Chapter 23

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 23

Chapter 23 - Swap Contracts, Convertible Securities, and Other

Embedded DerivativesQuestions 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 23 - 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?

• What are interest rate caps and floors and how are they related to interest rate swaps?

• How can the swap contracting concept be adapted to manage equity price risk?

Chapter 23 - 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?

• What are structured notes and what factors make their existence possible?

Chapter 23 - Swap Contracts, Convertible Securities, and Other

Embedded Derivatives

• 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

360Days ofNumber Principal NotationalRate Fixed - LIBOR

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

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Number of "30/360" DaysFixed-Rate Payment Swap Fixed Rate Notional Principal360t

OTC Interest Rate Agreements• Forward-based interest rate contracts

– Interest Rate Swaps• Important Characteristic of Swap Agreement

– an asset to one party and a liability to the other as soon as market conditions change after the terms of contract are set

– entail credit risks

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

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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 Contracting Extensions• Equity index-linked swaps

– Equivalent to portfolios of forward contracts calling for the exchange of cash flows based on two different investment rates:

• a variable-debt rate (e.g., three-month LIBOR)• the return to an equity index (e.g., Standard and Poor’s

500)– Payment is based on:

• the total return, or • the percentage index change for the settlement period plus

a fixed spread adjustment.

Swap Contracting Extensions• Equity index-linked swaps

– Reasons for Development of Equity Swaps• To take advantage of overall price movement in a stock

market without purchasing the equity securities directly• Difficult to create a direct equity investment in a foreign

country• Not able to obtain sufficient exchange-traded futures or

option contracts to hedge a direct equity transactions.– The common application involves a counterparty that

receives the index-based payment in exchange for making the floating rate payment.

Swap Contracting Extensions

Number of DaysPayment = LIBOR - Spread × Notional Principal

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Index - IndexReceipt = Notional Principal

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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

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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

StockCommon in Investment Equal from Income - Income BondValue Conversion - Price BondPayback

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 with Real Options

The InternetInvestments Online

http://www.isda.orghttp://www.numa.comhttp://www.goldmansachs.comhttp://www.calamos.comhttp://www.dir.co.jp/InfoManage/datarsc.htmlhttp://www.optionscentral.comhttp://www.amex.com/strProd/SPMain.jsp

End of Chapter 23–Swap Contracts, Convertible Securities, and Other Embedded Derivatives

Future topicsChapter 24

• Professional Asset Management