PRESENTED BY:

ABIHA SYED
AMNA ZAHID
 Fixed income or Interest rate options
 Four basic option strategies
 Buying a call option on a bond
 Writing a call option on a bond
 Buying a put option on a bond
 Writing a put option on a bond
 What is call option?
 What is premium?
 Two important things about bond call
options
 when interest rates rise
 when interest rates fall
 This is the second strategy
 There are two important things to
notice
 when interest rates rise and bond prices
fall
 when interest rates fall and bond prices
rise
 What is put option?
 Two important things to notice here
are:
 when interest rates rise
 when interest rates fall
 This is the fourth strategy
 In this case again there are two
important considerations:
 when interest rates rise and bond prices
fall
 when interest rates fall and bond prices
rise
 Two reasons:
 Economic reasons for not wring
options
 Regulatory reasons
 In calculating the fair value of an
option two models can be used
 Binomial model
 Black-Scholes Model
 “The value of the put option increases
with the increase in the underlying
variance of asses returns”

 MATHEMETICAL MODEL
 ZERO COUPON BOND
 HELD TILL MATURITY
 FACE VALUE $100
 N = 2 YEARS
 PV = $ 80.45
 R2 :

P2 = 100/(1+R2)^2
 Fearing unexpected deposits withdrawal,
the FI manager may be forced to liquidate
and sell this two year bond before maturity
 Manager may have to sell the bond at the
end of the first year
R2 = 11.5%

R2 = 10 R2 = 13.82% or 12.18%

0 1 2
 P1 = 100/ 1+r1

 @ 13.82% = $87.86
 @ 12.18% = $89.41

 EXPECTED RATE = 0.5(0.1382) + 0.5(0.1218) =13%

 EXPECTED PRICE = $88.5

VALUE OF PUT OPTION

 Max: (88.5 – 87.86, 0) = 0.64
 Max: (88.5 – 89.14, 0) = 0

 Worth: 0.5(0.64) + 0.5(0) = $ 0.32

 P = $ 0.29 or 29 cents
 Interestrate increases to 14.82%
instead of 13.82%

 Max: 88.5 – 87.09, 0 = 1.41

 P= 64 cents
 The preferred method of hedging that they
use is an option on an interest rate futures
contract.

 FIs hedges by buying put options on futures

 Ifthe interest rate rises and bond

prices fall, the exercise price higher than
the cost of bond

 Profiton future options may be made to

offset the loss on the market value of bonds
held directly in the FIs portfolio.
 Ifinterest rates fall while bond
prices increase

 The buyer of the future option will

exercise the put, and losses on the
futures put option are limited to the put
premium.
 Using Put Option by analyzing Macro hedging.
 Determine the optimal number of put options to buy to
insulate the FI against moving rates.
 Use a put option position that generates profits to offset
loss in net worth due to a rate shock.
Change in P = (Np * change in p)
(1)
 Change in P is total change in value of put position in T
bonds
 Np is number of put options on T bond contracts to be
purchased
 Change in p is change in dollar value for each face value T
bond
Change in p = dp/dB *dB/dR * Change in R/
1+R (2)
 For put options, delta has a negative sign since value of
put options fall when bond prices rise.
 dB/dR shows change in market value of bond, if interest
 dB/B = - MD *dR
(3)
 It shows percentage change in bonds price for small
change in rates is proportional to bonds Modified duration.
 Rearranging it: dB/dR = - MD * B
(4)
 Rewrite eq 2 as:
Change in p = [(-d) * (-MD) * B * change in
R/1+R] (5)
 Where change in R/1+R is discounted shock to interest
rates
 The change in Total Value of Put Option(change in P) is:
Change in P = Np * [d * MD * B * change in
R/1+R] (6)
 To hedge net worth exposure, we require profits to offset
 FI bought one month T bill which is a sterling asset.
 FI liabilities are in dollars so it hedges the FX risk that
pound sterling will depreciate over the coming years.
 Pound value less than the current exchange rate , LOSS to
bank on its British T-bill investment when measured in
dollar terms.
 E.g if pound depreciated from $1.64/1£ to $1.50/1£ , then
assets would be worth 150 million instead of 164 million.
 To offset this exposure; banks buy 1-month put options on
sterling at exercise price of $1.60/1£ , due to this when
exchange rate falls to $1.50/1£ , the bank receives 160
million instead of 150 million.
 Number of put contracts to buy:
Value of T-bill sterling asset/size of each contract
 Options have a potential use in hedging Credit risk of an FI.
 In good economic states, loan portfolio would have low
credit risk and small loan losses.
 In bad economic states, loan portfolio would suffer
increased credit risk and losses.
 If there is strong correlation between movement in stock
market index and economic states; selling index futures
produces negative outcomes in very good economic
states.
 So index options may offer better credit risk hedging
choice.
 The put options reduces credit losses on loan portfolio and
even produces net profit in bad economic states.
 If constructed correctly the hedged put option can produce
a positive return in good economic states as well.