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Advanced Derivatives: ( plain vanilla to R a i n b o w s ) advanced swaps Structured notes exotic options

Advanced Derivatives: ( plain vanilla to R a i n b o w s ) advanced swaps Structured notes exotic options. S. Mann, 2006. Equity Swaps. Example: Thai Bank prohibited from holding domestic equity Bank circumvents regulation with total return swap: Thai bank buys US government securities

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Advanced Derivatives: ( plain vanilla to R a i n b o w s ) advanced swaps Structured notes exotic options

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  1. Advanced Derivatives:(plain vanilla to Rainbows)advanced swapsStructured notesexotic options S. Mann, 2006

  2. Equity Swaps Example: Thai Bank prohibited from holding domestic equity Bank circumvents regulation with total return swap: Thai bank buys US government securities Tiger fund buys Thai equity Enter into total return swap: returns swapped, not asset. Thai equity return Thai Financial Institution Tiger Fund or other Hedge Fund US Bond return Return details (what currency?) denoted by distinct swap names

  3. Asset swaps: Quantos Total return swap with exchange rate risk eliminated Payments determined by total return on different assets, multiplied by notional principal in one currency. Example: swap S&P 500 for CAC-40 (France) + spread (CAC-40 return + spread) x Notional principal U.S. Global Portfolio French Pension Fund S&P 500 total return x Notional Principal Payment details on next slide

  4. Quanto swap outcome example A possible sequence of events

  5. Equity Collars Long Stock Monetarize position without realizing gain. Zero-cost collar: sell call to pay for put: choose put so that loss possibility at least 10%. (Investor is “at risk”, not an IRS “constructive sale”). Borrow against hedged position at advantageous rate (Libor + 100 bp). Standard contracts available for large ($2 million) positions in liquid stock. Longer the term, higher upside percentage available. Cite: Braddock, 1997, “Zero-cost Collars,” Risk, November 1997. +25% -10% Stock plus collar Collar value (% of original stock price) ST

  6. Swap floating for floating BasisSwap: Libor - spread T-bill Payer Libor payer T-bill rate Constant Maturity swap Libor + spread Libor payer Constant Maturity Payer Five-year T-note Constant maturity yield

  7. Amortizing swap Notional principal reduced over time (e.g. mortgage) N1 N2 N3 N4 T1 T2 T3 T4 Valuation: 0 =B(0,T1)(SFR - F1)N1 + B(0,T2)(SFR - F2)N2 + B(0,T3)(SFR - F3)N3+ B(0,T4)(SFR - F4)N4 where Ft = appropriate forward rate SFR = swap fixed rate

  8. Diff swaps: (currency hedged basis swap) Floating for floating swap Floating rates are in different currencies All swap payments in one currency Example: swap 5 year gilt (£) yield for 5 year CMT T-note yield swap payments in $ (5-year £ gilt yield) x Notional principal ($) U.S. Firm desiring exposure to UK yield U.S Firm reducing exposure to UK yield (5 -year CMT yield) x Notional principal ($)

  9. Commodity derivatives Commodity-linked loans Merrill Lynch - $250 mil Aluminum-linked bond for Dubal (Barrick) Price protection standard for project financing hedging to assure break-even as loan requirement. Gold hedging used to raise LBO funds. Gas swaps Basis swaps (Enron) Oil swaps Crack Spread swaps

  10. Credit derivatives First generation: Bankers Trust (BT) and Credit Suisse (CS) notes (Japan 1993) objective: free up credit lines to Japanese financial sector note payoffs: coupon = Libor + 100 bp ; but: coupon and principal reduced if defaults occur. one lego (building block) is credit default swap: Notional Principal x (40 bp) Protection Seller Protection Buyer Floating payment contingent on defaults; payment mirrors loss incurred by creditors Contingent payment based on post-default value of reference security

  11. Enron Credit default swaps – Fall 2001

  12. GM Credit default swaps: 2002-2004

  13. GM Credit default swaps – Fall 2005

  14. Structured notes: Range Floaters (Range contingent accrual bonds) Bonds that accrue interest only on days when range conditions satisfied. Example: $10 million bond: 12% coupon, accrual range contingent; range is ($.50, $.59) $/DM semiannual coupon = $10m x (.12) x (S (days within range)/365) (this is a restart accrual; can be barrier terminal accrual)

  15. Structured notes - Inverse floater Example: GNMA 10-year note; maturity 12/15/07 coupon paid semi-annually: 6/15 and 12/15 coupon = max(0.02, (0.18- 2xLibor)) x (180/360) x Face coupon on $1 million note a function of Libor: Libor coupon .050 40,000 .055 35,000 .060 30,000 .070 20,000 .080 10,000 .090 10,000 Coupon 40,000 30,000 20,000 10,000 T-note coupon Floater coupon 5% 6% 7% 8% 9% Libor

  16. Exotic options Binaries: Digital ; Gap ; Ranges. Chooser (as you like it) Rainbow (welcome to OZ) option on best of two Asian (average price or average strike) Bermudan (exercise windows) Lookback (no regret) barrier options: knockouts: up and out; down and out Knockins: up and in; down and in many, many more, including “Down and in” Arrow, or Arrow-Debreu (advanced*) (* see Carr and Chou, 1997, RISK magazine, vol 10 #9)

  17. Digital and Gap options Examples: 1) European Gap call option, with G=0 PayoffT Payoffs: ST - G if ST > K 0 if ST < K K 2) digital European call Payoffs: K if ST > K 0 if ST < K K ST

  18. Range Binary options Example: 1) binary $/DM range option with range = ( $.56, $.575) PayoffT Payoff: 3x premium if $.56 < ST < $.575 0 if ST < $.56 or ST > $.575 Typical underlying: exchange rates, interest rates commodity prices 3x premium $0.56 $0.575 ST Usage example: Corp long DM, buysputand range. Outcomes: 1) DM up : gain on long DM position 2) DM down: hedged with put 3) unchanged: range pays off, pays for put.

  19. Quattro option (Banker’s Trust 1996) binary quad-range option: four ranges! PayoffT 8x premium Payoff: 8x premium if all four ranges unbroken 6xpremium if only one range broken 4xpremium if two ranges unbroken 2xpremium if only one range unbroken 0 if all ranges broken All four ranges! ST Note this allows sale of volatility with limited loss (as opposed to sale of straddle)

  20. Rainbow Options

  21. Asian (Average price) Options Average=94.75 Option life (averaging period= 180 days)

  22. Barrier Options: down and out Lower barrier Option ceases to exist

  23. Barrier Options: down and in Lower barrier Lower barrier Option is activated

  24. Up and out knockout put Knockout upper barrier Option ceases to exist

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