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Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby 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
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
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 OTC Interest Rate Agreements
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
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
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
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 Warrants and Convertible Securities
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
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 Valuing Flexibility: An Introduction to Real Options
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 The InternetInvestments Online
End of Chapter 24 • Swap Contracts, Convertible Securities, and Other Embedded Derivatives
Future topicsChapter 25 • Professional Asset Management