Lecture 8-9 Flashcards
Advantages and disadvantages of hedging with futures?
Hedging with futures can reduce the firm’s
losses if prices move adversely but they also
eliminate gains if prices move favourably.
Example of James wanted to purchase long term bonds.
Where are options traded?
on the Australian
Securities Exchange
Calls definition:
Calls: A Call option gives the holder the right (but not the obligation) to buy a specified asset at a specified price (strike or exercise price) any time up until a specified expiration date (exercise date)
Puts definition:
Puts: A Put option gives the holder the right (but not the obligation) to sell a specified asset at a specified price (strike or exercise price) any time up until a specified expiration date (exercise date)
Exercise Price (Strike Price):
Price at which the asset may be
purchased in the case of calls, or sold in case of puts.
Expiration date:
Last date on which an option can be exercised.
– American options – can be exercised up to expiration
– European options – can only be exercised at expiry.
Option premium:
Price paid by the option buyer to the seller of the
option, whether a put or a call, for the right to exercise.
Options advantages:
Allow you to limit your losses, take advantages of any gains and decide later what you want to do – for a price (option premium)
The price of an option (the premium) depends
on a number of factors:
–The price variance of the underlying asset
– The changes in the price of the underlying asset
relative to the option’s exercise price
– The dividends of the underlying share
– The time left until the option expires
– Interest rates
There are 4 Basic Options strategies:
- Buying a call
– You have the right (not obligation) to buy at pre determined price. - Writing a call
– You are obligated to sell at pre-determined price if holder
exercises - Buying a put
– You have the right (not obligation) to sell at pre determined price - Writing a put
– You are obligated to buy at pre-determined price if holder
exercises
Are call option holders profit capped or not?
No uncapped.
Are put option holders profit capped or not?
Capped
Caps:
protect borrowers against rising interest rates by restricting variable-rate loans to a maximum interest rate.
FIs sell caps to borrowers why?
as part of a loan agreement or stand
alone
what is a ceiling agreement?
between a bank and its customer specifies
the maximum lending rate on a loan and, therefore, protects the customer from interest rate risk.
An interest rate cap is characterised by:
– A notional principal (ie, same as the loan amount)
– An interest-rate reference rate
– A cap rate (strike/exercise price)
– Period of agreement including payment dates and interest-rates dates.
A Maximum rate facility is?
is a floating-rate facility with a
cap agreement within it, with the roll-over dates for the
drawn down of the loan and the cap agreement synchronised.
Ie, with a capped floating rate loan, when interest
rates rise above the guarantee or strike price, the rate
is capped and the borrow pay no more than the guarantee.
what is a floor agreement?
A floor agreement specifies the minimum rate of
interest on a loan and, therefore, protect the bank from interest rate risk. If interest rates go below the floor, the customer pays the bank the difference between
the actual rate and the floor rate.
To protect against decreasing interest rates, FI will…
To protect against decreasing interest rates, a FI
will often take out a stand alone floor option with
another financial services provider so that the FI do
not earn less as rates fall.
An interest rate floor guarantee pays off if;
An interest rate floor guarantee pays off if the interest rate falls below the exercise price struck in the floor.
A collar is formed by?
purchasing a cap and selling a floor back to the bank simultaneously.
– Ie, by prescribing the limits on min and max i-rates
(purchased when holder is concerned about excessive
volatility in i-rates)
Zero-cost collar is where:
he premium for the cap will equal the premium for the floor.
Pricing model for caps, floors and collars:
Black-Scholes model (not covered in BTP)
Swap Contracts what are they?
Over-the-counter financial products that have been developed by the financial markets to allow parties to enter into a contractual agreement to exchange cash flows
– Swaps are not a source of funding for a borrower (ie
underlying loan contract and swap contract are 2
separate contractual commitments)
– Can be intermediated or direct swap
2 main types of swap contracts:
1) Interest rate swaps: Agreements between 2 parties to exchange a series of interest payments based on a notional principal amount for a specified period
2) Cross-currency swaps
Interest Rate Swaps types of swaps;
- Vanilla swap: Fixed-for-floating interest rate
* Basis swap : Floating-for-floating interest rate swap
Swap purpose?
Purpose: remove uncertainty for both parties
