Financial Engineering and Complex Instruments Involving Options

Financial Products Involving Options

Bonds with options
Callable bonds Retractable and extendible (put) bonds Convertible bonds

Bond-call option combinations Collateralized loans Warrants

Bond With Options I: Callable

Callable bonds: the firm has the option to repay the face value of the bond after a pre-specified time before the bond matures. It will exercise the option if interest rates have gone down: the value of the bond is then higher than the face value that it will repay. This is an option whose exercise depends on the level of the interest rates.

Bond With Options II: Retractable

These are bonds where the options are held by the investor. They are also known as put bonds in the US. Retractable: the investor has the option to receive the face value of the bond after a pre-specified time before the bond matures. He will exercise the option if interest rates have gone up: the value of the bond is then lower than the face value.

Bond With Options II: Extendible

Extendible: the investor has the option to extend the bonds maturity for a prespecified number of years. He will exercise this option if interest rates have gone down. These are options whose exercise depends on the level of interest rates.

Bond With Options III: Convertible Bonds

These are also bonds where the options are held by the investor. They are bonds that can be converted into shares of stock of the issuing firm. Each convertible bond is a coupon bond that can be exchanged against a specified number of newly issued shares ( the conversion ratio) at the investors discretion. It has a value as a straight bond and a value as a portfolio of shares. The investor will convert if the latter is higher than the former. The shares dilute the equity of the original stockholders. These are options whose exercise depends on both the level of interest rates and the value of the issuing firm. Most convertibles are also callable at the issuers discretion.

Bond-Call Option Combinations

These are traded instruments or bank deposits that have a fixed and a variable (random) return component. They are designed to protect the principal of an investment but also to give the investor the right to participate in the stockmarket. They are offered by many major banks in Canada and the US.

Collateralized Loans
These are loans where the borrower puts up an asset as collateral, giving the lender the right to take possession of it at loan maturity if the borrower defaults on his loan. The borrower has an option to either repay the loan, or surrender the collateral to the lender. This is an option on the value of the collateral as the underlying asset. It is a put option: the borrower sells the collateral for the face value of the loan when its value is less.

Warrants
A warrant is an option to receive a share of the issuing firm for a fixed price after a given period (a call option). Unlike regular options, warrants are issued by the firm whose shares underlie the option. Upon warrant exercise the warrant investor receives newly-issued shares of the firm. Hence, exercise of a warrant dilutes the equity of the firms stockholders, as with convertible bonds.

Bond-Call Option Combinations: an Example

A bank account (term deposit) with a two-year term that gives the investor the highest of the following at the end of two years: 3% fixed return; 80% of the return of a broad market index (the S&P/TSE 60). This is equivalent to a portfolio of a zerocoupon bond and a call option on the S&P/TSE60 index. Its value should be compared to the alternative of investing your money in a two-year fixed-interest term deposit.

Bond-Call Option Combinations: an Example

To value this instrument: we have a 5% per year spot rate for two years. The cash payoff for a $100 investment is the current value of Max{103, 80(IT/I0)}, where IT and I0 are the index values at expiration and at the origin.

Bond-Call Option Combinations: an Example

This value is equal to the current value of {103} plus the current value of Max{0, 80(IT/I0103} = 80Max{0, IT - 103I0/80}/I0 = (80/I0)C(I0,1.2875I0) = 80C(1,1.2875,2). If the volatility of the index is 20% and the dividend rate 1%, the call option is 0.0498 and the value of the instrument is 103e2x.05+80x0.0498 = 97.182 < 100. Hence, the instrument is not a good buy.

Another Example
Citybank in Athens offered in May 2001 a one-year instrument that guaranteed 90% of the principal and paid a return of one-half the average rate of return on the Athens FSTSE/ASE20 index over the year, computed as the average of each monthend. Is it a good buy? Assume that the rate of interest is 4.5% over the period and consider a $100 investment

Another Example (cont.)

This instrument pays off 100Max{.90, 1+.5(Iav/I0 - 1)}, where Iav is the average and I0 the starting index values. Hence, the holder receives Max{90, 100+50 (Iav/I0 - 1)}. Applying the same analysis as before, we find that this translates into a value of: 90e-.045+50Cav(1,.8,1), where Cav is an average price option on the index

Another Example (concl.)

This value should be compared to the current value of $100. It is clear that it is less than $100 for any realistic values of the index volatility. For a volatility of 20% DerivGem yields an average price option value of 0.214, yielding a total of $96.65, while for a volatility of 40% the total becomes $97.35. Hence, this is not a good buy

More Exotic Instruments

Athens Eurobank offered in May 2001 a 3month instrument (the Euro-Dollar range Rover) that paid the maximum of 1% annual or 10% annual, the latter if the Euro/USD exchange rate stayed within +0.03425 of its starting value. One reset was allowed if the band was exceeded, and the observation was continuous. This is a binary option with a barrier and a reset