week 10 Flashcards
plain vanilla products
derivatives which have standard well-defined properties and trade actively
non-standard or exotic produts are all traded?
who developed them and why?
- All of these products are traded over the counter.
- These exotic products have been developed by financial engineers to meet a genuine need in the market:
exotic options - packages
examples
how are they structured
•A Package is a portfolio of standard European calls and puts, forward contracts, cash, and the underlying asset itself.
bull spreads, bear spreads, straddles etc.
Packages are often structured by financial engineers to have zero cost
Exotic Options – Non-standard American Options
difference with standard american options
•In a standard American option, exercise can take place at any time during the life of the option, and the exercise price is always the same.
non-standard:
- A Bermudan option’s early exercise may be restricted to certain dates.
- Early exercise allowed during only part of the life of the option (e.g. there may be an initial “lock out” period).
- The strike price may change over the life of the option.
Exotic Options - Forward Start Options
These are options that will start at some time in the future
Exotic Options - Forward Start Options
examples
employee stock option plans, where a company promises that it will grant at-the-money options to executives at certain times in the future.
Exotic Options - Forward Start Options
what happens when the forward start option has no income?
•When the underlying asset provides no income, an at-the-money forward start option is worth the same as a regular at-the-money option with the same life.
–For example, an at-the-money option that will start in three years and mature in five years is worth the same as a two-year at-the-money option initiated today.
Exotic Options - Compound Option
•Compound options are options on options. In effect, they are an option to buy or sell an option. There are four main types of compound options:
–Call on call;
–Put on call;
–Call on put; and,
–Put on put.
disadvantage of compound optoins
very sensitive to volatility
- Exotic Options - Compound Option
describe a call on a call option
on the first exercise date, the holder of the compound option is entitled to pay the first strike price X1 and receive a call option.
The call option gives the holder the right to buy the underlying asset for the second strike price X2, on the second exercise date.
The compound option will only be exercised on the first exercise date if the value of the second option on that date is greater than the first strike price.
Exotic Options - Chooser Options (“As you like it”)
- A chooser option (sometimes referred to as an “as you like it” option) gives the holder the ability to choose after a specified period of time whether the option is a call or a put option.
- The value of the chooser option at the time this choice is made is max(c,p).
Exotic Options - Barrier Options
•Barrier options are options where the payoff depends on whether the underlying asset’s price reaches a certain level during a certain period of time.
Exotic Options - Barrier Options
what are they attractive?
•These options are attractive to some market participants because they are less expensive than the corresponding regular option.
Exotic Options - Barrier Options
Barrier options are classified as
•Barrier options are classified as either knock-out options or knock-in options.
–A knock-out option ceases to exist when the underlying asset price reaches a certain level (called the barrier) before maturity.
–A knock-in option comes into existence only when the underlying asset price reaches a certain level (called the barrier) before maturity.
•The four types of knock-out options are:
- An up-and-out call option
- A down-and-out call option
- An up-and-out put option
- A down-and-out put option
•The four types of knock-out options are:
An up-and-out call option
An up-and-out call option is a regular call option that ceases to exist as soon as the asset price reaches a barrier level
– the barrier level is greater than the asset price at the time the option is initiated
•The four types of knock-out options are:
A down-and-out call option
–A down-and-out call option is a regular call option that ceases to exist as soon as the asset price reaches a barrier level
– the barrier level is below the asset price at the time the option is initiated.
•The four types of knock-out options are:
An up-and-out put option
–An up-and-out put option is a regular put option that ceases to exist as soon as the asset price reaches a barrier level
– the barrier level is greater than the asset price at the time the option is initiated.
•The four types of knock-out options are:
A down-and-out put option
–A down-and-out put option is a regular put option that ceases to exist as soon as the asset price reaches a barrier level
– the barrier level is below the asset price at the time the option is initiated.
•The four types of knock-in options:
An up-and-in call option
An up-and-in call option is a regular European call option that starts to exist as soon as the asset price reaches a barrier level.
The barrier level is greater than the asset price when the option is initiated
•The four types of knock-in options:
A down-and-in call option
–A down-and-in call option is a regular call option that starts to exist as soon as the asset price reaches a barrier level.
The barrier level is below the asset price when the option is initiated.
•The four types of knock-in options:
An up-and-in put option
–An up-and-in put option is a regular European put option that starts to exist as soon as the asset price reaches a barrier level.
The barrier level is greater than the asset price when the option is initiated.
•The four types of knock-in options:
A down-and-in put option
A down-and-in put option is a regular put option that starts to exist as soon as the asset price reaches a barrier level.
The barrier level is below the asset price when the option is initiated
Exotic Options – Lookback Options
payoff from a lookback call
•The payoff from a lookback call is: ST – Smin at time T.
A lookback call allows a buyer to buy stock at the lowest observed price in some interval of time
Exotic Options – Lookback Options
payoff from a lookback put
- The payoff from a lookback put is: Smax– ST at time T.
- A lookback put allows a buyer to sell stock at the highest observed price in some interval of time.
Exotic Options – Lookback Options
The payoff from lookback options depend on
•the maximum or minimum asset price reached during the life of the option.
Exotic Options – Shout Options
•A shout option is a European option where the holder can ‘shout’ to the writer at one time during its life.
Exotic Options – Shout Options
what is the payoff
- The final payoff at the end of the life of the option is either:
- Payoff: max(ST – St , 0) + St – X
–Usual option payoff, max(ST – X, 0), or:
–Intrinsic value at time of shout, St – X.
Exotic Options – Shout Options
what is the payoff
•The final payoff at the end of the life of the option is either:
–Usual option payoff, max(ST – X, 0), or:
–Intrinsic value at time of shout, St – X.
Distinguish between shout and lookback option
•A shout option has some of the same features as a lookback option, but it is considerably less expensive.
Exotic Options – Asian Options
Asian options are options where the payoff depends on the average price of the underlying asset during at least some part of the life of the option
Exotic Options – Asian Options
average price options pay
- Average Price options pay:
- max(Save – X, 0) (call), or:
–max(X – Save , 0) (put).
Exotic Options – Asian Options
•Average Strike options pay:
•Average Strike options pay:
–max(ST – Save , 0) (call), or:
–max(Save – ST , 0) (put).
. Exotic Options – Options to Exchange
- Options to exchange are options to exchange one asset for another in various contexts.
- For example, a stock tender offer is an option to exchange shares in one company for shares in another company.
- When an asset with price U can be exchanged for an asset with price V payoff is max(VT – UT, 0).
A Mortgage-Backed Security is created when
•a financial institution decides to sell part of its residential mortgage portfolio to investors.
–The mortgages are put into a pool and investors acquire a stake in the pool by buying units.
These units are known as the mortgage-backed-securities
A Mortgage-Backed Security
secondary market?
–A secondary market is usually created for the units so that investors can sell them to other investors as desired.
A Mortgage-Backed Security
what is investor entitled to
–An investor who own units representing X% of a certain pool is entitled to X% of the principal and interest payments received from the mortgages in the pool.
This is an example of a pass through MBS where all investors receive the same return and bear the same prepayment risk.
A collateralized mortgage obligation
•A collateralized mortgage obligation differs from pass throughs as investors are divided into a number of classes, and rules are developed for determining how principal repayments are channeled to different classes.
A collateralized mortgage obligation
example
one with three classes. The principal repayments are channeled to class A until investors in this class have been completely paid off, then channeled to class B until they have been completely paid off and then finally to class C investors.
In a stripped mortgage backed security
•all principal payments are separated from interest payments.
–All principal payments are channeled to one class of security, known as principal only (PO);
–All interest payments are channeled to one class of security, known as interest only (IO); and,
–Both POs and IOs are risky investments. As prepayment rates increase, a PO becomes more valuable and an IO becomes less valuable. As prepayment rates decrease, the reverse it true.
Non-Standard Swaps
Step-up swaps:
where the notional principal is an increasing function of time – could be useful for a construction company that wants to borrow an increasing amount as time progresses at a floating rate and swap it for a fixed rate
Non-Standard Swaps
Amortizing swap
where the notional principal is a decreasing function of time;
feature of non-standard swaps
–The principal could also be different on the two sides of the swap, or the payment frequency could be different; and,
Also, the floating reference rate for a swap is not always LIBOR. It could for example be the commercial paper rate
Non-Standard Swaps
compounded swap
the interest is compounded instead of being paid or received. Usually the payments are made at the end of the life of the swap
Non-Standard Swaps
currency swaps
they enable an interest rate exposure in one currency to be swapped for an interest rate exposure in another currency
•
Non-Standard Swaps
fixed-for currency swap
–In a fixed for fixed currency swap, a fixed rate of interest is specified in each currency.
Non-Standard Swaps
In a floating for floating swap,
–In a floating for floating swap, a LIBOR or floating rate of interest is specified in each currency.
Non-Standard Swaps
In a cross-currency interest rate swap
–In a cross-currency interest rate swap, a floating rate in one currency is exchanged for a fixed rate in another currency.
Non-Standard Swaps
LIBOR-in-arrears swaps
difference with normal plain vanilla interest rate swap
•In a LIBOR-in-arrears swap, the floating rate paid on a payment date equals the rate observed on the payment date itself.
in a normal plain vanilla interest rate swap, the floating rate of interest is observed on one payment date and is paid on the next payment date
Non-Standard Swaps
Constant Maturity Swap
–an interest rate swap where the floating rate equals the swap rate for a swap with a certain life.
•For example, the floating payments on a CMS swap might be made every six months at a rate equal to the five-year swap rate.
Non-Standard Swaps
Equity Swaps
one party promises to pay the total return on an equity index applied to a notional principal and the other party promises to pay a fixed or floating return on the notional principal
. Non-standard Swaps - Swaps with Embedded Options
Accrual swaps
•swaps where the interest on one side accrues only when the floating reference rate is within a certain range. Sometimes the range remains fixed during the entire life of the swap, and sometimes it is reset periodically.
. Non-standard Swaps - Swaps with Embedded Options
Cancelable swaps
•a plain vanilla swap where one side has the option to terminate on one or more of the payment dates.
Non-Standard Swaps - Other Swaps
Indexed principal swap:
a swap where the principal reduces in a way dependent on the level of interest rates.
The lower the interest rate, the greater the reduction in the principal.
Non-Standard Swaps - Other Swaps
Commodity swap
•a swapwhere one party agrees to pay a certain amount each year in return for a fixed volume of a commodity. This has the effect of locking in the price of the commodity.
