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A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. Investopedia explains Over-The-Counter - OTC In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered a stock exchange. As such, OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB) or on the pink sheets. Be very wary of some OTC stocks, however; the OTCBB stocks are either penny stocks or are offered by companies with bad credit records. Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities. Most debt instruments are traded by investment banks making markets for specific issues. If an investor wants to buy or sell a bond, he or she must call the bank that makes the market in that bond and asks for quotes. =============================================================== *What Does Bond Mean? A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents. Investopedia explains Bond The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range. ===============================================================
* Bond vs Stock Stocks and bonds are financial instruments for investors to obtain a return and for companies to raise capital. Put very simply, stocks offer an ownership stake in the company and bonds are akin to loans made to the company. Stocks of a company are offered at the time of an IPO (Initial Public Offering) or later equity sales. The company offers investors an ownership stake by selling stocks. With the equity that stocks offer comes greater risk. The value of stocks corresponds to the value of the company and therefore, stock price fluctuates depending upon how the market values the company. In contrast, bonds are loans offered at a fixed interest rate. When a company believes that it can raise capital cheaper by borrowing money from banks, institutional investors or individuals, they may choose to offer interest-paying corporate bonds. With bonds, an investor is promised a fixed return. While bonds are "safer" than stocks because of lower volatility, it should be noted that there is always a chance that company will be unable to repay bond-holders. In that sense, bonds are not "risk-free". However, when a company declares bankruptcy, stockholders are the first to bear losses. Creditors (including bond-holders) are next. * What Does Equity Mean? 1. A stock or any other security representing an ownership interest. 2. On a company's balance sheet, the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Also referred to as "shareholders' equity". 3. In the context of margin trading, the value of securities in a margin account minus what has been borrowed from the brokerage. 4. In the context of real estate, the difference between the current market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off the mortgage. 5. In terms of investment strategies, equity (stocks) is one of the principal asset classes. The other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset allocation planning to structure a desired risk and return profile for an investor's portfolio. Investopedia explains Equity In broad terms, equity represents the ownership interests in a business by its shareholders. The term's meaning depends very much on the context. In finance, in general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered the owner's equity
because he or she can readily sell the item for cash. Stocks are equity because they represent ownership in a company. =============================================================== * The most common types of equity securities include: Common Stock Preferred Stock Tracking Stock (Letter Stock) =============================================================== * What Does Common Stock Mean? 1. A security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority ladder for ownership structure. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debtholders have been paid in full. In the U.K., these are called "ordinary shares". Investopedia explains Common Stock If the company goes bankrupt, the common stockholders will not receive their money until the creditors and preferred shareholders have received their respective share of the leftover assets. This makes common stock riskier than debt or preferred shares. The upside to common shares is that they usually outperform bonds and preferred shares in the long run. Also, receiving dividends is not a legal typical right granted to common stockholders. =============================================================== *What Does Dividend Mean? 1. A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield. Also referred to as "Dividend Per Share (DPS)." 2. Mandatory distributions of income and realized capital gains made to mutual fund investors. Investopedia explains Dividend 1. Dividends may be in the form of cash, stock or property. Most secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this. High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth. 2. Mutual funds pay out interest and dividend income received from their portfolio holdings as dividends to fund shareholders. In addition, realized capital gains from the
a company looks to see who its shareholders or "holders of record" are. the dividend yield is the return on investment for a stock. It is indicated in newspaper listings with an x. =============================================================== *What Does Dividend Yield Mean? A financial ratio that shows how much a company pays out in dividends each year relative to its share price. To better explain the concept. Thus. =============================================================== *What Does Ex-Date Mean? The date on or after which a security is traded without a previously declared dividend or distribution. =============================================================== *What Does Record Date Mean? The date established by an issuer of a security for the purpose of determining the holders who are entitled to receive a dividend or distribution. an investor looking to supplement his or her income would likely prefer ABC's stock over that of XYZ. Investopedia explains Record Date On the record date. The ex-date is usually two business days before the record date. then ABC has a dividend yield of 5% while XYZ is only yielding 2. a stock is said to trade ex-dividend. assuming all other factors are equivalent. This is the date after which buyers are no longer eligible to receive dividends.portfolio's trading activities are generally paid out (capital gains distribution) as a yearend dividend. refer to this dividend yield example: If two companies both pay annual dividends of $1 per share. Investopedia explains Ex-Date This is the date on which the seller. but ABC company's stock is trading at $20 while XYZ company's stock is trading at $40. =============================================================== .in other words. a date of record ensures the dividend checks get sent to the right people. Dividend yield is calculated as follows: Investopedia explains Dividend Yield Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position . stable dividend yields. how much "bang for your buck" you are getting from dividends. of a stock will be entitled to a recently announced dividend. Essentially. Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high. and not the buyer.5%. After the ex-date. In the absence of any capital gains.
issuance of employee stock options. before common shareholders can receive dividends. However. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation and they have a fixed dividend (paid before common stockholders). etc. Investopedia explains Preferred Stock There are certainly pros and cons when looking at preferred shares. to preferred holders. it will first have to pay back all of the dividends that are owed to preferred share holders. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights. but investors must weigh these positives against the negatives. Votes can be used to: * Elect the company’s board of directors * Vote on other matters as specified by the company’s charter (i. they must be paid out to preferred shareholders first. the best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). The precise details as to the structure of preferred stock is specific to each corporation. =============================================================== *What Does Participating Preferred Stock Mean? A type of preferred stock that gives the holder the right to receive dividends equal . Also known as "preferred shares". If the company gets through the trouble and starts paying out dividends again. If a company runs into some financial problems and is unable to meet all of its obligations. it will likely suspend its dividend payments and focus on paying the business-specific expenses. =============================================================== *What Does Cumulative Preferred Stock Mean? A type of preferred stock with a provision that stipulates that if any dividends have been omitted in the past. Investopedia explains Cumulative Preferred Stock A preferred stock will typically have a fixed dividend yield based on the par value of the stock. issuance of additional shares. usually quarterly.. mergers. including giving up their voting rights and less potential for appreciation.e. This dividend is paid out at set intervals.) * Vote on matters regarding changes to the company’s charter * There are two types of voting procedures that are used for electing the company’s board of directors: Statutory Voting Cumulative Voting =============================================================== *What Does Preferred Stock Mean? A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock.*What Does Voting Rights Mean? Common stock normally carries one vote per share.
00 + 0. . The preferred shares also carry a clause on extra dividends for participating preferred stock.to the normally specified rate that preferred dividends receive as well as an additional dividend based on some predetermined condition. In this case. in the event of liquidation. =============================================================== *What Does Convertible Preferred Stock Mean? Preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares. suppose Company A issues participating preferred shares with a dividend rate of $1 per share.05) as well. If.05 per share ($1. A type of security specifically designed to mirror the performance of a larger index. current shareholders are issued stock that gives them the right to new common shares at a bargain price in the event of an unwanted takeover bid. usually anytime after a predetermined date. the participating preferred shareholders will receive a total dividend of $1. which is triggered whenever the dividend for common shares exceeds that of the preferred shares. Also known as "designer stock". The value of convertible common stock is ultimately based on the performance (or lack thereof) of the common stock. Participating preferred stock is rarely issued. 2. Company A announces that it will release a dividend of $1. =============================================================== *What Does Tracking Stock Mean? 1. during its current quarter. but one way in which it is used is as a poison pill. The additional dividend paid to preferred shareholders is commonly structured to be paid only if the amount of dividends that common shareholders receive exceeds a specified per-share amount.05 per share for its common shares. Investopedia explains Convertible Preferred Stock Most convertible preferred stock is exchanged at the request of the shareholder. participating preferred shareholders can also have the right to receive the stock's purchasing price back as well as a pro-rata share of any remaining proceeds that the common shareholders receive. Furthermore. but sometimes there is a provision that allows the company (or issuer) to force conversion. Investopedia explains Participating Preferred Stock For example. Also known as "convertible preferred shares". Common stock issued by a parent company that tracks the performance of a particular division without having claim on the assets of the division or the parent company.
which mirror the returns of the S&P 500 index. An additional advantage of tracking stock is that it can be used to issue stock options to management. The parent company and its shareholders. 3. thereby giving them a direct incentive linked to the performance of that specific business line. younger companies seeking the capital to expand. Another type of tracking stock is Standard & Poor's depository receipts (SPDRs). a market maker can enter multiple orders. the issuer obtains the assistance of an underwriting firm. NYSE Euronext comprises exchanges operating in the US. which helps it determine what type of security to issue (common or preferred). When a parent company issues a tracking stock. 3. and Paris stock exchanges. Users of NASDAQ's SuperMontage system can view the quote size for each market maker at up to five price leve 8.IPO Mean? The first sale of stock by a private company to the public. Euronext was initially created from the merger of the Amsterdam.Investopedia explains Tracking Stock 1. which is an exchange-traded fund that mirrors the returns of the Nasdaq 100 index. Using the SuperMontage system. if necessary buying or selling the stock for his own account. Liability Orders on the NASDAQ are sub 6. Dividends on normal preferred shares are normally fixed. 7. IPOs are often issued by smaller. still control the operations of the subsidiary. the best offering price and the time to bring it to market. issuing companies must comply with the rules of the . this is done to separate a subsidiary's highgrowth division from a larger parent company that is presenting losses. =============================================================== *Notes: 1. This is the latest date that a stock can be purchased if it is to receive the next dividend payment. Oftentimes. however. An international fund invests in non-domestic stocks whereas a global fund invests both in domestic and international stocks. 2. and Portugal. The most popular tracking stock is the QQQQ. but can also be done by large privately owned companies looking to become publicly traded. at different price levels. Belgium. 10. France. the NYSE DMM is required to act as a dealer. Brussels. In the event of an order imbalance. Prior to the ex-dividend date. 5. In an IPO. the Netherlands. 9. Before they can go public. Also referred to as a "public offering". =============================================================== *What Does Initial Public Offering . Retail orders are handled electronically at the NYSE 4. It is Participating Preferred shares whose dividends rise with company earnings. 2. all revenues and expenses of the applicable division are separated from the parent company's financial statements and bound to the tracking stock.
Advise on the size of the offering Estimate costs and negotiate fees.IPO IPOs can be a risky investment. or the German Stock Exchange.g. Decide on the commitment the bank is prepared to make to selling the stock. When a private company needs additional funding it can either: Borrow money in the form of a bank loan Seek private investors and issue preferred stock Issue debt in the form of bonds Sell equity in the form of stock =============================================================== *Role of the Investment Bank? Before a company can sell either debt or equity to the public. TSE. e. it is tough to predict what the stock will do on its initial day of trading and in the near future because there is often little historical data with which to analyze the company. The bank is referred to as the underwriter. The role of the Investment bank is first to: Assess and value the company. it must first engage an investment bank to manage the process and eventually distribute the stock. =============================================================== *The Registration Statement . LSE. Agree the type and price of the security. the SEC in the US or the FSA in the UK – and meet the requirements of one of the major stock exchanges. NYSE Euronext. NASDAQ. Advise on the amount of capital to be raised. For the individual investor. The company must also appoint lawyers and auditors to advise on the IPO process. which are subject to additional uncertainty regarding their future values. Investopedia explains Initial Public Offering . most IPOs are of companies going through a transitory growth period. Also.regulators – for example.
also commonly known as the Red Herring. This distinguishes the Preliminary Prospectus from the Final Prospectus. If the issue is approved. which requires a response from the investment bank or issuer. There may be a number of issues and queries which the SEC raises. while the issue is said to be in registration. During this period. including the potential risks and pitfalls. =============================================================== *The Red Herring The preliminary prospectus is a version of the S-1 statement filed with the SEC with a declaration printed in red which states that the document is not final and is subject to change. Filing information is recorded on the Securities and Exchange Commission's Edgar Database and is available to the public. and officers The number of shares held by each insider The reason for the public offering of stock The size and details of the offering Comprehensive financial statements – including all outstanding debts Disclosure of all legal issues Risk factors Dividend policy Director’s other interests Information on potential competition =============================================================== *The Cooling-Off Period Following the filing of the S-1 Registration Statement with the SEC a cooling-off period is required. the SEC investigates to ensure that full disclosure has been made. directors. The Statement must include: A clear description of the company and its business Details about the owners. and this marks the end of the cooling-off period. During the cooling-off period the underwriting bank compiles a Preliminary Prospectus for the offering. If the SEC does not approve the offering a Letter of Deficiency is sent to notify the issuers what amendments are necessary before the IPO can be approved. The registration statement must include all the information that an investor may need in order to make an investing decision about the company’s stock. . which is issued only after the offering has been fully approved by the SEC. an Effective Date is set for the offering.In order to register the impending offering with the SEC the underwriting bank must prepare a Registration Statement S-1 which complies with the Act of Full Disclosure as laid out in the 1933 Securities Act.
The minimum lockup period specified by the SEC (Rule 144) is 90 days. a strict "Chinese Wall" must be maintained between the analysts in an investment bank and those bankers involved in underwriting the IPO. including research reports or analyst recommendations.The Red Herring contains all the information set out in the Registration Statement. =============================================================== *The Lockup Period Once the IPO is closed and the shares are trading on the secondary market. The document needs be read very carefully by investors to determine if the language contains hints which may deter certain types of investors. Such selling – especially in volume – could force down the share price and damage future prospects for the shares. key shareholders might be tempted to make quick profits by selling shares shortly after the IPO when the share price usually has risen. . 2. A Red Herring is so-called because it contains notice. though it can vary by agreement between the company and the underwriters from months to years. The share price is only decided when the effective date is known. 4. that says that the prospectus is not complete and may be cha 3. so that prevailing market conditions and the initial reaction of investors can be assessed. Companies. Without the lockup period. When the lockup period expires the share price can often show a steep fall as share holders take profits. Some investors. =============================================================== *Notes: 1. especially institutional investors who are not subject to the lockup restrictions. This practice is called flipping and it can cause an unstable and volatile share price. but it does not contain the Effective Date which has not yet been set. or the price at which the shares will be offered. the insiders – like directors and key employees – are subject to a lockup period during which they cannot sell any shares. In addition. but is customarily 180 days after an IPO. sell newly acquired stock within a few days to capitalize on the profit. The cooling-off period is the period between Registration Date and Effective Date. do not like flipping. The Red Herring is the only document which is made available to potential investors to stimulate interest in the offering. Investors cannot place orders at the road shows. who need long term investment. No other documents may be provided to support the offering. printed in red. especially if the shares have risen sharply after the IPO. The effective date is the date when shares can actually be sold.
to give basic details of the shares being issued. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. then the value of the basket of stocks underlying the contract is $300. =============================================================== *Trade Unit This defines the value of the basket of stocks underlying the stock index contract. 7. an index is an imaginary portfolio of securities representing a particular market or a portion of it. the buyer would make a loss =============================================================== *What Does Index Mean? A statistical measure of change in an economy or a securities market. but must be at least 90 days. Equity index futures provide users with a rapid and cost-effective means of buying or selling all of the stocks in a market index. rather than transacting in individual shares. =============================================================== Equity index futures Equity index futures provide users with an effective way of buying or selling the stock market as a whole. Investopedia explains Index The Standard & Poor's 500 is one of the world's best known indexes. the buyer would profit.5. . if the index fell. and is the most commonly used benchmark for the stock market. 6. The lockup period is normally 180 days. if the trade unit is $250. Thus. but at a price fixed today. the percentage change is more important than the actual numeric value. Of course. technically. Because.000. Stock and bond market indexes are used to construct index mutual funds and exchangetraded funds (ETFs) whose portfolios mirror the components of the index. Other prominent indexes include the NASDAQ 100 Index. The buyer of an equity index future is effectively buying a basket of stocks for notional delivery on a specific future date. The quiet period normally extends 25 days after the effective date. If the basket of stocks underlying the index were then to rise. and the means by which investors can apply. For example. you can't actually invest in an index. and the stock market index is standing at 1200. rather than having to transact in each of the underlying shares. index mutual funds and exchange-traded funds (based on indexes) allow investors to invest in securities representing broad market segments and/or the total market. Nikkei 225 Index and FTSE 100 Index. Tombstones are adverts placed in the press to announce an IPO. In the case of financial markets.
for instance.50. =============================================================== *Last Trading Day The last day of trading before a contract expires.00 (each contract is worth $100 multiplied by the index). and the tick size is 0. For example.25 with a tick value of $12. September. then the tick value is $25. and December. the stock has a tick value of one cent (each tick is worth one cent for one stock).50 to 1110. A stock. For example.25 (from 1110. The price movements of different trading instruments varies. if the trade unit is $250. it is the minimum increment in which prices can change. either up or down depending on the direction of the price movement. These are most commonly: March. The tick value is what each price movement is worth in terms of dollars. the Russell 2000 e-mini futures contract (TF) has a tick size of . The e-mini S&P 500 contract has a tick size of . For example.50. the value of each tick is $10. Futures markets typically have a tick size that is specific to the instrument. if the minimum price movement of a stock is 0. has a tick size of 0.01. with a tick value of one cent. =============================================================== *Months Available The calendar months in a year when futures contracts expire.1. =============================================================== *Settlement Date . Investopedia explains Tick Size The tick size of a trading instrument is its minimum price movement. June.75 for example) the value changes $12.=============================================================== *What Does Tick Size Mean? The minimum price movement of a trading instrument. in other words.10.01. =============================================================== *Tick Value The profit on one futures contract if the futures price rises by one tick. each time price moves .
0. Then. there will be a margin call. If losses eventually take the margin account below the maintenance margin. When a new trade is executed. and the affected party will need to post additional margin to bring the margin account back to the initial margin level. =============================================================== *Settlement Price The closing price for a futures contract each day. the exchange calculates the profits or losses earned by each party.800 to cover the short sale of one S&P 500 contract priced at 1210.. while the Maintenance Margin is the minimum level to which the margin account can fall before a margin call is made. Profits are credited to the margin account. The Initial Margin is the amount of money deposited at the outset. =============================================================== *Margin Required Both parties to a futures contract are required to deposit a sum of money with the exchange. each party deposits the required level of initial margin in the form of cash or securities. Margin Example Suppose that a trader has deposited the required initial margin of $17. It is usually the day following last trading day. while losses are debited. . The example below may make this clearer. after every trading day..The date when the futures contract finally expires. and final settlement of profits and losses takes place. =============================================================== *Understanding Margin All futures contracts require that both parties post margin for each contract bought or sold. The settlement price for the contract is based on the opening price of the stocks in the index on the following day.
The formula for calculating the interest rate on an adjustable-rate mortgage is the adjustment-index rate (e. This portion is retained as profit by the lender. you have to maintain a certain amount of margin depending on how the market value of the contracts change. 4.the potential for greater losses. In a general business context. the contract price has risen to 1227. For example. the difference between a product's (or service's) selling price and the cost of production.250 Let's look at the effect on the margin account: Balance on margin a/c at start: less Loss on open position: Balance on margin account now: $17. 4.250. 3. 2. the account must be restored to the initial margin level. For .550. Treasury Index) plus the percentage of the margin. When a margin call is made.0 – 1210. This practice is referred to as "buying on margin". The amount of equity contributed by a customer as a percentage of the current market value of the securities held in a margin account. 3.250 in additional funds. and the trader’s position shows a cumulative loss of $4.0.800 $4. The portion of the interest rate on an adjustable-rate mortgage that is over and above the adjustment-index rate. while the potential for greater profit exists. Investopedia explains Margin 1. This will require the trader to deposit $4. Buying with borrowed money can be extremely risky because both gains and losses are amplified.0) × $250 = $4.250: (1227. Gross profit margin (which is the difference between revenue and expenses) is one measure of a company's performance.250 $13. then there will be a margin call. this comes at a hefty price . if you hold futures contracts in a margin account. because the margin balance has fallen to only $13.550 If the maintenance margin prescribed by the exchange is $14. =============================================================== *What Does Margin Mean? 1. 2. Margin also subjects the investor to a number of unique risks such as interest payments for use of the borrowed money. Borrowed money that is used to purchase securities.g. That is.Sometime later.
You are a dealer in financial products with the reputation of being able to provide innovative solutions to your clients’ needs. An equity index futures price is not a prediction of the future. the time period from now until the contract’s settlement date The interest rate over the deferral period The dividend yield on the shares in the underlying index during the deferral period Combining these variables gives the fair value of an equity index futures contract – the theoretical price at which the contract should trade. You have no opinion as to the future price of MHH stock.00. Actually. you have devised the following scheme: Calculate the forward price for the delivery of MHH shares to ensure that you at least break even on the transaction. but want to be certain that whatever price you quote to the client will not result in a loss to you upon delivery. the margin is 2%. =============================================================== *Cash and Carry Pricing You could easily be forgiven for thinking that the price of an equity index futures contract represented the market's view of where the underlying index was eventually going to be on the contract's expiry date. this is not the case. and pay no dividend. =============================================================== *Creating a Forward Price Let’s imagine that there is no such thing as a futures market. if the Treasury Index is 6% and the interest rate on the mortgage is 8%. .’s common stock (MHH) for delivery in one year. the price at which equity index futures trade is actually governed by a straightforward mathematical relationship combining: The current price of the underlying equity index The deferral period – in other words.example. At the end of the 12 month period: • Deliver the MHH stock to the client and receive the money based on the price agreed at the outset. Right now: Buy MHH stock now and finance the purchase with borrowed funds. In fact. A client has approached you with the following request. The shares are publicly traded. with a current market price of $30. • Repay the debt plus interest with the money just received. The client would like you to make him a forward price for the purchase of 100 shares of Magna Health and Hospital Corp. After much thought.
If the cost of carry is negative. This involves selling the shares short. the lower the cost of carry. If the actual futures price is above its fair value. then cost of carry will be negative. The cost of carry is determined by: a) The interest expense to fund the purchase of the shares. and buying the future. a cash and carry trade can be used to arbitrage this disparity. If the actual futures price is below its fair value. if interest rates are lower than the dividend yield. b) The dividend yield on the shares. If the cost of carry is positive. The higher the rate. futures prices will be above cash prices. futures prices will be below cash prices. a reverse cash and carry can be used. The higher the dividend yield.This is called a "cash-and-carry" strategy because it involves paying cash for the stocks right now and carrying them until delivery. =============================================================== *Fair Value Pricing Formula Let's set out the formula for the calculation of the fair value of an equity futures contract: Fair Value of = Cash + Cost of Carry Futures Cost of Carry = Cash × ( I −D ) × Term so: so finally: Where: Cash I D Term Fair Value of = Cash + (Cash × ( I −D ) × Term) Futures Fair Value of = Cash × [ 1 + ( I −D )×Term ] Futures The cash or spot market price of the underlying index Interest rate (as a decimal) Dividend yield (as a decimal) Length of the futures period (in years. and the futures price will be greater than the cash price. and the futures price will be lower than the cash price. the higher the cost of carry. . This involves buying the shares and selling the future. On the other hand. also expressed as a decimal) If the interest rate is greater than the dividend yield. then the cost of carry is a positive number. c) The term until settlement of the futures contract. =============================================================== *Fair Value Pricing The fair value of an index futures contract is a function of the index's current price and the cost of carrying the stocks in the index until the expiry date of the futures contract in the delivery month.
a producer of corn could use futures to lock in a certain price and reduce risk (hedge). such as a physical commodity or a financial instrument. =============================================================== Notes: 1. to earn a profit on either type of arbitrage. The futures markets are characterized by the ability to use very high leverage relative to stock markets. =============================================================== *What Does Futures Mean? A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset). This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). such as a futures contract. On the other hand. This serves to exit your position. they are standardized to facilitate trading on a futures exchange. while the holder of a futures contract is obligated to fulfill the terms of his/her contract. you could go short in the same type of contract to offset your position. a hedge consists of taking an offsetting position in a related security. Some futures contracts may call for physical delivery of the asset. Investopedia explains Futures The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration. . For example. =============================================================== *What Does Hedge Mean? Making an investment to reduce the risk of adverse price movements in an asset. if you were long in a futures contract. For example. the actual delivery rate of the underlying goods specified in futures contracts is very low. Futures contracts detail the quality and quantity of the underlying asset. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. transaction costs such as bid-offer spreads and commissions must be considered. The futures price is derived from the current cash price using a cash-and-carry relationship. while others are settled in cash. Normally.However. at a predetermined future date and price. In real life. much like selling a stock in the equity markets would close a trade. anybody could speculate on the price movement of corn by going long or short using futures.
7 million invested in a broadly diversified portfolio of large-capitalization common stocks. =============================================================== *Hedging an Equity Portfolio Suppose a US investment manager has $11. therefore avoiding market fluctuations. A perfect hedge reduces your risk to nothing (except for the cost of the hedge). the investor buys it for less than he or she sold it. commodity or currency with the expectation that the asset will fall in value. 2. =============================================================== *What Does Short (or Short Position) Mean? 1. =============================================================== *What Does Long (or Long Position) Mean? 1. commodity or currency. not the obligation to buy (or sell) a specific commodity or asset for a specified amount at a specified date. 2. 2. The manager is concerned that the market will experience a short-term decline. an investor who borrows shares of stock from a broker and sells them on the open market is said to have a short position in the stock. Investors use this strategy when they are unsure of what the market will do. buying a call (or put) options contract from an options writer entitles you the right. . For example. If the stock falls in price. For example. For example. The buying of a security such as a stock. not the obligation to buy from (or sell to) you a specific commodity or asset for a specified amount at a specified date. it is the sale (also known as "writing") of an options contract. and therefore wants to protect the value of the portfolio against the expected losses. In the context of options. In the context of options. selling a call (or put) options contract to a buyer entitles the buyer the right. with the expectation that the asset will rise in value. is said to be "long McDonald's" or "has a long position in McDonald's". The sale of a borrowed security. thus making a profit. an owner of shares in McDonald's Corp. then sold a futures contract stating that you will sell your stock at a set price. Investopedia explains Long (or Long Position) 1. the buying of an options contract. The investor must eventually return the borrowed stock by buying it back from the open market. For example. 2. Investopedia explains Short (or Short Position) 1.Investopedia explains Hedge An example of a hedge would be if you owned a stock.
300.90% p. 1. a portfolio with a beta of 1. Futures Term How long from now that the futures contract expires.313.00% p. Portfolio Beta The relative volatility of the portfolio as compared to that of the market index.00 1.5 can be expected to decline by 15% if the index declines by 10%. . S&P 500 Futures Contract Price The price of the S&P futures contract right now. Futures Expiry The month when the futures contract expires. For example.00 The first step in designing the hedge is to calculate how many futures contracts should be sold.The table below provides details of market rates and prices in our example. Interest Rate The level of six-month interest rates. Here we calculate the number of futures contracts required: Futures Contract Trading Unit S&P 500 NASDAQ 100 FTSE 100 DAX $250 $100 £10 € 25 The current (spot) market level of the cash index underlying the futures contract.65 December 6 months 4. Description Value S&P 500 Cash Index Value The level of the S&P stock index right now.. You can pass your mouse over any of the items to find out more. Dividend Yield on Index The annual rate of return from dividends on S&P 1.a. stocks.a.. 1.
850 Contracts: $250 = Loss On Portfolio : Net Gain (Loss) [(1235/1300) – 1] × $11. Investopedia explains Futures Contract The terms "futures contract" and "futures" refer to essentially the same thing.000 –$585. The financial results of the hedge are evaluated below: Gain on Futures 36 × (1313. while others are settled in cash. which means the same thing as "oil futures contract".00) × $707. =============================================================== *What Does Futures Contract Mean? A contractual agreement.850 Result The hedge produced a net gain of $122.300 to 1.850.000 = $122. to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. while "futures" is more general and can also refer to the overall market as in: "He's a futures trader.235 by the time we reach the December contract’s settlement date. Let's suppose that the S&P 500 index declined from 1. Some futures contracts may call for physical delivery of the asset.700. If you want to get really specific." =============================================================== *What Does Index Futures Mean? It means “futures contract on a stock or financial index”. you might hear somebody say they bought "oil futures". Futures contracts detail the quality and quantity of the underlying asset. While this may appear to be an unforeseen bonus. you could say that a futures contract refers only to the specific characteristics of the underlying asset. generally made on the trading floor of a futures exchange. For each index there may be a different multiple for determining the price of the futures contract. . it does raise some concern as to why the gain on the hedge does not match the loss on the portfolio. For example.65 – 1235.Let's apply this formula to the investment manager's portfolio: The portfolio manager should therefore sell 36 S&P futures contracts to hedge the portfolio fully. they are standardized to facilitate trading on a futures exchange.
Interest Rate The level of three-month interest rates. Stock portfolio managers who want to hedge risk over a certain period of time often use S&P 500 futures to do so. Example: An investment manager has $10.Investopedia explains Index Futures For example.50% p. and therefore wants to decrease his equity exposure by reducing the portfolio’s beta.300. The details of the portfolio. stock portfolio managers can use index futures to increase their exposure to movements in a particular index.309. The process is similar to hedging. 1.a. Futures Term How long from now that the futures contract expires.S. and of other market prices and rates. This can be viewed as adjusting the portfolio beta. Alternatively. are given below: Description Value S&P 500 Cash Index Value The level of the S&P stock index right now. essentially leveraging their portfolios. stocks. the manager's portfolio will not participate in any gains on the index. the portfolio will lock in gains equivalent to the risk-free rate of interest. stock portfolio managers can protect themselves from the downside price risk of the broader market.a. if perfectly done.75 September 3 months 4. by using this hedging strategy. Futures Expiry The month when the futures contract expires. however the formula for determining the number of contracts required is slightly different. portfolio managers desire to reduce their exposure rather than to completely eliminate it.00 1. Portfolio Beta 1. the S&P 500 Index is one of the most widely traded index futures contracts in the U. Dividend Yield on Index The annual rate of return from dividends on S&P 1. =============================================================== *Adjusting a Portfolio’s Beta Often. S&P 500 Futures Contract Price The price of the S&P futures contract right now. However.4 million invested in a broadly diversified portfolio of common stocks. instead. The manager is concerned that the market will experience a short-term decline. By shorting these contracts.50% p.25 .
035.300.00 5.25 to 0.0445 × 0. =============================================================== More Examples: 1. An equity portfolio with a current market value of £100 million.366. and assuming that this was a perfect hedge.5) ] = £102.45% Answer: The portfolio value will be £102.000.00 1.00 5.25 5. Formula for Adjusting a Portfolio’s Beta Let's apply this formula to the investment manager's portfolio: By selling 24 futures contracts. the beta of the portfolio will be reduced from 1.5 can be expected to decline by 15% if the index declines by 10%. determine the value of the portfolio at the end of the six-month period.000 × [ 1 + (0.50. and with a composition exactly matching that of the FTSE100 index.225.225.95% 4. The maturity value of the deposit can be calculated as: £100. Given the data below.000 . Item FTSE 100 Index at beginning of period FTSE 100 Index at end of period FTSE 100 Futures at beginning of period FTSE 100 Futures at end of period Dividend Yield on FTSE 100 (annual) Interest Rate on 6 month deposits (annual) Market Data 5.000 This is because the hedge created a synthetic cash deposit.035. For example. a portfolio with a beta of 1. has been hedged for a period of six months using the appropriate number of FTSE 100 contracts.The relative volatility of the portfolio as compared to that of the market index.
In addition to this.2. c) The futures price when the hedge is closed may not equal the then current level of the S&P 500 index. so the volatility of the portfolio may be different from the volatility of the index. 50. called stock certificates.94. At the time the hedge was placed. Generally. these words are used interchangeably to refer to the pieces of paper that denote ownership in a particular company. or about 151 contracts The manager intends to close out his hedge sometime in late November. and hence the futures contract. the formula did not include a factor for the portfolio's beta relative to that of the index. b) The volatility of the portfolio may be different than that of the index used to hedge it with. the manager has hedged his portfolio by selling 151 December S&P 500 futures contracts. An investment manager has a portfolio of $50 million that is composed of an almost equal mixture of large-capitalization and small-capitalization companies. as the hedge will be closed out prior to the contract's settlement date. the denominator used the futures price of the index rather than the spot index level.000. the distinction between stocks and shares has been somewhat blurred. e) None of the above. =============================================================== *Stock Vs Shares In today's financial markets. the futures price may well be different from that of the underlying index at that date. The number of contracts used in the hedge has been incorrectly calculated for two reasons. Which of the following factors could prevent this hedge from working as intended? a) The number of contracts has been calculated incorrectly. Answer: (d) is correct .300 and the futures contract was priced at 1. the S&P cash index was 1. and believes that this hedge will be perfect in offsetting any losses that the portfolio might experience.325. Foreseeing a short-term market decline.all of the factors could prevent the hedge from working as intended. as determined by the calculation given below. First. . Second.000 / (1325 × 250) = 150. d) All of the above.
Investopedia explains Depositary Receipt Depositary receipts make it easier to buy shares in foreign companies because the shares of the company don't have to leave the home state. One of the most common types of DRs is the American Depositary Receipts (ADRs). which has been offering companies. Technically. and other banks issue global depositary receipts (GDRs). if someone says that they own shares .the question then becomes . and "shares" refers to a the ownership certificates of a particular company. interest rates and market indexes. commodities. The derivative itself is merely a contract between two or more parties. For example. the difference between the two words comes from the context in which they are used. and it has more to do with syntax than financial or legal accuracy. if investors say they own stocks. they are generally referring to their overall ownership in one or more companies. Investopedia explains Spinoff Businesses wishing to 'streamline' their operations often sell less productive. which are traded on LSE. The most common underlying assets include stocks. European banks issue European depositary receipts. . currencies. bonds. A spinoff is a type of divestiture. in general. "stock" is a general term used to describe the ownership certificates of any company. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.However. The minor distinction between stocks and shares is usually overlooked.shares in what company? Bottom line. So. investors and traders. stocks and shares are the same thing. Global investment opportunities. Most derivatives are characterized by high leverage. The depositary receipt trades on a local stock exchange. =============================================================== *What Does Depositary Receipt Mean? A negotiable financial instrument issued by a bank to represent a foreign company's publicly traded securities. or unrelated subsidiary businesses as spinoffs. =============================================================== *What Does Derivative Mean? A security whose price is dependent upon or derived from one or more underlying assets. =============================================================== *What Does Spinoff Mean? The creation of an independent company through the sale or distribution of new shares of an existing business/division of a parent company. Its value is determined by fluctuations in the underlying asset. ADRs are usually traded on US exchanges (ie NYSE).
we will use the exact number of days (183) divided by 360. Fair Value of Futures = Cash × [ 1 + I × Days/365 ] − Adjusted Dividends Where "Adjusted Dividends" are the estimated amount of dividends to be received.5 as the term. such as the amount of rain or the number of sunny days in a particular region. dollars to do so) would be exposed to exchange-rate risk while holding that stock. Instead of using 0.Investopedia explains Derivative Futures contracts. For example. traders can exploit this arbitrage possibility by executing the cash and carry (buying the basket of stocks) and selling the future short position: If it is possible to replicate a short position in a future more expensively than the current futures price. adjusted to convert it to index points. a more accurate formula for the fair value of an index futures contract is given below. To hedge this risk. a European investor purchasing shares of an American company off of an American exchange (using U. =============================================================== Let's adapt the previous example by using the revised fair-value formula. =============================================================== *Revising the Fair Value Formula Taking into account only those issues regarding interest and dividends discussed previously. =============================================================== long position: If it is possible to replicate a long position in a future more cheaply than the current futures price. . There are even derivatives based on weather data. but can also be used for speculative purposes. In addition. we need to convert the dividend yield of 1. forward contracts. and the expense of the interest paid on the borrowed funds. traders can exploit this arbitrage possibility by executing the reverse cash and carry (selling the basket of stocks) and buying the future. options and swaps are the most common types of derivatives. The net cost of a cash and carry (excluding commissions and any bid-offer spreads) is the difference between the income earned from the dividends received. plus any interest earned until the end of the transaction period. the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.S.8% into an actual dollar amount of dividends paid over this period. This difference is known as the “cost of carry”. Derivatives are contracts and can be used as an underlying asset. Derivatives are generally used as an instrument to hedge risk.
and stock dividends. Applying these numbers gives: Fair Value of Futures = 1300 × [ 1 + 0.31m The total capitalization-weighted dividends to be paid during this 183-day period by the 500 shares comprising the S&P 500 index. dividing the MC of 11.31 by the index divisor of 9.734m by the divisor of 9005. to give 11.438bn.18 gives the value of the index as 1300. The figure of about $108bn corresponds to an annual dividend yield of 1.00 183 days 4% (Actual/360) $107. including any interest earned during the period. Index Value of Adjusted Dividends: The divisor is updated from time to time by the index’s proprietor to adjust for changes in the component stocks and capitalization.97 points Every market index has a unique divisor.The table below provides the revised figures that we can insert into the revised fair-value formula: Input Parameters Cash S&P 500 Index: Term: Interest Rate: 1. which is used to obtain the current value of the index from the total market capitalisation (MC) of the stocks. stock splits.005. 11.46 =============================================================== Dollar Value of Adjusted Dividends: . For example.88% on the S&P500 stocks having a market capitalisation of around 11.300.795.706.795.97 index points.04× 183/360 ] − 11.97 = 1314.18. Converting the dollar amount of the dividends to index points is done by dividing the adjusted dollar dividends of $107.
This differential is equivalent to 1.*The Costs of Index Arbitrage A mis-pricing of index futures versus their fair value is not sufficient to guarantee a profit for an arbitrageur. that the difference between the fair value of a futures contract and the price of the underlying index depends on two broad components: .37 index points. 6.46.02 around the fair futures price of 1314. The chart below shows this no-arbitrage zone given the following assumptions: Bid/offer spreads and commissions amount to the equivalent of 1.65 index points.25% below market rates. there is a range of prices around fair value than cannot be arbitraged. 4. and investing rates are 0. We have seen so far.25% above market rates. mispricing is not great enough to offset the costs of arbitrage. =============================================================== *Arbitrage Thresholds Given the fact that profitable index arbitrage can only be implemented when futures mispricing is greater than the costs of executing the arbitrage.44 and 1. Borrowing rates are 0.48. The combination of these two gives rise to a no-arbitrage zone ±3. and depend upon the following: 1.311. Arbitrage costs such as commissions and bid-offer spreads are highly variable.317. The mis-pricing must be large enough to generate a profit after considering the costs of executing the arbitrage. 2. 3. Who is Performing the Arbitrage Number of Stocks in Index Liquidity of the Underlying Stocks Liquidity of the Index Futures Contract If full interest credit is received on the proceeds of short sales Access to favorable investment and/or borrowing rates. 5. At futures prices between 1.
As a contract's time to expiry approaches. To exploit this. the arbitrageur buys the underlying stocks. In other words.interest rates and dividends bid-offer spreads and commissions As time passes: 1. =============================================================== . Fair value converges to equal the price of the underlying index as of the contract’s expiry date. while simultaneously buying the appropriate index futures contracts. =============================================================== *Note: The arbitrageur's costs will increase as a result of wider cash market spreads. That is. *Sell Programs A sell program is executed by index arbitrageurs when futures are undervalued. That is. arbitrageurs will implement a cash and carry trade. =============================================================== *Buy Programs A buy program is executed by index arbitrageurs when futures are overvalued. 2. arbitrageurs will implement a reverse cash and carry trade. The differences between both the cash and carry prices and the reverse cash and carry prices converge to the fair value line. while simultaneously selling the appropriate index futures contracts. the resulting futures bid/offer spread will widen. This increased cost will cause the break-even price for selling futures to increase. To exploit this. cost of carry will decrease in value. the arbitrageur sells the underlying stocks. 2. Upon expiry: 1. and that for buying futures to decrease. The sole difference between the contract’s fair value and either the cash and carry or the reverse cash and carry is the cost of executing the arbitrage: bid-offer spreads and commissions.
2. Warrants are derivative products. Normal warrants generally have only one exercise price.*What Does Warrant Mean? A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Covered warrants allow the warrant holder to buy or sell the underlying asset. usually a bank or a similar financial institution. and can be assigned to the general category of options. Covered warrants are only issued by financial institutions. They give the buyer the right to buy (call warrant) or to sell (put warrant) an underlying security at a previously specified price. while the lifetime of a typical option is measured in months. Normal warrants only have a company's stock as their underlying financial product. Covered warrants can have a wide variety of underlying financial products. Normal warrants allow the warrant holder only to buy the underlying equity. currency or other financial instruments from the issuer. at a specific price and time. Also. 3. 4. Investopedia explains Covered Warrant The main differences between normal warrants and covered warrants are: 1. =============================================================== *Comparison of Traditional and Covered Warrants The table below summarizes the main differences between traditional warrants and covered warrants: . the lifetime of a warrant is often measured in years. Warrants are often included in a new debt issue as a "sweetener" to entice investors. whereas options are exchange instruments and are not issued by the company. Normal warrants are only issued by the company that issued the underlying equity. Covered warrants can have a variety of exercise prices depending on the conditions set forth by each issue. which differ mainly in the relationship between the issuer of the warrant and the company whose shares are deliverable if the warrant is exercised: a) Company Warrant b) Covered Warrant =============================================================== *What Does Covered Warrant Mean? A type of warrant that allows the holder to buy or sell a specific amount of equities. Investopedia explains Warrant The main difference between warrants and call options is that warrants are issued and guaranteed by the company. There are two major categories of warrants.
it's a warrant that gives the right to sell. Ans: Lower than $23 Ques: A stock is trading at $30.00.00. =============================================================== Ques: A trader has bought a put warrant struck at $25.Item Issuer Settlement Maturity Strike Price Liquidity Traditional Warrant Underlying company Covered Warrant Third party New shares issued Cash settlement Up to seven years Fixed at issue Generally poor Up to two years New strikes offered as market price of shares changes Generally good as issuer is required to make a market =============================================================== *What Does Call Warrant Mean? A warrant that gives the holder the right to buy the underlying share for an agreed price. what must the price of the underlying be for the trader to make a profit. Investopedia explains Put Warrant Basically. and paid a premium of $2. At expiry. =============================================================== *What Does Put Warrant Mean? A warrant that gives the holder the right to sell the underlying share for an agreed price on or before a specified date. Investopedia explains Call Warrant A warrant is similar to an option. Which of the following warrants is in the money? (more than one answer may be correct) Ans: Put warrant struck at $35 / Call warrant struck at $25 =============================================================== *Variations on Covered Warrants . the main difference is that warrants are issued by a company attempting to raise capital. on or before a specified date.
The principal characteristics of a plain vanilla option are the following: The option’s life is fixed at its issuance.There are a wide variety of covered warrants available in the marketplace. . The major variations fall into two categories: Variations in the underlying security Variations in the warrant’s structure *Variations in the Underlying Security *Variations on Covered Warrant Structures A standard option or warrant is also known by the term “Plain Vanilla”.
A barrier warrant is also classified as a type of “path dependent” warrant as the payoff of the warrant is dependent not only upon the price of the underlying at expiry. =============================================================== *Exotics: Corridor Options A corridor warrant is another form of path dependent warrant. The option is insensitive to the path of the underlying’s price movement throughout the life of the option. but also on the path that the underlying price takes over the life of the warrant. but modifies the warrant’s payoff. and consequently this class of warrant is also known as a barrier warrant. On the negative side. the buyer faces the possibility that the barrier will be breached. Up and Out: A knock-out where the barrier is placed above the current market price of the underlying. The offset to this. * The strike price of a barrier warrant is more likely to be reached than a similar warrant lacking the barrier.The option’s payoff function is linear. the premium of the warrant is lower than that of a comparable plain vanilla warrant lacking a barrier. A typical structure for a corridor warrant is to accrue payouts for each day that the underlying price stays within the corridor. there are two price points which serve a function similar to that of a barrier. In this case. =============================================================== Note: * The sole advantage of a barrier warrant for a buyer (call) is that the premium is lower than that of a similar warrant lacking a barrier. There are two forms of knock-out warrants: (mousover for details) Down and Out: A knock-out where the barrier is placed below the current market price of the underlying. the touching of the barriers dos not trigger premature expiry. The obvious disadvantage to an investor in a barrier warrant is that the warrant may be terminated prior to its normal expiration. thereby terminating the warrant prematurely. currency or commodity at the time of exercise. however. In the case of corridor warrants. The price level that triggers the termination of the warrant is known as the “barrier”. while accruing no payouts on days that either of the barriers is breached As the band of a corridor warrant is made narrower. The options payoff is determined by the price of a single security. =============================================================== *Exotics: Knock-Out Warrants A knock-out warrant is one with an additional feature that has the effect of terminating the warrant prematurely if a previously specified price level is reached. Typically used with call warrants. Typically used with put warrants. the warrant’s payouts will decrease .
=============================================================== *Elements of Warrant Pricing The pricing of warrants is based on the same principals as those of option pricing. it compares the price sensitivity of a warrant to that of the underlying. as interest rates have some effect on time value.£ .55 =============================================================== *Why Time Value Exists Time value is largely a function of two elements: the warrant’s remaining time until expiry and the volatility of the underlying stock.17 = £ 1.Strike).0 For example. The main point is that the buyer of a call (put) warrant is paying not only for the current intrinsic value of the warrant.67. Intrinsic Value of Call = > (Market Price of Stock. The premium of a warrant can be decomposed into two elements: 1. however this effect is generally small.72 . but also for the possibility that the price of the underlying will increase (decrease) prior to expiry such that it will have a greater intrinsic value.That part of a warrant’s premium that is in excess of it’s intrinsic value.72. expiring in approximately six months. Time Value *Intrinsic Value . That is. if a stock increases in price by $1. as the holder of a warrant has the right.17. i. but not the obligation to exercise.17 (£ 22. the amount that the option is in-the-money. For example. The warrant’s intrinsic value is £. the shares of AstraZeneca are currently trading in London at a price of £22. =============================================================== *Understanding a Warrant’s Delta The delta of a warrant is a measure of its moneyness. Intrinsic Value 2. the warrant is said to have a delta of 50 .50.50 with a premium of £1. while a call warrant with a strike of £22. is priced at £1. While a rigorous treatment of option pricing is beyond the scope of this course. we will examine the major elements that determine a warrant’s price.72 and an intrinsic value of £.00 while a call warrant increases by $.0 Intrinsic Value of a Put = > (Strike-Market Price of Stock).67.£ 22. Time Value = Premium – Intrinsic Value For the AstraZeneca warrant struck at £22. time value is: £ 1.e. This is something of a simplification.Value that a warrant would generate if it were exercised immediately.50) *Time Value.50. Intrinsic value cannot be negative.. and can quickly become highly mathematical.
Delta ranges from 0 for warrants that are deeply out-of-the-money. but changes both as expiry approaches and as the price of the underlying changes. delta converges to either a value of 100 or 0. Effect on Warrant Price Variable Direction Call Putt Price of the Underlying Strike Price Time to Expiry Input Volatility Interest Rates Increase Decrease Increase Decrease Increase Decrease Increase Decrease Increase Decrease Dividend Payments Increase Increase Decrease Decrease Increase Increase Decrease Increase Decrease Increase Decrease Decrease Decrease Increase Increase Decrease Increase Decrease Increase Decrease Decrease Increase Increase .(percent). At expiry. depending on whether the warrant is in or out of the money. =============================================================== *Warrant Pricing: The Inputs The inputs required to price a warrant are listed below: =============================================================== Warrant Pricing: Sensitivities The table below shows the sensitivity of warrant prices to changes in any of the input variables. to 100 for warrants that are deeply in-the-money. Delta is not a static measure.
Leverage The reason that the warrant investment outperformed the stock investment when stock prices rose to £36 or above. for a total cost of £1. The trader is willing to lose his entire risk capital. to a price of £ 27. currently trading at £30. The trader has £ 1. and sell the stock should it decline by £3. for a premium of £ 2. the calculation is as shown below: This shows that a trader can control 15 times the amount of stock through the use of a call warrant as compared with the purchase of the shares. but no more than that amount. However.00 or lower. is due to the leverage inherent in warrants.500. and is also known as “gearing”. Therefore. he is prepared to buy 500 shares.00.00.Decrease Increase Decrease =============================================================== *Why Use Warrants? The two greatest advantages of warrants when compared to other instruments are: Limited Losses Leverage Limited Losses The buyer of a call or put warrant limits his losses to the amount invested.) As an alternative.00 per share. Consider the trader who believes that the shares of ABC. (The trader will place a stop-loss order which will be executed if the price of the stock drops to the targeted level or lower.00 are due to rise sharply. Ltd. Leverage is the ability to control more shares of stock with a given amount of capital.500 to risk in the trade. there is no guarantee that the trade will not be executed at a price lower than £ 27. Leverage is measured by the following formula: Assuming that the conversion ratio for the warrants used in our previous trading example was 1:1.00 or more. =============================================================== *Hedging With Put Warrants . the trader can buy 750 call warrants on the stock struck at £ 30.
. b) More significantly. =============================================================== *Notes: .000 x . and the market has declined by 5. and wants to protect himself from this possibility.2450 £4. for a net loss of £2.000 invested in the UK market in a broadly diversified equity portfolio.000 when the level of the index is 5. First. and decides to hedge by purchasing put warrants on the FTSE 100 index.0985 £1. we must determine the number of puts required to hedge the portfolio. have a conversion ratio of 1.930 Net Change Change in Value -£5. they did not completely offset it. for a total loss in time value of £1.85 p. The time value at purchase was 9.070 1) The pricing of the puts has been calculated with a warrant pricing model based on the given starting and ending level of the FTSE 100. Example: An investor has £100. for a FTSE of 4. The formula is given below: The hedge is evaluated after one month has passed.759. 2) The portfolio has lost £5.000 -£2.The purchase of put warrants to hedge an exposure is a very common application. 3) While the puts mitigated the loss on the portfolio.000 Value of Put Options 20. The purchase of puts permits an investor to reduce his risk of loss while simultaneously retaining his ability to earn profits should the price of this investments rise. or a loss of 9. while the time value after one month was 0. which are struck at 5.900 = £2.000 x .50 Value of Portfolio NOW In 1 Month £100.0%.45p.070.000 £95.970 = 20.000:1.010.40p per put. This is due to two factors: a) The puts were somewhat out-of –the money when they were purchased.000. The investor purchases at-the-money puts on the FTSE.930. The investor is concerned that the market will drop. the time value on the puts has eroded during the month that they were held.85 p. The puts expire in approximately 6 months. while the value of the puts has increased by £2.890. and are selling at a premium of 9.
if the investor wishes. and an expiry date in three months. What is the amount of the payout received by the trader on this call? Ans: When the share price moved below the knockout of 20. 5. 6.50) 3. Since leverage is calculated as stock price/premium. the warrants premium will increase. Investopedia explains Convertible Bond Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example. Ques: A trader has purchased call warrants on the shares of ABC Ltd. the market usually interprets this as a sign that the company's share price is somewhat overvalued. a convertible bond has a value-added component built into it.50 × 5 + 50 = 52. Although the warrant would have closed in-the-money with a payout of 2. the shares were trading at 22.50. Convertibles are sometimes called "CVs". As the strike price of a warrant decreases.00 At what price must the underlying stock trade at the warrant's expiry for the trader to break even on this transaction? Ans: The stock price must be above the strike by the amount of the premium paid times the conversion ratio. Therefore.75. no payout will be received as the option is no longer active.50. it is essentially a bond with a stock option hidden inside. the warrant was terminated. Indicate which actions the investor should implement: Ans: To implement a cash extraction strategy. the purchaser of such a warrant is implicitly taking a view that the price will exhibit low volatility.00. Ques: An investor has 6. From the investor's perspective. 2. . the leverage decreases. and has decided that he would like to implement a cash extraction strategy. To avoid this negative impression. usually at the discretion of the bondholder. Company warrants can have lives of five years of longer. OR A convertible bond is one which can be converted. if an already public company chooses to issue stock. the investor should sell some existing shares and substitute for them with the purchase of calls. A corridor warrant makes payouts only when the price of the underlying remains within a specified price band. Covered warrants typically expire in no more than two years from their date of issue. The warrants have a price of 0.75. =============================================================== *What Does Convertible Bond Mean? A bond that can be converted into a predetermined amount of the company's equity at certain times during its life. with a knockout at 17. it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock. One month after the purchase the price of the XYX shares declined to 16. Thus. Ques: A trader has purchased a call warrant on XYZ struck at 20. 4. into shares of the issuer.1.00. a conversion ratio of 5:1 and a strike price of 50. (0. but at the expiry date. which bondholders will likely convert to equity anyway should the company continue to do well.000 shares of a stock. the company may choose to issue convertible bonds.
=============================================================== *Issuer's Share Price The issuer's stock price is one of the key factors which influence an investor in deciding whether or not to convert the bond. Are willing to accept more risk than on straight bonds. c. however. d. it also gives the investor the right to convert the bond into a fixed number of shares of the issuer's stock. but want more potential for appreciation. Hedge funds desiring on opportunity to arbitrage equity. . and contains all the basic features of a fixed-income security like a coupon rate and final maturity.A convertible bond therefore starts life as the debt obligation of a particular issuer. Want a less risky substitute for common stock. fixed-income and options market. In addition. Pass your mouse over the diagram below to see what the investor might do if the stock price rises or falls: Typical Investor: a. b. Want a higher-yielding substitute for common stock.
Typical Issuer: a. Generally have less than investment grade credit ratings. b. May lack the ability to benefit from tax deductions. c. May lack a long operating history. d. May be in an industry with perceived high growth. e. May be interested in issuing shares, but views current equity price as undervalued. =============================================================== Advantages of Convertibles for Issuer: If the stock price rises and the bond is converted.
Advantage of Convertibles for Investors: a) Provides protection against a fall in the stock price. b) Provides an opportunity for capital gains. c) Provides higher income than the dividend yield on the underlying stock. Disadvantages of Convertibles: Although convertibles have their advantages, they also have some disadvantages as well. Again, pass your mouse over the images below to investigate...
Disadvantages of Convertibles:
. the conversion price is set at a significant amount higher than the current price of the common stock. such as corporate bonds or preferred shares. Investopedia explains Conversion Price The conversion price is determined when the convertible security is issued and can be found in the bond indenture (in the case of convertible bonds) or in the security prospectus (in the case of convertible preferred shares). by computing the quotient of the principal value of the convertible security divided by the conversion price. can be converted into common stock.=============================================================== *What Does Conversion Price Mean? The price per share at which a convertible security. The conversion price is essential in determining the number of shares to be received. so as to make conversion desirable only if a company's common shares experience a significant increase in value. =============================================================== Call Provisions Some convertibles are issued with a call feature which gives the issuer the right to call (repay) the bond prior to its stated maturity. Example of a Call Feature A convertible bond is issued with a coupon of 5% and a stated maturity of 10 years. Usually.
0% 102.0% As in the example above. 103% in this case. An issuer’s motivations for calling a convertible bond differ from those of calling a straight bond. but only after a period of time. and is five years in the above example.The bond is callable at the end of year five at a price of 103% of par.5% 101. =============================================================== *Calling a Convertible Call features may not be activated immediately. and annually thereafter at reduced premiums.5% 102. The premium is to compensate investors for taking away their opportunity to convert into shares in the future. as specified in the table opposite: Year 5 6 7 8 9 Call Price 103.0% 101. the call feature often involves repayment at a call price slightly higher than par – the premium being about one-half of the annual coupon on the convertible. This delay is called the deferment period. .
00) = $19 Since the after-tax funding cost is reduced by $13. Faced with an issuer's call. the issuer will elect to call the bond. . To illustrate the thinking behind an issuer calling. If an issuer calls a convertible under such circumstances.00% (annual) Price of Convertible 105% Call Price 103% Conversion Ratio 38 shares per $1.00% × (1-0. and an investor converting.50 (annual) Issuer’s Tax Rate 36% *The Issuer’s Perspective After-Tax Cost of Bond: After-Tax Cost if Converted $1.000 bond Stock Price $29.36) = $32 38 × $0.=============================================================== *Calling a Convertible – Perspectives Issuers may call a convertible bond if they can substitute it with lower-cost debt.00 Stock Dividend $0. consider the following convertible: XYZ Corporation Convertible Coupon on Convertible: 5. thereby forcing conversion. this is called a forced conversion. an investor may find it preferable to convert rather than receive redemption of the bond.50 × (1-0.000 × 5.
Yield to Maturity . Yield on Equivalent Debt : 7. Over the next few pages we will explain how to calculate: Yield to maturity Debt (or floor) value Breakeven years A convertible can also be considered as a bond plus an embedded call option on the issuer's stock. Face Value: $1. To illustrate how the various analytical techniques can be applied.) =============================================================== *Analyzing Convertible Bonds As is true of most investments. some of the methods are based on bond valuation techniques. we will use the following convertible bond: Bond Description: ABC Corp. there are a number of ways to analyse convertible bonds.a. Given that a convertible is a hybrid instrument.00 Dividend on Stock: $0.102 Since the conversion value exceeds the call value. the rational investor will elect to convert the bond rather than allow it to be called..000 × 103% = $1. 5. containing features of both debt and equity.50% =============================================================== *Yield to Maturity The calculation of yield-to-maturity is identical to that for a straight bond (see the course on Bond Maths and Analytics for further information)..00% s.a. (This is known as a forced conversion.*The Investor’s Perspective Value if Called: Value if Converted: $1.030 38 × $29 = $1.0% Convertibles of 2013 Time to Maturity: 10 years Coupon: 5.00 Current Price 98% of par First Call: 5 years at 103% Conversion Ratio: 40 shares per bond Stock’s Current Price: $20. Let's illustrate this for ABC's convertible.000.40 per share p.
the dividend yield is the annual dividend divided by the current share price.40 / $20 = 2%. This means that if the issuer's stock price showed no prospects of rising above the . the dividend yield is: $0.50% 2. Face value Semi-annual payments Then press the Calculate button next to PV to obtain the convertible's debt value of 82. The discount rate should be the current market rate for straight bonds having comparable credit ratings and maturity. Face value Semi-annual payments Then press the Calculate button next to I%YR to obtain the convertible's yield to maturity of 5. Let's illustrate this for ABC's convertible. In this case.Using a financial calculator (click the Calculator link at the top of the screen). the current yield is the annual coupon rate divided by the current price.26%. You can calculate the debt value by using the normal bond pricing formula to discount all the bond’s cash flows back to the present time.10% Dividend Yield As with a regular stock..63. Debt Value Using a financial calculator (click the Calculator link at the top of the screen). Current Yield As with a straight bond..a.a. enter these values as inputs: N PV PMT FV P/YR 20 –98 2. the current yield is: 5 / 98 = 5. =============================================================== *Debt Value The debt value of a convertible is the straightforward value of the bond component excluding the conversion feature. enter these values as inputs: N I%YR PMT FV P/YR 20 7.5 100 2 Semi-annual payments for 10 years Current price of convertible Semi-annual coupon at 5% p.5 100 2 Semi-annual payments for 10 years Yield on equivalent straight debt Semi-annual coupon at 5% p. In this case.
However.63% of par. . conversion value. investors will keep the convertible as a bond. the minimum value for the convertible should be 82. The debt value is sometimes also called the floor value. when plotted against the share price of ABC's common stock.conversion price. The conversion value is also known as the parity value. the price is determined on the initial trade date. On the other hand. the conversion value is $800.000 of bonds held. =============================================================== *Minimum Price for a Convertible The chart opposite compares the current price. The conversion value can be calculated as: Conversion Value = Conversion Ratio × Current Share Price So if ABC's share price is currently $20. Debt Value – This was defined on the previous page as the value of the convertible bond excluding its conversion feature. Conversion Value – This is value of the convertible if an investor immediately chose to convert the bond into shares of ABC at prevailing market prices. this term may be misleading as it only establishes a minimum price for the convertible at current yields. Current Price – This is simply the price at which ABC's convertible is currently trading in the market. and its value should not fall below the debt value. and will be tempted to convert. if ABC's share price rises. and the conversion ratio is $40. =============================================================== *What Does Forward Contract Mean? A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. namely $826. The debt value and conversion value together establish minimum values for the convertible bond itself.30 per $1. Although the delivery is made in the future. and debt value for ABC Corporation. If interest rates rise or the issuer’s credit rating deteriorates. the floor value will drop accordingly. so that the conversion value is low. realising the conversion value. investors will want to realise the potential value of the underlying shares. If ABC's share price falls.
=============================================================== *Short-Term Interest Forwards An FRA (Forward Rate Agreement) guarantees an interest rate for a specified short-term period in the future.Investopedia explains Forward Contract Most forward contracts don't have standards and aren't traded on exchanges.000oz of gold to ABX. .000 oz of gold from Precious Metals Inc (PMI) for delivery on 18th September at a price of $935 per oz. two days hence. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest. and ABX will pay PMI $935. This is therefore a forward contract.3965 per Euro. The FRA covers the three-month period 18th September to 18th December.50%. but where delivery will take place on a specified date in the future. ABX Bullion agrees to buy 1. Citibank agrees today to purchase EUR 10m from BMW at a rate of $1. On 18th December. Example: Today is 16th June.396. Chase sells Ford a $100m 3x6 FRA on $100m at the fixed rate of 6. On 18th September. and Citibank will deliver $1. Example: Today is 16th June. =============================================================== *Foreign Exchange Forward An FX forward contract sets the exchange rate today between two currencies which will be delivered on a specified date in the future. but for delivery in six months time. However. Example: Today is 16th June. PMI will deliver 1. =============================================================== *Commodity Forward This sets the price of a commodity (such as gold) today. and the usual date for settling spot FX transactions is 18th June.500 to BMW.000. BMW will deliver EUR 10m to Citibank.
. with payment in three months. three-month LIBOR settles at exactly 7. and pay a fixed rate of 7. and then sell the EUR 1m at the prevailing spot rate. effectively converting the floating rate loan into a fixed loan at 7.On 16th September. Every six months. borrowing $10m at LIBOR+50bp. If the US exporter does nothing to hedge the currency exposure. =============================================================== *Using Forward Contracts to Speculate Forward contracts are often used to take a speculative position in pursuit of profit. he would wait until he receives payment. The dollar proceeds will depend on the spot rate at the time.00% on $10m. Phico Inc has just arranged a long-term loan. agreeing to sell the EUR 1m and buy dollars. =============================================================== *Using Forward Contracts to Hedge Forward FX contracts are often used by companies to hedge a future receivable or payable denominated in foreign currency Example: A US exporter has sold EUR 1m worth of cars to a European customer. reset every six months. Phico enters into a swap transaction with Bank of America. and Ford will have to borrow its $100m 50bp more expensively than it anticipated.388. Under the FRA. at a rate fixed today of EUR1 = $1. Example: Today is 16th June. =============================================================== *Long-Term Interest Rate Forwards An Interest Rate Swap (IRS) guarantees a fixed interest rate for a specified long-term period in the future. To avoid the FX risk.4 The exporter is no longer exposed to FX risk. whereby it will receive interest payments at the six month LIBOR rate on $10m. the exporter could execute a three-month forward deal. Phico exchanges interest payments with BofA. The extra interest cost will be $126. Chase pays Ford a settlement sum to offset exactly this extra cost.50%.00%. because the dollar proceeds are fixed today.89.
80 per oz. Action Buy 100oz of gold at $895 per oz. Action Sell 100oz of gold at $921 per oz.75 per oz. Instead. Example: Scenario at Start Gold Prices Spot: One month forward: Three months forward: $890. The profit is locked in. I can lock in my profit by executing a second forward contract.00 per oz. Analysis I expect the price of gold to rise over the next three months. Given a view. . $895.50 per oz. $923.75 per oz. Scenario after Two Months Gold Prices Spot: One month forward: Three months forward: $919. though it will not be received until both contracts mature. This is a forward gold contract. $921.00 per oz.The speculator usually has no underlying commercial transaction. I want to profit from this view. Sell short using a forward contract if a fall in price is expected. This is a second forward gold contract. and therefore does not intend to take delivery. the strategy is straightforward: Buy using a forward contract if a price rise is expected. Analysis I was right! Gold has risen in price. $891. Even if I did. for delivery in one month. I don't want to store it. I don't have the money to buy gold now. speculative forward contracts are often closed out by executing a second forward contract in the opposite direction to the first contract. for delivery in three months.
500. Analysis Although gold has fallen in price over the last month. The speculator has made a profit of $2. The Swap contract *Outright Forward Contract The two parties agree to exchange currencies on a specific future date. . Example: Deutsche Bank agrees today to sell BMW EUR 1m in exchange for receiving USD $1.60 and he executes a forward purchase at this price.Scenario after Three Months Gold Prices Spot: One month forward: Three months forward: $905.650 will be paid when the contracts mature.000. Deliver 100oz of gold under the second forward contract receiving $92. The total profit of $2. the exchange to take place in three month's time.650 that he will receive in two months Yes.50 per oz.50 per oz.357. it does not affect my profit Action Take delivery of 100oz of gold under the first forward contract paying $89. Profit is therefore $2. =============================================================== *Quiz A speculator believes that the price of WTI Crude oil has risen too far and is likely to fall.25 per barrel. =============================================================== *Types of Forward FX Contract There are two principal type of FX contract: The Outright Forward contract.60. He is quoted $58. $906. The speculator sells short 1.. He checks the price of a three-month forward contract and is quoted $61.000 barrels forward at this price. but at an FX rate agreed today.25 and buying low at $58.65 per barrel by selling high at $61. Which of these statements are correct? The speculator has made a profit of $2.20 per oz.600.100. After one month the price has fallen and the speculator checks the two months forward price. $909.
=============================================================== .000 right now. and to exchange them back again on a specific future date.*Swap Contract The two parties agree to exchange currencies now. and to sell EUR 1m back to Citi in three month's time receiving $1.357. all at FX rates agreed today. Example: Deutsche agrees today to buy EUR 1m from Citi and pay USD $1.000.350.
as they sound quite similar – "Currency" Swap and "FX" Swap. It is easy to get the last two mixed up. There are Interest Rate Swaps. =============================================================== . and binds GM to pay Citibank $920. and FX Swaps. GM is concerned that the Japanese Yen may strengthen over the next three months – if it waits until then. it may have to pay more. A second use of forward contracts is by speculators who wish to exploit their view that the future exchange rate between two currencies will be different from today's forward rate. The contract binds Citibank to deliver ¥100m to GM. In this course. GM enters into a forward FX contract with Citibank today. and is characterized by an exchange of currencies on just two dates. and buys the Yen on the spot FX market. The shipment is due in three months time. both payments to be made in three months time. The word "swap" is an over-used word in finance. Currency Swaps. This is the oldest of the "swap" transactions.500. we will be looking at the FX Swap. Example General Motors has placed an order for steel with one of Japan's largest steel producers. and GM will then need to pay ¥100m. Later courses will look at interest rate and currency swaps. =============================================================== *Using Outright Forward Contracts Outright forward contracts are mainly used by corporations to hedge the foreign exchange risk in a future receivable or payable denominated in foreign currency.*FX Swaps and Currency Swaps First. Instead. What distinguishes these transactions is that there are exchanges of payments on multiple dates. a word of caution.
Yes. assuming your customer's view is right =============================================================== *FX Swap Terminology FX swap traders never say that they are “buying a swap” or “selling a swap”. and I buy USD on the far date both against Euros. . Which of the following actions would you advise? Wait two weeks until the Yen weakens. it means that the near date is spot (by default) and the far date is three months after spot. Your customer expects the Yen to weaken in the next two weeks and then to strengthen. then enter into a six week forward contract to buy Yen. and I sell Euros on the far date both against US dollars.*Using Forwards – Quiz You work on the Corporate Desk for Bank of America and you take a call from a customer who tells you that they need to pay for imported computer components from Japan in two months. Pass your mouse over these buttons to follow through a worked example dayby-day. Because swap transactions involve buying and selling of both currencies at different times. simply referring to "buying" or to "selling" would be ambiguous. The Japanese company wants to be paid in Japanese Yen. Instead. this will be the optimal time to execute the forward transaction.. traders say: “I buy and sell Euros against US Dollars” or: “I sell and buy US Dollars against Euros” This means: I buy Euros on the near date. or: I sell USD on the near date. Your customer is happy to remain exposed to the exchange rate risk for a short period of time.. If a trader says: “I sell and buy US Dollars against Euros” . =============================================================== *Using Swaps to Manage Cash Flows One of the most common uses for FX swap transactions is by banks managing short-term cash flows.
Tuesday The spot FX rate has not yet moved.000 cost of executing the Tom/Next Swaps. less $2. To handle the remaining cash flows. but the trader still wants to maintain the position. She buys EUR 10m paying $14m. Our trader executes a spot deal. To handle this cash flow. Here is an example: This Morning A trader believes that three-month US interest rates will rise this afternoon.2m. she executes a Tom/Next swap. She therefore decides to execute a 3m swap. and buys back the EUR 10m for $14. settlement will take place after two business days. Wednesday The spot FX rate has finally strengthened to $1. selling EUR 10m for $14. on Wednesday. she executes a second Tom/Next deal.000 from the strengthening of the spot rate. As this is a spot FX transaction.Example: Monday A trader thinks that the spot FX rate for the Euro will strengthen against the dollar. selling the Euro spot and buying the Euro forward. because she still thinks that the Euro will strengthen. value Friday. and buying back the EUR 10m for $14. Total profit is $198.001m value the next day (Thursday).2m. selling EUR 10m for $14m value tomorrow (Wednesday).42. It is therefore possible to exploit a view on interest rates by using FX swaps. The forward leg of the swap transaction involves buying Euros at $1. She knows that such a move will strengthen the forward Euro relative to the spot rate. The problem is that Monday's spot deal will settle tomorrow. .3533 per Euro.000. =============================================================== *Using Swaps to Speculate on Interest Rates In the next section we will see that forward foreign exchange rates are influenced by interest rates in the currencies concerned. This rolls Wednesday's cash flows into Thursday.201m value the next day (Friday). This is the $200. selling EUR 10m value tomorrow (Thursday) for $14.
She therefore buys and sells the Euro.as the diagram opposite shows.000 on the pair of swaps. =============================================================== . This Afternoon US interest rates did rise! The trader decides to close out the position by executing a swap in the opposite direction.3550. This secures a profit of $17. the forward leg enabling her to sell the forward Euros at $1. which will be realized when the two swaps settle in three months time.
The forward price is then the sum of the original cash price and the cost of carry (i. and selling dollars against Euros forward =============================================================== *Pricing Forward Contracts In this section we will investigate how to price: • • • Commodity forward contracts FX outright forward contracts FX swap contracts • Most forward contracts are priced using one of two methods: • • Cash and Carry pricing Arbitrage pricing "Cash and Carry" pricing can be applied to any forward contract on a physical commodity that can be bought for cash right now. We have two broad alternatives: Wait for three months. The disadvantage of the first alternative is that we are exposed to fluctuations in the price of gold over the next three months.e. Three-month I/R: 6% . On the next page we will look at the pricing of a gold futures contract as an example. and stored or held until the forward delivery date. and buy the gold in the cash market at the then prevailing price.*Using Swaps – Quiz What does the statement "I sell and buy Euros against dollars in the 3s" mean? I do a swap. Buy the gold now. financing. The second alternative avoids this risk. buying dollars against the euros spot . and then deliver it. "Arbitrage" pricing can be applied to any forward contract where it is possible to duplicate or synthesize the forward contract by using other contracts or transactions where the price or rates are already known. but it means that we Market Data Spot gold price: $900 per oz. keep it for three months. selling Euros spot and agreeing to buy them back three months later at a fixed rate • I execute a swap. or service costs). We will illustrate this idea shortly by illustrating how to price a forward FX contract. storage. =============================================================== *Pricing a Commodity Forward Suppose we have been asked to deliver 100oz of gold in three months time.
have to buy the gold now and store it.59. Let's explore the cost of this alternative. What should you quote per ounce as the fair price for the six-month (180-day) forward contract in gold? The forward price should be $924. Look at the diagrams opposite to see how the cash flows from the FX outright forward deal can be duplicated exactly by cash flows from this trio of other deals. You have been asked to quote the price of gold for delivery in six months time (180 days). . As the diagram shows. per year for safe storage of gold (including insurance cover).50% per annum.59) =============================================================== *Pricing FX Outright Forward Contracts The principle behind pricing an FX outright forward is to observe how it can be duplicated by a combination of three other financial transactions: A spot FX transaction. So the least we could charge for threemonth gold is $913. and a reputable depository will charge you $1 per oz. A borrowing in the other currency.065 × (180/360)) + $0.50.. This is the forward price of gold. *Outright Forward An outright forward deal involving: Buying EUR and selling USD 90d forward can be created synthetically. we need to take into account the cost of financing the purchase of gold over the three month period.. =============================================================== *Pricing a Commodity Forward – Quiz Gold is currently trading at $895 per oz. ($895 × (1 + 0.50.50 = $924. Six-month interest rates are 6. an interest cost of $13. A loan in one currency.
*Synthetic Forward An outright forward deal involving: Buying EUR and selling USD 90d forward can be created synthetically by: Buying EUR and selling USD spot.3533. =============================================================== .010. and Borrowing USD for 90d The fair outright forward rate is the FX rate that equates the two final cash flows.000 = 1. and Lending EUR for 90d.875/1.366. and this is the outright forward rate. In the example. 1.
.*Formula for Pricing FX Outright Forwards The relationship between: the spot FX rate the interest rate in one currency the interest rate in the other currency the outright forward FX rate . however. to obtain an intuitive feel for this link. The key fact to remember is that interest rates and the forward FX rate are inversely .3500 4% 5% =============================================================== *Link between Interest Rates and the Forward FX Rate The formula on the previous page provides an exact relationship between interest rates and the forward FX rate. It's important.. can be summarized in the equation: Outright Forward FX Rate Example Spot FX Rate EUR/USD: 90-day EUR interest rate: 90-day USD interest rate: EUR 1 = USD 1.
the weaker is its strength in the forward market. so the forward Euro is higher than the spot Euro. In the other case. The diagrams on this page show two contrasting situations. The higher the interest rate in a currency. In one case. the opposite is true. the Euro interest rate is lower than that of the dollar. =============================================================== .related.
5%.0625 × 180/360) =============================================================== *Swap Points The FX outright forward rate expresses the absolute exchange rate between a pair of currencies for a particular forward date.e. To avoid dealers having to revise their quotations every few seconds. and so does the forward rate in step.25%.58 Calculated as 105 × (1 + 0.=============================================================== *Pricing FX Outright Forward Rates – Quiz Ques: Dollar six month interest rates are 6.0150 × 180/360) / (1 + 0. the difference between: the outright forward rate. The FX outright forward rate is influenced by: the spot FX rate the interest rate in the base currency the interest rate in the pricing currency The spot FX rate fluctuates from moment to moment. Calculate the six-month (180-day) outright forward FX rate between dollars and yen. banks find it more convenient to quote the relative exchange rate.00. and the spot rate . while Japanese Yen six-month rates are 1. Ans: $1=¥102. The spot FX rate is quoted at $1=¥105. i.
and is relatively stable. *Formula for Swap Points =============================================================== *What is a Future? a legally binding contract to take or make delivery of a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future In other words: A futures contract fixes the price NOW for a transaction that will take place in the FUTURE =============================================================== *Key Features of Futures Contracts . even when the spot rate fluctuates.This difference is called the swap rate.
The largest are the CME Group (in Chicago). or by electronic order matching on a screenbased system. An example of this is shown later. The futures exchanges create an orderly market and regulate all aspects of trading. dates. and profits and losses settled the next day. Price Unlike the OTC market – where deals are bilateral between two parties and are not disclosed – trading on futures exchanges is completely transparent. There are. EUREX (in Germany). Together. Standardization of Contracts Futures contracts are completely standardized. Whether by "open outcry" on the trading floor of the exchange. on the other hand. and Euronext-LIFFE (in London). and calculating the profit or loss that would arise if the position were liquidated at current prices. Trades are executed at the best possible price with all transactions being visible. the definition of what is acceptable to deliver – are rigidly prescribed by the futures exchange. and the profits or losses arising are settled in cash the following day. All futures contracts are marked-to-market daily.So far. The parties to a futures contract are subject to margin requirements. Margin Requirements Each party to a futures contract must lodge an initial margin with the exchange. the description of a futures contract may not sound so very different from a forward contract like an FRA or an FX outright forward transaction – both of these being OTC (over the counter) contracts written by banks. OTC contracts with banks. and it is possible to negotiate and agree any of these details. users obtain the best possible prices. Futures contracts are highly standardized. however. a number of features which make futures contracts different: Trading takes place only at a number of recognized futures exchanges. Futures Exchanges There are now around 80 futures exchanges around the world. are completely flexible. and then . Positions are marked-to-market daily. Marking-to-Market The process of marking-to-market involves comparing the book value of an instrument with its current market value. There is no possibility to negotiate any details – all aspects like amounts. they account for around a billion trades each month. and the price of all trades is visible to everyone.
This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times.adjust the level of this margin account with daily flows of variation margin as profits or losses are incurred. For example. however. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation. such as a financial crisis. The result would be a lowered shareholders' equity. Investopedia explains Mark To Market .MTM 1. but there is no settlement of profits and losses. =============================================================== *Notes: There is difference between the daily marking-to-market of a futures contract and the daily marking-to-market of an OTC forward contract. There is no such guarantee with OTC contracts. This issue was seen during the financial crisis of 2008/09 where many securities held on banks' balance sheets could not be valued efficiently as the markets had disappeared from them. There is no such requirement with OTC transactions. 3. the current selling price of a bank's assets could be much lower than the actual value. the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation. The futures exchange assumes the counterparty risk. 2. and no payments take place until the contracts mature. The accounting act of recording the price or value of a security. where contracts are exchanged at the outset. Counterparty Risk The futures exchange guarantees the performance of a futures contract in case one party defaults – effectively assuming the counterparty risk. . such as assets and liabilities. if the liquidity is low or investors are fearful. In April of 2009. starting in the first quarter of 2009. A measure of the fair value of accounts that can change over time. =============================================================== *What Does Mark To Market . When the net asset value (NAV) of a mutual fund is valued based on the most current market valuation. With futures there is a daily settlement of profits and losses. mark-to-market often takes place daily.MTM Mean? 1. Problems can arise when the market-based measurement does not accurately reflect the underlying asset's true value. With OTC contracts. where each party must consider the creditworthiness of the other party with whom it is dealing. portfolio or account to reflect its current market value rather than its book value.
Trying this with an OTC contract would still leave two equal and opposite transactions in place. administer. 3. This completely eliminates the original position. Mutual funds are marked to market on a daily basis at the market close so that investors have an idea of the fund's NAV. Cash settlement – where only the difference in value between the original contract price and the final closing price is paid. This means that counterparties need not be worried about the financial standing of the other party to the contract. If the current market value causes the margin account to fall below its required level. After every trade is executed between members. not as a source of supply of the underlying commodity. In practice. =============================================================== *Physical Delivery is Unusual Even when a contract permits physical delivery. =============================================================== *Physical Delivery vs. the Clearing House effectively interposes itself between buyer and seller. cash settlement is still by far the most common outcome. and two deal settlements at maturity. This is done most often in futures accounts to make sure that margin requirements are being met. Hedgers use futures contracts as a means to provide protection against adverse price movements. an entity established to process. positions in futures contracts are: . and clear all trades. the trader will be faced with a margin call. and removes all further obligations. because it does not matter. =============================================================== *The Clearing System An important feature of futures contracts is the role of the Clearing House. and a user needs the underlying commodity. Cash Settlement There are two ways in which the maturity of futures contracts can be handled: Physical delivery – where the party who is short the futures actually delivers the underlying commodity.2. and becomes responsible for guaranteeing the execution and settlement of the deal to both parties. The fact that the Clearing House becomes the "other party" to a futures contract after the trade makes it very easy to close out a futures position – just execute a trade in the opposite direction.
If a position loses money. In either case. Members opening new positions deposit an initial margin. long eurodollar against short T-Bill contracts. ensuring the performance of all contracts. The daily mark-to-market allows profits to be realized in cash each day. They are intended solely to . Initial Margin The initial margin may be deposited either as a cash deposit. Margin is deposited both by buyers and sellers of futures. Here's how it works. the margin account will be credited. this will result in a margin call. requiring the member to make good the deficit. and the surplus can be withdrawn in cash. If a position makes profit. The margin account is intended to protect the Clearing House in case a member should default. but requires losses to be made good each day in cash. Size of Margin Exchanges set out the margin requirement for each contract. The mechanism behind this is the margining system. rather than resulting in physical delivery. Margin is a performance bond. or in the form of interestbearing securities. the larger the margin requirement will be. Subsequent variations in market prices give rise to flows of variation margin. for example. Variation Margin Variation margin is usually paid or received in cash. The size of the margin depends upon the size and nature of futures positions.Prior to Maturity – reversed or rolled forward into the next delivery month. If the margin account falls below a specified level. The more volatile the underlying price. Margin as a Performance Bond It is important to remember that futures margins are not intended as a down-payment towards the eventual purchase of the underlying commodity. At maturity – cash settled. the member is entitled to benefit from any interest earned on margin balances. the margin account will be debited. =============================================================== *Margining We have so far seen that futures contracts have an number of unique features: The Clearing House acts as guarantor. Many exchanges reduce the margin requirement for offsetting positions in related contracts.
=============================================================== . The Initial Margin in this illustration is $2. The fact that per contract margins are usually a tiny fraction of the face value of the underlying commodity means that futures provide a highly cash-efficient way to hedge risk or to speculate.25 (1/32nd of the $100. you should remember the following: T-Bond futures in Chicago are quoted in points and 1/32nds. To understand the example. The size of margins should normally be adequate to meet the maximum likely daily loss. the table at the bottom of this page provides an example over five successive days in the life of a new T-Bond futures position. the Clearing House has the right to immediately liquidate the member's positions. and meet losses from the remaining funds in the margin account. =============================================================== *Example of Margining To illustrate how the margining system works. 2.50 in decimals. Default In the unlikely event that a member of the futures exchange should default on payment of a margin call. So 102-16 means 102 16/32 or 102. The value of each tick movement in market price is $31.protect the Clearing House against losses that might be incurred if a member were to default.000 face value) =============================================================== *Notes: 1. the whole profit or loss is received or paid when the contract matures. With a futures contract. There is a Maintenance Margin in this illustration of $1. With an OTC contract.025 for each contract. profits and losses are received and paid through the daily flows of variation margin.500 for each contract.
=============================================================== Definition of an FRA An FRA is: An agreement between two parties One party – the FRA buyer – is a notional borrower.*Forward Rate Agreements In this course we will explore Forward Rate Agreements (FRAs). This substantially reduces counterparty risk when compared to contracts like FX forwards and swaps. An investor may fear lower rates. A borrower may fear higher rates. . The other party – the FRA seller – is a notional lender. a small cash payment from one party to the other provides complete settlement of both parties' interests under the agreement. The second point is a significant difference. =============================================================== *How and Why FRAs are Used There are two principal reasons why companies and banks use FRAs. FRAs are forward agreements on interest rates rather than FX rates or commodity prices FRAs are derivative instruments. These are forward contracts. Hedging Speculation Hedging An FRA user may wish to obtain protection against future changes in interest rates. but they differ in two main respects from the forward agreements like FX forwards. Unlike FX forward contracts – which result in the ultimate delivery of the underlying commodity or currencies – FRAs are contracts for differences. The notional loan covers a period in the future. Instead of actual delivery of the underlying commodity. Hedging Example: A company needs to borrow $1m for a 90 day period starting in three months.
75% FRA rate.000 profit. being the 50bp difference between the 6. Situation in three months 3m interest rates have fallen to 6. =============================================================== Features and Terminology of FRA Contracts The key features and terminology of an FRA are: The FRA fixes the interest rate for both parties over a specified contract period.75% 3 x 6 FRA rate: 5. The notional loan is for a specified contract amount and denominated in the contract . Market rates now Current 3m offered rate: 6.Market rates now Current 3m offered rate: 4. If that view differs from that of the market. The fixed interest rate is called the contract rate.25%. Fortunately. The FRA involves a notional loan. The company will have to borrow at the higher prevailing rates and pay extra interest of $2. the FRA will compensate the company for this extra interest cost.75% Action now The fund sells a 3 x 6 FRA on $100m at a contract rate of 6. The investment fund will receive about $125.50% 3 x 6 FRA rate: 6. and the final 3m rate. There is a shorthand terminology to describe the contract period.00% Action now The company buys a 3 x 6 FRA on $1m at a contract rate of 5. FRAs can be used to exploit that view. Speculation A user may have a view on the way that future interest rates will evolve.00%. even though the market believes otherwise. Speculation Example: An investment fund believes that US interest rates in three months time will be lower than at present.75%. for a three-month period. Situation in three months Interest rates have risen to 6.500 (1% on $1m for three months).00%.
The FRA provides rate protection through the settlement sum. The size of the settlement sum depends upon the reference rate. Contract Period The specified period in the future which the FRA covers. there are standard periods covering three. the contract amount and currency should match the size of the underlying exposure. When FRAs are used for hedging. When FRAs are used for hedging. and twelve-month contract periods up to two years in the future. six. and can cover any contract period desired by the parties. Terminology Practitioners normally abbreviate the contract period to a pair of numbers like "3x6". the contract amount and currency should match the size of the underlying exposure.currency. and used in the calculation of the settlement sum. This means that the contract period starts three months from now. Contract Rate The fixed interest rate agreed at the outset by the two parties. A "1x7" FRA covers the six-month period starting in one month. Contract Amount This is the amount of notional principal defined in the FRA contract. However. FRAs are OTC instruments. . and written into the FRA contract. they must make arrangements (perhaps with a bank) to fulfill their requirements. and finishes six months from now. Notional Loan No actual lending or borrowing actually takes place under the FRA contract. If one or both parties to the contract do have funding or investing requirements. nine. Contract Currency This is the currency in which the contract amount is denominated. • The FRA seller fixes the interest rate for lending or investing. The contract rate covers a specified time period in the future. Fixing the Interest Rate Both parties are locked into the rate they agree under the FRA: • The FRA buyer fixes the interest rate for borrowing or funding.
6. As an example. Spot Date By convention. including the contract rate. where "time zero" is the spot date. Trade Date On this date. Fixing Date On this date. normally two working days after the trade date. Settlement Date . Standard FRA contracts use contract periods of 3. both parties agree to all the terms and conditions of the FRA. starting a whole number of months after the spot date. and used to calculate the settlement sum. Under FRABBA terms. the reference rate is the published 11am LIBOR fixing rate for the relevant time period. 9. the contract period. or 12 months. usually by reference to a generally accepted and well-publicized market rate like LIBOR. The market interest rate eventually transpiring. FRAs follow the normal convention for most financial transactions. a 3x6 FRA would cover the time period starting three months and finishing six months after the spot date. the reference rate is determined. All standard maturities are counted starting from the spot date. and confirmation of how the reference rate will be determined. Reference Rate This is the market-determined rate which is compared to the original contract rate. The fixing date is normally two days before the start of the contract period Contract Period The future time period covered by the FRA contract.Settlement Sum This is the cash sum paid by one party to the other to compensate each one for the difference between: The interest rate originally agreed. =============================================================== Key Dates The key dates in the life of an FRA contract are pictured in the diagram below.
00%.500. As a result. The company has bought an FRA at a contract rate of 5.500 of interest calculated as: This extra interest cost is actually incurred on the final maturity date. The size of the settlement sum will already have been determined on the fixing date.00%. =============================================================== *Settlement Sum Formula FRA Settlement Sum Formula . If the FRA settlement sum was paid on the same date.By convention. it would be the same amount – $2. the settlement sum is paid on the settlement date – which is at the beginning of the contract period – rather than on the final maturity date. the company will pay an extra $2. =============================================================== *Calculating the Settlement Sum The settlement sum is designed to compensate an FRA user for the difference between the contract rate and the reference rate eventually prevailing. Let's go back to the hedging example we saw earlier. two days earlier. but the reference rate is now 6.
and how the FRA provides an accurate hedge to cover short-term interest rate risk. This compensates notional borrower for higher borrowing rates. =============================================================== Who Pays Whom? We have seen how to calculate the settlement sum. If the same settlement sum – as calculated on the previous page – were paid out at the beginning of the contract period. resulting in the formula opposite. but it is important to remember who pays whom. the settlement sum is reduced or discounted by the amount of this extra interest.Conventionally. which is at the beginning of the contract period. the recipient would have the advantage of being able to earn interest by investing the settlement sum until it was needed at the end of the contract period. not the end. however. Reference Rate < Contract Rate . To rectify this. It all depends on whether the reference rate is higher or lower than the FRA contract rate. Reference Rate > Contract Rate Settlement sum is paid by seller to buyer. The next page provides a fully worked example showing how the settlement sum is calculated. the settlement sum is paid on the settlement date.
Settlement sum is paid by buyer to seller. Value the stream of dividend payments made by the company. =============================================================== *Equity valuation Equity valuation is all about answering the question: What is a company worth? There are a number of different ways of approaching this problem. include the capital investment Operating Profit Ratios. and dividends. there are several approaches to equity valuation – including methods based on accounting concepts like earnings and assets. required to generate the profits. Future free cash flow after Concept is valid. capital requirements. Present value of future Dividends are discretionary. very difficult to forecast. Base the analysis on accounting concepts such as “Earnings” or “Assets”. Does not Price/Earnings Ratios (P/E). Pass your mouse over the methods listed in the table below to see a comparison of the different techniques. and working capital. and cash flows. Use Discounted Cash Flow (DCF) analysis to assess the ability of a firm to generate excess cash flow beyond that which is needed to fund its operations. Book Value. Does not consider future growth or Cash Flow Multiples. =============================================================== FRA Buyer's Viewpoint FRA Buyer is protected against higher interest rates. FRA Seller's Viewpoint FRA Seller must pay if rates rise. but required data considering capital expenditures can be difficult to estimate. dividend payments. Replacement Does not consider profits. This compensates notional investor for lower investment rates. Approach Methodology Shortcomings Earnings are not cash. Value. =============================================================== *Basic Valuation Concepts As we saw from the previous page. =============================================================== *Choosing a Valuation Method • • • .
net of the investment required to generate those earnings. The contract offers the buyer the right. Adjusting the size of the anticipated cash flow – the greater the uncertainty. Uncertainty with respect to the probability of a cash flow occurring can be addressed either by: Adjusting the discount rate – the greater the uncertainty. which is why the probability of the cash flow occurring is one of the four variables that we must consider. It provides for an objective method for recognizing the cost of capital. =============================================================== *What Does Option Mean? A financial derivative that represents a contract sold by one party (option writer) to another party (option holder).Most analysts believe that the DCF methodology provides the best approach to valuation for the following reasons: It is not dependent upon accounting measures of earnings or assets. but not the obligation. It includes only cash “earnings”. the smaller the cash flow. =============================================================== *Principles of Valuation The present value of any future cash flow is influenced by four variables: Quantity What is the size of the cash flow? Probability What is the probability that the cash flow will actually occur? Timing When will the cash flow occur? Discount Rate What discount rate (interest rate) should be used to use to calculate the present value of the cash flow? Unlike a bond. . It recognizes the time value of money. the cash flows from equities are uncertain. the bigger the discount rate. to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
For this reason. break even). Short Options Here we contrast the values for: a) the holder of an option to buy 100 shares. who is "short options" You can see that: Option holders have unlimited possibilities to gain. which is a relatively risky practice. while hedgers use options to reduce the risk of holding an asset. an option writer that sells a call option believes that the underlying stock's price will drop relative to the option's strike price during the life of the option. For example. Instead. the buyer will be able to acquire the stock for a lower price and then sell it for a profit. The option buyer clearly has better prospects! =============================================================== *Option Premiums If options came free. who is "long options" b) the writer of an option to buy 100 shares. because if this happens. option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security. the buyer must pay the seller a premium to acquire the option. as that is how he or she will reap maximum profit. break even). In terms of speculation. and sellers would only suffer losses (or at best. Buyers would only be able to gain (or at worst. The buyer believes that the underlying stock will rise. =============================================================== *Long vs. Traders use options to speculate. because the option writer will need to provide the underlying shares in the event that the stock's market price will exceed the strike. Investopedia explains Option Options are extremely versatile securities that can be used in many different ways. This is exactly the opposite outlook of the option buyer. options don't come free.Call options give the option to buy at certain price. =============================================================== . with no possibility to gain. with no possibility to lose. Option writers have unlimited possibilities to lose. so the buyer would want the stock to go up. so the buyer would want the stock to go down. everyone would want to buy them – nobody would want to sell them. Put options give the option to sell at a certain price.
Investors who "write" covered calls or puts use option premiums as a source of current income in line with a broader investment strategy to hedge all or a portion of a portfolio. Other Products – Summary Options: The buyer of an option has a right but not the obligation to perform. The buyer of other products acquires rights and obligations and thus pays no premium. =============================================================== *Call Options A call option grants: the right to buy a given quantity of an underlying asset at a given price on or before a specific date Note: An option grants a right. Buyers and sellers of other products have symmetrical opportunities and costs. The seller of other products acquires rights and obligations and thus pays no premium.*What Does Option Premium Mean? 1. 2. the premium is quoted as a dollar amount per share and most contracts represent the commitment of 100 shares. but does not impose an obligation. The income received by an investor who sells or "writes" an option contract to another party. Investopedia explains Option Premium 1. shares.g. The current price of any specific option contract that has yet to expire. The buyer of an option acquires rights and pays a premium. Call options offer investors a way to leverage their capital for greater investment returns. =============================================================== *Options vs. =============================================================== . Buyers and sellers of options have asymmetric opportunities and costs. For stock options. bonds. futures): The buyer (and seller) of other products have both the right and the obligation to perform. For a call option. the right granted is the right to buy the underlying asset. Other Instruments (e. The seller of an option grants rights and receives a premium.
the right granted is the right to sell the underlying asset... =============================================================== *Exercising Options If a call option is exercised: the call buyer pays the agreed price the call seller delivers the underlying asset If a put option is exercised: the put buyer delivers the underlying asset the put seller pays the agreed price =============================================================== *Underlying Assets Options can be written on a very wide range of underlying assets: Shares Bonds Foreign currencies Bills Commodities You can also obtain options on derivatives and market indices. but does not impose an obligation. Put option allow investors to hedge an investment they own or speculate in an investment they don't own. For a put option. FRAs Futures Swaps Stock indices .*Put Options A put option grants: the right to sell a given quantity of an underlying asset at a given price on or before a specific date Note: An option grants a right.
2. some more definitions: . Right. If I sell a call option. BUY the underlying asset and PAY the agreed price. I: BUY the underlying asset and RECEIVE the agreed price. (to a buyer) The "flavor" of the option determines what you can do with the underlying asset. Put options give the buyer the right to ______ the underlying asset. Selling It can seem a bit confusing at first. Put options are all about the right to sell the underlying asset. I may end up having to deliver the underlying asset. You can buy or sell either "flavor": The option buyer has the right to decide whether to exercise the option. 1. Options come in two "flavors": Call options are all about the right to buy the underlying asset. 3. SELL the underlying asset and PAY the agreed price. Buying or selling is all about rights and obligations. Puts. SELL the underlying asset and RECEIVE the agreed price. Sell =============================================================== *Exercising an Option First. and options in turn give you the right to buy or sell the underlying asset. The option seller has the obligation to honor the decision made by the option buyer. You can buy or sell call or put options.You can even get an option on an option! =============================================================== *Calls vs. =============================================================== *Notes 1. If I sell a call option. When I exercise a call option. It's easy to remember the differences if you remember two basic rules. so I would end up having to deliver. the holder has the right to buy the underlying asset from me. Buying vs.
If the underlying asset price is above the strike price. The strike price is normally fixed at the outset. while the other party delivers the underlying asset. in turn. And: Expiry Date or Maturity Date . thereby buying the underlying asset at the cheaper strike price. If the underlying asset price is below the strike price.. thereby selling the underlying asset at the higher strike price.. This. When an option is exercised. =============================================================== *In. one party pays the strike price. A call option gives the holder the right to buy the underlying asset at the (fixed) strike price. =============================================================== *Moneyness The moneyness of an option expresses whether or not the option is worth exercising. is the last date when an option can be traded or exercised. is the price at which an option can be exercised. Out.. it makes sense to exercise the call. it makes sense to exercise the put.. A put option gives the holder the right to sell the underlying asset at the (fixed) strike price. and At-The-Money Definitions: An In-The-Money (ITM) option is one that is worth exercising. . An Out-of-The-Money (OTM) option is one that is not worth exercising. depends upon the relationship between: the strike price the underlying asset price A call option is only worth exercising when the underlying asset price is above the strike price Correct.Strike Price or Exercise Price . A put option is only worth exercising when the underlying asset price is below the strike price Correct.
Time Value Premium less Intrinsic Value . =============================================================== *Intrinsic and Time Value Intrinsic Value If the option is In-The-Money: the difference between the underlying asset price and the strike price. If the option is Out-of-The-Money: zero Premium The total amount paid by the buyer to the seller to obtain the option.An At-The-Money (ATM) option is one where the underlying asset price equals the strike price.
Time Value is the true cost of an option.=============================================================== *How Much Should Time Value Be? To recap on Time Value: Time Value is the amount by which the total premium exceeds intrinsic value. The option buyer can defer the purchase or sale of the underlyin . The two reasons why an option buyer will pay for Time Value are: The option buyer can defer the decision whether or not to exercise the option.
For example.. Now. . if we want to answer the question: How Much Should Time Value Be? .Of these.. or even eliminate. For example. One component of Time Value is the value of having this right. =============================================================== *Floors A floor is a hedge which limits exposure to an adverse fall in the underlying market price. Time Value is greatest for options which have a Long time to expiry. =============================================================== *Option Spreads An option spread comprises: Buying one option Selling another option Both options must be of the same type. the first reason – the right to defer the exercise decision – is the most important. we need to answer the question: How Valuable is the Right to Defer the Exercise Decision? =============================================================== Notes: 1. This is because selling the floor brings in premium income to offset. 4. 2. both calls. i. a money market fund will be adversely exposed to lower interest rates. the cost of the cap. =============================================================== *Caps A cap is a hedge which limits exposure to an adverse rise in the underlying market price. 3. =============================================================== *Collars A collar is a combination of buying a cap and selling a floor. One component of Time Value is the value of having this right. An option gives the holder the right to defer the exercise decision. Borrowers use collars to hedge against rising interest rates more cheaply than buying a cap. a company borrowing money will be adversely exposed to higher interest rates.e. An option gives the holder the right to defer the purchase or sale of the underlying asset. Time Value is greatest for ATM Options.
but different dates Diagonal spreads involve buying and selling options with different dates and strikes =============================================================== *Option Straddles and Strangles An option straddle comprises: Buying a call Buying a put at the same strike price. An option strangle comprises: Buying a call Buying a put at different strike prices. You can buy straddles and strangles (by buying both options). Straddles and strangles are often used to take advantage of expected changes in volatility. but different strikes Vertical spreads involve buying and selling options with the same strike. =============================================================== *Definition of an Interest Rate Swap (IRS) An Interest Rate Swap (IRS) is an agreement between two parties whereby: Each party contracts to make interest payments to the other. or sometimes monthly) in the future.or both puts Spreads come in three main varieties: Horizontal spreads involve buying and selling options with the same date. quarterly. semi-annually. One party is the fixed rate payer (The interest payments are at a fixed rate deter-mined . The payments are made on a pre-determined set of dates (These are usually annually. The interest payments are based on a notional principal (This is only used in the calculation of interest payments. or sell straddles and strangles (by selling both options). but are calculated on different bases. The principal sum itself is never exchanged between parties in an IRS).
usually being linked to a market standard rate like LIBOR) =============================================================== *Eurocurrency and Interbank Deposits The term eurocurrency applies to a currency traded outside the country of the currency. and these are called eurodollar deposits. In this example. and the other side of the quotation is called LIBID (London Interbank BID rate). Most common are dollar deposits placed in London. =============================================================== *LIBOR and LIBID LIBOR is the offered rate – the rate of interest which a bank having surplus funds will wish to receive. This is the interest rate that a bank seeking funds will pay on deposits. A is the index payer (interest rate receiver) and B is the index receiver (interest rate payer). Instead of swapping a fixed rate of interest for a floating rate. with many financial contracts and transactions being linked to LIBOR. but with the key difference being what is swapped. sometimes even longer. standing for London Inter-Bank Offered Rate. an equity swap exchanges the returns from an equity index or equity product for a rate of interest.at the inception of the swap) The other party is the floating rate payer (The interest payments are at a rate determined during the lifetime of the swap. An interbank deposit is where one bank places funds on deposit with another. There is usually a 1/8% spread between LIBID and LIBOR. The rate of interest quoted for interbank eurocurrency deposits is called LIBOR. Banks usually quote a "two-way" price. and is one of the most important market rates. =============================================================== *Equity Swaps – A Definition An equity swap is similar to the interest rate swap previously described. . A eurocurrency deposit is therefore a deposit placed with a bank denominated in a foreign currency. usually for fixed periods ranging from overnight to six months.
Market and Regulatory Requirements: The trade and transaction reporting requirements. and the other stream is based on an interest rate.We can define an equity swap as being: A legal agreement between two parties – the index payer and the index receiver – to exchange cash flows or payments. One stream is based on the returns of an equity index or similar. Trade Confirmation and Affirmation: Getting the counterparties to confirm the trade details. =============================================================== Basically the overall flow of the pre-settlement process looks like this: Trade Capture Trade Validation Trade Enrichment Trade Report and Transaction report sent Trade Confirmation Trade Affirmation . Static Data: The importance and uses of static data when gathering trade details. =============================================================== The pre-settlement process comprises the following stages of the trade life cycle: Trade Capture: Ensuring the integrity and accuracy of the trade data as quickly as possible. Validation and Enrichment: Making sure the trade adheres to a set of preset business rules.
Combined. it enables the settlement and clearing of trades on all major US exchanges (like the NYSE and NASDAQ). Euroclear This organization is the product of a merger between two corporations: Euroclear. each country will have only one CSD (although there are some that split equities. but its client base is more custodial than market participant. and transaction processing such as clearing and settlement of securities. the UK CSD.Trade Instruction sent for settlement =============================================================== A Central Securities Depository (CSD) is an organization holding securities either in certificated or uncertificated (dematerialized) form. Euroclear provides cross-border transaction processing and clearance facilities on a global scale. and funds into separate CSD's). which by its very international nature enabled Crest to rightfully claim that it had more than just a UK dimension to its service provision. an organization akin to Euroclear based in Luxembourg. but was created from a merger between Cedel. Along with the National Securities Clearing Corporation (mainly for US Treasuries). Euroclear itself offers a number of services including: Trade confirmation/affirmation Trade instruction matching Settlement Valuation Custody Regulatory advice Clearstream Clearstream offers a range of services very similar to Euronext. Deutsche Borse Clearing. In some cases these organizations also carry out centralized comparison. based in Europe. In general. Clearstream The DTCC The Depository Trust and Clearing Corporation (DTCC) is the major US settlement and clearing agency. The physical securities may be immobilised by the depository. fixed-income. It too works on DVP. utilising an automated book-entry system. to enable book entry transfer of securities. or securities may be dematerialised (so that they exist only as electronic records). The UK CSD was focused primarily on the UK domestic market. The CSD will normally only have local financial institutions regulated in the country of the CSD as clients. and CrestCo. it can be seen that Euroclear has bought into the international market place of the UK. and the main German CSD. It offers services to all comers. The Central Counterparty . and Crest can offer its UK members access to the full range of Euroclear services for cross-border transactions.
With multilateral netting. and the seller will get their money. Netting With a central counterparty. but to the CCP instead of the original counterparty. However. However. this comes at a cost: each member of the scheme has to deposit with the CCP "margin" (a percentage of the trade value). The main benefit of using a CCP is the decrease in settlement risk. if a member defaults. When two market participants agree on a deal. and a fine and full recompense will be taken by the CCP. the number of cash and asset movements can be greatly reduced.000 ABC shares. This reduction in the number of transactions processed each day again reduces the risk of something going wrong. only one net movement of 50. and along with it. . all of a market participant’s trades in each security can be "netted" against one another. they "give up" their obligations to each other. For example. In this case. the Central Counterparty (CCP) has come to prominence. and sells 50.000 of them in a single day. an increased risk to participants of trade failure due to delay or default. This "giving up" of obligations is known as novation. but multilateral netting could simplify these to just a single net transaction. From this standpoint. the CCP guarantees that the buyer will get their stock at the agreed price. Each counterparty still has a duty to deliver the stock or cash.Many markets in recent years have seen the expansion of trade. thus increasing market confidence and increasing trade volume as a result. a market participant could do 100 trades in a single security with 20 different counterparties. Suppose a counterparty buys 100. reducing cost and risk at the same time. In order to minimize this risk. Multilateral – This netting agreement covers each participant’s trades across the entire market. A CCP basically guarantees a transaction. This reinforces DVP and prevents delays. After this happens. and the CCP becomes their counterparty. This is refunded once settlement has been completed. There are two types of netting: Bilateral – This is a netting agreement between a specific pair of counterparties. The CCP can rigorously enforce discipline whenever necessary. and the seller to every buyer. the "margin" payment is appropriated. the CCP effectively becomes the buyer to every seller.000 shares needs to be processed.
Agency Mortgage Backed – These are bonds issued by agencies such as Fannie Mae (FNMA) that are collateralised by the pooling of a number of home mortgage loans. such as the ECGD in the UK. Contractual Settlement Date (CSD) – the date contracted to settle – this can be different from the intended date. Federal Agencies– Various governmental agencies that issue debt to provide funds for some desired social or economic objective. In the US.Terms to remember are: Intended Settlement Date (ISD) – the date settlement is intended. whose purpose is to provide liquidity to the home mortgage market. or Finnvera in Finland. These discrepancies are known as “breaks”. JGBs (Japan). There are often tight regulations on reconciliation – making firms undertake the process frequently. The frequency depends on the firm's risk exposure and the type of business they are undertaking. . the Federal National Mortgage Association (Fannie Mae) is an example of such an agency. These are bonds issued by state and local governments. a derivatives fund will have to undertake reconciliation much more often than a straightforward blue-chip share fund. In general. Reconciliation Reconciliation is the process of checking the accuracy of the firm’s accounts. and the different records are then compared – or reconciled – to ensure any discrepancies are spotted and resolved. Municipals – Largely a US phenomenon. Also known as Government Bonds. etc. which exposes clients' money to much less risk. As most agency obligations are not directly guaranteed by the central government. Outside of the US. The accounts are adjusted as a result of the positioning process. Many countries have agencies to promote their exports. Actual Settlement Date (ASD) – The date the trade actually settles. and typically have favourable tax treatment for investors with regard to their interest payments. their credit ratings fall slightly below that of treasuries. For example. BTPs (Italy). Treasuries – Bonds issued by the central government of a country. as the ISD might be earlier than CSD. Bunds (Germany). these bonds may be known under different names such as Gilts (UK). these bonds command the highest credit rating of all bonds and therefore sell at the lowest yields for any given maturity.
Asset Backed – These are bonds collateralised by an underlying pool of assets. These can be further sub-divided into highgrade. A corporate bond that is not collateralised is called a debenture. It takes into account the fact that bonds have differing coupons. Types of Credit Risks ================ Credit Risk . two of which we explored in the previous examples. Corporate – Bonds issued by corporations. The Yield To Maturity In the bond pricing formulas. or the creation of additional loan provisions. Although an actual default has not happened yet. we used an annual interest rate to discount all the future cash flows to the present day. We can start illustrating how yield-to-maturity works by looking at three bonds. and investment-grade bonds are those with a credit rating of BBB or higher. but which offer investors a higher return to compensate. investment-grade. and each pays a 10% coupon annually. In bond pricing. and holds it until maturity*. they are not usually considered to be part of the fixed income market because their maturities are one year or shorter. this annual interest rate is given a special name – the yield to maturity (YTM). This will lead to a decline in the value of the assets affected. and high-yield debt. They are safer than other types of corporate bonds. but credit risk also applies to any asset or financial instrument having positive net present value. These bonds have a four-year maturity.. Money Market – While these are debt instruments. the perceived probability of default has increased. The yield to maturity is the rate of return that an investor will receive if he purchases the bond. because the pool of assets provides a dedicated and tangible source of income from which investors can be renumerated. and in all the examples we have just seen. is where the default by a borrower impairs the value of a bank's assets. like auto loans or credit card loans. Sovereign Risk . This most commonly applies to loans which go into default. High-yield bonds are those with credit ratings lower than BBB. High-grade bonds are those which have a credit rating of AA or higher.. and may be purchased at prices different from their face value. either through the widening of a credit spread. Credit risk also can arise when rating agencies announce a downgrade.
.. This can follow a change in the political climate or a military coup. Credit risk and counterparty risk are similar. Our bank re-hedges by selling €1m to FirstBank. an interest rate swap counterparty may default on an interest settlement payment..000. Settlement Risk . but the term credit risk is usually used when there is a partial or complete loss of principal. The impact can vary from the relatively minor. Bans on repatriation of profits – forcing banks to reinvest profits locally.. Time lags between payment and receipt.. arises when foreign governments impose new rules and regulations.. but where the principal is not at stake.1510 for delivery in one year. For example. Failures of clearing houses or other intermediaries When settlement risk occurs. there is a temporary or permanent loss of principal.. occurs when a counterparty to a financial transaction is unable or unwilling to honour its contractual obligations. Example Our bank buys €1m against dollars one year forward from a customer at €1=$1. locking in a profit of $1. However. but losses may still occur.9500. while counterparty risk applies when losses occur. This may be temporary or permanent.000. and hedges by selling €1m to LastBank at €1=$1. This may avoid the loss of principal. or exercise force majeure. Examples include: Imposition of exchange controls – limiting transactions involving the national currency. Types of Market Risks . to the complete loss of overseasdomiciled assets. Failures of electronic payment systems.... Pre-Settlement Risk . six months later. arises when a counterparty defaults before cash settlement is due to take place. arises when a bank fails to receive a cash payment when expected. so our bank now faces a loss of $200. Default or bankruptcy. and can be caused by: Errors in payment instructions. LastBank enters into bankruptcy. Appropriation of assets – a complete loss of assets caused by forcible takeover or force majeure.1500. but the exchange rate is now €1=$0. Counterparty Risk .
. or when currencies in which they have obligations strengthen. many instruments held by banks – like bonds and interest rate swaps – have valuations which are directly affected by the level of interest rates Currency Risk . FX rates have become much more volatile. and affects the value of assets and liabilities denominated in foreign currencies.. is the variation in profit or net worth caused by changes in the prices of individual shares. . and the burgeoning growth in international trade and investment. There may also be an indirect affect. The income from floating-rate loans. As with some of the other market risks.. while a bank will have to adjust the interest paid on savings accounts to remain competitive. agriculturals. will fluctuate with the level of interest rates. arises when FX rates fluctuate. or of the level of stock markets as a whole. for example. and equity derivatives held by the bank. Equity Risk . Banks will be adversely affected when currencies in which they hold assets weaken. when declining equity prices can affect the viability of a company to which the bank has loaned money. Fluctuations in stock prices will directly affect the value of individual shares.. First. Commodity Risk ..================= Interest Rate Risk Commercial banks are affected by interest rate risk in two distinct ways. equity risk has both a direct and an indirect impact. is the fluctuation in bank earnings and asset values caused by a fluctuation in commodity prices like metals.. share portfolios. Second. Currency risk also arises indirectly when changes in FX rates affects the competitive position (and hence viability) of organizations operating in different countries. and energy. With the abandonment of fixed exchange rates in the early-1970s. the majority of assets (like loans) and liabilities (like deposits) will be sensitive to interest rates.
In many ways, commodity risk is similar to equity risk, and may also have a dual impact. Some commercial banks are active in the commodity derivative market, offering derivative contracts linked to commodity prices. These instruments will be directly affected by fluctuations in commodity prices. A bank may also be affected if one of its borrowers is affected by commodity prices, e.g. the impact of oil prices on airline operations. Basis Risk ... is the variation in profit or net worth caused by changes in the relationship between two linked market rates. For example, corporate bond yields normally move in step with US Treasury yields, separated by a relatively stable spread. A bank may therefore hedge a long position in corporate bonds with a short position in US Treasuries. If interest rates generally rise, the loss on corporate bonds will be offset by the gain on the short Treasuries position. If the corporate bond spread unexpectedly widens, however, the hedge will no longer be valid, because the price of the two securities will start to move separately. Volatility Risk One of the most important variables required to price a financial option is the volatility of the underlying asset. This is a market-determined number influenced in part by the actual fluctuations in market prices measured objectively (historical volatility), and in part by the subjective judgement of traders assessing the likely future fluctuations in market prices (implied volatility). The value of a stock option, for example, is therefore affected both by the current level of equity prices, and the future fluctuations in these prices – making volatility a separate dimension of market risk. Objective of VaR VaR attempts to quantify: the maximum probable financial loss at a particular confidence level arising from a financial instrument or portfolio when exposed to changes in market rates over a specified period of time
Methods of Calculating VaR The first step in calculating VaR was to generate the distribution of net income statements for the instrument or portfolio over the specified time horizon. In fact, this first step is the most difficult process. Once this is done, slicing the distribution to give a 5% or 1% tail, and determining the loss at this point – which is the VaR – is relatively straightforward. Generating the distribution of net income is therefore the key to calculating VaR, and there are three methods for producing this distribution: Historical Simulation This uses a database of historical market price movements to develop scenarios of how market rates may evolve over the future time horizon. Each of these scenarios is eminently plausible, because it has already happened in the past. The bank's portfolio is valued under each of the scenarios to generate the set of net income statements, from which the VaR can be determined. Monte Carlo Simulation This uses a random number generator to produce thousands of possible scenarios for the way in which market rates may evolve over the future time horizon. By deriving the parameters for the random number generator from historical rate movements, the scenarios produced have the same statistical characteristics as those that have actually occurred in the past. The bank's portfolio is then valued under each scenario to generate the set of net income Parametric Approach This is quite different from the other two methods. By assuming that all market rates follow a normal distribution, it follows that the distribution of net income will also be normal, provided that the portfolio contains only linear instruments like FX spot and equity positions, and not non-linear instruments like options. It is then possible to calculate the statistical parameters of the net income distribution, thus determining the point at which the 5% or 1% tail starts, and hence the value-at-risk.
Historical Simulation Advantages A full valuation approach – so non-linear instruments are correctly handled. Simulated scenarios are based on actual price changes that have occurred – so are realistic. No assumptions about shape of distributions are necessary. Actual volatilities and correlations are embodied within the historical data – so basis risk is explicitly taken into account. Disadvantages Computationally very demanding, as every instrument must be revalued under every scenario. Does not consider scenarios that might have happened, but which didn't. Most implementations assume equal weights for oldest and newest scenarios. Events occurring before period covered by historical data are not included in analysis. Monte Carlo Simulation Advantages A full valuation approach – so non-linear instruments are correctly handled. Simulated scenarios can be based on any distribution supplied – not limited by historical data. An unlimited number of scenarios can be simulated (historical simulation limits numbers to the availability of historical data).. Disadvantages Computationally very demanding, as every instrument must be revalued under every scenario. Requires tens of thousands of simulation runs to obtain a stable result for VaR. Results for VaRs can differ from run to run owing to sparseness of scenarios in the extreme left- hand tails. Parametric Approach Advantages Easily copes with large numbers of instruments. Once cashflows have been mapped, VaR calculation speed does not depend upon portfolio size. Methodology is standardized. Volatility and correlation data is published and in public domain – can therefore be used as a market standard. Disadvantages Assumes that all market rates follow a normal distribution – "fat tails" are ignored. Assumes that all instruments have a linear payoff profile – convex instruments like options are handled badly. FX Swaps – Key Points
of which almost 50% comprises FX swaps. • Depositing the lower yielding base currency and borrowing the higher rate pricing currency loses money. Transacting FX swaps involves either buying spot offer and selling forward bid. and the majority of these are short-term FX swaps (with an original maturity of less than seven days). • This results in a FX loss. or sell and buy base currency against pricing currency. Earning the points refers to buying spot and selling forward at a higher rate. When the forward rate is higher than the spot rate (so the base currency is at a premium in the forward market) … Paying the points refers to selling spot and buying forward at a higher rate. • This results in a FX profit. . FX swaps are quoted as either buy and sell base currency against pricing currency. The FX market trades in excess of $4 trillion per day. or selling spot bid and buying forward offer. and are a method of quoting the forward rate. • The loss made on the FX trade is exactly offset by the money earned from the interest rate differential. • Depositing the higher yielding pricing currency and borrowing the lower rate base currency makes money. the opposite is true. • The profit made on the FX trade is exactly offset by the money lost from the interest rate differential. Swap points operate on a bid/bid and an offer/offer basis. FX swaps are mainly affected by the relative level of interest rates between the base and pricing currencies rather than changes in the FX rate.FX swaps involve the purchase (or sale) of spot FX and the simultaneous sale (or purchase) of forward FX. When the forward rate is lower than the spot rate.
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