March 28

1
March 28

• Stock Project two options
• Hand in Friday as scheduled
• Role dates one week forward and in next Friday
• Hand old projects back next Wed. 3-5 my office
  or in class next Thursday
• Tuesday
• Bonus Exam 20 points, similar questions as exam
  minimum partial credit
• Today Options and Swaps
• Bank project Post new (appropriate) data by
  Friday

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Objectives

• Develop an understanding of options and swaps
• Understand payoffs for option positions
• How to implement a macrohedge with options
• Understand caps, collars, and floors

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Basics of Options

• A call option gives the buyer the right (but not
  the obligation) to buy the underlying security at
  the exercise (strike) price Buyer must pay the
  seller (writer) a price premium
• A put option gives the buyer the right (but
  not the obligation) to sell the underlying
  security at the exercise (strike) price Buyer
  must pay the seller (writer) a price premium

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Options

• All options have an expiration date
• Some are traded on exchanges
• Some are trade OTC
• Interest rate risk concentrate on bond contracts

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Basic Features
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Payoffs for Forward or Futures Contracts
Profit
Profit
BondPrice
Bond Price
BuyerLong position
SellerShort Position
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Payoffs for Call Options(right to buy)
Profit
Profit
Exercise Price
Call premium
BondPrice
BondPrice
Call premium
Exercise Price
BuyerLong position
SellerShort position
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Payoffs for Put Options(right to sell)
Profit
Profit
Exercise Price
Put premium
BondPrice
BondPrice
Put premium
Exercise Price
BuyerLong position
SellerShort position
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Writing Options

• Writing options profits limited, but downside
  risks are not
• Some institutions are regulated from holding
  these contracts
• Must tie the option position to a particular
  asset/liability

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Actual Bond Options

• CBOE options not heavily traded
• More OTC
• Preferred method is option on a futures contract
• More liquidity
• Incorporate credit risk
• Homogenity of asset
• Mark-to-market

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Caps

• Cap a call option on interest rates. i.e if
  interest rates rise above the cap, the seller of
  the cap (a bank) compensates the buyer (another
  FI) in return for an up-front premium
• Cap has a notional amount
• Payments made are the spread over the cap times
  notional amount
• Maybe single/multiple payment (exercise) dates
• Like insurance against excessive increase in
  interest rates

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Caps
InterestRate
6
5Cap Rate
year
Cost to writer to buyer (6-5) times notional
amount
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Floors

• Floor a put option on interest rates. i.e if
  interest rates fall below the floor, the seller
  of the floor (a bank) compensates the buyer
  (another FI) in return for an up-front premium
• Cap has a notional amount
• Payments made are the spread over the cap times
  notional amount
• Maybe single/multiple payment (exercise) dates
• Like insurance against excessive decreases in
  interest rates

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Floor
InterestRate
5Cap Rate
4
year
Cost to writer to buyer (5-4) times notional
amount
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Collars

• Collars are combinations of a cap and a floor.
  Typically buying a call and selling a floor or
  vice versa
• Result hedge against rising interest rates and
  finances with selling a floor

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Examples
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Hedging w/swaps

• Basics of SwapsSuccession of forward contracts
  on interest rates arranged by two parties
• Swap buyer agrees to make a number of fixed
  interest rate payments on specified dates to swap
  seller
• Swap sellers agrees to make floating rate
  payments to swap buyer. Payments are tied to a
  specific index (like LIBOR) at the time of each
  payment

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Swaps

• Notional valuemore than futures, options, caps,
  floors combined

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Why swaps?

• FIs may have a comparative advantage in the fixed
  or variable rate market asset or liability market
  and want to offset their interest rate risk.

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Examples and Problems