Market Call Option & Put Option – Stock Exchange – Exam
These finance chapter discuss Bonds, Call Option & Put Option, Stock Exchange, privatization, stock market price. Exam 1 is based on these chapters.
When would you exercise a put option?
Consider if an investor purchased one put option contract for 100 shares of ABC Co. for $1, or $100 ($1*100). The exercise price of the shares is $10 and the current ABC share price is $12. This contract has given the investor the right, but not the obligation, to sell shares of ABC at $10.
If ABC shares drop to $8, the investor’s put option is in-the-money and he can close his option position by selling the contract on the open market. On the other hand, he can purchase 100 shares of ABC at the existing market price of $8, then exercise his contract to sell the shares for $10.
When would you exercise a call option?
the owner of the option purchases the underlying shares at the strike price FROM the option seller
For instance, if you exercise 1 contract of a $40 strike price call option, you would buy 100 shares of the underlying stock at $40 no matter what price it is at the time of exercise. This price is known as the Exercise Price.
Strike Price
The price at which a specific derivative contract can be exercised. Strike prices is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold.
Money Market Mutual Fund
a mutual fund concentrating in money market securities.
Organized Exchange
a visible marketplace for secondary market transactions, i.e. NYSE and the American Stock Exchange
Over-the Counter (OTC) Market
a telecommunications network facilitating financial market transactions.
Perfect Market
a market in which all information about any securities for sale in primary or secondary markets is continuously and freely available to investors.
Under these conditions, financial intermediaries would not be necessary.
Imperfect Market
securities buyers and sellers do not have full access to information and cannot always break down securities to the precise size they desire.
Financial Institutions are needed to resolve the problems caused by market imperfections; they receive requests from surplus and deficits units on what securities are to be purchased or sold, and they use this information to match up buyers and sellers of securities.
Primary Market
a market that facilitates the issuance of new securities.
These market transactions provide funds to the initial issuer of securities.
Secondary Market
a market that facilitates the trading of existing securities, transactions do not provide funds to the initial issuer.
An important characteristic of securities that are traded in this market is liquidity, some securities have an active market – meaning that there are many willing buyers and sellers of the security at any given moment.
Privatization
because of the increased deregulation in the late 1980’s and 1990’s, the sale of government-owned firms to individuals and in addition, stocks of firms were allowed to be publicly traded, i.e. fannie mae and fannie mac.
Stocks
certificates representing partial ownership in a firm. They are classified as market securities because they have no maturity and therefore serve as a long-term source of funds.
Speculation
derivative securities allow an investor to speculate on future movements in the underlying assets without having to purchase those assets, they also enable investors to take a large investment position without a large initial outlay and therefore to have a high degree of financial leverage, i.e.allow investors to benefit from an increase in the value of debt securities, while others allow investors to benefit from a decrease in the value of debt securities.
As a result of high leverage, the returns from investing in derivative securities are more pronounces than from simply investing in the underlying assets themselves.
Hedging
is an investment position intended to offset potential losses that may be incurred by a companion investment.
It can be constructed from many types of financial instruments, including stocks, ETFs, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts. Public futures markets were established in the 19th century[1] to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.
Surplus Spending Units (SSU)
those participants that provide funds.
Has more inflows than outflows. Other terms: Saver, Lender, investor (households are surplus units)
Deficit Spending Units
those participants that enter financial markets to obtain funds.
More outflows than inflows, Other terms: borrower, demander of loanable funds, seller of securites
Money Market Securities
T-Bills, CD’s, NCD’s, Commercial paper, Eurodollar deposits, banker’s acceptances, federal funds, and Repurchase agreements.
These have maturities that are 1 year or less with a relatively high degree of liquidity, tend to have a low expected return but also have a low degree of risk.
Treasury Bills (T-Bills)
Issued by: the Federal Government
Common Investors: Households, firms & financial institutions
Common Maturities: 13, 26 weeks or 1 year
Secondary Market Activity: HIGH
Retail Certificate of Deposits (CD’s)
Issued by: Banks & Savings Institutions
Common Investors: Households
Common Maturities: 7 days to 5 years or longer
Secondary Market Activity: Non-existent
Negotiable Certificates of Deposits (NCD’s)
Issued by: Large Banks & Savings Institutions
Common Investors: Firms
Common Maturities: 2 weeks to 1 year
Secondary Market Activity: Moderate
Commercial Paper
Issued by: Bank holding companies, finance & other companies.
Common Investors: Firms
Common Maturities: 1 day to 260 days
Secondary Market Activity: Low
Eurodollar Deposit
Issued by: Banks located outside the U.S.A.
Common Investors: Firms and Governments
Common Maturities: 1 day to 1 year
Secondary Market Activity: Nonexistent
Banker’s Acceptance
Issued by: Banks (exporting firms can sell the acceptances at a discount to obtain funds)
Common Investors: Firms
Common Maturities: 30 days to 270 days
Secondary Market Activity: High
Federal Funds
Issued by: Depository Institutions
Common Investors: Depository Institutions
Common Maturities: 1 day to 7 days
Secondary Market Activity: Nonexistent
Repurchase Agreements
Issued by: Firms and Financial Institutions
Common Investors: Firms and Financial Institutions
Common Maturities: 1 day to 15 days
Secondary Market Activity: Nonexistent
Treasury Notes and Bonds
Issued by: the Federal Government
Common Investors: Households, firms & financial institutions
Common Maturities: 3 – 30 years
Secondary Market Activity: HIGH
Municipal Bonds
Issued by: state and local governments
Common Investors: Households & firms
Common Maturities: 10 – 30 years
Secondary Market Activity: Moderate
Corporate Bonds
Issued by: firms
Common Investors: Households & firms
Common Maturities: 10 – 30 years
Secondary Market Activity: Moderate
Mortgages
Issued by: Individuals & Firms
Common Investors: Financial Institutions
Common Maturities: 15 – 30 years
Secondary Market Activity: Moderate
Equity Securities
Issued by: Firms
Common Investors: Households & Firms
Common Maturities: None
Secondary Market Activity: HIGH (for stocks of large firms)
Transferring Funds from SSUs to DSUs (3 types)
1. Direct Financing – Directly from SSUs to DSUs
2. Semi-Direct Financing – brought together by facilitator eg, brokers, dealres, invtmt banks. SSU – Facilitator – DSU
3. Indirect Financing – Am intermediary ( a deposits are used to make loans.) SSU – Intermediary – DSU.
Benefits from Financial Inter-mediation?
Economies of scale from specialization
Transaction and search costs are lowered for SSUs and DSUs.
Financial intermediaries may be able to gather information more effectively and discreetly.
Types of Financial Intermediaries
A) Depository Institutions:
1.Commercial Banks
2.Savings and Loan Associations
3.Credit Unions
B) Non depository Institutions:
1. Life Insurance Companies
2. Property/Casualty Insurance Companies
3. Pension Funds
4. Securities Firms
5. Mutual Funds
6. Finance Companies
Spot Exchange Rate
Present exchange rate
Futures Contract
Standardized contract allowing one to purchase or sell a specified amount of a specified instrument (such as a security or currency for a specified price and at a specified future point in time.
Options Market
facilitate the trading of stock options. options can be calls or puts. options requires that a premium be paid in addition to the price of the financial instrument and owners of the options can choose to let the option expire on the so-called expiration date without exercising it
Stock Options
can be used by speculators to benefit from their expectations and by financial institutions to reduce their risk. it provides the right to trade a specified stock index at a specified price by a specified expiration date.
Call Option
grants the owner the right (not an obligation) to purchase a specified financial instrument for a specified price (called teh exercise price or the strike price) within a specified period of time. the seller (called the writer) is obligated to procide the specified by the option contract if the owner exercises the option. Sellers can receive an up-front fee (the premium) from the purchaser as compensations.
A CALL Option is said to be “IN the money” when…
the market price of the underlying security EXCEEDS the exercise price
A CALL Option is said to be “AT the money” when…
the market price of the underlying security EQUALS the exercise price
A CALL Option is said to be “OUT of the money” when…
the market price of the underlying security BELOW the exercise price
Put Option
Grants the owner the right (not the obligation) to sell a specified financial instrument for a specified price within a specified period of time.
A PUT Option is said to be “IN the money” when…
the market price of the underlying security BELOW the exercise price
A PUT Option is said to be “AT the money” when…
the market price of the underlying security EQUALS the exercise price
A PUT Option is said to be “OUT of the money” when…
the market price of the underlying security EXCEEDS the exercise price
Foreign Exchange Market
facilitates the exchange in securities. Many banks and other financial institutions serve as intermediaries in the foreign exchange market. they also have a market-determined price (exchange rate ) that changes in response to supply and demand conditions.
Role of Depository Institutions
1. offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units.
2. They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units.
3. They accept risk on loans provided.
4. They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units.
5. They diversify their loans among numerous deficit units and therefore can absorb defaulted loans better than individual surplus units could.
Commercial Banks
In aggregate, they are the most dominant depository institution. They serve surplus units by offering a wide variety of deposit accounts and they transfer deposited funds to deficit units by providing direct loans or purchasing debt securities.
Savings Institutions
referred to as thrift institutions, another type of depository institution. includes savings and loans institutions (S&Ls). They concentrate on residential mortgage loans whereas commercial banks have concentrated on commercial loans.
Credit Unions
They differ from Commercial and Savings Banks in that they (1) are nonprofit and (2) restrict their business to the credit union members, who share a common bond (such as a common employer union). They use most of their funds to provide loans to their members.
NYSE and The American Stock Exchange
are examples of organized exchanges.
NASDAQ
Is an example of an over-the-counter (OTC) exchange
Bonds
_____ are long-term debt obligations issued by corporations and governments agencies to support their operations.
Decrease
When particular securities are perceived to be overvalued by the market, their prices ________ as these securities are sold.
Broker
The fee charged by a _____ is reflected in the difference between her bid and ask quotes.
Dealer
In addition to brokerage services, securities firms often act as _____, making a market in specific securities by adjusting their inventory of securities.
True
A financial market is a market in which financial asstes can be purchased or sold.
False
The federal government commonly act as a surplus unit.
True
Households are the main providers of funds.
False
Those financial markets that facilitates the flow of short-term funds (with maturities of less than one year) are known as capital markets, while those that facilitate the flow of long-term funds are known as money markets.
False
Primary markets facilitate the trading of existing securities.
False
An organized exchange is a telecommunications network.
True
Derivative securities are financial contracts whose values are derived from the value of underlying assets.
Higher; Higher
L-Term debt securities tend to have a _____ expected return and ____ risk than money market securities.
Efficient
When security prices fully reflect available information, the markets for these securities are said to be ____.
Overvalued
When particular securities are perceived to be _______ by the market, their prices decrease when they are sold by investors.
Europe
The most pronounced changes in international integration have occurred in ____.
Commercial Banks
________ maintain a larger amount of assets than the other types of depository institutions.
Finance Companies
The main source for funds for ____________ is proceeds from selling securities to households and businesses, while their main use of funds is providing loans to households and businesses.
What is a Mutual Fund?
an investment company that sells shares and uses the proceeds to manage a portfolio of securities.
Net Asset Value (NAV)
of a mutual fund indicates the value per share; it is estimated each day by first determining the market value of all securities comprising the mutual funds and is monitored by the SEC.
12b-1
charges that some mutual funds charge shareholders distribution fees to cover advertising expenses or to compensate brokerage firms that advised their clients to invest in that fund.
The higher the expense ratio in a mutual fund…
the lower the return for a given level of portfolio performance.
Load Mutual Fund
a mutual fund that contains (sales) charges typically between 3-8.5%. Is paid through the difference between the bid and ask prices. Brokerage firms help determine the type of fund that is appropriate for them.
No-Load Mutual Fund
funds that are promoted strictly by the mutual fund of concern, used by investors who feel capable of making their own investment decisions that can be purchased through a discount broker for relatively low fees, typically 1-2%. Investors receive no advice.
Open-End Investment Funds
are willing to repurchase the shares they sell from investors at any time. Attractive to investors because it offers liquidity at any time.
Closed-End Investment Funds
do not repurchase the shares they sell. Instead, investors must sell the shares on a stock exchange just like corporate stock. The # of shares outstanding sold by this investment company usually remains constant and is equal to the # of shares originally issued. When the demand for this mutual fund is strong, the market price may be higher than its NAV.
Growth Funds
are typically composed of stocks of companies that have not fully matured and are expected to grow at a higher than average rate in the future.
Capital Appreciation Funds
aka, aggressive growth funds, are composed of stocks that have a potential for high growth byt may also be unproven.
Index Fund
is intended to mirror or match the performance of a stock index of a particular country or group of countries.
Specialty Funds
aka, same mutual funds, focus on a group of companies sharing a particular characteristics, such as the industry the companies operate in.
Income Funds
usually composed of bonds that offer periodic coupon payments and vary in exposure to risk. Some are composed of only corporate bonds which are susceptible to risk, while those only composed of Treasury bonds are not. There are also some that are composed of funds that contain bonds backed by the government agencies which are normally perceived as less risky.
Asset Allocation
funds that contain a variety of investments such as stocks, bonds, and money market securities. Portfolio managers adjust the compositions of these funds in response to expectations. ex: a given fund will tend to concentrate more heavily on bonds if interest rates are expected to decline; it will focus on stocks if a strong stock market is expected.
inversely
The prices of bonds tend to be _____ related to changes in the risk-free interest rate.
Money Market Funds
are portfolios of short-term instruments constructed and managed by investment companies.
low
The expected returns on money market funds are ______ relative to bonds or stocks.
Beta
an estimation that measures the sensitivity of a mutual fund’s exposure to market conditions.
Real Estate Investment Trust (REIT)
is a closed mutual fund that invest in real estate or mortgages. Low minimum investment. Typically sold on the stock exchange.
What is a major advantage of a Mutual Fund?
Diversification, Economies of Sale (meaning that they can buy in large quantities at a discounted price), Divisibility (rather than having to wait until you have enough money to buy higher-cost investments, you can get in right away with mutual funds), Liquidity, and Professional Management.
What are the major Disadvantages of a Mutual Fund?
Over Diversification, Fluctuation of Returns, Not backed by the government in case of dissolution – meaning you wont get anything back, they pool money because of the liquidity and the inability to Evaluate a fund ie, eps and p/e ratios – MF’s are only evaluated with NAV which makes it hard to evaluate it against other mutual funds, Costs can be high.
Equity REIT
invest directly in properties.
Mortgage REIT
invests in mortgage and construction loans.
What are ETFs?
-Mimic index stock indexes, trade on the stock exchange, share price changes, consist of fixed # of shares, not actively manged.
A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. They experience price changes throughout the day as they are bought and sold. Because it trades like a stock, these funds do not have its net asset value (NAV) calculated every day like a mutual fund does.
By owning an these, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most the these funds are lower than those of the average mutual fund. When buying and selling these funds, you have to pay the same commission to your broker that you’d pay on any regular order.
most widely known: is called the Spider (SPDR), which tracks the S&P 500 index and trades under the symbol SPY.
What are the different types of mutual funds?
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds
Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of these funds because there are many different types of equities. A great way to understand the universe of these funds is to use a style box or investment box.
Fixed Income Funds
named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms “fixed-income,” “bond,” and “income” are synonymous. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cashflow to investors. As such, the audience for these funds consists of conservative investors and retirees.
Money Market Funds
consists of short-term debt instruments, mostly Treasury bills. You won’t get great returns, but you won’t have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD).
Bid-Ask Price
the fee charged by a broker
Bonds
long-term debt obligations issued by corporations and government agencies to support their operations.
Broker
a person or institution executing securities transactions between two parties.
Capital Market
a market that facilitates the flow of long term funds and generally have a maturity of more than one year, three common types are bonds, mortgages, and stocks but also include treasury notes & bonds, and equity securities.
Circuit Breakers
a device used to temporarily halt the trading of some securities or contracts.
This is regulation that has been imposed to reduce market volatility because the disruptions may reflect overreactions to rumors.
Dealer
a person making a market in specific securities by adjusting his inventory of securities
Derivative Securities
financial contracts whose values are derived from the values of underlying assets (such as, debt securites or equity securities).
traded in financial markets and enables investors to engage in speculation and hedging.
Financial Market
a market in which financial assets (securities) can be bought or sold. they facilitate the flow of funds from surplus units to deficit units.
Liquidity
the degree to which securities can easily be sold without a loss of value.
Money Market
a market that facilitates the flow of short-term funds with maturities of less than one year.
What is a hedge fund?
An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). They are historically unregulated, not allowed to advertise and organized as limited partnerships.
Legally, these funds are most often set up as private investment partnerships that are open to a limited number of investors (ie: wealthy individuals worth >1 million and institutions) and require a very large initial minimum investment. Investments in these funds are illiquid as they often require investors to keep their money in the fund for at least one year.
They strive for high returns but also have a very high degree of risk., their performance are not publicized and although some have performed well many have failed.
1-2% management fee with incentive fees at 20% depending upon performance.
What makes hedge funds unique?
investors are exceptionally secure in their financial positions. The high minimums required for hedge fund investments significantly increase its opportunity for larger than normal returns. This advantage also allows hedge funds to have a great degree of freedom in investment strategies, and keeps participants locked in for many periods at a time. When a market is failing, hedge funds can wait it out, as opposed to mutual funds that may have to liquidate assets or pay off withdrawals.
Hedge funds also profit from their many trading advantages. Some of these advantages include lower transaction costs, better market access, and size advantages. Other financial institutions, such as mutual funds, also possess some of these advantages. But hedge funds have greater investment flexibility. For example, hedge funds can profit from borrowing in up markets and short selling in down markets. These activities can increase market liquidity and can help depreciating currency to stabilize. Mutual funds, on the other hand, can’t use leverage, leaving them no other option for funding but to raise cash.
Front-End Load MF
A commission or sales charge applied at the time of the initial purchase for an investment, usually mutual funds and insurance policies. It is deducted from the investment amount and, as a result, it lowers the size of the investment.
Back-End Load MF
A fee (sales charge or load) that investors pay when selling mutual fund shares within a specified number of years, usually five to 10 years. The fee amounts to a percentage of the value of the share being sold. The fee percentage is highest in the first year and decreases yearly until the specified holding period ends, at which time it drops to zero.
Also known as a “contingent deferred sales charge or load.”
What is a derivative?
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most are characterized by high leverage.
Futures contracts, forward contracts, options and swaps are the most common types, generally used as an instrument to hedge risk, but can also be used for speculative purposes.
What is a forward contract?
A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date.
Most forward contracts don’t have standards and aren’t traded on exchanges. A farmer would use a forward contract to “lock-in” a price for his grain for the upcoming fall harvest.
Why are derivatives useful?
They help eliminate the price risk inherent in transactions that call for a future delivery of money, security, or a commodity.
What are futures contracts?
A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. It details the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
What are the differences between a futures and forwards contract?
Futures – Standardized and traded on the exchange, usually never default. are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates.
Forwards-Tailor Made and not organized/traded on the exchange. Are private agreements and have chance at default. settlement of the contract occurs at the end of the contract, only possess one settlement date.
Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset’s price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset’s price, and delivery of the asset or cash settlement will usually take place.
What is an option?
A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
Options are extremely versatile securities that can be used in many different ways. Traders use options to speculate, which is a relatively risky practice, while hedgers use options to reduce the risk of holding an asset.
In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security.
Call Option
An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period.
It may help you to remember that a call option gives you the right to “call in” (buy) an asset. You profit on a call when the underlying asset increases in price.
Can never be worth more than the stock price!
Put Option
An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date,called in the money. A gain is called”in the money” while a loss is called “out of the money”
Can never be worth less than the stock price!
What are the factors affecting the premium you pay on a call or put option?
There are several factors that affect the amount of an option’s premium. The premium will be a reflection of demand and supply. During periods of rising stock market prices, there is an increased interest in purchasing options. Conversely, individuals owning securities would be less interested in writing options, opting to hold their stock for further price appreciation. The combination of these two typically raises the level of option premiums. When stock prices are declining, there is greater interest in writing call options but less in buying them; premiums thus tend to decline.
In addition, there are at least four other factors that interact to influence the level, and movement, of call option premiums:
Stock Prices,
Time,
Volatility,
and the Risk Free Rate of Return
Writer/Seller
The seller of an option who collects the premium payment from the buyer.
For example, a writer holds a short position on a call option. If the call option is exercised, then the writer has to sell the underlying stock at the strike price of the option. Conversely, if you are the writer of a put option, you are said to be long, and must purchase the underlying stock at the particular price.
Being a writer is relatively risky – especially on a naked position. This technique should not be used by those who are new to option markets.
Buyer/Owner
Pays the premium payment to the seller, holds the long position.
Which bond is more sensitive to interest rate changes?
The value of zero coupon bonds is more sensitive to changes in interest rates however, so there is some risk if you need to sell them before their maturity date. Also, such bonds tend to be very sensitive to changes in interest rates, since there are no coupon payments to reduce the impact of interest rate changes.
Reinvestment Risk
The risk that future proceeds will have to be reinvested at a lower potential interest rate.
This term is usually heard in the context of bonds. It is especially evident during periods of falling interest rates where the coupon payments are reinvested at less than the yield to maturity at the time of purchase.
Price Risk
The risk that the value of a security or portfolio of securities will decline in the future.
Basically, it’s the risk the you will lose money due to a fall in the market price of a security that you own.
What is duration?
It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. Duration increases immediately on the day a coupon is paid, but throughout the life of the bond, the duration is continually decreasing as time to the bond’s maturity decreases.
Zero-Coupon – D=M also, no reinvestment risk.
Coupon Bonds- D<M as coupon rates Increase, D decreases and when D increases so does its volatility.
What is the Duration of a Zero-Coupon Bond?
D=M, no reinvestment risk
What is the Duration of Coupon Bond?
D<M
also, as the coupon rates increase, D increases and when D increases so does its volatility.
Immunization
is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor’s investment time horizon. It does this by locking in a fixed rate of return during the amount of time an investor plans to keep the investment without cashing it in.
Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time. In other words, the bond is “immune” to fluctuating interest rates.
Indenture
A contract between an issuer of bonds and the bondholder stating the time period before repayment, amount of interest paid, if the bond is convertible (and if so, at what price or what ratio), if the bond is callable and the amount of money that is to be repaid.
Sinking Fund Provision
Rather than the issuer repaying the entire principal of a bond issue on the maturity date, another company buys back a portion of the issue annually and usually at a fixed par value or at the current market value of the bonds, whichever is less. Should interest rates decline following a bond issue, sinking-fund provisions allow a firm to lessen the interest rate risk of its bonds as it essentially replaces a portion of existing debt with lower-yielding bonds.
Covenants
A promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out.
The purpose of a covenant is to give the lender more security. Covenants can cover everything from minimum dividend payments to levels that must be maintained in working capital.
Call Provision
A provision on a bond or other fixed-income instrument that allows the original issuer to repurchase and retire the bonds. If there is a call provision in place, it will typically come with a time window under which the bond can be called, and a specific price to be paid to bondholders and any accrued interest are defined.
Callable bonds will pay a higher yield than comparable non-callable bonds.
Collateralized Bonds
An investment-grade bond backed by a pool of junk bonds. Junk bonds are typically not investment grade, but because they pool several types of credit quality bonds together, they offer enough diversification to be “investment grade.”
Debentures
a type of debt instrument in which there is no collateral. Bond buyers generally purchase these based on the belief that the bond issuer is unlikely to default on the repayment. An example of a government bond like this would be any government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills are generally considered risk free because governments, at worst, can print off more money or raise taxes to pay these type of debts.
Junk Bonds
A bond rated ‘BB’ or lower because of its high default risk.
Also known as a “high-yield bond” or “speculative bond”.
These are usually purchased for speculative purposes. They typically offer interest rates three to four percentage points higher than safer government issues.
Zero Coupon Bond Value
sometimes referred to as a pure discount bond or simply discount bond, is a bond that does not pay coupon payments and instead pays one lump sum at maturity.
Long Position
- The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value.
- In the context of options, the buying of an options contract.
Short Positions
- The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.
- In the context of options, it is the sale (also known as “writing”) of an options contract.
Why would you be willing to exercise a call option at a loss?
You are better off exercising the option than holding it, not because of additional profit, but because you avoid a two-point loss. You must exercise the option early to ensure you break even.