71
f. describe the characteristics of forward rate agreements (FRAs);
A forward rate agreement or FRA is similar to a forward contract. Its payoff is based on an interest rate.
FRAs are typically based on rates like LIBOR or Euribor, quoted as an annual rate.
The underlying is for a specified term, such as 90 day LIBOR, 180 day Euribor etc.
One peculiarity of the FRA market is that it pays the amount due on the contract on the day of interest rate ascertainment. But the rate quoted in the market is for payment after the period specified with interest.
So, in general an FRA on an m-day interest pays off at expiration but the payoff is discounted for m days at the m-day rate.
Wednesday, February 27, 2008
Characteristics of Futures Contracts
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
A futures contract - is a type of forward contract with highly standardized and closely specified contract terms.
Distinguishing between a futures and a forward contract.
Differences between Futures contracts and Forward contracts:
Futures contracts always trade on an organized exchange.
Futures contracts are always highly standardized with a specific quantity of a good, with a specific delivery date and delivery mechanism.
Performance on futures contracts is guaranteed by a clearinghouse.
All futures require that traders post margin to trade. Margin is a good faith deposit.
Futures markets are regulated by an identifiable government agency, while forward contracts in general trade in an unregulated market.
contracts and forward contracts;
A futures contract - is a type of forward contract with highly standardized and closely specified contract terms.
Distinguishing between a futures and a forward contract.
Differences between Futures contracts and Forward contracts:
Futures contracts always trade on an organized exchange.
Futures contracts are always highly standardized with a specific quantity of a good, with a specific delivery date and delivery mechanism.
Performance on futures contracts is guaranteed by a clearinghouse.
All futures require that traders post margin to trade. Margin is a good faith deposit.
Futures markets are regulated by an identifiable government agency, while forward contracts in general trade in an unregulated market.
Margins in Futures Markets
LOS 72b
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
Maintenance margin - When the value of the funds on deposit with a broker reach a certain level where the trader is required to replenish the margin.
Variation margin - The additional amount the trader must deposit to return to the maintenance margin.
Initial margin - The amount a trader must deposit before trading any futures.
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
Maintenance margin - When the value of the funds on deposit with a broker reach a certain level where the trader is required to replenish the margin.
Variation margin - The additional amount the trader must deposit to return to the maintenance margin.
Initial margin - The amount a trader must deposit before trading any futures.
Friday, February 22, 2008
Closing Futures Contract
LOS
72
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
----------------
Delivery and Cash Settlement of futures contracts
All contract eventually expire. Each contract has a delivery month.
The delivery procedures varies among contracts.
Most non-cash settled financial futures contracts permit delivery any business day of the delivery month.
Delivery is three day sequence. Two business days before the intended delivery day, the holder of the a short position intending to deliver notifies the clearing house of his intention to deliver through his clearing member. This is day is termed position day.
On the next business day, termed the notice of intention day, the exchane selects the holder of the oldest long position to receive delivery. On the third day, the delivery day, delivery takes place and the long position holder pay the short position holder who made the delivery.
For many of the financial futures delivery is consummated by wire transfer as the securities are with depositories and money is with banks.
On cash settled financial futures contracts, the settlement price on the last trading day is fixed at the closing spot price of the underlying instrument. All contracts are market to market at this settlement price and cash settlement takes place.
Offsetting: About 90 per cent of all futures contracts are not delivered.Most of the contracts get closed prior to expiration through a process called offsetting. The futures market is not the best route to acquire the underlying asset. Hence long position holders close their position before delivery month.
Exchange for physicals (EFP): Some contracts are actually delivered through this process. This transaction occurs outside the exchange, and is reported to the exchange and exchange accepts it to offset the positions of long and short position holders.
72
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
----------------
Delivery and Cash Settlement of futures contracts
All contract eventually expire. Each contract has a delivery month.
The delivery procedures varies among contracts.
Most non-cash settled financial futures contracts permit delivery any business day of the delivery month.
Delivery is three day sequence. Two business days before the intended delivery day, the holder of the a short position intending to deliver notifies the clearing house of his intention to deliver through his clearing member. This is day is termed position day.
On the next business day, termed the notice of intention day, the exchane selects the holder of the oldest long position to receive delivery. On the third day, the delivery day, delivery takes place and the long position holder pay the short position holder who made the delivery.
For many of the financial futures delivery is consummated by wire transfer as the securities are with depositories and money is with banks.
On cash settled financial futures contracts, the settlement price on the last trading day is fixed at the closing spot price of the underlying instrument. All contracts are market to market at this settlement price and cash settlement takes place.
Offsetting: About 90 per cent of all futures contracts are not delivered.Most of the contracts get closed prior to expiration through a process called offsetting. The futures market is not the best route to acquire the underlying asset. Hence long position holders close their position before delivery month.
Exchange for physicals (EFP): Some contracts are actually delivered through this process. This transaction occurs outside the exchange, and is reported to the exchange and exchange accepts it to offset the positions of long and short position holders.
Tuesday, February 12, 2008
Future Markets and Contracts Part E
Reading 72
LOS
e. describe the characteristics of the following types of futures contracts: Eurodollar, Treasury bond, stock index, and currency.
---------------
Eurodollar futures contract
Trade Eurodollar Futures at Trade Center, LLC.
Eurodollars are U.S. dollars on deposit in commercial banks located outside of the United States. Eurodollars deposits play a major role in the international capital market, and they have long served as a benchmark interest rate for corporate funding.
The Eurodollar futures contract reflects the London Interbank Offered Rate (LIBOR) for a three-month, $1 million offshore deposit. Eurodollar deposits are direct obligations of the commercial banks accepting the deposits and are not guaranteed by any government. Although they represent low-risk investments, Eurodollar deposits are not risk-free.
CME developed and launched Eurodollar futures in 1981, and since then Eurodollar futures has evolved into one of the world’s most innovative and popular contracts—and is now the most actively traded futures contract in the world with open interest recently surpassed the four million mark.
CME Eurodollar futures are cash-settled, therefore, there is no delivery of a cash instrument upon expiration because cash Eurodollar time deposits are not transferable.
Eurodollar futures contract size has a principal value of $1,000,000 with a three-month maturity. Eurodollar futures move in 1 point increments, or .01, equaling $25.
The Eurodollar tick reflect the dollar value of a 1/100 of one percent change in a $1 million, 90-day deposit, determined by the following equation:
$1,000,000 notional value x .0001 x 90/360 = $25.
Trading can also occur in minimum ticks of .0025, or ¼ ticks, representing $6.25 per contract and in .005, or ½ ticks, representing $12.50 per contract. Eurodollar contracts trade Mar, Jun, Sep, Dec; Forty months in the March quarterly cycle, and the four nearest serial contract months
Since the Eurodollar contract’s inception, it has become one of the most versatile trading vehicles offered on the listed markets, offering numerous opportunities for hedgers and arbitrageurs. The contract’s exceptional growth and its adaptability and versatility continues to evolve due to nonstop enhancements. As a result, today’s Eurodollar contract offers even more trading opportunities.
Besides Eurodollar futures and options on futures, CME also developed the following as part of the Eurodollar contract:
Eurodollar Bundles—allow traders to simultaneously buy or sell a consecutive series of Eurodollar futures in equal proportions beginning with the front quarterly contract.
Eurodollar Packs—simultaneous purchase or sale of an equally weighted, consecutive series of four Eurodollar futures, quoted on an average net change basis from the previous day’s close.
Serial Eurodollars—identical to quarterly Eurodollar futures with the exception of expirations dates. Serial Eurodollars expire in months other than those in the March, June, September and December quarterly cycles.
Contract Specification for Eurodollar Futures
Trade Unit:
Eurodollar Time Deposit having a principal value of $1,000,000 with a three-month maturity.
Point Descriptions:
1 point = .01 = $25.00
Contract Listing:
Mar, Jun, Sep, Dec, Forty months in the March quarterly cycle, and the four nearest serial contract months.
Hours: 7:20 a.m.-2:00 p.m.Holidays LTD(Monday 5:00 a.m.)
Minimum Fluctuation:
Regular 0.01=$25.00
Half Tick 0.005=$12.50
Quarter 0.0025=$6.25 for nearest expiring month.
----------
Treasury Bond Futures
Contract Specification for 30 year T-Bond Futures
Contract Size
U.S. Treasury notes having a face value at maturity of $100,000 or multiple thereof.
Deliverable Grades
U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.
Tick Size
Minimum price fluctuations shall be in multiples of one thirty-second (1/32) point per 100 points ($31.25 per contract) except for intermonth spreads, where minimum price fluctuations shall be in multiples of one-fourth of one-thirty-second point per 100 points ($7.8125 per contract). Par shall be on the basis of 100 points. Contracts shall not be made on any other price basis.
Price Quote
Points ($1,000) and thirty-seconds of a point; for example, 80-16 equals 80 16/32
Contract Months
Mar, Jun, Sep, Dec
Last Trading Day
Seventh business day preceding the last business day of the delivery month.
Last Delivery Day
Last business day of the delivery month.
Delivery Method
Federal Reserve book-entry wire-transfer system
Trading Hours
Open Auction: 7:20 am - 2:00 pm, Central Time, Monday - Friday
Electronic: 7:01 pm - 4:00 pm, Central Time, Sunday - Friday
Trading in expiring contracts closes at noon, Central Time, on the last trading day
Daily Price Limit
None
--------
Stock Index Futures Contracts
DJIA Futures ($10 Multiplier)
Contract Size
Ten dollars ($10) times the Dow Jones Industrial Average Index. The DJIA is a price-weighted index of thirty (30) stocks.
Final Settlement Day
The third Friday of the contract month.
Settlement
Cash settlement on the final settlement day. The final settlement price is $10 times a Special Opening quotation of the index.
Tick Size
Minimum price increment is one index point (equal to $10 per contract).
Price Quote
The DJIA Index, quoted in index points.
Contract Months
Mar, Jun, Sep, Dec. Four nearest months in March quarterly cycle and two additional December contracts listed at all times.
Last Trading Day
The trading day preceding the final settlement day.
Trading Platform
Open Auction and Electronic.
Trading Hours
Monday: Thursday 3:30 pm - 4:30 pm and 5:00 pm - 8:15 am next day
Sunday: 5:00 pm - 8:15 am next day
Trading in expiring contracts ceases at 3:15 p.m. Central Time on the last trading day.
Ticker Symbols
Open Auction: DJ
Electronic: ZD
Fungibility
BIG Dow futures ($25 multiplier), mini-sized Dow futures ($5 multiplier), and DJIA futures ($10 multiplier) are fungible contracts
Daily Price Limit
Successive 10%, 20%, and 30% limits. For details, please see CBOT Regulation 1008.01.
Position Limits
The aggregate position limit in BIG Dow futures ($25 multiplier), mini-sized futures and options ($5 multiplier), and DJIA futures and options ($10 multiplier) is 50,000 DJIA futures ($10 multiplier) equivalent contracts, net long or short in all contract months combined.
http://www.cbot.com/cbot/pub/cont_detail/1,3206,1411+14424,00.html
---------------
currecny futures
CME Japanese Yen Futures
Trade Unit 12,500,000 Japanese yen
Point Descriptions 1 point = $.000001 per Japanese yen = $12.50 per contract
Contract Listing Six months in the March Quarterly Cycle, Mar, Jun, Sep. Dec.
Minimum Fluctuation
Regular 0.000001=$12.50
Calendar Spread 0.0000005=$6.25
All or None 0.0000005=$6.25
http://www.cme.com/trading/prd/fx/japanese_FCS.html
LOS
e. describe the characteristics of the following types of futures contracts: Eurodollar, Treasury bond, stock index, and currency.
---------------
Eurodollar futures contract
Trade Eurodollar Futures at Trade Center, LLC.
Eurodollars are U.S. dollars on deposit in commercial banks located outside of the United States. Eurodollars deposits play a major role in the international capital market, and they have long served as a benchmark interest rate for corporate funding.
The Eurodollar futures contract reflects the London Interbank Offered Rate (LIBOR) for a three-month, $1 million offshore deposit. Eurodollar deposits are direct obligations of the commercial banks accepting the deposits and are not guaranteed by any government. Although they represent low-risk investments, Eurodollar deposits are not risk-free.
CME developed and launched Eurodollar futures in 1981, and since then Eurodollar futures has evolved into one of the world’s most innovative and popular contracts—and is now the most actively traded futures contract in the world with open interest recently surpassed the four million mark.
CME Eurodollar futures are cash-settled, therefore, there is no delivery of a cash instrument upon expiration because cash Eurodollar time deposits are not transferable.
Eurodollar futures contract size has a principal value of $1,000,000 with a three-month maturity. Eurodollar futures move in 1 point increments, or .01, equaling $25.
The Eurodollar tick reflect the dollar value of a 1/100 of one percent change in a $1 million, 90-day deposit, determined by the following equation:
$1,000,000 notional value x .0001 x 90/360 = $25.
Trading can also occur in minimum ticks of .0025, or ¼ ticks, representing $6.25 per contract and in .005, or ½ ticks, representing $12.50 per contract. Eurodollar contracts trade Mar, Jun, Sep, Dec; Forty months in the March quarterly cycle, and the four nearest serial contract months
Since the Eurodollar contract’s inception, it has become one of the most versatile trading vehicles offered on the listed markets, offering numerous opportunities for hedgers and arbitrageurs. The contract’s exceptional growth and its adaptability and versatility continues to evolve due to nonstop enhancements. As a result, today’s Eurodollar contract offers even more trading opportunities.
Besides Eurodollar futures and options on futures, CME also developed the following as part of the Eurodollar contract:
Eurodollar Bundles—allow traders to simultaneously buy or sell a consecutive series of Eurodollar futures in equal proportions beginning with the front quarterly contract.
Eurodollar Packs—simultaneous purchase or sale of an equally weighted, consecutive series of four Eurodollar futures, quoted on an average net change basis from the previous day’s close.
Serial Eurodollars—identical to quarterly Eurodollar futures with the exception of expirations dates. Serial Eurodollars expire in months other than those in the March, June, September and December quarterly cycles.
Contract Specification for Eurodollar Futures
Trade Unit:
Eurodollar Time Deposit having a principal value of $1,000,000 with a three-month maturity.
Point Descriptions:
1 point = .01 = $25.00
Contract Listing:
Mar, Jun, Sep, Dec, Forty months in the March quarterly cycle, and the four nearest serial contract months.
Hours: 7:20 a.m.-2:00 p.m.Holidays LTD(Monday 5:00 a.m.)
Minimum Fluctuation:
Regular 0.01=$25.00
Half Tick 0.005=$12.50
Quarter 0.0025=$6.25 for nearest expiring month.
----------
Treasury Bond Futures
Contract Specification for 30 year T-Bond Futures
Contract Size
U.S. Treasury notes having a face value at maturity of $100,000 or multiple thereof.
Deliverable Grades
U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.
Tick Size
Minimum price fluctuations shall be in multiples of one thirty-second (1/32) point per 100 points ($31.25 per contract) except for intermonth spreads, where minimum price fluctuations shall be in multiples of one-fourth of one-thirty-second point per 100 points ($7.8125 per contract). Par shall be on the basis of 100 points. Contracts shall not be made on any other price basis.
Price Quote
Points ($1,000) and thirty-seconds of a point; for example, 80-16 equals 80 16/32
Contract Months
Mar, Jun, Sep, Dec
Last Trading Day
Seventh business day preceding the last business day of the delivery month.
Last Delivery Day
Last business day of the delivery month.
Delivery Method
Federal Reserve book-entry wire-transfer system
Trading Hours
Open Auction: 7:20 am - 2:00 pm, Central Time, Monday - Friday
Electronic: 7:01 pm - 4:00 pm, Central Time, Sunday - Friday
Trading in expiring contracts closes at noon, Central Time, on the last trading day
Daily Price Limit
None
--------
Stock Index Futures Contracts
DJIA Futures ($10 Multiplier)
Contract Size
Ten dollars ($10) times the Dow Jones Industrial Average Index. The DJIA is a price-weighted index of thirty (30) stocks.
Final Settlement Day
The third Friday of the contract month.
Settlement
Cash settlement on the final settlement day. The final settlement price is $10 times a Special Opening quotation of the index.
Tick Size
Minimum price increment is one index point (equal to $10 per contract).
Price Quote
The DJIA Index, quoted in index points.
Contract Months
Mar, Jun, Sep, Dec. Four nearest months in March quarterly cycle and two additional December contracts listed at all times.
Last Trading Day
The trading day preceding the final settlement day.
Trading Platform
Open Auction and Electronic.
Trading Hours
Monday: Thursday 3:30 pm - 4:30 pm and 5:00 pm - 8:15 am next day
Sunday: 5:00 pm - 8:15 am next day
Trading in expiring contracts ceases at 3:15 p.m. Central Time on the last trading day.
Ticker Symbols
Open Auction: DJ
Electronic: ZD
Fungibility
BIG Dow futures ($25 multiplier), mini-sized Dow futures ($5 multiplier), and DJIA futures ($10 multiplier) are fungible contracts
Daily Price Limit
Successive 10%, 20%, and 30% limits. For details, please see CBOT Regulation 1008.01.
Position Limits
The aggregate position limit in BIG Dow futures ($25 multiplier), mini-sized futures and options ($5 multiplier), and DJIA futures and options ($10 multiplier) is 50,000 DJIA futures ($10 multiplier) equivalent contracts, net long or short in all contract months combined.
http://www.cbot.com/cbot/pub/cont_detail/1,3206,1411+14424,00.html
---------------
currecny futures
CME Japanese Yen Futures
Trade Unit 12,500,000 Japanese yen
Point Descriptions 1 point = $.000001 per Japanese yen = $12.50 per contract
Contract Listing Six months in the March Quarterly Cycle, Mar, Jun, Sep. Dec.
Minimum Fluctuation
Regular 0.000001=$12.50
Calendar Spread 0.0000005=$6.25
All or None 0.0000005=$6.25
http://www.cme.com/trading/prd/fx/japanese_FCS.html
Options - Part A European Option, American Option
Reading 73: Option Markets and Contracts
LOS
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
--------
Reference: An INtroduction to Derivatives and Risk Management by Don Chance
An option is a contract between two parties - a buyer and a seller- that gives the buyer the right, but not the obligation to purchase or sell something at a later date at a price agreed upon today.
the option buyer pays the seller the price or premium for the option that he is buying.
There are two types of basic options.
Call option:An option to buy is called a call.
Put option: An option to sell is called a put.
Options now trade in organized exchanges. But the creation of an organized options exchange was done in 1973 only. Prior to that options were bought and sold through dealers as contract between two parties. This type of market, called anover the counter market was actually the first type of options market.
Over the counter market is active now also and is used by corporations and financial institutions to enter into contracts tailor made for their requirements.
While options on OTC can have terms are convenient to the parties involved, exchange traded contract have various features standardized and prescribed by the exchange.
They are assets for which options are traded, contract size, exercise price, expiration date, position abd exercuse limits.
European option and American option,
European Call and American Call
European options can be exercised only on the termination date of the option. The buyer can demand delivery of the underlying asset or choose to allow the option (call) unexercised on the termination date. Till that termination date, he has no interaction with the option writer.
In the case of American option (call), the buyer can exercise the option on any day till the maturity day. The writer of seller of the option has to deliver on the day the buyer makes the demand for delivery.
Moneyness of an option
Moneyness is a relation between the current market price of the asset underlying an option contract.
In case of calls
If the current market price is equal to the exercise price the call is said to be at the money.
If the current market price is higher than the exercise price the call is said to be in the money.
If the current market price is lower than the exercise price the call is said to be out of the money.
LOS
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
--------
Reference: An INtroduction to Derivatives and Risk Management by Don Chance
An option is a contract between two parties - a buyer and a seller- that gives the buyer the right, but not the obligation to purchase or sell something at a later date at a price agreed upon today.
the option buyer pays the seller the price or premium for the option that he is buying.
There are two types of basic options.
Call option:An option to buy is called a call.
Put option: An option to sell is called a put.
Options now trade in organized exchanges. But the creation of an organized options exchange was done in 1973 only. Prior to that options were bought and sold through dealers as contract between two parties. This type of market, called anover the counter market was actually the first type of options market.
Over the counter market is active now also and is used by corporations and financial institutions to enter into contracts tailor made for their requirements.
While options on OTC can have terms are convenient to the parties involved, exchange traded contract have various features standardized and prescribed by the exchange.
They are assets for which options are traded, contract size, exercise price, expiration date, position abd exercuse limits.
European option and American option,
European Call and American Call
European options can be exercised only on the termination date of the option. The buyer can demand delivery of the underlying asset or choose to allow the option (call) unexercised on the termination date. Till that termination date, he has no interaction with the option writer.
In the case of American option (call), the buyer can exercise the option on any day till the maturity day. The writer of seller of the option has to deliver on the day the buyer makes the demand for delivery.
Moneyness of an option
Moneyness is a relation between the current market price of the asset underlying an option contract.
In case of calls
If the current market price is equal to the exercise price the call is said to be at the money.
If the current market price is higher than the exercise price the call is said to be in the money.
If the current market price is lower than the exercise price the call is said to be out of the money.
Options - Part B
LOS
b. identify the types of options in terms of the underlying instruments;
Types of options
Stock options
Index options
Currency options
Options on bonds
Interest rate options
Real options - Corporate investment decisions
b. identify the types of options in terms of the underlying instruments;
Types of options
Stock options
Index options
Currency options
Options on bonds
Interest rate options
Real options - Corporate investment decisions
Options - Part C
c. compare and contrast interest rate options to forward rate agreements (FRAs);
A forward rate agreement or FRA is similar to any type of forward contract, but the payoff is based on an interest rate, rather than the price of an asset.
Interest rate options are a lot like forward rate agreements. Instead of being a firm commitment, they represent the right to make a fixed interest payment and receive a floating interest payment or to make a floating interest payment and receive a fixed interest payment. Interst rate options have a strike rate or exercise rate instead of price.
Don chance, pages 466, 474, 475
A forward rate agreement or FRA is similar to any type of forward contract, but the payoff is based on an interest rate, rather than the price of an asset.
Interest rate options are a lot like forward rate agreements. Instead of being a firm commitment, they represent the right to make a fixed interest payment and receive a floating interest payment or to make a floating interest payment and receive a fixed interest payment. Interst rate options have a strike rate or exercise rate instead of price.
Don chance, pages 466, 474, 475
Options - Part D
d. define interest rate caps, floors, and collars;
A combination of interest rate calls designed to protect a borrower in a floating rate loan against increases in interest rates is called an interest rate cap.
A combination of interest rate puts designed to protect a lender in a floating rate loan against decreases in interest rates is called an interest rate floor.
A combination of long cap and short floor is called an interest rate collar. The collars are most often used by borrowers and consist of long position in a cap, financed by selling a short position in a floor.
A combination of interest rate calls designed to protect a borrower in a floating rate loan against increases in interest rates is called an interest rate cap.
A combination of interest rate puts designed to protect a lender in a floating rate loan against decreases in interest rates is called an interest rate floor.
A combination of long cap and short floor is called an interest rate collar. The collars are most often used by borrowers and consist of long position in a cap, financed by selling a short position in a floor.
Options - Part F
f. define intrinsic value and time value, and explain their relationship;
in the money options has an intrisic value.
In the case of a call option, current market price - Exercise price, if it is a positive quantity is its intrinsic value. If it is a negative value, then intrinsic value is zero.
Time value of an option is option value or premium at a market price minus the intrinsic value at that market price.
Even if intrinsic value is zero, options have time value.
in the money options has an intrisic value.
In the case of a call option, current market price - Exercise price, if it is a positive quantity is its intrinsic value. If it is a negative value, then intrinsic value is zero.
Time value of an option is option value or premium at a market price minus the intrinsic value at that market price.
Even if intrinsic value is zero, options have time value.
Options - Part G
g. determine the minimum and maximum values of European options and
American options;
The maximum value of a call option is the stock price - exercise price
The minimum value of an american call is 0 or intrinsic value. Because one can exercise the get the intrinsic value of the call.
In the case of a european call, the minimum value will be CMP - discounted value of exercise price. (As exercise price is paid only at termination date, its discounted value is taken as the present value of exercise price which the seller will get).
American options;
The maximum value of a call option is the stock price - exercise price
The minimum value of an american call is 0 or intrinsic value. Because one can exercise the get the intrinsic value of the call.
In the case of a european call, the minimum value will be CMP - discounted value of exercise price. (As exercise price is paid only at termination date, its discounted value is taken as the present value of exercise price which the seller will get).
Monday, February 11, 2008
CFA websites - Blogs
http://vanguardist.blogspot.com/2008/01/testtest.html
http://phdmbacfa.blogspot.com/
http://roadtocfa.blogspot.com/
http://cfathoughts.blogspot.com/
http://phdmbacfa.blogspot.com/
http://roadtocfa.blogspot.com/
http://cfathoughts.blogspot.com/
Saturday, February 9, 2008
CFA Level 1 Swap Markets and Contracts - Part IA
Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
Introduction
Swaps are derivative instruments customized to the requirements of the parties involved. The two parties involved are called counterparties.
IN a swap the two counterparties agree to exchange a stream of future cash for a specified period of time based upon agreed upon parameters in some underlying commodity or market index or currency.
The period of time for which the swap will be in operation is called tenor of the swap.
A swap calls for periodic payments.
swaps are over the counter transactions between two parties.
swap markets have swap facilitators. Swap facilitators help clients find ways via the swap market to alter or avoid unwanted risks.
Swap facilitators act as financial engineers and design swaps to solve client problems.
Swap facilitators act as brokers and bring counterparties together.
Swap facilitators act as dealers who enter into swap agreements with others as principals and carry the swaps on their books.
Swap dealers engage in offsetting swaps., whereby their long positions and short positions net to as close to zero position as possible. Through their understanding of the market for swaps and prices at which various parties are willing to enter into swaps, dealers price their quotes in which they are principals so as to earn a bid-ask spread on their overall book, even if their net exposure were to be zero. Sometimes, dealers may keep some net exposure when they feel the potential returns outweigh the risks.
Keeping a net position means, they will not offset the transaction immediately but wait for sometime to benefit from change in swap prices.
Termination of swaps
Swaps are normally designed with the intention of holding the position till the termination date.
If in case a party changes his mind and wants to get out of the swap, he may go to a dealer and ask for an offsetting swap. It may enter separately into another swaps that offsets the earlier swap and both swaps remain in force but the net effect for a firm is eqaul to terminating the swap. But with both swaps in force, the firm would be facing credit risk. Hence it is better to go in for direct termination of the swap from the origical dealer.
Forward swaps and swaptions also can be used to provide offsetting positions to existing swaps.
Source:
An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
Introduction
Swaps are derivative instruments customized to the requirements of the parties involved. The two parties involved are called counterparties.
IN a swap the two counterparties agree to exchange a stream of future cash for a specified period of time based upon agreed upon parameters in some underlying commodity or market index or currency.
The period of time for which the swap will be in operation is called tenor of the swap.
A swap calls for periodic payments.
swaps are over the counter transactions between two parties.
swap markets have swap facilitators. Swap facilitators help clients find ways via the swap market to alter or avoid unwanted risks.
Swap facilitators act as financial engineers and design swaps to solve client problems.
Swap facilitators act as brokers and bring counterparties together.
Swap facilitators act as dealers who enter into swap agreements with others as principals and carry the swaps on their books.
Swap dealers engage in offsetting swaps., whereby their long positions and short positions net to as close to zero position as possible. Through their understanding of the market for swaps and prices at which various parties are willing to enter into swaps, dealers price their quotes in which they are principals so as to earn a bid-ask spread on their overall book, even if their net exposure were to be zero. Sometimes, dealers may keep some net exposure when they feel the potential returns outweigh the risks.
Keeping a net position means, they will not offset the transaction immediately but wait for sometime to benefit from change in swap prices.
Termination of swaps
Swaps are normally designed with the intention of holding the position till the termination date.
If in case a party changes his mind and wants to get out of the swap, he may go to a dealer and ask for an offsetting swap. It may enter separately into another swaps that offsets the earlier swap and both swaps remain in force but the net effect for a firm is eqaul to terminating the swap. But with both swaps in force, the firm would be facing credit risk. Hence it is better to go in for direct termination of the swap from the origical dealer.
Forward swaps and swaptions also can be used to provide offsetting positions to existing swaps.
Source:
An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004
CFA Level 1 Swap Markets and Contracts - Part IB
Reading 74: Swap Markets and Contracts
-------------
LOS 74b
The candidate should be able to:
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
-----------------
All the three types of swaps are covered in An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004.
Plain vanilla interest rate swap:
An interest rate swap is a series of interest payments between two parties to the swap contract. Each set of payments is based on either a fixed or floating rate.
The most common type of interest rate swap is a swap in which one party pay a fixed rate and the other pays a floating rate. This instrument is called a plain vanilla interest rate swap. Sometimes vanilla swap.
Currency swap: Currecy swap is a series of payments between two parties in which the two sets of payments are in different currencies.
The payments are effectively equivalent to interest payments because they are calculated as though interst werebeing paid on a specific notional principal. However, there are two notional principals one in each currency. In a currency swap, the notional principals can be exchanged if the parties desire.
Equity Swaps: In an equity swap at least one of the two streams of cash flow is determined by a stock price, teh value of a stock portfolio, or the level of a stock index. The other stream can be a fixed rate, a floating rate, or it can be determined by the value of another stock, stock portfolio or stock index.
-------------
LOS 74b
The candidate should be able to:
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
-----------------
All the three types of swaps are covered in An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004.
Plain vanilla interest rate swap:
An interest rate swap is a series of interest payments between two parties to the swap contract. Each set of payments is based on either a fixed or floating rate.
The most common type of interest rate swap is a swap in which one party pay a fixed rate and the other pays a floating rate. This instrument is called a plain vanilla interest rate swap. Sometimes vanilla swap.
Currency swap: Currecy swap is a series of payments between two parties in which the two sets of payments are in different currencies.
The payments are effectively equivalent to interest payments because they are calculated as though interst werebeing paid on a specific notional principal. However, there are two notional principals one in each currency. In a currency swap, the notional principals can be exchanged if the parties desire.
Equity Swaps: In an equity swap at least one of the two streams of cash flow is determined by a stock price, teh value of a stock portfolio, or the level of a stock index. The other stream can be a fixed rate, a floating rate, or it can be determined by the value of another stock, stock portfolio or stock index.
Thursday, February 7, 2008
CFA Level 1 Buying Calls
LOS
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying calls and indicate the market outlook
of investors using these strategies;
----------
The maximum loss of the strategy of buying a call is the premium or the price paid for buying the call.
The maximum gain of buying a call is unlimited.
The break even point of buying a call is X + c where X is strike price and c is the call premium paid.
The market out look of the investor has to be bullish outlook for the underlying stock
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying calls and indicate the market outlook
of investors using these strategies;
----------
The maximum loss of the strategy of buying a call is the premium or the price paid for buying the call.
The maximum gain of buying a call is unlimited.
The break even point of buying a call is X + c where X is strike price and c is the call premium paid.
The market out look of the investor has to be bullish outlook for the underlying stock
CFA - Selling Calls
LOS
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of selling calls and indicate the market outlook
of investors using these strategies;
--------------
The maximum loss is unlimited. the increase in share price has to be born by the call writer.
The maximum gain is limited to the premium received.
The break even point is X + c.
Writer of a call (naked call) requires a moderately bearish outlook for the underlying stock
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of selling calls and indicate the market outlook
of investors using these strategies;
--------------
The maximum loss is unlimited. the increase in share price has to be born by the call writer.
The maximum gain is limited to the premium received.
The break even point is X + c.
Writer of a call (naked call) requires a moderately bearish outlook for the underlying stock
CFA - Buying a Put
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying puts, and indicate the market outlook
of investors using these strategies;
Maximum loss limited to the premium paid.
The maximum gain that it can produce is the exercise price (less the premium paid) as the stock price cannot fall below zero.
Breakeven point = X - p
Buyer of a put (naked put) requires a bearish outlook on the stock underlying the put.
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying puts, and indicate the market outlook
of investors using these strategies;
Maximum loss limited to the premium paid.
The maximum gain that it can produce is the exercise price (less the premium paid) as the stock price cannot fall below zero.
Breakeven point = X - p
Buyer of a put (naked put) requires a bearish outlook on the stock underlying the put.
CFA - Selling a Put
75 a (iv)
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategy of selling puts, and indicate the market outlook
of investors using this strategy.
Maximum loss = X -p
Maximum gain is the premium received
Breakeven point = X - p
Writer of a put requires moderately bullish outlook for the stock underlying the put.
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategy of selling puts, and indicate the market outlook
of investors using this strategy.
Maximum loss = X -p
Maximum gain is the premium received
Breakeven point = X - p
Writer of a put requires moderately bullish outlook for the stock underlying the put.
Wednesday, February 6, 2008
CFA - Derivatives - Risk Management Applications - Options - Covered Call Strategy
Covered Call Strategy
--------------
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a Covered Call Strategy, and explain the risk management application of the strategy.
--------------
IP (Price of the stock when the option contract is initiated) and
TP(terminal price at maturity of the stock)
X Exercise Price
Value of the option strategy at expiration
If TP ≤ X
V = TP - IP + C
If TP ≥ X
V = X - IP + C
Maximum profit occurs when the stock price exceeds the exercise price.
Maximum loss occurs if the stock price at expiration goes to zero.
Breakeven point or breakeven stock price is the stock price where the profit of the option strategy is zero.
This occurs when the stock is price IP - C.
Covered call writing is a very popular strategy among professional traders. This is because it is a low risk strategy of call writing. There are studies that showed that covered call writing is more profitable than buying options.
Many institutional investors also use a covered call writing strategy to earn extra income through call premiums.
--------------
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a Covered Call Strategy, and explain the risk management application of the strategy.
--------------
IP (Price of the stock when the option contract is initiated) and
TP(terminal price at maturity of the stock)
X Exercise Price
Value of the option strategy at expiration
If TP ≤ X
V = TP - IP + C
If TP ≥ X
V = X - IP + C
Maximum profit occurs when the stock price exceeds the exercise price.
Maximum loss occurs if the stock price at expiration goes to zero.
Breakeven point or breakeven stock price is the stock price where the profit of the option strategy is zero.
This occurs when the stock is price IP - C.
Covered call writing is a very popular strategy among professional traders. This is because it is a low risk strategy of call writing. There are studies that showed that covered call writing is more profitable than buying options.
Many institutional investors also use a covered call writing strategy to earn extra income through call premiums.
Monday, February 4, 2008
CFA Level 1 Derivatives - Risk Management Applications Option
Risk Management Applications of Option Strategies - Protective put Strategy
LOS
------------------------
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a protective put strategy, and explain the risk management application of the strategy.
--------------------
A protective put is a put bought to hedge an existing holding of a security. It provides protection against decline in value of the security.
If CP (current price) and TP(terminal price at maturity) on the cash security a profit is realized if TP>CP.
On the put, if TP>CP loss made to the extent of premium.
If TP
Profit will be maximum of [0, X-TP] minus the premium paid.
Example: An investor bought a put at strike price $100 for a stock quoting at $100. the premium paid is $5.
If the price remains at $100 at the expiry day, value of the put is zero and the loss of the investment strategy is $5 in comparison to unhedged position.
If the price goes to $98, value of the put is $2 and the loss of the investment strategy is $3 in comparison to unhedged position.
If the price goes to $95 value of the put is $5 and the loss of the investment is strategy is zero compared to unhedged position.
If the price goes up to $105, the investor makes only 100$ because of the premium paid on put. As price at maturity goes higher, investor makes profit.
Thus maximum loss this investment strategy is $5 and upside is available without any cap. So this strategy has a payoff similar to long call.
LOS
------------------------
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a protective put strategy, and explain the risk management application of the strategy.
--------------------
A protective put is a put bought to hedge an existing holding of a security. It provides protection against decline in value of the security.
If CP (current price) and TP(terminal price at maturity) on the cash security a profit is realized if TP>CP.
On the put, if TP>CP loss made to the extent of premium.
If TP
Profit will be maximum of [0, X-TP] minus the premium paid.
Example: An investor bought a put at strike price $100 for a stock quoting at $100. the premium paid is $5.
If the price remains at $100 at the expiry day, value of the put is zero and the loss of the investment strategy is $5 in comparison to unhedged position.
If the price goes to $98, value of the put is $2 and the loss of the investment strategy is $3 in comparison to unhedged position.
If the price goes to $95 value of the put is $5 and the loss of the investment is strategy is zero compared to unhedged position.
If the price goes up to $105, the investor makes only 100$ because of the premium paid on put. As price at maturity goes higher, investor makes profit.
Thus maximum loss this investment strategy is $5 and upside is available without any cap. So this strategy has a payoff similar to long call.
Sunday, February 3, 2008
Study Session 17 Derivative Investments
Study Session 17
Derivative Investments
Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.
This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.
LOS
Reading 70: Derivative Markets and Instruments
The candidate should be able to:
a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Reading 71: Forward Markets and Contracts
The candidate should be able to:
a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;
d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.
Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.
Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.
Specified Readings
"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
Derivative Investments
Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.
This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.
LOS
Reading 70: Derivative Markets and Instruments
The candidate should be able to:
a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Reading 71: Forward Markets and Contracts
The candidate should be able to:
a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;
d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.
Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.
Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.
Specified Readings
"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
CFA Level 1 Alternative Investments
The institute specified reading for this study session is chapter "Alternative Investments" from International Investments by Bruno Solnik and Dennis McLeavey published by Pearson Addison Wesley.
The chapter covers all learning outcome statements of the syllabus.
I prepared material for each LOS based on this source. Each LOS is covered in a separate post.
The chapter covers all learning outcome statements of the syllabus.
I prepared material for each LOS based on this source. Each LOS is covered in a separate post.
Saturday, February 2, 2008
CFA Level 1 Alternative Investments - Investment Companies
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;
Investment companies are financial intermediaries that pool and invest funds of varius individual and institutional investors, giving the investors rights to a proportional share of the pooled fund performance.
There are managed investment companies and unmanaged investment companies in United States.Unit investment trusts in United States are unmanaged investment companies and they hold a fixed portfolio of investments for the life of the company and they stan ready to redeem the investor's units at market value (net asset value) and also for reselling such shares to new investors.
------------------
Unit Investment Trusts (UITs)
A "unit investment trust," commonly referred to as a "UIT," is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.
Here are some of the traditional and distinguishing characteristics of UITs:
A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that the UIT will buy back an investor's "units," at the investor's request, at their approximate net asset value (or NAV) . Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.
A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.
A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.
A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.
A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.
Before investing in a UIT, you should carefully read all of the UIT's available information, including its prospectus.
UITs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 4 and Section 26.
Source:
http://www.sec.gov/answers/uit.htm
------------------------
Managed investment companies are categorised into open-end and closed-end companies
Open-end investment companies are called mutual funds and they stand ready to sell new shares or to redeem existing shares at NAV. Their assets under management expand or contract with each transaction that investors make.
Closed-end investment companies issue shares only once to the public and then those shares are traded in the secondary markets.
NAV calculation of investment companies
NAV is the per-share value of the investment company's assets minus liabilities.
Assets are all the cash and securities that are on its books, accrued dividends &interest payments due to from companies and payments due from stock brokers. Liabilities include payments due to brokers and other parties from whom securities are purchased and will include management fees due to investment managers.
Fees charged by Managers and Management Companies
Investment companies charge fees and also expenses are incurred in transactions and accounting/administration of the fund.
Annual charges comprise management fees, distribution fees and operating expenses.
One time charges at purchase and exit provide commission for sales agent. They do not provide any fee for fund management.
asset value of a fund is calculated and the nature of fees charged by investment
companies;
Investment companies are financial intermediaries that pool and invest funds of varius individual and institutional investors, giving the investors rights to a proportional share of the pooled fund performance.
There are managed investment companies and unmanaged investment companies in United States.Unit investment trusts in United States are unmanaged investment companies and they hold a fixed portfolio of investments for the life of the company and they stan ready to redeem the investor's units at market value (net asset value) and also for reselling such shares to new investors.
------------------
Unit Investment Trusts (UITs)
A "unit investment trust," commonly referred to as a "UIT," is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.
Here are some of the traditional and distinguishing characteristics of UITs:
A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that the UIT will buy back an investor's "units," at the investor's request, at their approximate net asset value (or NAV) . Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.
A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.
A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.
A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.
A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.
Before investing in a UIT, you should carefully read all of the UIT's available information, including its prospectus.
UITs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 4 and Section 26.
Source:
http://www.sec.gov/answers/uit.htm
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Managed investment companies are categorised into open-end and closed-end companies
Open-end investment companies are called mutual funds and they stand ready to sell new shares or to redeem existing shares at NAV. Their assets under management expand or contract with each transaction that investors make.
Closed-end investment companies issue shares only once to the public and then those shares are traded in the secondary markets.
NAV calculation of investment companies
NAV is the per-share value of the investment company's assets minus liabilities.
Assets are all the cash and securities that are on its books, accrued dividends &interest payments due to from companies and payments due from stock brokers. Liabilities include payments due to brokers and other parties from whom securities are purchased and will include management fees due to investment managers.
Fees charged by Managers and Management Companies
Investment companies charge fees and also expenses are incurred in transactions and accounting/administration of the fund.
Annual charges comprise management fees, distribution fees and operating expenses.
One time charges at purchase and exit provide commission for sales agent. They do not provide any fee for fund management.
CFA Level Alternative Instruments - Investment Strategies
b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
Style stategies: The funds or fund managers focus on some underlying characteristics common to various possible assets or securities of an asset.
In case of equity growth and value are very popular style strategies.
Growth strategies focus on identifying growth companies selling at high P/E ratios, but undervalued according to the analysis of the fund managers. The fund managers has expertise and confidence in his analysis of growth prospects as well as the valuation of those prospects. Growth style managers are willing to consider new companies for investing.
Value fund managers, rely on past performance to derive a value estimate, and find undervalued companies based on their valuation and then analyze whether there are serious weaknesses that disturb historical record. Value style managersl limit their analysis to companies with having a minimum number of years of existence to get historical data to analyse.
Sector investment funds focus on stocks of particular industry. ex: Pharmaceuticals, Financial industry
An index fund attempts to track an index.
An international fund invests only in foreign assets.
A global fund invests in foreign assets as well as domestic assets.
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
Style stategies: The funds or fund managers focus on some underlying characteristics common to various possible assets or securities of an asset.
In case of equity growth and value are very popular style strategies.
Growth strategies focus on identifying growth companies selling at high P/E ratios, but undervalued according to the analysis of the fund managers. The fund managers has expertise and confidence in his analysis of growth prospects as well as the valuation of those prospects. Growth style managers are willing to consider new companies for investing.
Value fund managers, rely on past performance to derive a value estimate, and find undervalued companies based on their valuation and then analyze whether there are serious weaknesses that disturb historical record. Value style managersl limit their analysis to companies with having a minimum number of years of existence to get historical data to analyse.
Sector investment funds focus on stocks of particular industry. ex: Pharmaceuticals, Financial industry
An index fund attempts to track an index.
An international fund invests only in foreign assets.
A global fund invests in foreign assets as well as domestic assets.
CFA ETFs
Exchange traded funds are index based investment products that allow nvestors to buy or sell exposure to an index on the stock exchange through a single financial instrument.
ETFs are shares of funds that trade on a stock market like shares of any individual companies.
ETFs are shares of funds that trade on a stock market like shares of any individual companies.
CFa Level 1 Advantages and Risks of ETFs
c. explain the advantages and risks of ETFs
-----------------
Applications
Implementing asset allocation
Diversifying sector/industry exposure
Gaining exposure to international markets
Equitizing cash
Managing cash flows
Completinng overall investment strategy
Bridging transitions in fund management
Managing portfolio risk
Risks
Market risk
Asset class/sector risk
Trading risk
Tracking error risk
Derivatives risk
Currency risk and country risk
-----------------
Applications
Implementing asset allocation
Diversifying sector/industry exposure
Gaining exposure to international markets
Equitizing cash
Managing cash flows
Completinng overall investment strategy
Bridging transitions in fund management
Managing portfolio risk
Risks
Market risk
Asset class/sector risk
Trading risk
Tracking error risk
Derivatives risk
Currency risk and country risk
CFA Level 1 Alt. Inv. Venture Capital
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
---------------------
Private equity investments are equity investments that are not traded on exchanges. private equity definition is now extended to making equity investment through bulk deals involving negotiated prices.
Venture capital falls under private equity definition. Venture capital investments are investments in business ventures from idea stage through expansion of an unlisted company already producing and selling a product. The exit from the investment is made through a buyout or an initial public offering.
Investments in private equity are done through limited partnerhships. Limited partnerships allow participation in funds with limited liability (the initial investment) and management of the fund by general partners who are private equity experts.
Funds of funds are available in private equity funds.
characteristics, and challenges to venture capital valuation and performance
measurement;
---------------------
Private equity investments are equity investments that are not traded on exchanges. private equity definition is now extended to making equity investment through bulk deals involving negotiated prices.
Venture capital falls under private equity definition. Venture capital investments are investments in business ventures from idea stage through expansion of an unlisted company already producing and selling a product. The exit from the investment is made through a buyout or an initial public offering.
Investments in private equity are done through limited partnerhships. Limited partnerships allow participation in funds with limited liability (the initial investment) and management of the fund by general partners who are private equity experts.
Funds of funds are available in private equity funds.
CFA L1 Alt. Inv. Venture Capital Investing
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
Stages of Venture Capital Investing
Seed-stage
Early-stage
Formative-stage
Later-stage
Expansion-stage
Venture capital investment characteristic
Illiquidity
Long-term commitment
Difficulty in determining current market values
Limited historical risk and return data
Limited information
Entrepreneurial management mismatches
Fundmanager incentive mismatches
Lack of knowledge of competitors
Vintage cycles
Extensive operations analysis and advice
types of liquidation
Exits
divestment by trade sale
divestment by IPO/Floatation
Sale of quoted equity
Divestment by writeoff
characteristics, and challenges to venture capital valuation and performance
measurement;
Stages of Venture Capital Investing
Seed-stage
Early-stage
Formative-stage
Later-stage
Expansion-stage
Venture capital investment characteristic
Illiquidity
Long-term commitment
Difficulty in determining current market values
Limited historical risk and return data
Limited information
Entrepreneurial management mismatches
Fundmanager incentive mismatches
Lack of knowledge of competitors
Vintage cycles
Extensive operations analysis and advice
types of liquidation
Exits
divestment by trade sale
divestment by IPO/Floatation
Sale of quoted equity
Divestment by writeoff
CFA Level 1 Alternative Investments - NPV VC Project
---------
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
----------
NPV calculation of the venture capital project is done first by calculating NPV in the normal manner as is done for projects of existing companies. The estimates mostly likely cashflows for each year of the project life are made and the cash flows are discounted to present value to determine NPV.
The risk of the venture is explicitly modelled in VC projects. For illustration let use take the following data regarding the probability of failure of a venture.
Year ----Failure probability
1---------------0.30
2.--------------0.25
3.--------------0.20
4.--------------0.15
5.--------------0.15
6.--------------0.10
7.--------------0.10
Becasue probablity of failure is given, probability of success is 1 minus probability of failure. For the first year 0.70 is the probability of success.
The seven years the probability of success is
(0.70)(0.75)(0.80)(0.85)(0.85)(0.90)(0.90) = 0.246
So the probability of venture surviving for seven year is .246.
If the estimate is that the investment outlay required is $2 million and it will give an exit value of 30 million at the end of seven years. The required return is 20%.
The present value of 30 million received at the end of 7 years is 30/(1.20^7) which comes out as 8.372 million.
If project fails at any during seven years the NPV(failure) is -$2 million and if its succeeds NPV(success) is $6.372 million.
The expected NPV of the venture = .754(-$2 mil) + .246($6.372) = $0.06 million
Based on the NPV the venture project can be accepted.
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
----------
NPV calculation of the venture capital project is done first by calculating NPV in the normal manner as is done for projects of existing companies. The estimates mostly likely cashflows for each year of the project life are made and the cash flows are discounted to present value to determine NPV.
The risk of the venture is explicitly modelled in VC projects. For illustration let use take the following data regarding the probability of failure of a venture.
Year ----Failure probability
1---------------0.30
2.--------------0.25
3.--------------0.20
4.--------------0.15
5.--------------0.15
6.--------------0.10
7.--------------0.10
Becasue probablity of failure is given, probability of success is 1 minus probability of failure. For the first year 0.70 is the probability of success.
The seven years the probability of success is
(0.70)(0.75)(0.80)(0.85)(0.85)(0.90)(0.90) = 0.246
So the probability of venture surviving for seven year is .246.
If the estimate is that the investment outlay required is $2 million and it will give an exit value of 30 million at the end of seven years. The required return is 20%.
The present value of 30 million received at the end of 7 years is 30/(1.20^7) which comes out as 8.372 million.
If project fails at any during seven years the NPV(failure) is -$2 million and if its succeeds NPV(success) is $6.372 million.
The expected NPV of the venture = .754(-$2 mil) + .246($6.372) = $0.06 million
Based on the NPV the venture project can be accepted.
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