Brian A. Eales

Overview of Fixed Income Securities

This chapter introduces fixed income analysis, especially the pricing of default-free zero-coupon and coupon fixed-term bonds. A zero-coupon bond makes a single payment on its maturity date, while a coupon bond makes regular interest payments at regular dates up to and including its maturity date. A coupon bond may be regarded as a set of strips, with each coupon payment and the redemption payment on maturity being equivalent to a zero-coupon bond maturing on that date. A zero-coupon bond is the simplest fixed income security. It is an issue of debt, the issuer promising to pay the face value of the debt to the bondholder on the date the bond matures. The majority of bonds in the market make periodic interest or coupon payments during their life and are known as coupon bonds. The coupons have a nominal value that is a percentage of the nominal value of the bond itself, with steadily longer maturity dates, while the final redemption payment has the nominal value of the bond itself and is redeemed on the maturity date.

3 – Forwards and Futures Valuation

This chapter discusses basic valuation concepts of forward and futures contracts. A forward contract is an agreement between two parties in which the buyer contracts to purchase from the seller a specified asset, for delivery at a future date, at a price agreed today. When a forward contract is written, its delivery price is set so that the present value of the payout is zero. This means that the forward price is then the price on delivery which would make the present value of the payout, on the delivery date, equal to zero. Forward contracts are tailor-made instruments designed to meet specific individual requirements. Futures contracts on the other hand are standardized contracts that are traded on recognized futures exchanges. The significant aspect for the buyer of a forward contract is that the payoff of the forward is identical to that of a portfolio containing an equivalent amount of the underlying asset, which has been constructed using borrowed funds.

11 – Option pricing

Publisher Summary This chapter explains how the Black and Scholes (B&S) model can be applied and will develop alternative pricing approaches: lattice frameworks and Monte Carlo simulation. It considers and explains several frameworks that are available for the calculation of option premia. The binomial and trinomial model is used in this chapter to examine the pricing of regular stock options and to demonstrate how the flexibility offered by these frameworks might lend itself to pricing options with non-standard payoff profiles. Turning to the assumptions on which the model is based, it is clear that in some respects they are untenable. The assumption concerning constancy of the risk-free rate of interest is also a problem. The first pricing framework to be considered is the binomial approach. This method offers an intuitively attractive approach to the pricing of options. In its most basic form it is simple to use and yet affords an insight into the potential power and flexibility it can offer. The trinomial is compared to its binomial counterpart and its advantages are discussed.

7 – Credit Derivatives

Publisher Summary Credit derivatives allow investors to manage the credit risk exposure of their portfolios or asset holdings, essentially by offering insurance against deterioration in credit quality of the borrowing entity. Credit risk is the risk that a borrowing entity will default on a loan, either through inability to maintain the interest servicing or because of bankruptcy or insolvency leading to inability to repay the principal itself. Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by offering insurance against losses suffered due to credit events. The use of credit derivatives assists banks with restructuring their businesses, because they allow banks to repackage and parcel out credit risk, while retaining assets on-balance sheet and thus maintain client relationships. A bank can reduce credit exposure either for an individual loan or a sectoral concentration, by buying a credit default swap. The occurrence of a specified credit event will trigger payment of the default payment by the seller of protection to the buyer of protection.

9 – Equity Swaps

Publisher Summary A basic equity swap involves two parties entering into a contractual agreement to exchange a stream of cash flows linked to the total return of an equity index against a schedule of returns derived from a short-term interest rate index. Equity swaps differ from the interest rate and currency swaps. In terms of construction, straightforward equity swap involves the exchange of the return from a stock market index against some short-term interest rate index like London Interbank offered rate (LIBOR). The index receiver pays a fixed spread of around 2.76 bps to the index payer each quarter. An alternative to this method of valuing the swap would be to obtain simulated values of the index at the relevant future dates. This type of approach, if it allowed for time-varying returns or stochastic volatility, would lead to scenarios where the index could fall rather than rise monotonically over time when the risk-free rate of interest is larger than the projected dividend yield.

Equity Futures Contracts

Futures contracts represent an agreement between two parties to undertake a transaction at some agreed future date at a price agreed now. These contracts are exchange-based instruments and have standard delivery dates. The contracts are tightly specified so that the market participants know exactly what they are agreeing to buy or sell. An innovation as far as the exchanges are concerned, is the introduction of universal stock futures (USFs) also known as single stock futures (SSFs). A short position in the index futures contract could be combined with a long USF position in the individual stock. The chapter states the uses of futures such as: speculation, arbitrage, hedging, and engineering; and discusses operational characteristics of equity futures contracts such as: margin, beta and basis, advanced hedges, basic risk hedging, and pricing equity futures.

Equity and Equity Index Options

Equity options offer a special type of vehicle for creating and manipulating payout profiles. The profile is quite different from that used to show the profit or loss regions associated with long and short futures positions. What makes the application of options so attractive is that they can be regarded as a set of easily understood building blocks that can be combined in many ways to engineer positions that will deliver a desired payout at some defined future point in time. One way of judging whether an option, or for that matter any other instrument, is mispriced is to replicate its structure. Using options in conjunction with other instruments will enable new classes of instruments to be developed and these instruments in turn can be used to satisfy the demands of the investing public. The seller of the option is known as writing an option.

Introduction to Derivatives

Derivative instruments play a vital role in managing the risk of underlying securities such as bonds, equity, equity indexes, currency, short-term interest rate asset or liability positions. Each instrument has its own characteristics, which offer advantages and disadvantages in using them. The disadvantages may not always be apparent to the end user. Derivatives may be used to speculate, hedge a portfolio of shares, bonds, and undertake arbitrage. Exchange-based futures contracts can be used to manipulate a portfolios risk exposure. By adjusting the number of contracts shorted or bought, the portfolio can be made neutral to market moves by creating a zero portfolio beta. Options too come in both exchange-based and off-exchange contract (OTC) varieties. Basically there are two types of option classes available: calls and puts. The cash flows are almost calculated by reference to the behavior of an index and are scaled by an agreed nominal principal.

Equity-linked Structured Products

Convertible bonds (CBs) represent an exciting but rather neglected section of the fixed income markets. This type of bond endows on its holder the right to purchase a defined quantity of shares at a defined price. Even in their most basic form, convertible bonds can be difficult to examine and hedge. An intuitively appealing starting point when examining the problem of pricing a CB would therefore be to make use of the binomial framework. At some points where redemption value plus coupon and terminal value of shares are very close, the decision to convert may become more complex. Institutional and transaction costs, the dilution factor and investor preferences may come into play and influence the final decision. Convertible bonds are often issued with a call feature that enables the issuer to force the holder to convert when the companys share price reaches a certain level.