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Debt OPTIONS

Debt OPTIONS. Options on Treasury Securities: T-Bill Options. Options on T-Bills give the holder the right to buy a T-Bill with a face value of $1M and maturity of 91 days. Exercise price is quoted in terms of the IMM index and the following formula can be used to determine X:

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Debt OPTIONS

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  1. Debt OPTIONS

  2. Options on Treasury Securities:T-Bill Options • Options on T-Bills give the holder the right to buy a T-Bill with a face value of $1M and maturity of 91 days. • Exercise price is quoted in terms of the IMM index and the following formula can be used to determine X: • The option premium is quoted in terms of annual discount points (PT). The actual premium is

  3. Options on Treasury Securities: T- Bond Options • Options on T-Bonds give the holder the right to buy a specified T-Bond with a face value of $100,000. • Exercise price is quoted as a percentage of par (e.g. IN = 90). If the holder exercises, she pays the exercise price plus the accrued interest: • The option premium is quoted in terms of points (PT). The actual premium is

  4. Fundamental Strategies • There are six fundamental strategies: • Call Purchase • Naked Call Write • Covered Call Write • Put Purchase • Naked Put Write • Covered Put Write

  5. Profit Graph • Option Strategies can be evaluated in terms of a profit graph. • A profit graph is a plot of the option position’s profit and security price relation at expiration or when the option is exercised.

  6. Figure 17.3-1: Call Purchase • Buy T-Bond call: X = $100,000, C = $1000

  7. Figure 17.3-2: Naked Call Write • Sell T-Bond call for: X= 100,000, C=1000.

  8. Figure 17.3-3: Covered Call Write • Long T-Bond at 100,000, short 100 T-Bond call at 1.

  9. Figure 17.3-4: Put Purchase • Buy T-Bond put: X=100,000, P = 1000

  10. Figure 17.3-5: Naked Put Write • Sell T-Bond put: X =100,000, P = 1000

  11. Figure 17.3-6: Covered Put Write • Short T-Bond at 100,000, short 100 T-Bond put at 1.

  12. Other Strategies

  13. Figure 17.4-1: Straddle Purchase • Buy 100 T-Bond put for 1 and buy 100 T-Bond call for 1:

  14. Figure 17.4-2: Bull Spread • Buy 100 T-Bond call for 1 and sell 101 T-Bond call for .75:

  15. Hedging

  16. Table 17.8-4: Hedging the Cost of a September T-Bill Purchase with a T-Bill Call

  17. Table 17.8-5: Hedging a Future T-Bond Sale with a T-Bond Put

  18. Futures Options onTreasury Securities • Futures options give the holder the right to take a futures position: • Futures Call Option gives the holder the right to go long. When the holder exercises, she obtains a long position in the futures at the current price, ft, and the assigned writer takes the short position and pays the holder ft - X. • Futures Put Option gives the holder the right to go short. When the holder exercises, she obtains a short position at the current futures price, ft, and the assigned writer takes the long position and pays put holder X - ft. • Futures option on Treasuries: Options on T-Bill Futures, T-Bond Futures, and T-Note Futures.

  19. Exhibit 17.9-1: Futures Options onTreasury Securities Call on T-Bill Futures: • X = IMM 90 or X = $975,000 • PT = .5 or C = $1,250 • Futures and options futures have same expiration.

  20. Exhibit 17.9-2: Futures Options onTreasury Securities Put on T-Bill Futures: • X = IMM 90 or X = $975,000 • PT = .5 or P = $1,250 • Futures and options futures have same expiration.

  21. Table 17.9-1: Put-Call-Futures Parity

  22. Hedging Cases

  23. Exhibit 18.2-2: Hedging $5M CF in June with June T-Bill Futures Call

  24. Managing the Maturity Gap with T-Bill Put • Case: In June, a bank makes a $1M loan for 180 days which it plans to finance by selling a 90-day CD now at the LIBOR of 8.258% and a 90-day CD ninety days later (in September) at the LIBOR prevailing at that time. To minimize its exposure to market risk, the bank buys a T-Bill put at X = IMM = 90 for $$1250.

  25. Maturity Gap Hedged with T-Bill Puts

  26. Hedging future T-Bond Sale With T-Bond Puts • Case: Three months from the present (.25 of year), a bond manager plans to sell a T-Bond with maturity of 15.25 years, F = $100,000, and coupon rate = 10%. • Manager hedges the sale against interest rate increases by buying one put option on a T-Bond with a current maturity of 15.25 years and face value of $100,000. The put has an expiration of T = .25 years, exercise price of X = IN = 95 or X = $95,000, and is trading at P = 1 - 5 or P = [1.15625/100]($100,000) = $1156.

  27. Hedging future T-Bond Sale With T-Bond Puts • Hedge T-Bond Sale:

  28. Hedging Future Bond PortfolioSale With T-Bond Puts • Case: Three months from the present (.25 of year), a bond manager plans to liquidate a bond portfolio consisting of AAA, AA, and A bonds. The portfolio currently has a WAM of 15.25 years, F = $10M, WAC = 10%, and has tended to yield a rate 1% above T-Bond rates. • Manager hedges the sale against interest rate increases by buying put options on a T-Bond with a current maturity of 15.25 years and face value of $100,000. The put has an expiration of T = .25 years, exercise price of X = IN = 95 or X = $95,000, and is trading at P = 1 - 5 or P = [1.15625/100]($100,000) = $1156. • To hedge, the manager buys 105.26316 T-Bond puts for $121,684:

  29. Hedging Future Bond PortfolioSale With T-Bond Puts • Hedge Bond Portfolio Sale:

  30. Interest Rate Options

  31. Interest Rate Options • Interest rate call option gives the holder the right to a payoff if an interest rate (e.g., LIBOR) exceeds a specified exercise rate; interest rate put option gives the holder the right to a payoff if an interest rate is less than the exercise rate. • Interest rate options are written by commercial banks in conjunction with a future loan or CD investment.

  32. Interest Rate Call Option Case: • A company plans to borrow $10M in sixty days from Sun Bank. The loan is for 90 days with the rate equal to LIBOR in 60 days plus 100 BP. • Worried that rates could increase in the next 60 days, the company buys an interest rate call from the bank for $20,000. • Terms: Exercise Rate = 7%; call premium plus interest will be paid at the maturity of the loan; any interest rate payoff will be paid at the loan’s maturity. • See Chapter 17.

  33. Interest Rate Put Option Case: • A company plans to invest $10M in sixty days in a Sun Bank 90-day CD. The CD will pay the LIBBER. • Worried that rates could decrease in the next 60 days, the company buys an interest rate put from the bank for $15,000. • Terms: Exercise Rate = 7%; put premium plus interest will be paid at the maturity of the CD; any interest rate payoff will be paid at the CD’s maturity. • See Chapter 17

  34. Caps: Series of Interest Rate Call Options • A Cap is a series of interest rate calls that expire at or near the interest rate payment dates on a loan. They are written by financial institutions in conjunction with a variable rate loan. Case: • A company borrow $50M from Commerce Bank to finance its yearly construction projects. The loan starts on March 1 at 8% and is reset every three months at the prevailing LIBOR. • Cap: In order to obtain a maximum rate while still being able to obtain lower rates if the LIBOR falls, the company buys a Cap from the bank for $100,000 with exercise Rate = 8%. • See Chapter 17

  35. Floor: Series of Interest Rate Put Options • A floor is a series of interest rate puts that expire at or near the payment dates on a loan. They are purchased by financial institutions in conjunction with a variable rate loan they are providing. Case: • Commerce Bank purchases a floor with an exercise rate of 8% for $70,000 from another institution to protect the variable rate loan it made. • See Chapter 17

  36. Table 17.8-1: Profit and Interest Rate Relation from Closing a Long 94 T-Bill Call Purchased at 1

  37. Table 17.8-3: Profit and Interest Rate Relation from Closing a Long 94 T-Bond Put Purchased at $1000

  38. Table 17.8-2: Profit and Interest Rate Relation from Closing a Long 94 T-Bill Put Purchased at 1

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