503 - Structured Products
We have a spot of 100, strike of 100, vol of 25%, R = 5% and T = 1 Call price = 12.34 and Delta is equal to 0.63 How much of the underlying do you need to buy to be delta hedged?
0.63 shares.
What does a 1 year into 5 year swaption mean?
1 year maturity on the 5 year forward rate (The underlying)
What are some of the reasons to add commodities to an investment portfolio?
1. Low correlation with other assets - Diversification 2. Store of value - can perform well in periods of raising inflation and interest rates 3. Performance: Can significantly improve portfolio performance
What are the four ways to gain exposure to commodities?
1. Physical - Buying the commodities and storing it. Can be cumbersome and expensive. Prices tend to mean-revert. 2. Resource Stocks - (E.g buying BP for Oil exposure) Broad equity market exposure. Business Risk. Discounted Cash Flows. Tend to underperform especially when commodity prices are volatility. 3. Commodity Futures - Requires monthly rolls, Operational Risk, Admin Intensive 4. Commodity Indexes - The majority of investments are made via the GSCI (Goldman Sachs Commodity Index). Long-only passive index - Tracks performance of a diversified basked of commodity futures - Transparent and liquid ect.
How do the commodity indices generate returns?
1. Spot return (Change in the nearby futures prices and Commodities often have positive exposure to event risk) 2. Collateral Return/Yield (Treasury yield earning if 100% margin is invested in treasuries during the life of the futures contract) 3. Roll Return/Yield (Change in future prices not attributable to the change in spot prices)
Which gives a higher effective rate? Select one: A. 6.4% per annum quarterly compounded B. 6.5% per annum annually compounded
1.016^4 is greater than 1.065 The correct answer is: 6.4% per annum quarterly compounded
A stock index currently stands at 1,500. Interest rates are 1% per annum (with continuous compounding) and the dividend yield on the index is 7% per annum. What should the price for a nine-month forward contract be?
1500 * e^(0.01-0.07 * 9/12)
The spot price of silver is $25.10 per ounce. Interest rates are 5% per annum (with continuous compounding). What should the forward price for delivery of silver in three-months be to the nearest cent? *assume no storage costs
25.10 * e^(0.05*3/12)
Which gives a higher effective rate? Select one: A. 3.4% per annum quarterly compounded B. 3.5% per annum annually compounded
3.5% per annum annually compounded 1.035 is greater than 1.0085^4
In practice the money lender used to hand over 19 shillings (95 pence) and require £1 paid back the following week, what was the annual equivalent rate to the nearest 1%?
5/95 = 5.2631% so real loan rate = (1+5.2631%)^52 - 1 = 1,339%
You have £10,000 which you want to deposit in a bank, you will not want to touch the money or the interest on it for 5 years. There are three banks which are offering deals on five-year deposits. Which is the most attractive if interest is compounded annually in each case? A. 1% for the first year, then 2%, 3%, 4% and 5% for the next four years respectively B. 3% per year throughout the five years C. 1% per year throughout the five years, plus a terminal bonus of 10% of the money in the account at maturity
A = 11,587.28 B = 11592.74 C = 11,561.11 Answer is B
What is a range accrual note?
A range accrual note pays a coupon for every day that the underlying index falls within a defined range. If the underlying is outside the specific range, the coupon is zero.
Explain the mechanics of an IRS
An interest rate swap (IRS) is an exchange of interest payments, where one party has fixed interest payments and the other party has floating payments based on a reference rate (Libor, Euribor ect.) An IRS does not involve any exchange of capital, only interest rate cash flows are exchanged.
Who would buy an inverse floater?
An investor that believes that rates are going to remain low or even go lower.
Who would buy a range accrual note?
An investor that wants a higher than market coupon and will take the risk of forgoing coupon payments when Libor falls outside the range. The investor is short volatility.
What is an Asian option?
An option where the payoff to the option is a function of the average price of the underlying for some portion of life option the option. These options tend to be cheaper as the vol of the avg is lower than that of the spot itself
What is a bonus certificate? and what are the differences between a RC and BC?
BC aim to fix some of the main problems with reserve convertibles. The key different between BC and RC is that with BC you get a nice coupon but its conditionally and you have upside potential. These also tend to be longer in maturity (RCs are shorter)
What forward curve do we want for commodity structured products?
Backwardation - the options will be cheaper as the options are OTM.
What are the four main exotic options?
Barriers Binary Asian Basket
What are basket options and how can they be priced?
Basket Option - As its name suggests a Basket Option is simply an option on a basket of assets. A common example is an equity index option. The vol of a basket can be approximated from the individual vols in the assets in the baskets and their correlations. The payoff of a basket does not always have to be related to the performance of the baskets - there are also best of and worst of options. A best of option pays the difference between the best performing asset in the baskets and the strike price. The worst of option pays the difference between the worst best performing asset in the baskets and the strike price.
What are the key commodity linked structured notes? Growth Products
Bull Notes / Bear Shark Notes Capped commodity linked notes Basket of commodities
What goes into a Reserve Convertible?
Buy Coupon Paying Bond Sell Put Option (Vanilla or Barrier)
How do you construct a twin win?
Buy ZSC Buy ATM Call Buy 2x Down and out puts
How do you construct a Bonus Certificate?
Buy a zero strike call Buy a down and out put
How do you construct a capped bonus certificate?
Buy a zero strike call Buy a down and out put Sell OTM Call
Which of the following is true: A. Both forward and futures contracts are traded on exchanges. B. Forward contracts are traded on exchanges, but futures contracts are not. C. Futures contracts are traded on exchanges, but forward contracts are not. D. Neither futures contracts nor forward contracts are traded on exchanges.
C. Futures contracts are traded on exchanges, but forward contracts are not.
If the 1-year annually compounded interest rate is 4%, how much is 100 to be received in 1 years time worth today to the nearest 0.01?
CFt= 100, r=4% and t=1 96.15
Create x amount of equity protected structured products
Capital Protected Equity Linked Note Buy ZCB Buy Call Option Capped CPELN Buy ZCB Buy Call Sell OTM Call Shark Note Buy ZCB Buy Knock Out Call Option (Could be double!)
If you believe that interest rates are going down and the company only issues FRNs (floating rate notes)
We can enter into a swap to get fixed coupon bonds.
How can we cheapen the cost of a structure product to ensure profits for our investment bank?
We can: Cap the returns Make options barriers If already barriers, move barriers closer to strike Could vary cap protection (but investors want 100%)
One futures contract is traded where both the long and short parties are closing out existing positions. What is the resultant change in the open interest? A. No Change B. Decrease by one C. Decrease by two D. Increase by one
Decrease by one The open interest goes down by one because there is one less long position and one less short position.
Explain delta hedging and explain why it will change over time
Delta hedging is the process of developing a portfolio of an option and a position in the underling asset which is equal to the delta. By doing this, we have no exposure to the option prices. You need to continuously adjust your delta hedge because if the underlying asset moves by 1, the call option will change by the old delta amount and there will be a new delta. If we do not adjust our underlying, we will be under/over exposed to the underlying.
Explain the concept of delta
Delta is the rate of change of an option price with respect to the underlying. In other words, how much do you make or lose as the underlying asset changes.
What is backwardation? Why is it common in consumption products i.e oil?
Downward sloping forward curve. due to consumptions yield
Which of the following is NOT true A. Futures contracts nearly always last longer than forward contracts. B. Futures contracts are standardized; forward contracts are not. C. Delivery or final cash settlement usually takes place with forward contracts; the same isnot true of futures contracts. D. Forward contracts usually have one specified delivery date; futures contract often have a range of delivery dates.
Futures contracts nearly always last longer than forward contracts
How does cheapening the option change between growth and yield products?
Growth - Varying the level of capital protection and varying the option payoff. For growth we wanted low vol. Yield - Varying the level of downside protection (You will get a lower coupon for more downside protection and Selecting stocks or baskets that can provide high dividend yield and high volatility.
What is a key different between growth and yield products?
Growth products have a floor price due to the ZCB and the delta gets smaller as the price falls (Due to us being long gamma) Yield products do not have this floor price, the only floor is 0. Our delta increases are the price falls.
Which stocks are great for BC?
High dividend yield stocks - (These cheapens the ZSC) Higher vol stocks - The ZSC is inisentivity to vol, but the down and out put is short vega therefor an increase in vol means a cheaper option
What is Rho?
How does the value of an option chance in respect to changes in interest rates I.e. How much do you make or lose on the option as IR moves? - This is only very important for longer dated options.
What is Gamma?
How much does the Delta change with respect to the price of the underlying asset? It is the slope of the delta curve. I.e., how much your delta change as the underlying asset moves.
What is Vega?
How much does your option value chance as implied volatility changes.
When do commodities do well?
In times of rising inflation
What factors will affect the price of an option in the primary market?
Interest Rates - Higher rates, less in zero coupon, more money to buy options give more participation. Volatility - Increased vol means more expensive options and less participation in growth products
What factors will affect the price of an option in the secondary market?
Interest Rates - Rising rates, value of zero-coupon bond falls thus product price falls Volatility - Increase in vol means the option becomes more expensive. If long options, then the product price rises. Price of the Underlying - Product WILL move with the underlying BUT if participation is 100% product the change will NOT be 100% (This back to the delta is week 2 & 3).
What is a swaption?
It gives the buyer the right to enter into a swap trade receiving either fixed or floating rates and paying the opposite. There is a premium that is paid upfront.
What is an inverse floater note?
It pays a coupon of the inverse of the floating rate. (x% - floating rate). You receive a higher rate when rates go down and lower when rates go up.
How do you structure a Inverse Floater?
Long FRN Receive Fixed IRS Long Cap
What is the prime environment for a growth product?
Low Volatility and High Yield.
A company enters into a short futures contract to sell 50,000 units of a commodity for 70 cents per unit. The initial margin is $4,000 and the maintenance margin is $3,000. What is the futures price per unit above which there will be a margin call?
Margin call = Initial Margin - Maintained = 1000 Price needs to price by 2c to hit 1000 Price = 72
If in a 1 year into 5-year swaption, you are a receiver getting the fixed rate at 1.25% and paying to float. If in one year, the rates are 1.5%, would you exercise this option?
No, you would receive the 1.5% and let the option expire worthlessly. If the interest rates go down, you exercise the option, pay the floating and receive the spread.
Are FRNs sensitive to market rates?
No. FRN is not sensitive to market rates, as rates = coupon up = price is almost unchanged. FRN is sensitive to the credit of issuer - Credit spread up = price down.
What stocks are typically good for a reserve convertible?
Ones that have recently "Bombed" Big fall leads to increase implied vol - Selling down and in puts is short vega - Also helps to convinece people... "it can't go any further" These are often structure with the barrier, how can be without the barrier (not as common).
What is the difference between a payer and receiver swaption?
Payer gives the right to pay the fixed rate and to receive the floating rate (Payer wants the rate to go higher) The receiver gives the right to receive the fixed rate and pay the floating (receiver wants the rate to go lower)
How are swaptions paid out?
Physical settlement - The counterparties will enter a swap at 1.25% Cash Settlement - the seller pays the buyer the NPV of a 5 year swap at the rate of 2.5% using current rate s for discounting
Who would be the purchaser of a cap option?
Someone that does not want to pay more then a specific coupon on a loan.
Who would be the purchases of a floor option?
Someone that needs a minimum return.
What are the two main categories of interest rate options?
Swaptions Caps/floors
How is a range accrual structured?
The buyer is selling a digital cap and digital floor The premium from selling the option is what gives its attractive coupon. The payoff from the short options has to be equal to the coupon so there is a certain circularity in the pricing.
What happens if the interest rate exceeds the cap?
The buyer of the option will receive capital equal to the increase above the cap.
Which gives a higher effective rate? Select one: A. 3.5% per annum annually compounded B. 3.4% per annum continuously compounded
The correct answer is: 3.5% per annum annually compounded 1.035 is greater than e0.034
Do you make money or lose money delta hedging?
The goal is to make 0 profits. If the realised volatility over the life of the option is identical to the volatility, we used to price the option and we can continuously adjust our hedge (with no transaction costs) then the profit we make on our delta hedge will exactly offset the premium paid for the option.
A payday lender operating out of an East End London pub in the 1950s used to offer to lend workmen £1 per week in return for a shilling (5 pence), what was the annual equivalent rate of these loans to the nearest 1%?
The loan rate is 5% so annually this is (1+0.05)^52 - 1 = 1,164%
What is a reserve convertible note
The most popular yield note and after capital protected its the most popular equity notes. You are guaranteed a coupon + 100% capital protected as long as you don't hit the barrier. Even if you hit the barrier, you are above 1:1 with the underlying
What is the benefit of having a knock-in option?
The probability of the knock-in option getting knocked in is typically under-priced.
What happens if rates fall with an inverse floater?
The value of the floater will increase, the coupons will be higher and the PV of future cash flows will be higher
What is Theta?
Theta is the rate of change of the value of an option with respect to the passage of time. (i.e how much do you make or lose on the option as one day passes).
Where does roll return come from?
This comes from the shape of the future yield. If the curve is in backwardation, you are able to buy the next months contract for cheaper than the spot. Then you sell the contract at expiry for spot and buy the next contract. however, if the yield curve is in contango,
What happens if rate rise with an inverse floater?
This will result in lower coupon payments (x% - libor) and lower PV of future CF due to higher discount rate.
What is contango?
Upward sloping forward curve
What happens if we use a flat volatility smile?
Using a flat vol surface is flawed and dangerous because it does not reflect the true distribution of the underlying asset. We would under value OTM puts (portfolio insurance) and Underestimate the delta of OOM options. (Underhedged). If you use a flat vol surface - all your greeks will be wrong!
How does the forward yield curve impact option pricing?
With a commodity option, you are buying the right to buy the commodity at the spot price and the underlying is the forward price. If the forward curve is in contango (upward sloping) you are buying a call ITM option as Spot is less then underlying If the forward curve is in backwardation (Downward sloping) you are buying a call OTM option as Spit is greater then Underlying Therefore, it will be more expensive to purchase a commodity option when the yield curve is in Contango.
What is a key difference between owning a equity linked note and owning the underlying?
You are not exposed to the downside risk however, you do forego future dividends as a result.
Explain Inverse floater
You pay a premium and at the end you get par + coupon. In the meantime, you recieve x% - libor
You want to buy a bond but think interest rates are rising and the company only issues fixed rate bonds, what do you do?
You should not buy this bond, we want a FRN but the issue doesn't have these, so we need to do a swap. We'll swap our fixed coupons for a floating coupon.