1 Overview of Derivatives
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Interest Rate Options
Interest Rate Options Saurav Sen April 2001 Contents 1. Caps and Floors 2 1.1. Defintions . 2 1.2. Plain Vanilla Caps . 2 1.2.1. Caplets . 3 1.2.2. Caps . 4 1.2.3. Bootstrapping the Forward Volatility Curve . 4 1.2.4. Caplet as a Put Option on a Zero-Coupon Bond . 5 1.2.5. Hedging Caps . 6 1.3. Floors . 7 1.3.1. Pricing and Hedging . 7 1.3.2. Put-Call Parity . 7 1.3.3. At-the-money (ATM) Caps and Floors . 7 1.4. Digital Caps . 8 1.4.1. Pricing . 8 1.4.2. Hedging . 8 1.5. Other Exotic Caps and Floors . 9 1.5.1. Knock-In Caps . 9 1.5.2. LIBOR Reset Caps . 9 1.5.3. Auto Caps . 9 1.5.4. Chooser Caps . 9 1.5.5. CMS Caps and Floors . 9 2. Swap Options 10 2.1. Swaps: A Brief Review of Essentials . 10 2.2. Swaptions . 11 2.2.1. Definitions . 11 2.2.2. Payoff Structure . 11 2.2.3. Pricing . 12 2.2.4. Put-Call Parity and Moneyness for Swaptions . 13 2.2.5. Hedging . 13 2.3. Constant Maturity Swaps . 13 2.3.1. Definition . 13 2.3.2. Pricing . 14 1 2.3.3. Approximate CMS Convexity Correction . 14 2.3.4. Pricing (continued) . 15 2.3.5. CMS Summary . 15 2.4. Other Swap Options . 16 2.4.1. LIBOR in Arrears Swaps . 16 2.4.2. Bermudan Swaptions . 16 2.4.3. Hybrid Structures . 17 Appendix: The Black Model 17 A.1. -
3. VALUATION of BONDS and STOCK Investors Corporation
3. VALUATION OF BONDS AND STOCK Objectives: After reading this chapter, you should be able to: 1. Understand the role of stocks and bonds in the financial markets. 2. Calculate value of a bond and a share of stock using proper formulas. 3.1 Acquisition of Capital Corporations, big and small, need capital to do their business. The investors provide the capital to a corporation. A company may need a new factory to manufacture its products, or an airline a few more planes to expand into new territory. The firm acquires the money needed to build the factory or to buy the new planes from investors. The investors, of course, want a return on their investment. Therefore, we may visualize the relationship between the corporation and the investors as follows: Capital Investors Corporation Return on investment Fig. 3.1: The relationship between the investors and a corporation. Capital comes in two forms: debt capital and equity capital. To raise debt capital the companies sell bonds to the public, and to raise equity capital the corporation sells the stock of the company. Both stock and bonds are financial instruments and they have a certain intrinsic value. Instead of selling directly to the public, a corporation usually sells its stock and bonds through an intermediary. An investment bank acts as an agent between the corporation and the public. Also known as underwriters, they raise the capital for a firm and charge a fee for their services. The underwriters may sell $100 million worth of bonds to the public, but deliver only $95 million to the issuing corporation. -
Understanding the Z-Spread Moorad Choudhry*
Learning Curve September 2005 Understanding the Z-Spread Moorad Choudhry* © YieldCurve.com 2005 A key measure of relative value of a corporate bond is its swap spread. This is the basis point spread over the interest-rate swap curve, and is a measure of the credit risk of the bond. In its simplest form, the swap spread can be measured as the difference between the yield-to-maturity of the bond and the interest rate given by a straight-line interpolation of the swap curve. In practice traders use the asset-swap spread and the Z- spread as the main measures of relative value. The government bond spread is also considered. We consider the two main spread measures in this paper. Asset-swap spread An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating-coupon will be a spread over Libor (see Choudhry et al 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk.1 Asset swaps may be transacted at par or at the bond’s market price, usually par. This means that the asset swap value is made up of the difference between the bond’s market price and par, as well as the difference between the bond coupon and the swap fixed rate. -
Bond Liquidity and Dealer Inventories: Insights from US and European Regulatory Data
52 Financial Conduct Authority Occasional Paper Securities and Exchange Commission DERA Working Paper February 2020 Bond liquidity and dealer inventories: Insights from US and European regulatory data Plamen Ivanov, Alexei Orlov and Michael Schihl Occasional Paper 52 / DERA Working Paper Bond liquidity and dealer inventories Occasional Paper 52 / DERA Working Paper Abstract Most corporate bond research on liquidity and dealer inventories is based on the USD- denominated bonds transactions in the US reported to TRACE. Some of these bonds, however, are also traded in Europe, and those trades are not subject to the TRACE reporting require- ments. Leveraging our access to both TRACE and ZEN, the UK's trade reporting system which is not publicly available, we find an overlap of about 30,000 bonds that are traded both in the US and in Europe. This paper examines how using the CUSIP-level information from TRACE and ZEN affects the computation of bond liquidity metrics, dealer inventories, and the relationship between the two. We find that in the combined dataset, the weekly volume traded and number of trades are significantly higher than in TRACE: e.g., the average unconditional number of trades in investment-grade (high-yield) bonds is 17% (20%) higher and the average uncondi- tional volume traded is 15% (17%) higher when we incorporate the information from ZEN. We find a strong positive relationship between inventories and liquidity, as proxied by the trading activity metrics (i.e., number of trades, zero trading days, or par value traded) in TRACE data, and this result carries over to the combined dataset. -
Mortgage-Backed Securities & Collateralized Mortgage Obligations
Mortgage-backed Securities & Collateralized Mortgage Obligations: Prudent CRA INVESTMENT Opportunities by Andrew Kelman,Director, National Business Development M Securities Sales and Trading Group, Freddie Mac Mortgage-backed securities (MBS) have Here is how MBSs work. Lenders because of their stronger guarantees, become a popular vehicle for finan- originate mortgages and provide better liquidity and more favorable cial institutions looking for investment groups of similar mortgage loans to capital treatment. Accordingly, this opportunities in their communities. organizations like Freddie Mac and article will focus on agency MBSs. CRA officers and bank investment of- Fannie Mae, which then securitize The agency MBS issuer or servicer ficers appreciate the return and safety them. Originators use the cash they collects monthly payments from that MBSs provide and they are widely receive to provide additional mort- homeowners and “passes through” the available compared to other qualified gages in their communities. The re- principal and interest to investors. investments. sulting MBSs carry a guarantee of Thus, these pools are known as mort- Mortgage securities play a crucial timely payment of principal and inter- gage pass-throughs or participation role in housing finance in the U.S., est to the investor and are further certificates (PCs). Most MBSs are making financing available to home backed by the mortgaged properties backed by 30-year fixed-rate mort- buyers at lower costs and ensuring that themselves. Ginnie Mae securities are gages, but they can also be backed by funds are available throughout the backed by the full faith and credit of shorter-term fixed-rate mortgages or country. The MBS market is enormous the U.S. -
Tax Treatment of Derivatives
United States Viva Hammer* Tax Treatment of Derivatives 1. Introduction instruments, as well as principles of general applicability. Often, the nature of the derivative instrument will dictate The US federal income taxation of derivative instruments whether it is taxed as a capital asset or an ordinary asset is determined under numerous tax rules set forth in the US (see discussion of section 1256 contracts, below). In other tax code, the regulations thereunder (and supplemented instances, the nature of the taxpayer will dictate whether it by various forms of published and unpublished guidance is taxed as a capital asset or an ordinary asset (see discus- from the US tax authorities and by the case law).1 These tax sion of dealers versus traders, below). rules dictate the US federal income taxation of derivative instruments without regard to applicable accounting rules. Generally, the starting point will be to determine whether the instrument is a “capital asset” or an “ordinary asset” The tax rules applicable to derivative instruments have in the hands of the taxpayer. Section 1221 defines “capital developed over time in piecemeal fashion. There are no assets” by exclusion – unless an asset falls within one of general principles governing the taxation of derivatives eight enumerated exceptions, it is viewed as a capital asset. in the United States. Every transaction must be examined Exceptions to capital asset treatment relevant to taxpayers in light of these piecemeal rules. Key considerations for transacting in derivative instruments include the excep- issuers and holders of derivative instruments under US tions for (1) hedging transactions3 and (2) “commodities tax principles will include the character of income, gain, derivative financial instruments” held by a “commodities loss and deduction related to the instrument (ordinary derivatives dealer”.4 vs. -
Corporate Bonds and Debentures
Corporate Bonds and Debentures FCS Vinita Nair Vinod Kothari Company Kolkata: New Delhi: Mumbai: 1006-1009, Krishna A-467, First Floor, 403-406, Shreyas Chambers 224 AJC Bose Road Defence Colony, 175, D N Road, Fort Kolkata – 700 017 New Delhi-110024 Mumbai Phone: 033 2281 3742/7715 Phone: 011 41315340 Phone: 022 2261 4021/ 6237 0959 Email: [email protected] Email: [email protected] Email: [email protected] Website: www.vinodkothari.com 1 Copyright & Disclaimer . This presentation is only for academic purposes; this is not intended to be a professional advice or opinion. Anyone relying on this does so at one’s own discretion. Please do consult your professional consultant for any matter covered by this presentation. The contents of the presentation are intended solely for the use of the client to whom the same is marked by us. No circulation, publication, or unauthorised use of the presentation in any form is allowed, except with our prior written permission. No part of this presentation is intended to be solicitation of professional assignment. 2 About Us Vinod Kothari and Company, company secretaries, is a firm with over 30 years of vintage Based out of Kolkata, New Delhi & Mumbai We are a team of qualified company secretaries, chartered accountants, lawyers and managers. Our Organization’s Credo: Focus on capabilities; opportunities follow 3 Law & Practice relating to Corporate Bonds & Debentures 4 The book can be ordered by clicking here Outline . Introduction to Debentures . State of Indian Bond Market . Comparison of debentures with other forms of borrowings/securities . Types of Debentures . Modes of Issuance & Regulatory Framework . -
An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting
Federal Reserve Bank of New York Staff Reports An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting Michael Fleming John Jackson Ada Li Asani Sarkar Patricia Zobel Staff Report No. 557 March 2012 Revised October 2012 FRBNY Staff REPORTS This paper presents preliminary fi ndings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the authors and are not necessarily refl ective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting Michael Fleming, John Jackson, Ada Li, Asani Sarkar, and Patricia Zobel Federal Reserve Bank of New York Staff Reports, no. 557 March 2012; revised October 2012 JEL classifi cation: G12, G13, G18 Abstract This paper examines the over-the-counter (OTC) interest rate derivatives (IRD) market in order to inform the design of post-trade price reporting. Our analysis uses a novel transaction-level data set to examine trading activity, the composition of market participants, levels of product standardization, and market-making behavior. We fi nd that trading activity in the IRD market is dispersed across a broad array of product types, currency denominations, and maturities, leading to more than 10,500 observed unique product combinations. While a select group of standard instruments trade with relative frequency and may provide timely and pertinent price information for market partici- pants, many other IRD instruments trade infrequently and with diverse contract terms, limiting the impact on price formation from the reporting of those transactions. -
Corporate Bond Market Dysfunction During COVID-19 and Lessons
Hutchins Center Working Paper # 69 O c t o b e r 2 0 2 0 Corporate Bond Market Dysfunction During COVID-19 and Lessons from the Fed’s Response J. Nellie Liang* October 1, 2020 Abstract: Changes in the financial sector since the global financial crisis appear to have increased dramatically the demand for liquidity by holders of corporate bonds beyond the ability of the markets to provide it in stress events. The March market turmoil revealed the costs of liquidity mismatch in open-end bond mutual funds. The surprisingly large redemptions of investment-grade corporate bond funds added to stresses in both the corporate bond and Treasury markets. These conditions led to unprecedented Fed interventions, which significantly reduced risk spreads and improved market functioning, with much of the improvements occurring right after the initial announcement. The improved conditions allowed companies to issue bonds, which helped them to maintain employees and investment spending. The episode suggests several areas for further study and possible reforms. * J. Nellie Liang, Hutchins Center on Fiscal and Monetary Policy, Brookings Institution ([email protected]). I would like to thank Darrell Duffie, Bill English, Anil Kashyap, Donald Kohn, Patrick Parkinson, Jeremy Stein, Adi Sunderam, David Wessel, and Alex Zhou for helpful comments and insights, and Manuel Alcalá Kovalski for excellent research assistance. THIS PAPER IS ONLINE AT https://www.brookings.edu/research/corporate- bond-market-dysfunction-during-covid-19-and- lessons-from-the-feds-response/ 1. Introduction As concerns about the pandemic’s effect on economic activity in early March escalated, asset prices began to move in unusual ways—including the prices of investment-grade corporate bonds. -
The Use of Credit Default Swaps by U.S. Fixed-Income Mutual Funds
Sanjiv R. Das FDIC Center for Financial Research Darrell Duffie Working Paper Nikunj Kapadia No. 2011-01 Empirical Comparisons and Implied Recovery Rates The Use of Credit Default Swaps by U.S Fixed-Income Mutual Funds Risk-Based Capital Standards, kkk Deposit Insurance and Procyclicality November 19, 2010 Risk-Based Capital Standards, Deposit Insurance and Procyclicality An Empirical September 2005 An Empirical Analysis Federal Dposit Insurance Corporation •Center for Financial Researchh State- May, 2005 Efraim Benmel Efraim Benmelech June 20 May , 2005 Asset S2005-14 The Use of Credit Default Swaps by U.S. Fixed-Income Mutual Funds Tim Adam, Humboldt University* and Risk Management Institute (Singapore) Andre Guettler, University of Texas at Austin and EBS Business School† November 19, 2010 Abstract We examine the use of credit default swaps (CDS) in the U.S. mutual fund industry. We find that among the largest 100 corporate bond funds the use of CDS has increased from 20% in 2004 to 60% in 2008. Among CDS users, the average size of CDS positions (measured by their notional values) increased from 2% to almost 14% of a fund’s net asset value. Some funds exceed this level by a wide margin. CDS are predominantly used to increase a fund’s exposure to credit risks rather than to hedge credit risk. Consistent with fund tournaments, underperforming funds use multi-name CDS to increase their credit risk exposures. Finally, funds that use CDS underperform funds that do not use CDS. Part of this underperformance is caused by poor market timing. JEL-Classification: G11, G15, G23 Keywords: Corporate bond fund, credit default swap, credit risk, fund performance, hedging, speculation, tournaments * Humboldt University, Institute of Corporate Finance, Dorotheenstr. -
Panagora Global Diversified Risk Portfolio General Information Portfolio Allocation
March 31, 2021 PanAgora Global Diversified Risk Portfolio General Information Portfolio Allocation Inception Date April 15, 2014 Total Assets $254 Million (as of 3/31/2021) Adviser Brighthouse Investment Advisers, LLC SubAdviser PanAgora Asset Management, Inc. Portfolio Managers Bryan Belton, CFA, Director, Multi Asset Edward Qian, Ph.D., CFA, Chief Investment Officer and Head of Multi Asset Research Jonathon Beaulieu, CFA Investment Strategy The PanAgora Global Diversified Risk Portfolio investment philosophy is centered on the belief that risk diversification is the key to generating better risk-adjusted returns and avoiding risk concentration within a portfolio is the best way to achieve true diversification. They look to accomplish this by evaluating risk across and within asset classes using proprietary risk assessment and management techniques, including an approach to active risk management called Dynamic Risk Allocation. The portfolio targets a risk allocation of 40% equities, 40% fixed income and 20% inflation protection. Portfolio Statistics Portfolio Composition 1 Yr 3 Yr Inception 1.88 0.62 Sharpe Ratio 0.6 Positioning as of Positioning as of 0.83 0.75 Beta* 0.78 December 31, 2020 March 31, 2021 Correlation* 0.87 0.86 0.79 42.4% 10.04 10.6 Global Equity 43.4% Std. Deviation 9.15 24.9% U.S. Stocks 23.6% Weighted Portfolio Duration (Month End) 9.0% 8.03 Developed non-U.S. Stocks 9.8% 8.5% *Statistic is measured against the Dow Jones Moderate Index Emerging Markets Equity 10.0% 106.8% Portfolio Benchmark: Nominal Fixed Income 142.6% 42.0% The Dow Jones Moderate Index is a composite index with U.S. -
Taking the Risk out of Interest Rate Risk Protecting Countries Against Interest Rate Risk with IBRD Flexible Loans
ASE STUDY Taking the Risk out of Interest Rate Risk Protecting Countries against Interest Rate Risk with IBRD Flexible Loans OVERVIEW Interest rate risk can increase debt- servicing costs, putting pressure on national budgets and forcing countries to impose spending cuts or tax reforms. The World Bank helps countries manage this risk with market-based risk management tools such as the IBRD Flexible Loan (IFL). Over the past 17 years, the World Bank has helped over 40 countries with a combined US$70 billion portfolio use the IFL. Local fisherman in Mexico. Photo credit: Curt Carnemark / World Bank. strategies, many governments establish targets or Background benchmark ranges for key risk indicators to guide borrowing activities and other debt transactions. One Governments borrow from the global financial way that a country can achieve the target mix of markets to fund key development objectives such as fixed-rate versus floating-rate debt is by fixing the high-quality education, clean energy, and needed interest rates on loans. infrastructure. But borrowing at floating interest rates may expose governments to interest rate risk. Countries that have a high percentage of their debt Financing Objectives portfolio in floating interest rates could see interest The IBRD Flexible Loan allows countries to meet payments increase dramatically with the upsurge of several objectives: the reference rate. • Reduce interest rate risk of public debt stock If interest rate risk materializes, countries face higher • Keep the ratio of floating interest rate to fixed debt-servicing costs, which put pressure on the interest rate within the target benchmarks as country’s budget.