Finance Concepts: Options and Bonds
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Questions and Answers

What is the primary role of collateral in the context of repo transactions?

  • To facilitate the transfer of ownership of securities
  • To serve as a protection against default (correct)
  • To enhance the yield of the underlying assets
  • To provide liquidity for cash transactions

What does the term 'specials' refer to in repo transactions?

  • The use of collateral that is highly valued by the market
  • The borrowing of money in unsecured loans
  • The lending of specific securities rather than cash (correct)
  • Short-term investment funds targeting high returns

What advantage does the seller have in a repo transaction concerning collateral?

  • The power to enforce penalties on the buyer
  • The ability to sell the collateral freely during the term
  • The right to set the repo rate independently
  • The option to recall and substitute collateral of equivalent value (correct)

Why might a delivery repo be considered the most expensive option?

<p>Collateral transferred incurs settlement system costs (B)</p> Signup and view all the answers

In a hold in custody (HIC) repo, who maintains custody of the collateral?

<p>The seller (B)</p> Signup and view all the answers

What does the swap seller pay in a fixed-for-floating swap?

<p>Variable rate of interest (D)</p> Signup and view all the answers

Which party benefits from anticipating a rise in interest rates in a fixed-for-floating swap?

<p>Swap buyer (D)</p> Signup and view all the answers

What is the main risk associated with swaps from the perspective of a variable rate investment?

<p>Decrease in interest rates (C)</p> Signup and view all the answers

In a currency swap, what replaces the notional amount common in interest rate swaps?

<p>Two principal amounts in different currencies (A)</p> Signup and view all the answers

What does the Swiss bank effectively fund at through the currency swap after issuing a CHF Bond?

<p>LIBOR - 0.11% (C)</p> Signup and view all the answers

Which of the following best describes a covered bond?

<p>A debt instrument issued by a credit institution (C)</p> Signup and view all the answers

What do both participants in a fixed-for-floating swap exchange regarding their fixed and variable payment expectations?

<p>They exchange fixed and variable payments (D)</p> Signup and view all the answers

What is a common strategy for using swaps as a financial instrument?

<p>To hedge global interest rate risk (D)</p> Signup and view all the answers

What is the term for the amount that represents the difference between the observed rate and the guaranteed rate in a financial transaction?

<p>Net gain (B)</p> Signup and view all the answers

What calculation does the formula for repo interest amount include?

<p>Start proceed multiplied by the repo rate and the term basis (A)</p> Signup and view all the answers

What does the haircut refer to in the context of the dirty price of a bond?

<p>The reduction in the value of collateral (B)</p> Signup and view all the answers

What is a characteristic of a callable bond?

<p>It allows the issuer to repay the bond on specified future dates. (D)</p> Signup and view all the answers

In a Forward Rate Agreement (FRA), what does FRA (3*6) represent?

<p>3 months rate starting 3 months from now (B)</p> Signup and view all the answers

What is the primary purpose of over-the-counter (OTC) derivatives?

<p>Useful market instruments for hedging rate exposure (A)</p> Signup and view all the answers

Why do callable bonds typically pay higher coupons than straight bonds?

<p>Investors are compensated for the early repayment risk. (B)</p> Signup and view all the answers

What situation would benefit an issuer of a callable bond?

<p>When interest rates fall. (B)</p> Signup and view all the answers

What is the implication for the buyer in a rate agreement when anticipating a potential rise in rates?

<p>They will borrow money and want a guarantee against a rise in rates (C)</p> Signup and view all the answers

How does the price of a callable bond typically compare to that of a straight bond?

<p>It is generally lower due to the call option's value to the issuer. (B)</p> Signup and view all the answers

In the repo interest calculation, which term refers to the initial value adjusted for any haircuts?

<p>Start proceed (A)</p> Signup and view all the answers

What advantage does a putable bond provide to the investor?

<p>It allows the investor to demand early repayment if rates rise. (C)</p> Signup and view all the answers

Which of the following statements about the seller in a rate agreement is true?

<p>They expect rates to fall and want protection against that (C)</p> Signup and view all the answers

What is one risk that investors face with callable bonds?

<p>Being forced to reinvest at possibly lower rates if the bond is called. (C)</p> Signup and view all the answers

What does a higher yield on a callable bond indicate compared to a straight bond?

<p>It compensates for the uncertainty of early repayment. (D)</p> Signup and view all the answers

How does the price of a putable bond normally compare to other types of bonds?

<p>It is typically higher due to the advantage it provides to investors. (A)</p> Signup and view all the answers

What distinguishes covered bonds from corporate bonds in the event of issuer insolvency?

<p>Bondholders have recourse to a specified collateral. (B)</p> Signup and view all the answers

What obligation does the credit institution have regarding the cover pool of a covered bond?

<p>To maintain sufficient assets in the cover pool at all times. (D)</p> Signup and view all the answers

Which of the following best characterizes a key difference between covered bonds and securitization?

<p>Securitization does not require the replacement of defaulted assets. (D)</p> Signup and view all the answers

What is the primary feature of a cover pool in a covered bond?

<p>It consists of assets that are ring-fenced from unsecured creditors. (A)</p> Signup and view all the answers

Which financial assets are most common in the cover pool of covered bonds?

<p>Mortgage loans secured on property. (C)</p> Signup and view all the answers

What does overcollateralization refer to in the context of covered bonds?

<p>The value of the cover pool exceeding the value of the covered bonds. (A)</p> Signup and view all the answers

What regulatory requirement applies to the issuance of covered bonds?

<p>They must be issued by a credit institution under public supervision. (D)</p> Signup and view all the answers

How does the credit institution's obligation differ between covered bonds and securitization?

<p>It must maintain asset quality in the cover pool for covered bonds. (C)</p> Signup and view all the answers

What is a key reason for a company to issue putable bonds?

<p>To offer a mechanism for credit risk reduction (B)</p> Signup and view all the answers

What defines a convertible bond's intrinsic value?

<p>The ability to exchange it for alternative securities at a fixed rate (C)</p> Signup and view all the answers

How does the yield on a putable bond typically compare to that of a straight bond?

<p>It is typically lower than that of a straight bond (A)</p> Signup and view all the answers

What is the primary reason for the lower coupon rates of inflation-linked bonds compared to nominal bonds?

<p>They are adjusted over time for inflation (C)</p> Signup and view all the answers

What is the relationship between the price of a putable bond and a straight bond?

<p>The price of a putable bond is always higher (D)</p> Signup and view all the answers

What benefit does an investor gain from a convertible bond?

<p>Potential capital gains from equity conversion (A)</p> Signup and view all the answers

In the context of bonds, what does the term 'premium' indicate?

<p>The additional cost of indirect purchasing of underlying shares (B)</p> Signup and view all the answers

What adjustment does an inflation-linked bond make to its cash flows over time?

<p>Increase linked directly to an index of inflation (A)</p> Signup and view all the answers

What does 'parity' refer to in the context of convertible bonds?

<p>The intrinsic value of the conversion option (D)</p> Signup and view all the answers

What describes the 'clean price' of a bond?

<p>The bond price excluding accrued interest (A)</p> Signup and view all the answers

Flashcards

Repo

A secured form of borrowing and lending money using specific securities as collateral. The borrower receives cash and gives the lender securities, and they agree to reverse the transaction later.

Repo Rate

The interest rate charged by the lender in a repurchase agreement. It can be positive, zero, or even negative, depending on market demand.

Substitution Right

The seller in a repo has the right to recall the collateral and replace it with another security of equal value and quality.

Delivery Repo

The buyer takes possession and custody of the collateral from the seller in a repo agreement.

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Hold in Custody (HIC) Repo

The seller retains custody of the collateral on behalf of the buyer in a repo agreement.

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Bullet Bond

A bond with fixed interest payments (coupons) and principal repayment at maturity.

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Callable Bond

A bond where the issuer has the right to repurchase (call) the bond before its maturity date.

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Why does the issuer have the advantage with a callable bond?

The issuer can refinance debt at lower interest rates if interest rates fall in the future. This allows them to save money on interest payments.

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What is the compensation for the investor in a callable bond?

The investor gets a higher coupon payment for the risk of early redemption, meaning they could be forced to reinvest at lower interest rates in the future.

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How does the price of a callable bond compare to a straight bond?

A callable bond typically has a lower price compared to a straight bond with the same features, because the call option adds value to the issuer and reduces value for the investor.

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Putable Bond

A bond that gives the investor the right to sell back (put) the bond to the issuer before its maturity date.

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What advantage does the investor have with a putable bond?

The investor can force the issuer to buy back the bond if interest rates rise, allowing them to reinvest their money at a higher rate.

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Why would the investor want a put option with a putable bond?

The investor might want to 'put' the bond back to the issuer if they are worried about the issuer's creditworthiness or if they want to invest their money elsewhere.

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Interest Rate Swap

An agreement between two parties to exchange interest rate payments on a notional principal amount. One party pays a fixed interest rate, while the other pays a floating rate, typically LIBOR or EURIBOR.

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Currency Swap

Similar to an interest rate swap, but involves exchanging principal amounts in different currencies, along with interest payments on those principals.

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Vanilla Swap

A type of interest rate swap where one party pays a fixed interest rate and the other pays a variable rate. The notional principal amount remains constant throughout the swap.

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Swap Seller

The party in a swap agreement who pays a variable interest rate and receives a fixed interest rate.

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Swap Buyer

The party in a swap agreement who pays a fixed interest rate and receives a variable interest rate.

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Covered Bond

A debt instrument issued by a credit institution, backed by a specific pool of assets, offering investors a lower risk compared to unsecured bonds.

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Hedging Interest Rate Risk

Using financial instruments like swaps to reduce the risk of losses due to fluctuations in interest rates.

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Net Cash Flow Through Currency Swap

The difference between the cash flows received from the currency swap and the cost of funding the loan.

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Repo (Repurchase Agreement)

A short-term loan where the borrower sells a security and agrees to repurchase it at a later date at a predetermined higher price. The difference in price is the interest.

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Haircut

A discount applied to the value of collateral in a repo agreement. It is a buffer to protect the lender against potential losses if the borrower defaults.

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Dirty Price

The price of a bond that includes accrued interest. This is the price the borrower sells the bond for in a repo agreement.

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Repo Interest

The interest earned by the lender in a repo agreement. Calculated based on the start proceed, repo rate, and term basis.

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Forward Rate Agreement (FRA)

An over-the-counter derivative that determines the interest rate to be paid on a principal amount starting at a future date.

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FRA (3*6)

A 3-month forward rate agreement starting in 3 months. It locks in the interest rate for a 3-month period starting in 3 months.

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Speculation with FRA

Using an FRA to bet on the direction of interest rates. Buyer expects rates to rise, while seller expects rates to fall.

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Hedging with FRA

Using an FRA to protect against potential changes in interest rates. Buyer wants to lock in a borrowing rate, while seller wants to lock in a lending rate.

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Why are putable bonds more expensive?

Putable bonds are more expensive than straight bonds because the put option offers investors added protection against losses if interest rates rise.

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Convertible Bond

A bond that gives the holder the right to exchange it for a specified number of shares of the issuing company's stock.

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Benefits of Convertible Bonds for Issuers

Issuers benefit from convertible bonds because they can raise debt at lower interest rates and potentially sell shares at a premium to their market price.

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Benefits of Convertible Bonds for Investors

Convertible bonds offer investors the certainty of fixed income payments while providing the potential for significant capital gains if the underlying stock performs well.

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Parity

Parity represents the intrinsic value of a convertible bond based on the current price of the underlying stock and the conversion ratio.

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Premium

The premium on a convertible bond indicates how much more expensive it is to buy the underlying shares indirectly through the convertible bond compared to the equity market.

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Inflation-Linked Bond

A bond that pays interest and principal adjusted according to inflation, protecting investors from purchasing power loss.

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How does Inflation affect Inflation-Linked Bonds?

Inflation-linked bonds have interest payments and principal repayments adjusted for increases in the price index, ensuring the bond's value maintains its purchasing power.

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Why do Governments Issue Inflation-Linked Bonds?

Governments issue inflation-linked bonds to reduce the risk of inflation eroding the value of their debt and manage their debt costs.

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Cover Pool

A collection of financial assets, such as mortgages, that are ring-fenced and used to repay covered bondholders in case of issuer default.

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Overcollateralization

The practice of requiring the value of the cover pool assets to exceed the value of the covered bonds by a specified amount, providing extra security to bondholders.

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Full Recourse Right

The issuer of a covered bond has an unrestricted obligation to repay the bondholders, regardless of the performance of the cover pool assets.

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How does a covered bond differ from securitization?

In covered bonds, the issuing credit institution remains responsible for repayment even if cover pool assets default. In securitization, the originator typically does not provide this guarantee.

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What are the common cover assets for covered bonds?

The most frequent cover assets include mortgage loans secured on residential or commercial property, ships, and loans to government entities.

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Why is public supervision important for covered bonds?

Public supervision ensures that the credit institution maintains sufficient assets in the cover pool to satisfy bondholder claims at all times.

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Ongoing obligation

The issuer of a covered bond must continuously maintain enough cover pool assets to cover outstanding bonds, even if asset performance varies.

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Study Notes

Black-Scholes-Merton Formula

  • Applies to European options on non-dividend-paying stocks
  • Formula for call option price: C = So • N(d₁) – Ke-rT. N(d2)
  • Variables:
    • C = Call option price
    • So = Current stock price
    • K = Strike price
    • r = Risk-free interest rate
    • T = Time to maturity (in years)
    • σ = Volatility of the stock
    • N() = Cumulative distribution function of the standard normal distribution
    • d1: ln(So/K)+(r+σ²/2)Τ/σ√Τ
    • d2: d₁ - σ√T

Option to Delay

  • Allows firms to avoid "bad" outcomes by delaying decisions
  • You lose some sales on delay
  • Avoid investment losses by delaying if the market turns bad
  • Examine if NPV now or delaying is more worthwhile

Bond Issuance and Debt Capital Markets

  • Corporations finance using debt and equity
  • Key differences from issuer and investor perspectives:
    • Debt: Promise to pay according to a schedule
      • Bond: Legal commitment; failure leads to bankruptcy
      • Repayment of principal is guaranteed
    • Equity: Payment is discretionary; management decides dividends or not

Hybrid Bonds

  • Include call/put options
  • Bullet bond: Coupon and principal repaid at maturity
  • Callable bond: Issuer can repay ahead of schedule if interest rates fall. Callables have higher coupons than straight bonds to compensate prepayment risk.
  • Putable bond: Investor has right to demand repayment. Putables have higher price than straight bonds, adding value for investor.

Convertible Bond

  • Allows holder to exchange principal for issuer's security (e.g., equity)
  • Combines features of debt and equity
  • Pays fixed coupon and has a maturity date
  • Investors participate in the issuing company's performance

Parity

  • The option's intrinsic value
  • Premium: Bond price less parity, indicating how much more costly it is to buy underlying shares indirectly.

Inflation-Linked Bonds (TIPS)

  • Interest and principal payments adjusted for inflation
  • Coupon payments vary based on the price index
  • Principal repayment adjusts to inflation
  • TIPS = (interest + principal) * inflation over time
  • Dirty price of TIPS = (clean price + accrued interest) * index ratio (inflation)
  • Governments issue for reduced financing costs and credibility.
  • Investors buy to hedge against inflation risk.

Repo Operations

  • Contract for selling and repurchasing securities over a specified period
  • Repo is used for short- or long-term positions.
  • Repo involves interest.
  • Collateral use: Collateral is essential to protect the buyer from seller default.
  • Legal ownership: Buyer doesn't own the collateral unless the seller defaults
  • Advantage to seller/buyer: Liquidation of collateral, etc.

OTC Derivatives (e.g., Forward Rate Agreements)

  • Over-the-counter contracts to determine interest rate at a future date
  • Used for speculation or hedging against interest rate risk

Currency Swaps

  • Exchange of interest payments in different currencies.
  • Involves two principal amounts at swap start, and again at maturity.

Covered Bonds

  • Debt issued by a credit institution
  • Has preferential recourse to collateral (cover pool) during insolvency
  • Bondholders are prioritized over unsecured creditors.
  • Cover pool must exceed the covered bonds amount, with ongoing obligation to the bondholders.
  • Attractive to institutions as a long term funding opportunity, reducing refinancing risk.

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Description

Explore the fundamentals of the Black-Scholes-Merton formula, which applies to European options, and discover the advantages of delaying investment decisions. Additionally, learn about bond issuance and the essential aspects of debt capital markets. This quiz covers key financial concepts and calculations essential for understanding market operations.

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