BUS307 Topic 10 - Topic 10 Valuing Risky Debt I Bank Loans BUS307 Commercial Banking OVERVIEW Interest-rate options may be used to manage interest rate

BUS307 Topic 10 - Topic 10 Valuing Risky Debt I Bank Loans...

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Topic 10 Valuing Risky Debt I Bank Loans BUS307 Commercial Banking
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OVERVIEW Interest-rate options may be used to manage interest rate risk. Financial Institutions use options to hedge their exposure to interest rate changes, and also make the market in various option products.
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OVERVIEW Interest-rate options are available over-the- counter, and are traded on organized exchanges. They are written and purchased in various forms as stand-alone options, incorporated in loans issued by financial institutions, or implicit options that are embedded within interest – rate instruments. This topic will focus on the features and pricing of the main interest – rate options, specifically, options on bonds, futures options, caps, floors and collars.
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OPTION PAY-OFFS The payoff from interest-rate options resembles the payoff from options on shares. This follows because they all permit the holder of the option to purchase the underlying asset at a fixed price in the case of call options, and to sell at a fixed price in the case of puts. For bond options, the underlying asset is a bond. Since the price of a bond determines its yield, a call option on a bond gives the holder the right to buy a specific bond at a fixed price, and therefore the ability to lend (invest) at a minimum rate. Conversely, a put option gives the holder the right to borrow at a maximum rate.
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OPTION PAY-OFFS For futures options, the underlying asset is a futures contract on a bond. A call option fixes the maximum price that the holder need pay to purchase a long position in futures on bonds. Since a long position in bond futures bestows the right to buy a bond at the futures price, or to lend (invest) at the interest rate implied by the futures price, the option indirectly provides the holder with a guaranteed minimum interest rate on an investment.
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OPTION PAY-OFFS For Caps and Floors, the underlying asset is the interest rate itself. Caps (caplets) are a call option that gives the holder the right to borrow at a fixed (maximum) interest rate. Floors are a put option that give the holder the right to lend at a (minimum) fixed rate.
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OPTION PAY-OFFS The (gross) payoff diagrams below must therefore be interpreted differently for share, bond, and bond futures options and for caps and floors with respect to the underlying asset. In common with each other, they all have an expiry date before which the option holder may choose to exercise the option. The option writer (short position) is obliged to respond accordingly.
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OPTION PAY-OFFS Long call Short call Long put Short put
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FACTORS AFFECTING OPTION PRICES Call Options:
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FACTORS AFFECTING OPTION PRICES Put Options: (A) – for American type options. Short dated European Put options may be either more or less valuable than longer dated options.
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OPTIONS ON BOND FUTURES On exercise of the option, a call option holder assumes a long position in bond futures, while a put holder exercises into a short futures position.
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