more_on_derivative_assets

# more_on_derivative_assets - More on Derivative Assets There...

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More on Derivative Assets There are several innovations to the standard (plain vanilla) options These innovations are also known as Exotic options Example 1: Interest rate caps Provide borrowers with protection against rates on a floating-rate loan

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Interest rate caps Suppose firm A borrows \$10 million at a variable-rate Then it can buy a cap from Bank B, at 12%, over some period, say 3 months Suppose over this period the variable-rate on the loan increases to 14% Then firm A receives \$50,000 from Bank That is; (0.02)x1/4x10 million=\$50,000
Standard oil bond Triggered by oil price volatility In 1986, Standard oil issued zero-coupon bonds, with Face Value=fixed amt + add’l. E.g., Fixed amt=\$1,000 Additional amt based on price of oil E.g., additional amt=170x(oil price – 25) oil price= price of oil at bond’s maturity Up to a maximum of \$2550 (i.e., \$40 p.b.)

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Index currency option notes ICONs are bonds linked to exchange rate First issued in 1985 by Banker’s Trust for Long Term Credit Bank (LTCB) of Japan LTCB wants to hedge against a fall in Yen For example, let \$1=¥S be the exΔ rate The an ICON may have the ff payoff: \$1000 if S>169 (i.e, \$1 is more than ¥169) \$0 if S<84.5 (i.e, \$1 is les than ¥169) 1000(2-169/S) is 84.5<S<169
The ICON: graph Payoff of ICON (as a function of \$/¥ rate) 8 4 5 . 1 6 9 weak yen strong yen 1 0 0 0

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Forward and Futures contracts Forward contract: A very simple derivative security. An agreement to buy or sell an asset/good at a future date at a certain ( delivery ) price Short position: if agree to sell Long position: if agree to buy Short position losses if the (market) price at time of delivery is greater than delivery price And vice versa
Forwards/Futures Furtures contract: Same as forwards but organized on an exchange Month (rather than date) of delivery E.g., Chicago Board of Trade and Chicago Mercantile Exchange Trade in: copper, alum, gold, pork bellies, live cattle, etc The exchange specifies quality, location, and margin requirements and daily settlements

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Example of features of futures Daily resettlement Minimizes the chance of default Initial Margin About 4% of contract value, cash or T-bills held in a street name at your brokerage. The margin account will then be marked using the futures rate/price (i.e, price expected by the delivery date/month)
Suppose you speculate on a rise of \$/¥; you enter into a 3-month futures contract to sell ¥ at the rate of \$1 = ¥150; you will make money if the yen depreciates . The contract size is ¥12,500,000

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## This note was uploaded on 03/26/2008 for the course EC 150 taught by Professor Kutsoati during the Spring '08 term at Tufts.

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more_on_derivative_assets - More on Derivative Assets There...

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