Ch24

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              to accompany

  Investment Analysis and
    Portfolio Management
              Seventh Edition
                   by
    Frank K. Reilly & Keith C. Brown

 Chapter 24
 Chapter 24 - Swap Contracts,
Convertible Securities, and Other
    Embedded Derivatives
Questions to be answered:
• What are forward rate agreements and how
  can they be used to reduce the interest rate
  exposure of a borrower or investor?
• What are interest rate swaps and how can they
  transform the cash flows of a fixed or floating
  rate security?
• How does the swap market operate and how
  are swap contracts quoted and priced?
 Chapter 24 - Swap Contracts,
Convertible Securities, and Other
    Embedded Derivatives
• How can swaps be interpreted as a pair of
  capital market transactions and how does this
  aid in the swap valuation process?
• How is credit risk measured in the interest rate
  swap market?
• What are interest rate caps and floors and how
  are they related to interest rate swaps?
 Chapter 24 - Swap Contracts,
Convertible Securities, and Other
    Embedded Derivatives
• How does a currency swap differ from a “plain
  vanilla” interest rate swap and what is it used
  for?
• How can the swap contracting concept be
  adapted to manage equity and commodity
  price risk?
 Chapter 24 - Swap Contracts,
Convertible Securities, and Other
    Embedded Derivatives
• How do the derivatives in convertible securities
  and warrant issues differ from traditional
  exchange-traded products?
• What are the similarities and differences
  between convertible preferred stock and
  convertible bonds?
 Chapter 24 - Swap Contracts,
Convertible Securities, and Other
    Embedded Derivatives
• What are structured notes and what factors
  make their existence possible?
• How can securities with embedded derivatives
  reduce the funding cost of a corporate
  borrower?
• What are real options and how can an investor
  use them to value company flexibility?
      OTC Interest Rate Agreements
• Forward-based interest rate contracts
    – Forward Rate Agreement (FRA)
       • two parties agree today to a future exchange of cash
         flows based on two different interest rates
       • one of the cash flows is tied to a fixed rate
       • the other is determined at a later date (floating rate)
       • LIBOR frequently used as the floating rate index
       • Single settlement date

                                                 Number of Days 
LIBOR - Fixed Rate  Notational Principal                  
                                                     360        
    OTC Interest Rate Agreements
• Forward-based interest rate contracts
  – Interest Rate Swaps
     • multiple exposure dates could be hedged using a
       series of FRAs
     • swap contract is a prepackaged series of forward
       contracts to buy or sell LIBOR at the same fixed
       rate
            OTC Interest Rate Agreements
         • Forward-based interest rate contracts
            – Interest Rate Swaps
               • priced off the LIBOR forward yield curve,
                 but quoted off the Treasury bond yield curve
                     – fixed rate side is
                          » the yield of a Treasury bond with a comparable
                            maturity, and
                          » a risk premium term known as the swap spread

                                                   Number of Days 
Fixed   - Rate Payment t  Swap Fixed Rate                     Notational Principal 
                                                       365        

Floating - Rate Payment t  Reference Rate t 1   Number of Days   Notational Principal 
                                                                      
                                                           360        
      OTC Interest Rate Agreements
• Option-based interest rate contracts
    – Cap agreement
        • a series of cash settlement interest rate options, typically
          based on LIBOR
    – Floor agreement
        • makes settlement payments only when LIBOR is below
          the floor rate
Cap Settlement :
Notational Principal   Number of Days   maxLIBOR t -1  X c ,0
                                         
                              360        
 Floor Settlement :
 Notational Principal   Number of Days   maxX f - LIBOR t -1 ,0
                                          
                               360        
     OTC Interest Rate Agreements
• Option-based interest rate contracts
  – Collars
     • combination of a cap and a floor
     • long in one and short in the other
     • cap-floor-swap parity occurs when the
       combination are at the same rates and have a net
       zero initial cost
     • can be viewed as a pair of option positions
  – Swap Options (“Swaptions”)
     • the right but not obligation to enter into an interest
       rate swap having a predetermined fixed rate at
       some later date
     Swap Contracting Extensions
• Currency swaps
  – Agreements wherein two counterparties make
    periodic cash flow exchanges based on two different
    interest rates
• Equity index-linked swaps
  – Equivalent to portfolios of forward contracts calling
    for the exchange of cash flows based on two
    different investment rates: (1) a variable-debt rate
    (e.g., three-month LIBOR) and (2) the return to an
    equity index (e.g., Standard and Poor’s 500)
Warrants and Convertible Securities
• Warrants
  – equity option issued by the company whose stock
    serves as the underlying asset
  – if exercised, the company will create new shares of
    stock to give to the warrant holder

            VT  NW X         
  WT  max               X ,0
             N  NW           
              1     
  WT               CT
       1   NW N  
Warrants and Convertible Securities
• Convertible securities
  – owner has right but not obligation to convert the
    existing investment into another form
• Convertible preferred stock
  – convertible into common stock at the discretion of
    the owner
• Convertible bonds
  – Can be viewed as a prepackaged portfolio containing
    two distinct securities: a regular bond and an option
    to exchange the bond for a pre-specified number of
    shares of the issuing firm’s common stock
             Warrants and Convertible
                    Securities
     • Convertible Bonds
         – Payback (or break-even time) – measures how
           long the higher interest income (associated with
           the bond) must persist to make up for the
           difference between the price of the bond and its
           conversion premium

                          Bond Price - Conversion Value
Payback 
          Bond Income - Income from Equal Investment in Common Stock
    Other Embedded Derivatives
• Dual Currency Bonds
  – Coupons denominated in a different currency
    than its principal amount
• Equity Index-linked Notes
  – Link payoff to an equity index
• Commodity-linked Bull and Bear Bonds
  – Link payoff with commodity price movements
• Swap-linked Notes
  – Connect payoff with interest rate changes
      Valuing Flexibility: An
   Introduction to Real Options
• Factors responsible for their increasing
  importance
  – The pace of technological innovation
  – Deregulation and privatization
  – Advances in option pricing theory and
    decreases in the computing costs
• Company Valuation and Real Options
         The Internet
      Investments Online
www.isda.org
www.numa.com
www.goldmansachs.com/qs/
www.calamos.com
www.dir.co.jp/InfoManage/datarsc.html
www.optionscentral.com
www.amex.com/structuredeq/structured_products.
 stm
End of Chapter 24
 –Swap Contracts,
 Convertible Securities, and
 Other Embedded Derivatives
       Future topics
        Chapter 25
• Professional Asset Management

				
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posted:7/11/2011
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