V2.1_20110220上海复旦CFA一&c

V2.1_20110220上海复旦CFA一&c

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Unformatted text preview: CFA Study Session 1 15 Study Session 2-3 Quantitative Methods 12 Study Session 4-6 Economic Analysis 10 Study Session 7-10 Financial Statement Analysis 20 Study Session 11 Corporate Finance 8 Study Session 12 Portfolio Management 5 Study Session 13-14 Equity Investments 10 Study Session 15-16 Fixed Income Analysis 12 Study Session 17 Derivative Investments 5 Study Session 18 Derivative Investments Derivative Ethics & Professional Standards Alternative Investments 3 Total: 2-77 100% Contribution Breeds Professionalism Derivative Forward (R68) Derivative Swap (R71) (R67) R.67 Derivative Markets and Instruments Option (R70) 3-77 Futures (R69) Risk management (R72) 100% Contribution Breeds Professionalism 4-77 100% Contribution Breeds Professionalism 100 R.67 Derivative Markets and Instruments R.67 Derivative Markets and Instruments Definition Exchange traded vs. Over the counter derivatives A derivative is a financial instrument that offers a return based on the return of some other underlying asset. Forward contract: A contract obligates one party to buy and the other party to sell a specific quantity of an underlying asset, at a set price, on a specific date in the future Exchange traded derivatives A Clearinghouse B OTC derivatives: A Future contract: A forward contract that is standardized and exchange traded B Swap contract: A series of forward contracts Option contract: Contract owner has the right, but not the obligation, to buy or sell in the future date Exchange-traded Over-the-counter trade with counterparty (default risk) trade in the a physical exchange not trade in a central location regulated 100% Contribution Breeds Professionalism customized backed by a clearinghouse 5-77 standardized unregulated 6-77 100% Contribution Breeds Professionalism 100% R.67 Derivative Markets and Instruments R.67 Derivative Markets and Instruments Forward commitments vs. Contingent claims Types of forward commitments Forward commitment: an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a price established at the start, forward, future and swap Contingent claim: the payoffs occur if a specific event happens option Forward contract Forward One party agrees to buy The counter party agrees to sell Delivery a physical asset or a security at a specific price on a specific dates in the future. If the future price of the underlying assets increase, the buyer has a gain, and the seller a loss. A Futures contract is a forward contract that is standardized and exchange traded. traded in an active secondary market Are regulated Backed by a clearinghouse Require a daily settlement of gains and losses. A Swap contract is a series of forward contracts . Exchange cash flows on periodic settlement dates 7-77 100% Contribution Breeds Professionalism 8-77 100% Contribution Breeds Professionalism R.67 Derivative Markets and Instruments Contingent claims Advantage Option contract: Options are contingent claims that depend on the price of the underlying assets(such as equity or bond) Basic characteristics of options Basic 1. An option to buy an asset at a particular price is termed a call option Buyer of a call Obligation to sell An option to sell an asset at a particular price is termed a put option Buyer of a put Price discovery Risk management: hedge and speculation Lowering transaction costs Right to buy Seller of a call 2. R.67 Derivative Markets and Instruments Too risky High leverage Right to sell Seller of a put Disadvantage Obligation to buy Option buyer/owner has the right, but not the obligation, to buy (or sell) in the future date Complex instruments Sometimes likened to gambling Option writer/seller has the obligation, but not the right, to sell (or buy) in the future date 9-77 100% Contribution Breeds Professionalism 10-77 10- 100% Contribution Breeds Professionalism R.67 Derivative Markets and Instruments Risk free arbitrage and no arbitrage rule Arbitrage occurs when equivalent assets or combinations of assets sell for two different prices Arbitrage involves earning over the risk free rate with no risk or earning an immediate gain with no future liabilities Law of one price: two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price R.68 Forward Markets and Contracts If a portfolio consisting of A and B has a certain payoff, the portfolio should yield the risk free risk 11-77 11- 100% Contribution Breeds Professionalism 12-77 12- 100% Contribution Breeds Professionalism R.68 Forward Markets and Contracts R.68 Forward Markets and Contracts Terms Terms A forward contract is a bilateral contract that obligates one party to buy and the other party to sell a specific quantity of an underlying asset, at a set price, on a specific date in the future Definition: Purposes of trading forward contracts Settling a forward contract at expiration Physical delivery: deliver an actual asset Cash settlement: the party that has a position with negative value is obligated to pay that amount to the other party Terminating a forward contract prior to expiration: Entering into an opposite forward contract with an expiration date equal to the time remaining on the original contract Hedge risk Speculation Long and short forward position No payments will be made at the inception of a forward contract. Offsetting with a different party: some credit risk remains Offsetting with the original party: can avoid credit risk Both parties of a forward contract is exposed to potential default risk 13-77 13- 100% Contribution Breeds Professionalism 100% Contribution Breeds Professionalism 14-77 14- R.68 Forward Markets and Contracts R.68 Forward Markets and Contracts Terms Equity forward Dealers vs. end users of forward contracts End users: An end user is generally a party with a risk management problem that is searching for a dealer to provide it with a financial transaction to solve that problem. Dealers: market maker banks and non banking financial institutions, that provides market liquidity. The bid ask price spread is the dealer’s compensation for administrative costs as well as bearing default risk and any un hedged positions. For forward contract risk management, dealer often use offsetting and spot transaction Definition: An equity forward contract is a forward contract on a stock, a stock portfolio, or an equity index. Settlement: Equity forwards: physical or cash settlement (based on the value of a stock, a specific portfolio of stocks). Stock index forward: cash settlement a portfolio stocks forward contract price better than a single stock (less administration/origination costs ) Dividends are usually not included in equity forward contracts, as the uncertainty about dividend amounts and payment dates is small compared to the uncertainty about future equity prices. Since forward contracts are custom instruments, the parties could specify a total return value (including dividends) rather than simply the index value. This would effectively remove dividend uncertainty as well. 15-77 15- 100% Contribution Breeds Professionalism 100% 16-77 16- 100% Contribution Breeds Professionalism R.68 Forward Markets and Contracts R.68 Forward Markets and Contracts Bond Forward Contracts LIBOR, Euribor, and FRAs Definition: Forward contracts on short term, zero coupon bonds (T bills in the U.S.) and coupon interest paying bonds are quite similar to those on equities. Eurodollar time deposit London Interbank Offer Rate (LIBOR) Underlying asset: short term, zero coupon bonds (T bills in the U.S.) and coupon interest paying bonds USD interest rates Equities do not have a maturity date, bonds do, and the forward contract must settle before the bond matures. Add on rate Quoted as an annualized rates based on a 360 day year Single interest Quote: 1million 30 30 LIBOR 6% 30 T bill prices are often quoted as 100 annualized discount in percent on the T bill. Coupon bonds are often quoted as a YTM Euribor is a similar rate for borrowing and lending in Euros If the quoted discount yield on a 128 day, $1 million T bill decreases from 3.15% to 3.07%, how much has the holder of the T bill gained or lost? 100% Contribution Breeds Professionalism 17-77 17- A forward rate agreement (FRA) is a forward contract on an interest rate (LIBOR) 18-77 18- 100% Contribution Breeds Professionalism R.68 Forward Markets and Contracts R.68 Forward Markets and Contracts LIBOR, Euribor, and FRAs LIBOR, Euribor, and FRAs Definition An FRA can be viewed as a forward contract to borrow/lend money at a certain rate at some future date. The long position: is the party that would borrow the money The short position: is the party that would lend the money Settled in cash, but no actual loan is made at the settlement date 3 6 FRA mean a contract expires in 3 month 90-day LIBOR 90-day FRA now underlying rate 90 day LIBOR 90 settlement or expiration 19-77 19- 100% Contribution Breeds Professionalism If the reference rate at the expiration date is above the specified contract rate, the long will receive cash payment from the short; If the reference rate at the expiration date is below the contract rate, the short will receive cash payment from the long The payment at settlement: is the present value of the difference in interest costs between a risk free loan at the market rate and one made at the rate specified in the contract. The general formula for the payment to the long at settlement is: 180 flo atin g rate at settlem en t fo rw ard rate n o tio n al p rin cip al 1 + flo atin g rate at settlem en t 20-77 20- 100% Contribution Breeds Professionalism 100% d ays 360 d ays 360 R.68 Forward Markets and Contracts R.68 Forward Markets and Contracts LIBOR, Euribor, and FRAs Currency Forwards FRA . 30 60 90 Off the run FRA FRA 120 Libor 45 Libor Suppose : T bill forward FRA add on rate T bill forward Currency forwards are widely used to hedge exchange rate risk and require delivery of a specified amount of a particular currency with a contract price in another currency or settled in cash. discount yield Sun will receive €20,000,000 in 90 days. A dealer’s quote of $0.875 for a currency forward contract to expire in 90 days. at the end of 90 days, the rate is $0.90. Calculate the cash flow at expiration €20,000,000*(0.875- 0.90) = -$500,000. (Sun pay to the dealer). 21-77 21- 100% Contribution Breeds Professionalism 100% Contribution Breeds Professionalism 100% 22-77 22- R.69 Futures Markets and Contracts Characteristics of Futures Definition A futures contract is an agreement that obligates one party to buy and the other party to sell a specific quantity of an underlying asset, at a set price, at a future date. It’s similar to forward contract in that both: Can be either deliverable or cash settlement contracts; Are priced to have zero value at the time an investor enters into the contract. R.69 Futures Markets and Contracts But they are key different in the following ways: Forwards Futures Private contracts Exchange-traded Unique customized contracts Standardized contracts Default risk is present Guaranteed by clearinghouse Little or no regulation 100% Contribution Breeds Professionalism 24-77 24- Daily settlement (mark to market) No margin deposit required 23-77 23- Regulated Settlement at maturity Margin required and adjusted 100% Contribution Breeds Professionalism R.69 Futures Markets and Contracts R.69 Futures Markets and Contracts Margin The first deposit is called the initial margin. Initial margin must be posted before any trading takes place If the margin balance in the trader's account falls below the maintenance margin, the trader will get a margin call and must deposit the variation margin into the account to bring the margin balance back up to the initial margin level. If the margin balance increases above the initial margin amount, the investor can withdraw funds from the account in the amount of the excess above the initial margin requirement. The settlement price is an average of the prices of the trades during the last period of trading, called the closing period, which is set by the exchange. The settlement price is used to make margin calculations at the end of each trading day. 170 1400 6.1 168 -100 -100 1300 6.2 163 -250 -350 1050 6.3 164 50 -300 1450 6.4 162 -100 -400 1350 6.5 165 150 -250 1500 6.6 161 -200 -450 1300 6.7 155 -300 -750 1000 6.8 155 0 -750 1400 6.9 160 250 -500 1650 < 1100 350 < 1100 400 …… 25-77 25- 100% Contribution Breeds Professionalism 100% Contribution Breeds Professionalism 100% 26-77 26- R.69 Futures Markets and Contracts R.69 Futures Markets and Contracts Margin Characteristics of Futures Margin in securities markets VS. margin in futures markets Margin in securities markets Margin in futures markets Price limits are exchanged imposed limits on how much the contract price can change from the previous day’s settlement price Limit up A percentage of the market value of the asset Paid to the seller of the security Performance guarantee Deposited by both the long and the short and paid to clearinghouse There is interest charged on the borrowed amount, the margin loan. There is no loan involved and, consequently, no interest charges. If falls below maintenance margin, Need back up to maintenance margin. If falls below maintenance margin, Need back up to initial margin. 27-77 27- 100% Contribution Breeds Professionalism Limit down Limit move: If traders wish to trade at prices outside these limits, no trades will take place. The settlement price will be reported upper or lower price limits Locked limit: If trades cannot take place because of a limit move, either up or down, the price is said to be locked limit, since no trades can take place and traders are “locked” into their existing positions. Marking to market: The margin requirement of a future contract is low because at the end of every day there is a daily settlement process called marking to market 28-77 28- 100% Contribution Breeds Professionalism R.69 Futures Markets and Contracts R.69 Futures Markets and Contracts Four ways to terminate a futures contract Five types of futures contracts Delivery of the asset specified in the contract: a short can be terminate the contract by delivering the goods, a long by accepting delivery and paying the contract price to the short Cash payment at expiration Close out or offsetting trade: most frequent An exchange for physicals: off the floor of the exchange (called an ex pit transaction) 100% Contribution Breeds Professionalism 29-77 29- Treasury bill futures contracts Eurodollar futures Treasury bond futures contracts Stock index futures Currency futures 100% Contribution Breeds Professionalism 30-77 30- R.69 Futures Markets and Contracts R.69 Futures Markets and Contracts Five types of futures contracts Five types of futures contracts T bill futures contracts Eurodollar futures based on a $1 million face value 90 day T bill, settled in cash. based on 90 day LIBOR, settled in cash. The price quotes are: 100 The price quotes are: 100 (1 annualized discount) (1 annualized LIBOR) One tick is $25 Quote: 94.75 Quote: 93.75 1) 100 94.75 = 5.25 1) 100 93.75 = 6.25 2) Price = 1,000,000* ( 1 5.25%*90/360) = 986,875 2) price = 1,000,000 * (1 6.25%*90/360) = 984,375 ST goes 1 bp (0.0001, e.g. 94.76) up, long gains $25; ST goes 1 bp (0.0001, e.g. 93.76) up, long gains $25; ST goes 1 bp (e.g. 94.74) down, short gains $25; ST goes 1 bp (e.g. 93.74) down, short gains $25; Minimum tick size is 1 bp, $25 Minimum tick size is 0.5bp, $12.5 31-77 31- 100% Contribution Breeds Professionalism 32-77 32- 100% Contribution Breeds Professionalism R.69 Futures Markets and Contracts Five types of futures contracts Treasury bond futures contracts Traded for treasury bonds with maturities greater than 15 years. A deliverable contract: a delivery option to the short Face value of $100,000 Quoted as a percent and fractions of one percent of face value R.70 Option Markets and Contracts Stock index futures A multiplier that is multiplied by the index to calculate the contract value. e.g. The most popular stock index is the S&P 500 index futures (a multiplier of 250) settled in cash. Currency futures for delivery of standardized amounts of foreign currency. 100% Contribution Breeds Professionalism 33-77 33- 100% Contribution Breeds Professionalism 34-77 34- R.70 Option Markets and Contracts R.70 Option Markets and Contracts Basic Concepts Different types of options Definition An option gives its owner the right, but not the obligation, to buy or sell an underlying asset on or before a future date (the expiration date) at a predetermined price (the exercise price or strike price) American options vs. European options American options allow the owner to exercise the option at any time before or at expiration European options can only be exercised at expiration Call option For two otherwise identical options, an American option has more flexibility than the European option, so it is worth at least as much and typically more Long call & Short call Put option Long put & short put The seller or short position in an options contract is sometimes referred to as the writer of the option Exchange listed options vs. Over the counter options Option premium is the option price the long should pay to the short to buy the option 35-77 35- Exchanged traded: regulated, standardized, liquid Strike price (X) represents the exercise price specified in the contract OTC options 100% Contribution Breeds Professionalism 36-77 36- customized, primarily for institutional buyers 100% Contribution Breeds Professionalism R.70 Option Markets and Contracts R.70 Option Markets and Contracts Different types of options Moneyness Financial options vs. commodity options Financial options: In the money: Immediate exercise would generate a positive payoff At the money : Immediate exercise would generate no payoff include equity options and other options based on stock indexes, Treasury bonds, interest rates, and currencies. The strike price for financial options can be in terms of yield to maturity on bonds, an index level, or an exchange rate for foreign currency options. Out of the money : Immediate exercise would result in a loss The following table summarizes the moneyness of options based on the stock's current price, S, and the option's exercise strike price, X. Options on futures: sometimes called futures options, give the holder the right to buy or sell a specified futures contract on or before a given date at a given futures price, the strike price. Moneyness 100% Contribution Breeds Professionalism S At-the-money S Put Option S=X Out-the-money Commodity options: give the holder the right to either buy or sell a fixed quantity of some physical asset at a fixed (strike) price. 37-77 37- Call option In-the-money X S X S=X X S X 100% Contribution Breeds Professionalism 38-77 38- R.70 Option Markets and Contracts R.70 Option Markets and Contracts Intrinsic Value Intrinsic Value Intrinsic Value: The amount that it is in the money, and zero otherwise Intrinsic value/value at expiration diagrams Intrinsic value of call option: C=max[0, S X] Intrinsic value of put option: P=max[0, X S] Value Value Time Value: The difference between the price of an option (called its premium) and its intrinsic value is due to its time value K Option value = intrinsic value + time value Prior to expiration At expiration K option value > intrinsic value option value = intrinsic value ST Value ST Value K K 39-77 39- 100% Contribution Breeds Professionalism 40-77 40- ST 100% Contribution Breeds Professionalism ST R.70 Option Markets and Contracts R.70 Option Markets and Contracts Payoff Diagram Payoff Diagram Long call option payoff diagram Short call option payoff diagram Profit ($) 30 Profit ($) 110 120 130 5 0 20 10 70 80 90 80 90 100 Terminal stock price ($) -10 Terminal stock price ($) 100 0 -5 70 -20 110 120 130 -30 100% Contribution Breeds Professionalism 41-77 41- 100% Contribution Breeds Professionalism 42-77 42- R.70 Option Markets and Contracts R.70 Option Markets and Contracts Payoff Diagram Payoff Diagram Long put option payoff diagram Short put option payoff diagram 30 Profit ($) Profit ($) 7 20 0 10 0 -7 Terminal stock price ($) 40 50 60 70 80 90 40 50 Terminal stock price ($) 60 70 80 90 -10 -20 100 -30 43-77 43- 100% Contribution Breeds Professionalism 44-77 44- 100% Contribution Breeds Professionalism 100 R.70 Option Markets and Contracts R.70 Option Markets and Contracts Minimum and Maximum Option Values Minimum and Maximum Option Values Lower bound. Theoretically, no option will sell for less than its intrinsic value and no option can take on a negative value. Expiration vs. value American call and put option, longer value no less than shorter Upper bound for call options. The maximum value of either an American or a European call option at any time t is the time t share price of the underlying stock. European call option, longer value no less than shorter Upper bound for put options. European put option, longer value may be larger or smaller The price for an American put option cannot be more than its strike price. If volatility higher, rf lower, the longer, the higher the value. Call options in value , when the asset price (st ) , the exercise price (x) , rf Put options in value ,when the asset price (st ) , the exercise price (x) , rf The maximum value for an European put option is the present value of the exercise price discounted at the risk free rate. Min value and Max value of options without dividend Option Min Value Max[0 , St American call European put St Max[0 , St European call X/(1+Rf)T t] St Max[0 , X/(1+Rf American put 100% Contribution Breeds Professionalism 100% 45-77 45- Max Value X/(1+Rf)T t] Pt )T t Max[0 , X St] S t] X/(1+Rf)T t X 100% Contribution Breeds Professionalism 46-77 46- R.70 Option Markets and Contracts R.70 Option Markets and Contracts Price Sensitivity Put call parity Put call parity means that portfolios with identical payoffs must sell for the same price to prevent arbitrage Factor European call European put American call American put Underlying asset price + - + - Strike price - + - + Time + ? + + Risk-less rate + - + - volatility + + + + C+X /(1+Rf)T = S+P C+ PV(X) = S+P call + bond = stock + put fiduciary call = protective put (portfolio insurance) 47-77 47- 100% Contribution Breeds Professionalism The single securities on the left hand side of the equations all have exactly the same payoffs at expiration as the portfolios on the right hand side. The portfolios on the right hand side are the "synthetic" equivalents of the securities on the left. The four relations all must hold to prevent arbitrage; if there is a profitable arbitrage opportunity all of these relations will be violated. If the equality does not hold, buy the "cheap" side of the equation and sell the other "expensive" side. This will produce an immediate arbitrage profit. 48-77 48- 100% Contribution Breeds Professionalism R.70 Option Markets and Contracts R.70 Option Markets and Contracts Put call parity Cash flow on underlying asset effects The lower bounds of option prices affected by CF: Put call parity. The lower bounds for European options at time t=0 can expressed as c T X / 1 RFR S p c0 p0 Positions replicating Condition A s c Condition B p c X / 1 RFR Condition C c pS Condition D p cS Condition E c p 49-77 49- X / 1 RFR X / 1 RFR T T ( s0 S 50-77 50- R.70 Option Markets and Contracts American call European put Max[0 , American put Pt 51-77 51- c p x /(1 RFR )T , 100% Contribution Breeds Professionalism American call options Max Value when the underlying makes no cash payments, no reason to exercise the call early, C0 = c0, PVD) X/(1+Rf)T t] (St PVD) when the underlying makes cash payments during the life of the option, early exercise can happen, C0 > = c0 PVD) X/(1+Rf)T t] (St PVD) Min Value Max[0 , (St pvcf ) Early Exercise of American Options Min value and Max value of options with dividend Max[0 , (St pvcf )] R.70 Option Markets and Contracts Cash flow on underlying asset effects European call ( s0 The put call parity relation can be adjusted to account for asset cash flow in the same manner T 100% Contribution Breeds Professionalism Option max[0, x /(1 rfr )T x /(1 rfr )T ] The put call parity affected by CF: S X / 1 RFR pvcf T p X / 1 RFR T max[0, s0 X/(1+Rf)T Max[0 , X t (St PVD)] (St PVD)] 100% Contribution Breeds Professionalism X/(1+Rf)T American put options P0 > p0 , nearly always true, t as long as there is a possibility of bankruptcy , P0 always > p0 X (consider an American put on a bankrupt company, stock lower, then put option holder may exercise it ) 52-77 52- 100% Contribution Breeds Professionalism 0, cannot go any R.70 Option Markets and Contracts R.70 Option Markets and Contracts Options on interest rate Options on interest rate For interest rate options, the exercise price is an interest rate, and payoffs depend on a reference rate such as LIBOR. A caplet is a European call option on interest rates. An interest rate cap is a series of interest rate call options, with each caplet having the same strike rate (cap rate), and the expiration dates having the corresponding reset dates to a floating rate loan. Caps place a maximum (upper limit) on the interest payments on a floating rate loan. Long interest rate call + short interest rate put = FRA Interest Rate Options Similarity Caps are often used to protect a floating rate borrower from an increase in interest rates. FRAs A floorlet is a European put option on interest rates. An interest rate floor is a series of interest rate put options, with each floorlet having the same strike rate (floor rate), and the expiration dates having the corresponding reset dates to a floating rate loan. There is no deliverable asset They are settled in cash, in an amount based on a notional amount and the spread between the strike rate and the reference rate. Floors place a minimum (lower limit) on the interest payments that are received from a floating rate loan. Floors are often used to protect a floating rate lender from a decline in interest rates. Can choose exercise or not Must exercise Payoffs are made at the end of the loan period Payoffs are made at the beginning of the loan period Payoffs need not to discount Differences Payoffs need to discount 100% Contribution Breeds Professionalism 53-77 53- An interest rate collar is a combination of a long (short) cap and a short (long) floor on the same underlying rate with the same expiring dates Caps and floors pay in arrears 54-77 54- 100% Contribution Breeds Professionalism R.70 Option Markets and Contracts Options on interest rate Figure: Interest Rate Caps and Floors Loan Rate without Caps or Floors Loan Rate Received by Cap Owner 10% 10% Cap R.71 Swap Markets and Contracts 5% Floor 5% Received by Floor Owner 0% 55-77 55- 5% 10% 100% Contribution Breeds Professionalism LIBOR 56-77 56- 100% Contribution Breeds Professionalism R71. Swap Markets and Contracts R71. Swap Markets and Contracts Characteristics of Swap Contracts Methods of Terminating a Swap A swap contract obligates two parties to change a series of cash flows on periodic settlement dates over a certain time period Mutual termination Offsetting swap contract Resale to a third party No payment required by either party at initiation except the principal values exchanged in currency swaps Exercising a swaption Swaption: An option to enter into an offsetting swap Custom instruments Not traded in any organized secondary market Largely unregulated Default risk is a critical aspect of the contracts Institutions dominate 100% Contribution Breeds Professionalism 57-77 57- 100% Contribution Breeds Professionalism 58-77 58- R71. Swap Markets and Contracts R71. Swap Markets and Contracts Three types of swap contracts Three types of swap contracts Interest Rate Swaps Interest Rate Swaps The plain vanilla interest rate swap involves trading fixed interest rate payments for floating rate payment ( paying fixed and receiving floating ). The Comparative Advantage Argument Counterparties: The parties involved in any swap agreement are called the counterparties BBB Corp: wants to borrow fixed. Pay fixed side: The counterparty that wants variable rate interest agrees to pay fixed rate interest AAA Corp: wants to borrow floating Fixed Floating AAA Corp 10.00% 6-month LIBOR + 0.30% BBB Corp 11.20% 6-month LIBOR + 1.00% Pay floating side: The counterparty that receives the fixed payment and agrees to pay variable rate interest 9.95% 10% AAA Corp BBB Corp LIBOR AAA Corp BBB Corp 59-77 59- 100% Contribution Breeds Professionalism 60-77 60- LIBOR+0.05%, saves 0.25% 10.95%, saves 0.25% 100% Contribution Breeds Professionalism LIBOR+1% R71. Swap Markets and Contracts R71. Swap Markets and Contracts Three types of swap contracts Three types of swap contracts Interest Rate Swaps Interest Rate Swaps Example of IRS Cash flow of an IRS An agreement by Microsoft to receive 6 month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million There is no need to actually exchange the cash at the initiation of the swap Net interest is paid by the party who owes it ---------Millions of Dollars--------LIBOR Date Rate Mar.5, 2001 4.8% Float payment =Libor *(number of days/360)*principle FIXED Net 4.2% Sept. 5, 2001 Fixed payment =fixed rate*(number of days/365)*principle FLOATING Cash Flow Cash Flow Cash Flow +2.10 –2.50 Net fixed rate payment= Fixed payment Float payment At the conclusion of the swap, only the final net payment is made, since the notional principal was not swapped –0.40 –0.10 Mar.5, 2002 5.3% +2.40 –2.50 Sept. 5, 2002 5.5% +2.65 –2.50 +0.15 Mar.5, 2003 5.6% +2.75 –2.50 +0.25 Sept. 5, 2003 5.9% +2.80 –2.50 +0.30 Mar.5, 2004 6.4% +2.95 –2.50 Swaps are a zero sum game: what one party gains, the other party loses +0.45 100% Contribution Breeds Professionalism 61-77 61- 62-77 62- R71. Swap Markets and Contracts R71. Swap Markets and Contracts Example: Interest rate swap (Textbook 142 Example 2) Three types of swap contracts Notional principal: 70 million Interest Rate Swaps Interest Payments The basic formula for the net fixed rate payment in an interest rate swap is: swap fixed net fixed rate payment 100% Contribution Breeds Professionalism t rate LIBOR t 1 number of days 360 Client: semiannual fixed payments @ 7% on a basis of 180 days in the settlement period and 365 days in a year notional Dealer: semiannual floating payments @ 6.25% on a basis of 180 days in the settlement period and 360 days in a year principal Payments are netted and calculate the payment amount. If this number is positive, the fixed rate payer owes a net payment to the floating rate party. Solution: If this number is negative, then the fixed rate payer receives a net payment from the floating rate party. Upcoming floating payment: 70,000,000*(0.0625)*(180/360)=2,187,500 In a swap, the floating rate payment is made based on what the floating rate was at the beginning of the settlement period. 63-77 63- 100% Contribution Breeds Professionalism 100% Fixed payment: 70,000,000*(0.07)*(180/365)=2,416,438 Net payment is from the party paying fixed to the party paying floating. 2,416,438 2,187,500 =228,938 64-77 64- 100% Contribution Breeds Professionalism R71. Swap Markets and Contracts R71. Swap Markets and Contracts Three types of swap contracts Three types of swap contracts Currency Swaps Equity Swaps In a currency swap, one party makes payments denominated in one currency, while the payments from the counterparty are made in a second currency. Typically, the notional amounts of the contract, expressed in both currencies, are exchanged at contract initiation and returned at the contract termination date in the same amounts. The cash flows that would occur in a currency swap are as follows: A swap in which one party pays the return (often including both capital gains and dividends) on a stock, a portfolio of stocks or a stock index, and the other pays a fixed rate or a floating rate payment. Purpose to obtain or hedge an equity exposure. Unique features among swaps Unlike an interest rate swap, the notional principal actually changes hands at the beginning of the swap. Equity swaps can be floating on both parties. Equity swaps payments are unknown until the end of the settlement date. Interest payments are made without netting. Full interest payments in two different currencies are exchanged at each settlement date. At the termination of the swap agreement (maturity), the counterparties return the notional amounts. Notional principal is swapped again at the termination of the agreement 65-77 65- 100% Contribution Breeds Professionalism 100% 66-77 66- 100% Contribution Breeds Professionalism R71. Swap Markets and Contracts Interest Rate Swaps Currency Swaps Equity Swaps At the initiation and the No need to exchange termination of the swap principle Notional principal is swapped During the periods Interest payments are The return is paid each period by made without netting one party in return for a fixed payment Net interest is paid by the party who owes it No need to exchange principle The netting payment is known at the beginning of a period May not pay more than the fixed rate interest 67-77 67- The netting payment is known at the end of a period R.72 Risk management applications of option strategies The fixed rate payer may pay more than the fixed rate if the equity return is negative over the period 100% Contribution Breeds Professionalism 68-77 68- 100% Contribution Breeds Professionalism R.72 Risk management applications of option strategies R.72 Risk management applications of option strategies Basic Concepts Call /Put Option Payoff Diagrams The intrinsic value (at expiration or maturity) of call option differs from its profit in that the profit diagram (see graphs on the page follows) reflects the initial cost of the option (the premium). The key here is your ability to interpret option payoff diagrams and calculate profit/loss Option positions Buyer of a call option Writer (seller) of a call option Buyer of a put option The option buyer pays the premium to the option seller and if the option ends up out of the money, the writer keeps the premium and the buyer loses the premium. long position. short position. long position. Writer (seller) of a put option Options are considered a zero sum game because whatever amount the buyer gains, the seller loses, and vice versa. short position. intrinsic value of a call option = max 0, S-X intrinsic value of a put option = max 0, X-S 100% Contribution Breeds Professionalism 100% 69-77 69- 70-77 70- 100% Contribution Breeds Professionalism 100% R.72 Risk management applications of option strategies R.72 Risk management applications of option strategies Payoff Diagrams Call Buying a call Value at expiration of buying a call: max(0,S X) Profit from buying a call: value at expiration minus option premium, max(0,S X) c Payoff Payoff Maximum profit: infinite Maximum loss: option premium (c) X X ST ST Breakeven underlying price at expiration: exercise price plus option premium (X+c) When selling a call, these results are reversed Payoff Value at expiration of selling a call: max(0,S X) Payoff Profit from selling a call: option premium minus value at expiration, max(0,S X)+c X Maximum profit: option premium (c) ST 71-77 71- 100% Contribution Breeds Professionalism X ST Maximum loss: infinite Breakeven underlying price at expiration: exercise price plus option premium (X+c) 72-77 72- 100% Contribution Breeds Professionalism R.72 Risk management applications of option strategies R.72 Risk management applications of option strategies Put Covered Calls Buying a put A covered call is the combination of a long stock and a short call Value at expiration of buying a put: max(0,X S) covered call=S Profit from buying a put: value at expiration minus option premium, max(0,X S) p Maximum profit: exercise price minus option premium (X p) C The term covered means that the stock covers the inherent obligation assumed in writing the call Maximum loss: option premium (p) Breakeven underlying price at expiration: exercise price minus option premium (X p) Why would you write a covered call? You feel the stock's price will not go up any time soon, and you want to increase your income by collecting some call option premiums. When selling a put, these results are reversed This strategy for enhancing income is not without risk. The call writer trades the stock's upside potential, above the strike price, for the call premium Value at expiration of selling a put: max(0,X S) Profit from selling a put: option premium minus value at expiration, max(0,X S)+p Maximum profit: option premium (p) Strategy Combination Breakeven price Max.Profit Max.Loss Covered call Stock + short call S0 C (X S0)+C S0 C Maximum loss: exercise price minus option premium (X p) Breakeven underlying price at expiration: exercise price minus option premium (X p) 73-77 73- 100% Contribution Breeds Professionalism 100% Contribution Breeds Professionalism 74-77 74- R.72 Risk management applications of option strategies R.72 Risk management applications of option strategies Covered Calls Protective Puts A protective put is constructed by buying a stock and a put option on that stock protective put=S+P A protective put is an investment management technique designed to protect a stock from a decline in value Profit X If the stock price is above the strike price, you make money on the stock's appreciation but the gain is reduced by the put premium paid ST If the stock price decreases, the loss on the stock is offset by the gain on the put. The loss on the position is the put premium and any amount that the strike price is below the original stock price Strategy 100% Contribution Breeds Professionalism 100% 76-77 76- Breakeven price Profit Loss Protective put 75-77 75- Combination Stock + long put S0+P Unlimited S0 X+P 100% Contribution Breeds Professionalism R.72 Risk management applications of option strategies Protective Puts Profit X ST 77-77 77- 100% Contribution Breeds Professionalism ...
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This note was uploaded on 11/02/2011 for the course FINANCE 612 taught by Professor Liyang during the Spring '11 term at Covenant School of Nursing.

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