Lecture Note Seven: Options and Credit

Derivatives

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

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 Outline
Fixed income options
Bond options
Interest rate options
Futures options
Swaptions

Credit derivatives

Reference: Fabozzi’s chapter 27, 28, 29, Tuckman’s chapter

18, 19
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 Options: Definition
Option: a contract in which the writer/seller of the
option grants the buyer of the option the right to
purchase from or sell to the writer a designated
instrument at a specified price within a specified period
of time.
• When an option grants the buyer the right to purchase the
designated instrument from the writer (seller), it is called
a call option.
• When the option buyer has the right to sell the designated
instrument to the writer, the option is called a put option.

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 Options: Terminology
To get the right, the option buyer pays the option seller a
certain amount of money, which is called the option price or
option premium.
The price at which the instrument may be bought or sold is
called the strike or exercise price.
The date after which an option is void is called the
expiration date.
• An American option may be exercised at any time up to
and including the expiration date.
• A European option may be exercised only on the
expiration date.
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 Options as Insurance Contracts
Options contracts can be considered as insurance
policies
• As with insurance contracts, there is (1) a premium to be
paid upfront, and (2) a payment at maturity that occurs if
some adverse event occurs
Similar to an insurance policy, the premium goes up the
higher the risk of being in the ‘bad’ situation;
specifically in interest rate options this is tied to the
volatility of interest rates

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 Options as Insurance Contracts
In an insurance policy, the amount of coverage and
deductibles affect the level of the insurance premium; in
financial options the option premium is affected by the
strike price
• If I purchase an interest rate option to hedge against an
increase in interest rates, the higher the strike price (rate),
the lower is the payment if interest rate increases;
consequently a lower premium has to be paid upfront

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 Options vs. Futures
Options differ from futures contracts in that the buyer
of an option has the right but not the obligation to
perform, whereas the option seller (writer) has the
obligation to perform.
In the case of a futures contract, both the buyer and the
seller are obligated to perform.
In a futures contract, the buyer does not pay the seller to
accept the obligation; in the case of an option, the buyer
pays the seller the option price.

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 Moneyness of Options
An option is said to be in-the-money (ITM) if the
payoff from exercising the option now is positive.
An option is said to be out-of-the-money (OTM) if the
payoff from exercising the option now is negative.
An option is said to be at-the-money (ATM) if the
payoff from exercising the option now is zero.
At expiration date, only ITM options will be exercised.

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Option Payoff Diagrams

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Option Profit Diagrams

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 Types of Fixed Income Options
Bond Options: The underlying variable in the option is
a fixed coupon instrument, such as a U.S. Treasury note.
Interest Rate Options: The underlying variable is an
interest rate, such as the 13-week Treasury discount rate
or the 3-month LIBOR
Futures Options: The underlying price is the futures
price of another contract, such as the 10-year U.S. T-
Note futures
Swaptions: The underlying is an interest rate swap.

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 I. Bond Options
Options on bonds, particularly government bonds, are
referred to as options on physicals. At one time, there
were several exchange-traded option contracts on bond.
In recent years, market participants have made
increasingly greater use of over-the-counter options on
Treasury and mortgage-backed securities.
Example: A two-year 99.25-strike European call option on
a three-year 5.25% annual coupon bond.
• Payoff in year 2: max(0, bond price in year 2 – 99.25)

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 Exercise
Consider a two-year 101.5-strike European call option
on a three-year 6% annual coupon bond. At what one-
year spot rate two years later, the call option is in-the-
money when it matures?
Solution:

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Models for Valuing Options on Bonds
Several models have been developed for determining the
theoretical value of an option.
The most popular model is the Black-Scholes option
pricing model. The option price derived from the Black-
Scholes option pricing model is “fair” in the sense that if
any other price existed, it would be possible to earn
riskless arbitrage profits by taking an offsetting position
in the underlying asset.
This model, however, is limited in pricing options on
bonds.
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Black-Scholes Option Pricing Model
The price of a European call option on a non-dividend-
paying stock is

where
and
S is the current stock price, K is the strike price, r is the risk-
free interest rate, t is the time to maturity, is the standard
deviation of the stock return.

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 Black-Scholes Option Pricing Model
Consider a two-year call option on a three-year zero-
coupon bond. Assume the current bond price is $83.96,
the strike price of the option is $88.00, the volatility of
the expected bond return is 10% and risk-free rate is 6%.
In terms of the values in the formula:
S = 83.96; K = 88.00; t = 2; = 0.10; r = 0.06
We have and

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 Black-Scholes Option Pricing Model
From a normal distribution table,
and
Therefore,
Now, consider an option with strike price $100.25, all
other things identical. By applying the formula, C =
$2.79.
The underlying zero-coupon bond will never have a value
greater than its maturity value of $100  a call option struck
at $100.25 must have value zero!

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 Black-Scholes Option Pricing Model
The problem of using BS model to price bond options
lies on the three assumptions underlying the Black-
Scholes model
• There is some probability that the value of the underlying
can take on any positive value
• However, unlike stock price, bond price has a maximum
value.
• The short-term interest rate is constant
• This results in no uncertainty in bond prices.
• The variance is constant
• Bond price volatility decreases over time.
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 Arbitrage-Free Binomial Model
The proper way to value options on interest-rate
instruments is to use an arbitrage-free model that takes
into account the yield curve.
• These models can incorporate different volatility
assumption along the yield curve.
Let’s again consider the two-year European call option
on 5.25% three-year annual coupon bond with a strike
price of 99.25.
• We use the same binomial interest rate tree as in the note
on “Bonds with other Features”.

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 Binomial Interest Rate Tree
Rick-neutral probability is 50%.

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Arbitrage-Free Binomial Model

0.482782
2×1.04976

0.22995 +0.92318
2 ×1.0 3 5 105.25/1.06757

0.482782+1.438797
2× 1.04 074

105.25/1.05532

105.25/1.0453
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 Arbitrage-Free Binomial Model
The price of call option is 0.55707 by backward
induction. The same procedure can be used to value a
European put option. The price is 0.15224. (In-class
exercise.)
Recall put-call parity: the price difference between the
call option and put option with same strike price is equal
to the present value of forward price minus the strike
price.

LHS = 0.55707 – 0.15224 = 0.40483

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 Arbitrage-Free Binomial Model
The present value of the strike price is 91.74409 and the
present value of the price of two-year forward on three-
year 5.25% annual coupon bond is 92.14892. (In-class
exercise.)

RHS = 92.14892 – 91.74409 = 0.40483

Put-call parity holds.

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 II. Interest Rate Options
Fixed income options can be written on interest rate
directly.
• Interest rate caps: OTC derivative contract in which the
issuer makes a payment to the holder when the underlying
interest rate (called the reference rate) exceeds a specified
strike rate.
• Interest rate floors: OTC derivative contract in which
the issuer makes a payment to the holder when the
underlying interest rate (called the reference rate) falls
below a specified strike rate.

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 Interest Rate Caps and Floors
Caps or floors are purchased for a premium and
typically have expirations between 1 and 7 years.
Caps and floors may make payments on a monthly,
quarterly or semiannual basis, with the period generally
set equal to the maturity of the reference rate.
• A single period cap is called caplet. A cap can be thought
of as a series of caplets.
• A single period floor is called floorlet. A floor can be
thought of as a series of floorlets.

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 Interest Rate Caps and Floors
Each period, the payment is determined by comparing
the current level of the index interest rate with the strike
rate. Payment on cap:

Note that the payoff of an interest rate cap looks like that
of an option, but the maximum of zero and the
difference between the rate and the strike is part of the
contract rather than a result of optimal exercise behavior.

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 Interest Rate Caps and Floors
Example: A 3-year, $200 MM notional cap with 6-
month Libor as its index rate, struck at 7.5%.
Suppose values for the index rate are 6.25%, 7.75%,
7.00%, 8.50%, 8.00%, and 6.25%. The exhibit shows
what the cap's payments are

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 Interest Rate Caps and Floors
The arbitrage-free binomial model can be used to
value a cap and a floor directly.

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 Interest Rate Caps and Floors
Let’s use the binomial interest rate tree to value a 4.75%,
three-year cap with a notional amount of $10 million.
The reference rate is the one-year rates in the binomial
tree and assume the payoff for the cap is annual.
• The settlement for a typical cap and floor is paid in
arrears. For example, at date 1, if the interest rate is
4.976%, the payment of will be made at date 2. The value
at date 1 is

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Valuing Interest Rate Cap

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Interest Rate Caps and Floors: Application

Interest rate options can be used for speculating on

future interest rate or for hedging against future interest
rate being too high or too low.
For example, bank A is currently borrowing at the 6-
month LIBOR rate. Thus, bank A faces higher cost if the
rate turns out to be high.
• The bank can purchase a cap to lock in a maximum rate,
the strike rate, that it pays on its funds.
• The bank still retains the opportunity to benefit from a
decline in rates.

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Interest Rate Caps and Floors: Application

Another example: an insurance company sells a 5-year

product that guarantees an annual 9% rate. If the
investment return turns out to be low, the company faces
loss.
The company can purchase a floor to set a lower bound
on its investment return.
• The company retains the opportunity to benefit from an
increase in rates.

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Interest Rate Caps and Floors: Application

Interest-rate caps and floors can be combined to create

an interest-rate collar.
• This is done by buying an interest-rate cap and selling an
interest-rate floor.
Some commercial banks and investment banking firms
write options on interest-rate agreements for customers.
• Options on caps are captions; options on floors are called
flotions.

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 III. Options on Futures Contract
An option on a futures contract, commonly referred to as
a futures option, is an option giving its owner the right
to buy/long or to sell/short a futures contract
• A futures call gives its owner the right to go long a futures
contract
• A futures put gives its owner the right to go short a
futures contract
The buyer of a futures option has a known and limited
maximum loss.

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 Futures Options: Trading Mechanics
Because the option writer has agreed to accept all of the
risk, the writer is required to deposit not only the margin
required on the interest rate futures contract position, but
also (with certain exceptions) the option price that is
received for writing the option.
Upon exercise, the futures price for the futures contract
will be set equal to the exercise price.
The position of the two parties is then immediately
marked to market in terms of the then-current futures
price.
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 Futures Options
Reasons for futures options having largely supplanted
options on physicals as the options vehicle of choice for
institutional investors.
1. Unlike options on fixed-income securities, options on
Treasury coupon futures do not require payments for
accrued interest to be made.
2. Futures options are believed to be “cleaner” instruments
because of the reduced likelihood of delivery squeezes.
3. In order to price any option, it is imperative to know at
all times the price of the underlying instrument.

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 Futures Options: Specification
All standard futures options are of the American type.

In an attempt to compete with the over-the-counter

(OTC) option market, flexible Treasury futures
options were introduced.
• The strike price, expiration date, and type of exercise
(American or European) can be customized subject to
CBOT constraints.

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 Models for Valuing Futures Options
The most commonly used model for futures options was
developed by Fischer Black.

where and
The model was initially developed for valuing European
options on forward contracts.
There are two problems with this model when valuing
futures options.
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 Limitation of Black Model
First, the Black model does not overcome the problems
cited earlier for the Black-Scholes model. Failing to
recognize the yield curve means that there will not be a
consistency between pricing Treasury futures and
options on Treasury futures.
Second, the Black model was developed for pricing
European options on futures contracts. Treasury futures
options, however, are American options.

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 Computing Implied Volatility
Despite the many limitations and inconsistent
assumptions of the Black model for valuing futures
options, it has been widely adopted by traders for
computing the implied volatility from options on
Treasury bond futures options.
• These implied volatilities are also published by some
investment houses and are available through data vendors.

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 IV. Swaptions
A swaption is an over-the-counter (OTC) contract that
gives the buyer the right, at expiration, to enter into a
fixed-for-floating interest rate swap at the maturity and
strike rate agreed to in the contract.
• A receiver swaption gives the buyer the right to receive
fixed and pay floating while a payer swaption gives the
buyer the right to pay fixed and receive floating.

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 Swaptions
The convention used to describe a swaption: “” (A into
B)
• A is the number of years when the option expires
• B is the number of years of the swap if the option is
exercised.
Example: a $100 million 5.28% “” or “5y5y” receiver
swaption traded on Oct 9, 2013.
• This option gives the buyer the right, in five years, on Oct
9, 2018, to receive 5.28% and pay LIBOR on $100
million for five years, that is, until Oct 9, 2023.

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 Swaptions
In the U.S. market, swaptions are almost always cash
settled.
• The cash settlement feature has no material effect on
valuation because the cash settlement value is found by
multiplying the appropriate annuity factor, evaluated
along the swap curve, by the difference between the strike
and the par rate.
In Europe, approximately half of all swaptions are cash
settled.

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 Hedge Strategies
Three basic hedging strategies for hedging a long bond
position (hedging against interest rate increase)
• hedging with short futures
• hedging with long protective put
• hedging with short call on futures
Similar but opposite strategies exist for those who want
to avoid the risk caused by decreases in interest rates.

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Hedge Strategies: Futures or Options?
The main trade-off when choosing to hedge with futures
or options is “costs” versus “upside potential”
• Futures, forwards and swaps have NO costs, but also NO
upside (exchange risky payments with fixed payments)
• Options cost money, but eliminate only the adverse
element (which implies an upside)
• Using options with different strike price costs differently

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Hedge Strategies: Futures or Options?
In theory, all seem trivial but the choice becomes crucial
when applied in a corporate governance setting
• For example, forward and swaps are costless at inception,
but will depress earnings in good states in order to offset
losses in the bad state
• If this isn’t clear to the management of a firm, there is the
risk of considering the hedging strategy a failure during
the ‘good’ states, since the company will not make as
many profits as it would un-hedged

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 Credit Derivative
A credit derivative is a financial contract that allows one
to take or reduce credit risk, the risk that the bond
issuer will fail to satisfy the term of the obligation with
respect to the timely payment of interest and principal.
• Historically the typical way to take on credit risk is
through purchasing risky bonds directly 。
Prior to 1998, the development of the credit derivatives
market was hindered by the lack of standardization of
legal documentation.
• Every trade had to be customized.
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 Development of Credit Derivatives
In 1998, the International Swap and Derivatives
Association (ISDA) developed a standard contract that
could be used by parties to trades of a credit derivatives
contract.

While the documentation is primarily designed for

credit default swaps and total return swaps, the
contract form is sufficiently flexible so that it can be
used for the other credit derivatives.

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 Categorization of Credit Derivatives

Asset Total Credit Credit

Swaps Return Default Spread
Swaps Products Products

Credit Default Credit Credit

Default Options Spread Spread
Swaps Options Forwards

Single Basket Index Underlying Underlying

Name Swaps Swaps is credit- is a credit
Swaps risky bond spread
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 Asset Swaps
When an investor owns an asset and converts its cash
flow characteristics, the investor creates an asset swap.
A common example is for an investor to buy a credit-
risky bond with a fixed rate, and convert it to a floating
rate using an interest rate swap.
• Most commonly, the notional amount of the interest rate
swap is equal to the face amount of the underlying asset.

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 Asset Swaps Example
An investor purchases $10 million face value of a
7.85%, five-year BBB-rated bond.
The investor buys a five year interest-rate swap.
• The investor pays a fixed rate of 7%
• The investor receives six-month LIBOR
Received from the bond +7.85%
Payment to the swap dealer -7%
Received from the swap dealer 6 month LIBOR
Net 0.85% + 6 month LIBOR

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 Asset Swaps Example
The investor has converted a fixed-rate BBB five-year
bond into a five-year floating-rate bond with a spread
over six-month LIBOR.
If the issuer of the bond defaults on the issue, the
investor must continue to make payments to the swap
dealer and is therefore still exposed to the credit risk of
the bond issuer.
Asset swap is not a true credit derivative. However, the
asset swap spread reflects the credit risk of the bond,
thus asset swap is closely associated with credit
derivative markets. 7-52
 Total Return Swaps
A total return swap is a swap in which one party makes
periodic floating-rate payments to a counterparty in
exchange for the total return realized on a reference
obligation, or a basket of reference obligations.
Total return receiver
• The party that make the floating payments and receive the
total return
Total return payer
• The party that receives the floating payments and pay the
total return
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 Total Return Swaps: Example
A manager is considering a $10 million 10-year Disney
bond at par, with a coupon rate of 9%. Coupon is paid
semi-annually.
The current 10-year Treasury yield is 6.2%.
The manager purchases a one year total return swap.
• During the year, the manager pays the six-month T-bill
rate plus 160 basis points every six months, in order to
receive the total return on the reference obligation, the 10-
year Disney bond.

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 Total Return Swaps: Example
Suppose that over the one year,
• The six-month T-bill rate is 4.8% at the beginning of the
year and 5.4% six month later.
• At the end of one year, the 9-year Treasury rate is 7.6%
and the credit spread for the Disney bond is 180 basis
points.
• The yield on the Disney bond is thus increased from 9% to
9.4%. This reduces the return on the bond.
• New bond price = $9.76 million with 9.4% yield.
• Return at the end of the year is coupon payment + price
appreciation.
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 Total Return Swaps: Example
Cash flows for the manager:
Period T-Bill Payment Receipt Net
1 4.8% 320,000.00 450,000.00 130,000.00
2 5.4% 350,000.00 210,630.44 -139,369.56
Coupon payment +
gain/loss on the bond
The total return swaps allows the manager to take on the risk
in the Disney bond without having to finance the purchase of
the bond.
Total return swap can also be used to hedge the risk.
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 Total Return Swaps
Total return swap is similar to an asset swap in the sense
that they both exchange the cash flows of a fixed rate bond
for floating cash flows.
The difference is that with an asset swap the holder of the
bond to be swapped retains the bond issuer's credit risk,
whereas with a total return swap the holder of the bond
passes that credit risk on to some other party.
It is this transfer of credit risk which makes a total return
swap a credit derivative.
A great many firms trade total return swaps and asset swaps
from the same trading desk.
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 Credit Default Swaps
A Credit Default Swap (CDS) is a financial agreement
between two parties to exchange the credit risk of an
issuer.
• Privately negotiated bilateral contract
• Contract specifies: reference obligation, notional,
premium (spread), and maturity
• Buyer of CDS makes periodic payments to the seller of
CDS
• Generally, seller of CDS pays compensation to the buyer
if a “credit event” occurs. Contract is terminated
afterwards.
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 Cash Flows in a CDS (Example)
Figure Depiction of the
cash flows in a credit
default swap.
The investor owns the
reference asset, which
was issued by XYZ. The
investor buys a credit
default swap and pays 40
basis points (bp) per year
in exchange for the swap
writer’s payment in the
event of a default by
XYZ.
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 CDS: Credit Event
The ISDA provides definitions of what credit events are.
A credit event can be bankruptcy, failing to pay
outstanding debt obligations, or in some CDS contracts,
a restructuring of a bond or a loan.
If a credit event occurs, the CDS will be settled.
• Physical Settlement: CDS buyer receives face value and
deliver bond
• Cash Settlement: CDS buyer receives the difference
between face value and current market value of bond,
determined by the third party

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 Profit and Loss
Even without a credit event, investors can capture gains
or losses from investing in CDS.
CDS spread widens when the market perceives credit
risk has increased and tightens when the market
perceives credit risk has reduced.
Example: Investor B bought a five-year CDS of 110bp
per year. If this CDS spread widens to 125bp after one
year, B could sell the four-year CDS at 125bp
(unwinding the swap) and collect profits (15bp per year
for four years).
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 More on CDS
Before crisis of 2007-2009, the coupon (premium, fee)
of newly initiated CDS trades was set such that there is
zero up-front payment. This convention made it difficult
to unwind trades.
• For example, B bought three-year protection from A at a
spread of 140bp and the market moved immediately to
128bp.
• By selling protection to A at the new market level of
128bp, B still owe net cash flows of 12bp.
• To completely unwind, B would have to make a lump-
sum payment that both would accept.
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 More on CDS
Since the crisis, in response to the promoting of
regulators, CDS contracts have become more
standardized, particularly between dealers.
• Settlement of most CDS is limited to the 20th of March,
June, September, or December.
• Contracts have been standardized by setting the coupon at
either 100 or at 500 basis points annually, with an up-front
amount adjusting to credit conditions as appropriate.
• This convention makes it particularly easy to unwind trades.

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End of the Notes!

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