_11 Valuing Risky Debt I Bank Loans 2013 - VALUING RISKY DEBT I Bank Loans REFERENCES Hogan W et al 2004 Management of Financial Institutions Brisbane

_11 Valuing Risky Debt I Bank Loans 2013 - VALUING RISKY...

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VALUING RISKY DEBT I Bank Loans REFERENCES Hogan, W. et al., 2004. Management of Financial Institutions. Brisbane Wiley, Chapter 14. Lange, H. et al., 2013. Financial Institutions Management. (3 rd ed). Sydney: McGraw Hill, Chapter 7. Hull, J.C., Introduction to Futures and Options Markets, 3 rd Edition, Prentice-Hall International Inc, 1998, Chapter 18. 1.0 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. Interest-rate options are available over-the-counter, and are traded on organised 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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2 2.0 Option Payoffs 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. 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. 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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3 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. Long call Short call Long put Short put
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4 2.1 Factors Affecting Option Prices Call Options: Call Option price up when: Bond Option Futures Option Current asset price Exercise price Term to expiry Share price volatility Risk-free interest rate (Over life of the option) Coupon rate on bond Higher
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