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?

Collateral transferred incurs settlement system costs Signup and view all the answers

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

The seller Signup and view all the answers

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

Variable rate of interest Signup and view all the answers

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

Swap buyer Signup and view all the answers

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

Decrease in interest rates Signup and view all the answers

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

Two principal amounts in different currencies Signup and view all the answers

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

LIBOR - 0.11% Signup and view all the answers

Which of the following best describes a covered bond?

A debt instrument issued by a credit institution Signup and view all the answers

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

They exchange fixed and variable payments Signup and view all the answers

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

To hedge global interest rate risk 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?

Net gain Signup and view all the answers

What calculation does the formula for repo interest amount include?

Start proceed multiplied by the repo rate and the term basis Signup and view all the answers

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

The reduction in the value of collateral Signup and view all the answers

What is a characteristic of a callable bond?

It allows the issuer to repay the bond on specified future dates. Signup and view all the answers

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

3 months rate starting 3 months from now Signup and view all the answers

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

Useful market instruments for hedging rate exposure Signup and view all the answers

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

Investors are compensated for the early repayment risk. Signup and view all the answers

What situation would benefit an issuer of a callable bond?

When interest rates fall. Signup and view all the answers

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

They will borrow money and want a guarantee against a rise in rates Signup and view all the answers

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

It is generally lower due to the call option's value to the issuer. Signup and view all the answers

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

Start proceed Signup and view all the answers

What advantage does a putable bond provide to the investor?

It allows the investor to demand early repayment if rates rise. Signup and view all the answers

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

They expect rates to fall and want protection against that Signup and view all the answers

What is one risk that investors face with callable bonds?

Being forced to reinvest at possibly lower rates if the bond is called. Signup and view all the answers

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

It compensates for the uncertainty of early repayment. Signup and view all the answers

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

It is typically higher due to the advantage it provides to investors. Signup and view all the answers

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

Bondholders have recourse to a specified collateral. Signup and view all the answers

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

To maintain sufficient assets in the cover pool at all times. Signup and view all the answers

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

Securitization does not require the replacement of defaulted assets. Signup and view all the answers

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

It consists of assets that are ring-fenced from unsecured creditors. Signup and view all the answers

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

Mortgage loans secured on property. Signup and view all the answers

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

The value of the cover pool exceeding the value of the covered bonds. Signup and view all the answers

What regulatory requirement applies to the issuance of covered bonds?

They must be issued by a credit institution under public supervision. Signup and view all the answers

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

It must maintain asset quality in the cover pool for covered bonds. Signup and view all the answers

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

To offer a mechanism for credit risk reduction Signup and view all the answers

What defines a convertible bond's intrinsic value?

The ability to exchange it for alternative securities at a fixed rate Signup and view all the answers

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

It is typically lower than that of a straight bond Signup and view all the answers

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

They are adjusted over time for inflation Signup and view all the answers

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

The price of a putable bond is always higher Signup and view all the answers

What benefit does an investor gain from a convertible bond?

Potential capital gains from equity conversion Signup and view all the answers

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

The additional cost of indirect purchasing of underlying shares Signup and view all the answers

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

Increase linked directly to an index of inflation Signup and view all the answers

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

The intrinsic value of the conversion option Signup and view all the answers

What describes the 'clean price' of a bond?

The bond price excluding accrued interest Signup and view all the answers

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.