow over term of the option with put call parity?
What happens to value of call option with and increase or decrease in interest rates? Does volatiltiy increase or decerease options?
When interest rates increase, it makes negative smaller hence greater price for call option.Additionally, it decreases the value of a put option
volatility increases option value, because there is a one sided risk of an option, you can't lose more than the fixed premium but your upside can change.
Is an option price or an underlying stock price more volatile?
- an option price
- Because they are valid for a limited period of time only and because the price of an option is only a fraction of the price of the underlying (not parent) stock, even though the option will tend to rise or fall (more or less) as many dollars as the price variation in the underlying shares.
Agreements to eschange a series of cash flows on periodic settlement dates over a certain period of time. Tenor of the swap is the length of the swap.
How are swaps terminated?
- 1. Mutual termination
- 2. Offsetting contract. ( if not made with original party exposed to counterparty risk)
- 3. Resale. possible to sell swap to another paty with permission of counterparty
- 4. Swaption is an option to enter into a swap that would terminate an existing swap.
Currency SSwap? is notional swapped?
Notional is swqpped
Money changes hands. For example I'm a US Company and I want to get AUD. There's a similar AUD company that wants dollars. Instead of borrowing AUD in Australia, I would swap a contract with the company. I could borrow the notional amount for the itnerest rate I would get at home, and would give it to them paying the interest rate on the foreign currency what it would cost me to borrow in australia. On the flip they would borrow notional amount in their currency, give it to me, and would pay me interest in my currency what they would pay.
Plain vanilla swap is?
It is a Fixed for a Floating.
Interest Rate Swaps?Is notional swapped?
notional is not swapped.
Net interest is paid by one who owes it.
Fixed Rate payer = (Swap Fixed Rate-LIBORt-1)(# of days/360)(Notional Principal) If number is negative, fixed rate would pay. Meaning fixed rate is greater than Floating, which makes sense.
Remmber that LIBOR Rates, you get paid at what rate was at begining of your term.
What is a covered call?
A covered call is when you own a stock or security and write a call option. This is a great bet when you don't think the Stock is going to increase by a lot. For example, say the strike price is 55 stock is 50 and preimum is 4$. If price raises above 55, you have to pay, but the stock appreciates as well, meaning stock stays at 50$. If price goes from 50-55, stock appreciaates, you get money, and option isn't excercisable so you make money of that. Profit is an exra 4-9$. If stock decreases, option will still have a premium to negate some of it's losses.
Protect a stock from a decline in value. When you own a stock, and buy a put option. IF the stock decreases in value, you get cash from the put to protect your downside losses, and pay a small premium. Additionally, you're upside potential is hampered a bit by the premium, but you still get a good amt back.
If strike price of put is 100, current price is 100 and premium is 4$, the max amout of loss would be any price below100, which would be 96$. soa 4 dollar decrease in value. You losses between 0-4$ between 100 and 104. Above 104 you begin to make profit.
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