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Introduction to Financial Markets

Introduction to Financial Markets. Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il. premium. Call Option. European Call. X Underlying. premium. Put Option. European Put. X. X Underlying. Collar. Firm B has shares of firm C of value $100

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Introduction to Financial Markets

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  1. Introduction to Financial Markets Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. premium Call Option European Call X Underlying Introduction to Financial Markets

  3. premium Put Option European Put X X Underlying Introduction to Financial Markets

  4. Collar • Firm B has shares of firm C of value $100 • They do not want to sell the shares, but need money. • Moreover they would like to decrease the exposure to financial risk. • How to get it done? Introduction to Financial Markets

  5. Collar 1. Buy a protective Put option (3y to maturity, strike = 90% of spot). 2. Sell an out-the-money Call option (3y to maturity, strike above spot). 3. Take a “cheap” loan at 90% of the current value. Introduction to Financial Markets

  6. Collar payoff payoff K 90 90 100 K stock Introduction to Financial Markets

  7. Inverse Floater Today -100 1 yr 7.5% 2 yr 9%-LIBOR 3 yr 10% - LIBOR 4 yr 11% - LIBOR 5 yr 12% - LIBOR + 100 Callable! Introduction to Financial Markets

  8. Inverse Floater D -call option 0 0 0 0 2 C -100 5 4 5 6 105 B -100 5 5 5 5 105 A -100 L L L L L+100 Today 1 yr 2 yr 3 yr 4 yr 5 yr B + C + D - A Introduction to Financial Markets

  9. Yield Enhancement Today you have 100 NIS invested in shekels for 1 year and 100 NIS invested in dollars for one year. Yields are 4.5% NIS, 2% USD. You can create a deposit that offers 7% NIS or 4.5% USD (the linkage is chosen by the bank!). Introduction to Financial Markets

  10. 1.07 1.045 Yield Enhancement Payoff at the year end Sell some amount of USD Put options, the money received invest in SHEKEL account! USD Introduction to Financial Markets

  11. Combined CPI deal • You are underexposed to CPI • You have TA25 exposure • One can sell an out-of-the-money call on TA25 • Buy a Call on CPI Introduction to Financial Markets

  12. Example of Risk Management Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  13. capital capital Investment Decision $1000M bonds $900M bonds 5% 13% $100M stocks Introduction to Financial Markets

  14. Investment Decision You manage $1B (OPM) and consider a decision to transfer $100M to a more risky investment (stocks). Your trader claims that on average he can earn 13% on the risky portfolio instead of 5% that you have now. Introduction to Financial Markets

  15. Investment Decision Your stockholders have required rate of return on capital 15%. 1. Calculate VaR before the transaction VaRo=15. 2. Calculate VaR after the transaction VaR1=24. 3. The difference is an additional capital that will be used to back this transaction: additional capital = (VaR1- VaR0)*3 = 27M Introduction to Financial Markets

  16. Investment Decision required additional net profit is Additional Capital * Required rate of return $27M * 15% = $4.05M required additional profit before tax is $4.05M/(1-tax) = $7.4M this profit should be earned by an extra return on the risky investment. Introduction to Financial Markets

  17. Investment Decision Thus the required return on the stock portfolio is $7.4M = (x%-5%)*100M x = 12.4% You should accept the proposed transaction. Introduction to Financial Markets

  18. Tax in Financial Sector Introduction to Financial Markets

  19. Options in Hi Tech Many firms give options as a part of compensation. There is a vesting period and then there is a longer time to expiration. Most employees exercise the options at vesting with same-day-sale (because of tax). How this can be improved? Introduction to Financial Markets

  20. Your option Result Sell a call Long term options payoff K 50 k K stock Introduction to Financial Markets

  21. Example You have 10,000 vested options for 10 years with strike $5, while the stock is traded at $10. An immediate exercise will give you $50,000 before tax. Selling a (covered) call with strike $15 will give you $60,000 now (assuming interest rate 6% and 50% volatility) and additional profit at the end of the period! Introduction to Financial Markets

  22. Result Your option exercise Example payoff K 60 50 10 15 26 Introduction to Financial Markets

  23. Bond Market Bootcamp:Handouts Session One http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  24. Bond Market Bootcamp 2001 FRM Certification Review Session One http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  25. Fixed Income Securities • Definition has evolved to include any security that obligates specific payments at specified dates. Introduction to Financial Markets

  26. Overview of Bond Markets • Bond • Note • Money Market Securities • Sovereign, Agency,Corporate Debentures • Handout A-1 & A-2, Street Software Inc Introduction to Financial Markets

  27. Fixed Income Securities • Overview of major bond markets • Types of instruments & day counts • Repo and Securities Lending • Basic tools of analysis • Mortgage Backed Securities • Forward Rate Pricing Introduction to Financial Markets

  28. Types of Fixed Income Securities • Corporate bonds • Foreign bonds • Eurobonds • Mortgage Backed Securities (pass throughs) • ABS • Brady Bonds Introduction to Financial Markets

  29. World Bond Markets • Particular focus on differences in nomenclature and conventions; expanded section of FRM in recognition of significant increase in candidates from emerging markets Introduction to Financial Markets

  30. Introduction to Financial Markets

  31. UK Government Bonds Gilts • straights = bullet bonds (some callable) • convertibles (option to holder to convert to longer gilts) • index linked low coupon 2-2.5% • irredeemable (perpetual) Introduction to Financial Markets

  32. Brady Bonds Argentina, Brazil, Costa Rica, Dominican Republic, Ecuador, Mexico, Uruguay, Venezuela, Bulgaria, Jordan, Nigeria, Philippines, Poland. Partially collateralized by US government securities Introduction to Financial Markets

  33. Types of Securities MBS & ABS • Mortgage Loans • Mortgage Pass-Through Securities • CMO and Stripped MBS • ABS • Bonds with Embedded Options • Analysis of MBS • Analysis of Convertible Bonds Introduction to Financial Markets

  34. Arbitrage Motivations of ABS • Direct descendant of zero coupon bonds, replacing rate risk with credit risk • Necessity for investors to comprehend motivation of arb desk maintaining syndication book of primary issue Introduction to Financial Markets

  35. Fixed income Analysis • Pricing of Bonds • Yield Conventions • Bond Price Volatility • Factors Affecting Yields and the Term Structure of IR • Treasury and Agency Securities Markets • Corporates & Municipals Introduction to Financial Markets

  36. Types of Fixed Income Securities • Government securities (sovereign) • Bills (discount) • Notes • Bonds (including new index linked) • Government agency and guaranteed securities • GNMA, SLMA, FNMA • Municipal Securities • State and local obligations Introduction to Financial Markets

  37. Securities Sectors • Treasury sector: bills, notes, bonds • Agency sector: debentures (no collateral) • Municipal sector: tax exempt • Corporate sector: US and Yankee issues • bonds, notes, structured notes, CP • investment grade and non-investment grade • Asset-backed securities sector • MBS sector Introduction to Financial Markets

  38. Fixed Income Universe • Fixed coupon securities • 6.75% UST 3/05 • Floating Rate notes • WB 3/05 T+15 • Zero Coupon Bonds • 0% USP 3/05 (or USC) Introduction to Financial Markets

  39. Fixed Income Universe • Perpetual notes (consols in UK) • Structured notes • Inverse floaters • Callable bonds • Puttable bonds • Convertible notes Introduction to Financial Markets

  40. Characteristics of a Bond • Issuer • Time to maturity • Coupon rate, type and frequency • Linkage • Embedded options • Indentures • Guarantees or collateral Introduction to Financial Markets

  41. Basic security structures • Coupon, discount and premium bonds • Zero coupon bonds • Floating rate bonds • Inverse floaters • Perpetual notes • Convertible bonds • Interest Only, Principal Only notes • ABS & Structured Products Introduction to Financial Markets

  42. Applications • Active Bond Portfolio Management • Indexation • Liability Funding Strategies • Bond Performance Measurements (AIMR) • Interest Rate Futures & Options • Interest Rate Swaps, Caps, Floors Introduction to Financial Markets

  43. Analytic Tools to be Reviewed • Time Value of $ • Yield Conventions • Pricing Factors for Specific Securities • Converting Yield Measurements • Yield Curve Analysis • Day Counts • Repo Introduction to Financial Markets

  44. Analytic Tools to be Reviewed (cont’d) • Price volatility for option free bonds • Duration • Convexity • Embedded options & their applications Introduction to Financial Markets

  45. FRM Cheat Sheet • The answers are (virtually always): • Negative convexity • Effective duration • SMM • Double the BEY big figure when quoting Europeans • Know your current duration ratios by heart Introduction to Financial Markets

  46. Basic Nomenclature Coupon securities are quoted in terms of price expressed in dollars. Clean price excludes accrued interest. Accrued interest = next coupon*fraction of time that passed. Bills are quoted in terms of discount rate as % of face value. Assuming 360 days in a year, i.e. multiplied by 360 and divided by the actual number of days remaining to maturity. Introduction to Financial Markets

  47. UST Nomenclature • Clean v. Dirty Pricing • 6.25% UST 5/30 104-12 • Actual/Actual Day Count • AI=Coupon x actual days since last coupon actual days in current coupon period Price 20mm bonds for settlement April 12 Introduction to Financial Markets

  48. Introduction to Financial Markets

  49. UST Pricing Example 1 • 8.75 UST 11/08 • Security was purchased 06 Jun @ 110-31 • Security was sold 06 Sep @ 109-27+ • Calculate the loss Introduction to Financial Markets

  50. UST Pricing Example 1 • Bought at 110-31 11,151,562,50 • Sold at 109-27 11,257,812.50 • Net “loss” is a profit of $106,350.00 • See Handouts 1-1 and 1-2 Introduction to Financial Markets

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