The dramatic growth of equity index futures has been accompanied by the substantial growth of equity index options. These options come in three forms:

1. Options on the spot index itself such as the contract traded in the London International Financial Futures and Options Exchange — like the futures, these options are settled in cash, rather than by delivery of the underlying securities. Sometimes both European and American options are traded on the same index.
2. Options on the index futures are American options that call for delivery of an equity index futures contract at expiry.

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Posted: June 26th, 2008 under Foreign Exchange Futures, Futures Contracts, Futures Index, Futures Market, Futures Options, Stock Market Futures, Swap Futures.
Comments: 6

The Black model should not be used for valuing American options on currency futures because it may be optimal to exercise the options early in the same way as it may be optimal to exercise options on the spot currency early. The binomial or the Barone-Adesi and Whaley models may be used for valuing those options.

The early exercise potential of American options on futures is different to that of options on the spot. Futures prices do not exhibit the discrete jumps that accompany spot market assets when the underlying spot asset makes discrete distributions. However, as the carry basis of the future converges to zero at delivery, the futures price converges to the spot price in an orderly manner. Read more »

Posted: June 22nd, 2008 under Currency Futures, Futures Options, Futures Prices, Swap Futures, investment.
Comments: 4

Average rate currency options are based upon the average exchange rate of the underlying currency as distinct from the exchange rate on a single date — the expiry date.

The advantage of an average rate option is that the volatility of a moving average of a variable is less than the volatility of individual observations of that same variable. With daily observations, and with the volatility levels seen in the currency markets, the volatility of the moving average is in the order of 60% of that of the raw observations. Consequently, the price of an average rate option with a given exercise price will be less than an otherwise identical standard European currency option. Read more »

Posted: June 21st, 2008 under Equity Futures, Future Market Trends, Futures Market, Futures Options, Futures Spreads, S&P Futures, Stock Market Futures, Swap Futures, investment.
Comments: 5

The valuation of interest rate options is currently the most contested area of option- pricing theory. The problem stems from the fact that although there is a reasonable consensus about the nature of the stochastic process of share prices, equity indices and currencies, the movements in interest rates and interest rate dependent instruments are not fully understood and full agreement on the underlying process has yet to be reached.

The stochastic process of interest rates, and therefore the prices of interest rate dependent claims, has proved to be very difficult to model for a number of reasons. Read more »

Posted: June 17th, 2008 under Equity Futures, Future Broker, Futures Contracts, Futures Quotes, Managed Futures, Stock Market Futures, Swap Futures.
Comments: 4

A detailed analysis of the empirical testing of the term structure is beyond the scope of this post; however, in summary it should be stated that the empirical tests give a substantial role to expectations. However, forward rates are not unbiased estimators of future spot rates, and the bias is consistent with a liquidity premium. There is also some evidence that the premium increases with the term to maturity, but at a decreasing rate. There is less support for the segmentation hypothesis.

The dynamics of the term structure

Clearly the term structure is dynamic, but exactly what is the nature of this dynamic process? It has long been observed that long rates are less volatile than short rates; for further discussion see Kessel (1965), Malkiel (1966) and Brooks and Livingston (1990). Current long-rate volatilities are linked to current short-rate volatilities by the concept of mean reversion — i.e. where short rates have a tendency to be pulled back towards some long-term average value following a movement up or down. Read more »

Posted: June 15th, 2008 under Currency Futures, Future Exchange, Futures Contracts, Managed Futures, Swap Futures.
Comments: 4

Bonds with equity warrants attached

Recently it has been popular among Japanese corporations to issue eurobonds with equity warrants attached. Their popularity has stemmed partly from the strength of the Tokyo stock market, the warrants giving an equity kicker to bond investors.

These warrants are usually detached from the bonds after issue, and traded separately. Bonds with warrants attached are different from convertible bonds because the warrants are long-term options which when exercised require new cash, not existing bonds, to be exchanged for the new equity. At the time of issue, the bonds constitute a portfolio consisting of one bond and one long-term option on the equity of the issuer. After the time of issue, and when the warrants have been stripped, the bonds are valued as straight bonds. Read more »

Posted: June 15th, 2008 under Future Trading, Futures Options, Futures Quotes, Stock Market Futures, Swap Futures, investment.
Comments: 4

The investment manager may have a number of bond-like assets in the portfolio, and corporate treasurers may have issued similar liabilities which have options embedded within them by virtue of the contract terms under which the bonds were issued. Common examples of such bonds are as follows.

• Bonds with call provisions allow the issuer to call the issue at a date earlier than the redemption date, at a price different from par but specified when the bond is issued. Bonds with sinking funds attached also have an embedded option.

• Putable bonds give the holder the option to put the bond back to the issuer at a predetermined price.

• Convertible bonds give the holder the option of converting the bond into the equity of the issuer. The rate of conversion and the time is specified when the bonds are issued. Some convertible bonds have been issued that provide for conversion into other bonds.

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Posted: June 15th, 2008 under Futures Options, Swap Futures.
Comments: 5

However, this theory of the development of the swaps market assumes that the financial markets remain informationally inefficient and that the benefits of comparative advantage are not arbitraged away. There is no doubt that in the early days of the interest rate and currency swaps markets it was possible to locate such inefficiencies that resulted in generous benefits to both parties, but in the years since the market’s inception the benefits have to some extent been reduced by arbitrage, yet the market still grows dramatically.

Thus there must be some other reason, or reasons, for the existence of the swaps market as the comparative advantage theory assumes that some markets persistently underprice credit risk relative to other markets. Three alternative reasons for the market’s existence can be postulated. Read more »

Posted: June 14th, 2008 under Currency Futures, Foreign Exchange Futures, Future Exchange, Future Investing, Future Management, Future Trading, Interest Rate Futures, Managed Futures, Stock Futures, Stock Market Futures, Swap Futures.
Comments: 4

Currency swaps, which were developed before interest rate swaps, were derivations of the 1970s practice of establishing parallel loans between two parties whereby, for example, company A would lend its domestic currency to company B, in return for a loan of company B’s domestic currency. These parallel loans were often used to manage exchange risk or to circumvent exchange control regulations.

This system of mutual lending had two serious drawbacks. First, there was no automatic off-set of the cash flows between parties. Thus, if company A defaulted on its loan from B, company B would still have to honour its commitment to A. Secondly, although the two loans effectively cancelled each other out, they were still shown on the balance sheets of each company. Read more »

Posted: June 14th, 2008 under Commodities Futures, Crude Oil Futures, Equity Futures, Future Exchange, Future Fund, Future Investing, Future Management, Future Trading, Futures Contracts, Managed Futures, Swap Futures.
Comments: 3

Another new area of the swaps market is that of commodity swaps. The mechanics of these swaps are similar to interest rate swaps, in that the swap establishes a fixed commodity price and a floating commodity index, with which the fixed price can be compared. There is a notional principal physical quantity of the commodity which establishes the value of the periodic cash flows. To illustrate these mechanics and give some insight into the use of commodity swaps as risk management instruments, consider the following scenario regarding a manufacturer that is a substantial consumer of copper. Read more »

Posted: June 9th, 2008 under Commodities Futures, Future Broker, Future Exchange, Future Fund, Future Investing, Future Management, Future Trading, Futures Contracts, Futures Quotes, Futures Trader, Managed Futures, Swap Futures.
Comments: 5