Chapter 13

Question 1

What fixed income cash equivalents exist?

Answer 1

The Interbank Market

Question 2

What does the interbank market offer? and timeframes

Answer 2

deposits and loans from overnight up to one year

Question 3

What rates does the interbank market offer?

Answer 3

o London Inter-Bank Offered Rate (LIBOR) – rate looked at when think about borrowing. ICE Benchmark administration set this.
o London Inter-Bank Bid Rate (LIBID) – Depositor rates

Question 4

What fixed income near cash instruments exist?

Answer 4

Certificates of Deposits (CDs)	
Treasury Bills 
Commercial Paper 
Floating Rate Notes (FRNs) 
Gilt Repo

Question 5

What are features of Certificates of Deposits (CDs)

Answer 5

• Tradable time deposits issued by institutions (with a UK Banking licence)
• Maturities range from one month to one year
• Redeemed at par (plus fixed interest)

Question 6

What are features of Treasury Bills

Answer 6

• Short-term government debt securities
• Issued by the DMO
• No coupons issued for these
• Discounted instruments – to par value and this is how there is a return
• Issued to manage cash in the banking system. If these are purchased then money is coming out of the economy for instance

Question 7

how does time to expiry determine the option premium?

Answer 7

options with longer terms to maturity have higher premiums

this is because the further we go into the future, the higher the probability that the option will expire in-the-money. ‘Time value’ reflects this probability

Question 8

how does volatility of the share price affect the option premium?

Answer 8

if the share price is very volatile, then there is a higher probability that the option will expire very deeply in the money. The potential profit from buying a call or a put on a volatile share is greater than for a less volatile share.

So the time value of the option will be higher, and the premium higher.

In options markets, we measure volatility by the annualised standard deviation of returns

Question 9

how does discount rate affect the option premium for calls?

Answer 9

if interest rates rise, the cot of borrowing money to buy an investment rises, making it more attractive to buy call options instead of the actual stock itself. Hence, call option premium rises

Question 10

how does discount rate affect the option premium for puts?

Answer 10

Put options are substitutes for shorting shares - when an investor shorts shares, they get cash to deposit.

when interest rates rise buying put options is less attractive than shorting shares, leading to lower put option premiums.

Conversely when interest rates fall, shorting shares becomes less attractive than buying put options, as the extra cash will not be making as much interest revenue. Hence, demand for put options rises along with their premiums.

Question 11

how does delta affect the option premium for puts?

Answer 11

the sensitivity of the option price relative to other factors is a critical point of analysis for determining the value of the option