Portfolio Theory and Financial Engineering

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Portfolio Theory and Financial Engineering

• FIN 428
• Lecture Nineteen Other Derivatives
• Tuesday, April 3, 2007

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Other Derivatives

• Swaps
• Convertible Securities
• Warrants
• Embedded Derivatives
• Others
• In the end, these are all just forms of forwards
  and option.

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OTC Interest Rate Agreements

• Forward-based interest rate contracts
• Forward Rate Agreement (FRA)
• two parties agree today to a future exchange of
  cash flows based on two different interest rates
• one of the cash flows is tied to a fixed rate
• the other is determined at a later date (floating
  rate)
• LIBOR frequently used as the floating rate index
• Single settlement date

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OTC Interest Rate Agreements

• Forward-based interest rate contracts
• Interest Rate Swaps
• multiple exposure dates could be hedged using a
  series of FRAs
• swap contract is a prepackaged series of forward
  contracts to buy or sell LIBOR at the same fixed
  rate

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OTC Interest Rate Agreements

• Forward-based interest rate contracts
• Interest Rate Swaps
• priced off the LIBOR forward yield curve, but
  quoted off the Treasury bond yield curve
• fixed rate side is
• the yield of a Treasury bond with a comparable
  maturity, and
• a risk premium term known as the swap spread

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OTC Interest Rate Agreements

• Forward-based interest rate contracts
• Interest Rate Swaps
• Important Characteristic of Swap Agreement
• an asset to one party and a liability to the
  other as soon as market conditions change after
  the terms of contract are set
• entail credit risks

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OTC Interest Rate Agreements

• Option-based interest rate contracts
• Cap agreement
• a series of cash settlement interest rate
  options, typically based on LIBOR
• Floor agreement
• makes settlement payments only when LIBOR is
  below the floor rate

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OTC Interest Rate Agreements

• Option-based interest rate contracts
• Collars
• combination of a cap and a floor
• long in one and short in the other
• cap-floor-swap parity occurs when the combination
  are at the same rates and have a net zero initial
  cost
• can be viewed as a pair of option positions

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Swap Contracting Extensions

• Equity index-linked swaps
• Equivalent to portfolios of forward contracts
  calling for the exchange of cash flows based on
  two different investment rates
• a variable-debt rate (e.g., three-month LIBOR)
• the return to an equity index (e.g., Standard and
  Poors 500)
• Payment is based on
• the total return, or
• the percentage index change for the settlement
  period plus a fixed spread adjustment.

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Swap Contracting Extensions

• Equity index-linked swaps
• Reasons for Development of Equity Swaps
• To take advantage of overall price movement in a
  stock market without purchasing the equity
  securities directly
• Difficult to create a direct equity investment in
  a foreign country
• Not able to obtain sufficient exchange-traded
  futures or option contracts to hedge a direct
  equity transactions.
• The common application involves a counterparty
  that receives the index-based payment in exchange
  for making the floating rate payment.

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Swap Contracting Extensions
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Warrants and Convertible Securities

• Warrants
• equity option issued by the company whose stock
  serves as the underlying asset
• if exercised, the company will create new shares
  of stock to give to the warrant holder

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Warrants and Convertible Securities

• Convertible securities
• owner has right but not obligation to convert the
  existing investment into another form
• Convertible preferred stock
• convertible into common stock at the discretion
  of the owner
• Convertible bonds
• can be viewed as a prepackaged portfolio
  containing two distinct securities a regular
  bond and an option to exchange the bond for a
  pre-specified number of shares of the issuing
  firms common stock

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Other Embedded Derivatives

• Dual Currency Bonds
• Coupons denominated in a different currency than
  its principal amount
• Equity Index-linked Notes
• Link payoff to an equity index
• Commodity-linked Bull and Bear Bonds
• Link payoff with commodity price movements
• Swap-linked Notes
• Connect payoff with interest rate changes

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Valuing Flexibility An Introduction to Real
Options

• Factors responsible for their increasing
  importance
• The pace of technological innovation
• Deregulation and privatization
• Advances in option pricing theory and decreases
  in the computing costs
• Company Valuation with Real Options

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Next Class

• Test Thursday.
• Project due Sunday.