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CO17 T-4

Gaurav Pansari

CFIN - II

Dinosaur Publications
ISB Mohali
None of that. Janhit me jaari.

Contents
1.

2.

Bond - 007 ................................................................................................................................................................. 1


1.1.

Some terms to know ......................................................................................................................................... 1

1.2.

Bond Valuation.................................................................................................................................................. 1

1.3.

Price Sensitivity ................................................................................................................................................. 2

1.4.

Some gyaan about yield .................................................................................................................................... 2

Bond Theory .............................................................................................................................................................. 3


2.1.

3.

Some types of Bonds......................................................................................................................................... 3

Options ...................................................................................................................................................................... 4
3.1.

Some terms before we start ............................................................................................................................. 4

3.2.

Payoffs............................................................................................................................................................... 4

3.3.

Put-call Parity .................................................................................................................................................... 5

3.4.

Some Trivia........................................................................................................................................................ 5

1. Bond - 007
Fancy name for a Loan which can be traded

1.1. Some terms to know

Principal / face / par value (say Rs. 100) Base value of the bond might be different from market value1
Coupon (say Rs. 10 @ 10%) Archaic term for Interest payment.
Zero coupon - doesnt mean no interest implies that interest will be paid will the Principal (after 2 years,
you will be paid back Rs. 100 why will I buy then??? Well come to that)
Term Time period after which the principal will be paid back (2 years in our example)
Yield to maturity Required discount rate. At the current price, YTM = IRR of the bond, i.e. at YTM
discounting, price of bond = PV using YTM2

1.2. Bond Valuation3


Value of the Bond in the market different from face/ principal value
Remember CFIN I? Same funda discount all future cash flows to present

Discount all
cash flows

Cash Flow 1 - Interest/ Coupon (if


any)
(Periodic)


1
(1

1+

10

9%

(1

1
)
1+9% 2

= 17.59

Cash Flow 2 - Principal Repayment


(End of term)

1+

100
1+9% 2

= 84.17

Coupon value is absolute (Rs. 10), y is yield to maturity, or the expected return you need to invest in this
bond (say 9% is what we want from this bond), and N is Term period of bond (2 years)
o Value of coupon bond = 17.59 + 84.17 = 101.76; Value of Zero coupon = 84.174
As in above, Bond price (market value) is higher than face value if expected earnings (yield) are lower than
coupon rate5 and vice-versa.
Note: Zero coupon bonds will always6 trade below face value.

Unless Coupon rate and expected yield are same relax, coming to yield in a moment
Come back to this after the end of chapter 1
3
Daniel Craig is pretty expensive, and probably not on sale women. Well stick with financial bonds
4
Thats why youll buy the zero coupon bond The interest is implicit in the lower price you would be willing to pay
5
Pretty intuitive A jujus coupon is priced at Rs. 20 for 50% discount on a Rs. 60 burger. I will be willing to pay Rs. 30 for
coupon, which is my opportunity cost. If a bond gives me 10% when I expect 9%, I can pay more than face value for it.
6
Unless we get to a negative interest rate scenario
2

Dinosaur Publications | Gaurav Pansari

1.3. Price Sensitivity


Duration7
Weighted average of timing of various cash flows from a bond (in # of periods) i.e. to say, had I received all the
payment at # year, the PV of that would be equal to the bond price.
For eg. 5% coupon bond with 2 year to maturity, selling at par (i.e. y = C) Weight the PV of each cash flow (interest
+ principal) as a proportion of total PV (i.e. price). Duration = 1.928 years. PV of a payment of 1100 at 1.928 years =
PV of all CF from bond = price = 1000.
Interest rate sensitivity8
Percent change in bonds price = - Duration * change in discount rate / (1 + y)9

1.4. Some gyaan about yield


Clean vs. Dirty price
In case of coupon bond, the price has 2 components PV of interest payment + PV of principal. However, coupon are
paid at intervals. When a seller sells a bond, it may include accrued interest as well10
Dirty price = flat price + accrued interest (each dip below is on the date of the coupon payment)
Flat price

103.0

Invoice price
101.5

101.1

102.4

102.0

101.0
99.0
97.0
06-30-16

99.0

98.6
10-08-16

01-16-17

04-26-17

08-04-17

100.0

99.5

11-12-17

02-20-18

05-31-18

Realized yield11
Actual yield realized may differ from yield to maturity. YTM has an assumption that the cash flows can be reinvested
at the same rate In case the rate of reinvestment changes, the actual yield realized would change. To evaluate,
compute FV of all cash flows (@ prevalent reinvestment rate), and then compute IRR to get realized yield.
(Computation in excel)
Law of one Price
Discount rate for each period of a coupon bond can be different, if zero coupon rates are different for bonds of
different period. Therefore, in case the zero coupon rates are different for ZC bonds of different length, use that to
discount the coupon bond cash flow for that year. Say, a 1 year ZCB is at 7% while a 2 year ZCB is at 8% - to value a
coupon bond, discount cash flow of year 1 at 7% and cash flow of year 2 at 8%.

Read slowly, and then read again each word.


Rough measure only for small changes I would normally prefer to do the full computation for both bonds if given a choice
9
Y = yield. Its implied throughout the notes that a interest rate is for a period and not a year, for semiannual discounting, the
rate to be used would be yield rate/ 2, and the number of period would be number of years * 2. All formulas and funda remain
same.
10
Only in case of resale. Accrued implies should be given to bond owner, but has not been given yet. Say a FD interest is paid
after 1 year @ 10% of Rs. 100. At the end of 9 months the value of the FD would be 100 discounted for 3 months + Rs. 10
discounted for 3 months (interest due) vs. Rs. 2.5 discounted for 3 months (actual interest for 3 months). The value of the Rs. 7.5
discounted for the 3 months is the accrued interest, which when added to flat price, gives the dirty price.
11
Can be ignored in dearth of time come back later sometime. LOL
8

Bond - 007 | Dinosaur Publications

2. Bond Theory12
2.1. Some types of Bonds

Corporate Bonds Issued by corporations. Riskier than government bonds. Credit Risk (risk of default)
involved
o Notes Unsecured loans, <10 years
o Debentures Long term secured/ unsecured loans
o Mortgage Bonds secured against real property13
o Asset-backed bonds secured against any asset
Speculative Bond high risk, high return bond
By nationality
o Domestic Bond Local entity. Local Market. Foreign investor
o Foreign Bond Foreign entity. Local Market. Local investor
o Eurobond Foreign country. Not denominated in that local currency.
o Global bond issued simultaneously in various countries
o Masala and dim sum bonds Indian/ Chinese company. Rupee/renminbi denominated in foreign
countries. Repayment in dollars. Currency risk for investors.
Sovereign bonds issued by national governments
o T bills ZCB. Short term (91, 182 or 364 days)
o Cash Management bills (CMB) ZCB. Less than 91 days
o Dated security Long term. Coupon bonds (fixed or floating). Up to 40 years
Inflation indexed14 Real return promised (inflation +)
STRIPS Separate trading of registered interest and principal securities. Each coupon sold as individual bond
Callable bonds Issuer can buy back bond at pre-specified price on specified date before maturity
o Callable bond will have lower price than non-callable/ normal bond
o Yield to call same as YTM, but only till date of recall
Convertible bond Can be converted to equity by bondholder

Some Terms
Bond ratings credit risk ratings given to bonds by agencies like CRISIL. More risk would require more return
Bond covenants reduce default risk by binding bond issuers actions

12

Yawnnnnnnnn
Usually secured loans get paid before unsecured loans in case of bankruptcy.
14
Called Treasury inflation protected securities (TIPS) in US
13

Dinosaur Publications | Gaurav Pansari

3. Options15
Right to buy or sell an asset (shares mostly)

3.1. Some terms before we start16

CALL Right to BUY17


o I can BUY the share if I want at a certain price
PUT Right to SELL
o I can SELL the share if I want at a certain price
Types
o European the date of using the right is fixed
o American date is not defined. Can be used any day before expiry.
Transactions types
o Long when you buy the option. Lower risk limited losses only cost of buying the right.
o Short When you sell the option. Higher risk unlimited losses
For whom it gets confusing18 - My attempt to resolve by confusing you further
o When you LONG CALL you buy a (right to buy a share)19
o When you SHORT CALL you sell a (right to buy a share)
o When you LONG PUT you buy a (right to sell a share)
o When you SHORT PUT you sell a (right to sell a share)
Moneyness
o At the money payoff = 0; Strike price = market price
o In the money payoff > 0; MP > SP for Calls; MP < SP for Puts
o Out of the money payoff < 0; MP < SP for calls; MP > SP for Puts20

3.2. Payoffs21

Options

"CALL"

"PUT"

Long Call

Short Call

Long Put

Short Put

max (Market Price - Strike Price, 0)

min (Strike Price - Market Price, 0)

max (Strike Price - Market Price, 0)

min (Market Price - Strike Price, 0)

SP > MP
Do not use

SP < MP
Exercise

SP > MP
Buyer will not
use

15

SP < MP
Buyer will
exercise

SP > MP
Exercise

SP < MP
Do not use

SP > MP
Buyer will
exercise

SP < MP
Buyer will not
exercise

Hope we had an option not to study this


I have skipped Straddles, Butterfly, etc strategies for now please look up in your notes
17
.here's my number, so call me, maybe The guy got a right to call this fair lady. He can choose not to. LONG CALL for the
guy, SHORT CALL for the lady
18
This is Inception part 2. (Dubbed in Hindi Sapno ka mayajaal - Dwitiya)
19
Right to buy a share is like Right to buy a burger at jujus for Rs. 60. I am selling the right for Rs. 5, valid for 1 year. In case
jujus does not increase the price in 1 year, then you will not exercise the right since you can buy it anyway for Rs. 60, and end
up losing the Rs. 5 you paid me. But say jujus increases the price to Rs. 100, after killing Amit, you shall exercise the right to buy
the burger, thus saving Rs. 35 (40 cost of right Rs. 5). This is LONG CALL for burger.
20
Book and professor uses S for Market Price and K for Strike Price which confuses me. Hence, MP and SP
21
Longs profit is shorts loss and vice versa
16

Options | Dinosaur Publications

Chart charts everywhere22

Long CALL

Long PUT
200

150

150

100

100

50

50

Stock Price

Payoff

0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150

0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150

200

Strike Price

Stock Price

Payoff

Strike Price

3.3. Put-call Parity

Protective Put I have a share. I buy a put. In case the share falls, I exercise the PUT right and save my
derriere
o It is same as a (call + fixed amount of cash in risk-less deposit)
Therefore, max (MP SP, 0) + SP = MP + max (SP MP, 0)
o Market Price + Strike Price = Call Premium + PV of Strike price

Share + Put Payoff


200

150

150

100

Put

100

Stock Price

50

Total

0
0

10

20

30

40

50

60

70

80

90

100 110 120 130 140 150

Call + FD Payoff
200

150

150

100

Call

100

FD

50

Total

0
0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

3.4. Some Trivia


With increase in (ceteris paribus)

Call Value
Increases
Decreases
Increases
Increases

Stock Price
Strike Price
Time to expiration (higher risk exposure)
Volatility of returns (higher risk to seller who doesnt have a say)
American option Premium >= European Premium
Put premium <= Strike Price
Call Premium <= Strike Price
American Call premium >= max (MP SP,0) MP being market price at the time of issue
American Put premium >= max (SP MP, 0)
22

Put Value
Decreases
Increases
Increases
Increases

Know that zero payoff here does not account for the cost of the option itself it is always a cost for the buyer

Dinosaur Publications | Gaurav Pansari