A comprehensive summary of lecture content, textbook chapters and a few of the essential readings. This all-in-one document includes all the explanations you will need for Finance IIB.
This assumes that market prices are fairly set.
- Only seek to control the interest rate risk of their bond portfolio
ACTIVE MANAGEMENT
These strategies are based on the belief that the market misprices securities.
- Aim to increase the returns.
- They trade on market inefficiencies
- They aim to predict market movements (interest rate movements)
- A key source of return is capital gain
NOTE: Both are concerned with concepts of interest rate risk.
INTEREST RATE RISK
Interest rate risk is driven by fluctuations in interest rates. It is essentially the risk of losing
money – the risk that the actual returns are different from the expected returns.
FORMS OF INTEREST RATE RISK
Reinvestment risk:
This affects the income from the reinvestment of coupons.
- Reinvesting coupons at a lower interest rate than expected.
Price risk:
This affects capital gains/losses. It is the variability in bond prices caused by their
inverse relationship with interest rates.
- Selling bonds at a lower price than expected.
The magnitude of the gains/losses is measured by the bond price/interest rate
sensitivity/volatility.
Derivative securities are financial instruments whose value depends on some basic
underlying asset.
EXAMPLE: shares, bonds, commodities, foreign currencies
Derivatives are also known as contingent claims (pay-out dependent on the realisation of
some uncertain future event).
- As the value of derivatives depend on other securities, they can be used as
powerful tools for hedging and speculating.
They are traded on several exchanges, and are written on common stock, stock indexes,
foreign exchanges, interest rates, commodities, etc.
THE OPTIONS CONTRACT
The seller (writer) of options receives the premium upfront from the holder. If the holder
chooses to exercise the option, the option seller (writer) must make (call) or take (put)
delivery of the underlying asset.
- Sellers (writers) of options are obligated to honour the agreement.
In a European option, it may only be exercised on the maturity date.
An American option may be exercised on or before maturity. An
American option, because it has more leeway, is usually more
expensive.
There are two types of options:
CALL
This gives the holder the right to buy an asset on or before the maturity date for a certain
price (known as the exercise/strike price).
EXAMPLE: a February call option on IBM shares with an exercise price of $150 entitles owner
to buy IBM for $150 at any time up to and including the maturity date. This will be exercised
when the share price of IBM is above the strike price.
The holder is not required to exercise the call. It merely gives them the option.
VALUE
The value of a call option is calculated as follows:
, !"#$% = '()*+ -./*% − '(./+% -./*%
The value therefore increases when the asset price increases. This is why it is only
reasonable to exercise call options when the stock price is above the strike price.
If the price of the stock is less than the strike price, then the value of the option falls to 0 as
it will not be exercised.
The payoff to call holder can therefore be depicted as:
ST – X if ST > X
0 if ST ≤ X
Where:
- ST = value of the stock at maturity
- X (or K) = strike price
PROFIT
The purchase price for a call option is known as a premium. This is what gives the buyer
of the call option the right to exercise the call when the price is desirable.
- The sellers receive the premium as payment of having to deliver the asset in future
for a lower strike price than the market value.
The net profit of exercising the call option is therefore calculated as the value of the option
minus the price originally paid to purchase it:
EXAMPLE: August 2019 expiration call option on IBM with exercise price of $150 selling on
June 30, 2019, for $4.10. Therefore, until maturity, the holder may exercise the option to buy
shares of IBM for $150.
If:
- The stock price on June 30 is $149,60, it does not make sense to exercise the option to
buy at $150.
- If IBM remains below $150 by maturity, then the call will expire unexercised and
worthless
- If IBM sells above $150 by maturity, then holder will exercise the option.
o If IBM sells at $152 on August 02 – exercise option and holder has right to pay
$150 for a stock worth $152.
Value at expiration = Stock price – Exercise price = $152 - $150 = $2
Profit = Final value – original investment = $2 - $4,10 = -$2,1 (loss)
Clear profit only if IBM sells above $154,10
, It can therefore be seen that a profit will only be made if the difference between the stock
price and the strike price is higher than the premium. However, if the value is positive then
the option should still be taken as it would reduce your losses.
FROM THE WRITER’S PERSPECTIVE
As the stock price increases, the losses made by the writer will increase. What is a “loss”
to the writer is a “profit” to the buyer.
The writer will receive a call and will be obligated to deliver the stock worth ST for only
the exercise price.
The payoff to the call writer can therefore be depicted as follows:
-(ST – X) if ST > X
0 if ST ≤ X
Where:
- ST = value of the stock at maturity
- X (or K) = strike price
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