PTI 20.2 cc0 Financia. uanaceMent 7.4.1 Factors Affecting Value of an Option There are a number of different mathematical formulae, or models, that are designed to compute the fair value of an option. You simply input all the variables (stock price, time, interest rates, dividends and future volatility), and you get an answer that tells you what an option should be worth. Here are the general effects the variables have on an option's price: (2) Price Movement of the Underlying: The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value and puts should decrease. Put options should increase in value and calls should drop as the stock price falls. (b) Time till expiry: The option’s future expiry, at which time it may become worthless, is an important and key factor of every option strategy. Ultimately, time can determine whether your option trading decisions are profitable. To make money in options over the long term, you need to understand the impact of time on stock and option positions. With stocks, time is a traders ally as the stocks of quality companies tend to rise over long periods of time. But time is the enemy of the options buyer. If days pass without any significant change in the stock price, there is a decline in the value of the option. Also, the value of an option declines more rapidly as the option approaches the expiration day. That is good news for the option seller, who tries to benefit from time decay, especially during that final month when it occurs most rapidly (c) Volatility in Stock Prices: Volatiity can be understood via a measure called Statistical (sometimes called historical) Volatility, or SV for short. SV is a statistical measure of the past price movements of the stock; it tells you how volatile the stock has actually been over a given period of time. But to give you an accurate fair value for an option, option pricing models require you to put in what the future volatility of the stock will be during the life of the option. Naturally, option traders don't know what that will be, so they have to try to guess. To do this, they work the options pricing model "backwards" (to put it in simple terms). After all, you already know the price at which the option is. trading: you can also find the other variables (stock price, interest rates, dividends, and the time left in the option) with just a bit of research. So, the only missing number is future volatility, which you can calculate from the equation (a) Interest Rate- Another feature which affects the value of an Option is the time value of money. The greater the interest rates, the present value of the future exercise price are less. Now let us discuss these measures. 7.4.2 Delta by-product of the Black-Scholes model is the calculation of the delta. It is the degree to which an option price will move given a small change in the underlying stock price. For example, option price (with a delta of 0.5) will move half a rupee for every full rupee movement in the underlying stock. © The Institute of Chartered Accountants of IndiaDERIVATIVES ANALYSIS AND VALUATION WER A deeply out-of-the-money call will have a delta very close to zero; a deeply in-the-money call will have a delta very close to 1. The formula for a delta of a European call on a non-dividend paying stock is: Delta = N (di) (see Black-Scholes formula above for d1) Call Deltas are positive; Put Deltas are negative, reflecting the fact that the Put option price and the underlying stock price are inversely related. The Put Delta is equal to (Call Delta - 1). ‘As discussed earlier the delta is often called the Hedge Ratio. If you have a portfolio consisting short ‘1’ options (e.g., you have written n calls) and holding number of shares (units of the underlying i., 1n multiplied by the delta). This gives you a riskless position - i.e., a portfolio which would be worth the same whether the stock price rose by a very small amount or fell by a very small amount. In such a “delta neutral" portfolio any gain in the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa Note that as the Delta changes with the stock price and time to expiration the number of shares would need to be continually adjusted to maintain the hedge. How quickly the delta changes with the stock price are given by ‘Gamma In addition to Delta there are some other "Greeks" which some find useful when constructing option strategies. 7.4.3 Gamma tmeasures how fast the Delta changes for small changes in the underlying stock price i.e. the Delta of the Delta. f you are hedging a portfolio using the Delta-hedge technique then you will want to keep gamma as small as possible, the smaller itis the less often you will have to adjust the hedge to maintain a delta neutral position. If gamma is too large, a small change in stock price could wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using options i.e. it cannot be done by selling or buying underlying asset rather by selling or buying options 7.4.4 Theta Itis change in the option price upon one day decrease in time to expiration. Basically, itis a measure of ime decay. Unless you and your portialio are travelling at close to the speed of light the passage oftime is constant and inexorable. Thus, hedging a portfolio against time decay, the effects of which are completely predictable, would be pointless. 7.4.5 Rho The change in option price given a one percentage point change in the risk-free interest rate. Its sensitivity of option value to change in interest rate. Rho indicates the absolute change in option value for a one percent change in the interest rate. For example, a Rho of 0.06 indicates the option's, theoretical value will increase by 0.06 ifthe interest rate is decreased by 1.0. © The Institute of Chartered Accountants of IndiaPE 20. cco Financia uanaceMent 748 Vega Sensitivity of option value to change in volatility. Vega indicates an absolute change in option value for a one percent change in volatility. For example, a Vega of 0.09 indicates an absolute change in the option’s theoretical value will increase by 0.09 if the volatility percentage is increased by 1.0 or decreased by 0.09 if the volatility percentage is decreased by 1.0. Results may not be exact due to rounding, It can also be stated as the change in option price given a one percentage point change in volatility. Like delta and gamma, Vega is also used for hedging 7.5 Exotic Options Exotic options are the classes of option contracts with structure and features different from plain vanilla options i.e, American and European style options. Not only that Exotic options are different from these vanilla options in their expiration dates also. As mentioned earlier an American option allows the option buyer to exercise its right at any time on or before expiration date. On the other hand European option can be exercised only at the expiry of maturity period. Exotic option is some type of hybrid of American and European options and hence falls somewhere in between these options. 7.5.4 Exotic Vs. Traditional Option a. Anexofic option can vary in terms of pay off and time of exercise. b. These options are more complex than vanilla options. ©. Mostly Exotic options are traded in OTC market. 7.5.2 Types of Exotic Options The most common types of Exotic options are as follows: (2) Chooser Options: This option provides a right to the buyer of option after a specified period of time to decide whether purchased option is a call option or put option. It is to be noted that the decision can be made within a specified period prior to the expiration of contracts. (b) Compound Options: Also called split fee option or ‘option on option’. As the name suggests this option provides a right or choice not an obligation to buy another option at specific price on the expiry of first maturity date. Thus, it can be said in this option the underlying is an option. Further the payoff depends on the strike price of second option. (c) Barrier options: Though itis similar to plain vanilla call and put options, but unique feature of this option is that contract will become activated only if the price of the underlying reaches a certain price during a predetermined period. () Binary Options: Also known as ‘Digital Option’, this option contract guarantees the pay-off based on the happening of a specific event. If the event has occurred, the pay-off shall be pre- decided amount and if event it has not occurred then there will be no pay-off. © The Institute of Chartered Accountants of IndiaDERIVATIVES ANALYSIS AND VALUATION WER (e) Asian Options: These are the option contracts whose pay off are determined by the average of the prices of the underlying over a predetermined period during the lifetime of the option. (f) Bermuda Option: Itis somewhat a compromise between a European and American options. Contrary to American option where it can be exercised at any point of time, the exercise ofthis option is restricted to certain dates or on expiration like European option. (g) Basket Options: In this type of contracts the value of option instead of one underlying depends on the value of a portfolio i.e., a basket. Generally, this value is computed based on the weighted average of underlying constituting the basket. (h) Spread Options: As the name suggests the payoff of these type of options depend on difference between prices of two underlying (i) Look back options: Unlike other type of options whose exercise prices are pre-decided, in this option on maturity date the holder of the option is given a choice to choose a most favourable strike price depending on the minimum and maximum price of an underlying achieved during the life time of option. G 8. CREDIT DERIVATIVES Credit Derivatives is summation of two terms, Credit + Derivatives. As we know that derivative implies value deriving from an underlying, and this underlying can be anything we discussed earlier ie. stock, share, currency, interest etc. Initially started in 1996, due to the need of the banking institutions to hedge their exposure of lending portfolios today it is one of the popular structured financial products. Plainly speaking the financial products are subject to following two types of risks: (@) Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange rates. (0) Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obligation by the counter party While, financial derivatives can be used to hedge the market risk, credit derivatives emerged out to mitigate the credit risk. Accordingly, the credit derivative is a mechanism whereby the risk is transferred from the risk averse investor to those who wish to assume the risk. ‘Although there are number of credit derivative products but in this chapter, we shall discuss two types of credit Derivatives ‘Collaterised Debt Obligation’ and ‘Credit Default Swap! © The Institute of Chartered Accountants of IndiaPN 20.2 cc0 Financia uanaceMent 8.1 Collateralized Debt Obligations (CDOS) While in securitization the securities issued by SPV are backed by the loans and receivables the CDOs are backed by pool of bonds, asset backed securities, REITs, and other CDOs. Accordingly, it covers both Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs). 8.1.1 Types of CDOs The various types of CDOs are as follows: (2) Cash Flow Collateralized Debt Obligations (Cash CDOs): Cash CDO is CDO which is backed by cash market debt or securities which normally have low risk weight. This structure mainly relies on the collateral’s risk weight and collaterals ability to generate sufficient cash to pay off the securities issued by SPV. (b) Synthetic Collateralized Debt Obligations: It is similar to Cash Flow CDOs but with the difference that instead of transferring ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are structured in such a manner that credit risk is transferred by the originator without actual transfer of assets. Normally the structure resembles the hedge funds where in the value of portfolio of CDO is dependent upon the value of collateralized instruments and market value of CDOs depends on the portfolio manager's ability to generate adequate cash and meeting the cash flow obligations (principal and interest) in timely manner. While in cash CDO the collateral assets are moved away from Balance Sheet, in synthetic CDO there is no actual transfer of assets instead economic effect is transferred. This effect of transfer economic risk is achieved by creating provision for Credit Default Swap (CDS) or by issue of Credit Linked Notes (CLN), a form of lability Accordingly, this structure is mainly used to hedge the risk rather than balance sheet funding Further, for banks, this structure also allows the customer's relations to be unaffected. This was started mainly by banks who want to hedge the credit risk but not interested in taking administrative burden of sale of assets through securitization. Technically, speaking synthetic CDO obtain regulatory capital relief benefits vis-8-vis cash CDOs. Further, they are more popular in European market due to the reason of less legal documentation requirements. Synthetic CDOs can also be categorized as follows: (i) Unfunded: - It wll be comprised only CDs. (i) Fully Funded: - It will be through issue of Credit Linked Notes (CLN) (ii) Partially Funded: - It wll be partially through issue of CLN and partially through CDs. © The Institute of Chartered Accountants of IndiaDERIVATIVES ANALYSIS AND VALUATION WERE (c) Arbitrage CDOs: Basically, in Arbitrage CDOs, the issuer captures the spread between the return realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to this issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisition of relatively high yielding securities with large spread from open market. 8.1.2 Risks involved in CDOs CDOs are structured products and just lie other financial products are also subject to various types of Risk. ‘The main types of risk associated with investment in CDOs are as follows: (2) Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying party to the instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall (b) _ Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis of interest rates. For example, asset may be based on floating interest rate but the liability may be based on fixed interest rates. Though this type of risk is quite dificult to manage fully but commonly used techniques such as swaps, caps, floors, collars etc. can be used to mitigate the interest rate risk (c) Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity risks as there may be mismatch in coupon receipts and payments. (a) Prepayment Risk: - This risk results from unscheduled or unexpected repayment of principal amount underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and the debtors have a call option. Since, in case of faling interest rates they may pay back the money, (e) Reinvestment Risk: - This risk is generic in nature as the CDO manager may not find adequate opportunity to reinvest the proceeds when allowed for substitutions. (f) Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from countries other than the country of issue. In such a case, in addition to above mentioned risks, CDOs. are also subject to the foreign exchange rate risk. 8.2 Credit Default Swaps (CDSs) Itis @ combination of following 3 words: Credit : Loan given Default : Non payment Swap : Exchange of Liability or Risk Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a debt which may be debentures, bonds ete. © The Institute of Chartered Accountants of IndiaA 20 vaxcco eiwanciat uanacenent Under this arrangement, one party (called buyer) needing protection against the default pays a periodic premium to another party (called seller), who in turn assumes the default risk. Hence, in case default takes place then there will be settlement and in case no default takes place no cash flow will acorue to the buyer alike option contract and agreement is terminated. Although it resembles the options but since element of choice is not there it more resembles the swap arrangements. Amount of premium mainly depends on the price of underlying and especially when the credit risk is more. 8.2.1 Main Features of CDS The main features of CDS are as follows: (@) CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered in the category of Forward Contracts. (b) They are normally not traded on any exchange and hence remains free from the regulations of Governing Body. (c) The International Swap and Derivative Association (ISAD) publishes the guidelines and general rules used normally to carry out CDS contracts. (d) CDS can be purchased from third party to protect itself from default of borrowers. (@) Similarly, an individual investor who is buying bonds from a company can purchase CDS to protect his investment from insolvency of that company. Thus, this increases the level of confidence of investor in Bonds purchased (f) The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore, higher the risk attached to Bonds or loans, higher will be premium or cost of CDS. (g) __ fan investor buys a CDS without being exposed to credit risk of the underlying bond issuer, itis called ‘naked CDS’. 8.2.2 Uses of Credit Default Swap Following are the main purposes for which CDS can be used: (2) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus, by buying CDS, risk can be passed on to CDS seller or writer. (b) Arbitrage. It involves buying a CDS and entering into an asset swap. For example, a fixed coupon payment of a bond is swapped against a floating interest stream. (c) _ Speculation- CDS can also be used to make profit by exploiting price changes. For example, a CDS writer assumed risk of default, will gain from contract if credit risk does not materialize during the tenure of contract or if compensation received exceeds potential payout. © The Institute of Chartered Accountants of IndiaDERIVATIVES ANALYSIS AND VALUATION WR! 8.2.3 Parties to CDS Ina CDS at least three parties are involved which are as follows: i. The initial borrowers: Itis also called a ‘reference entity, which are owing a loan or bond obligation, ii, Buyer- It is also called ‘investor’ i.e. the buyer of protection. The buyer will make regular payment tothe seller for the protection from default or credit event of reference entity iii Seller- It is also called ‘writer’ of the CDS and makes payment to buyer in the event of credit event of reference entity. It receives a regular pay off from the buyer of CDS. Example Suppose BB Corp. buys CDS from $$ Bank for the Bonds amounting $ 10 milion of Danger Corp. In such case, the BB Corp. will become the buyer, SS Bank becomes seller and Danger Corp. becomes the reference entity. BB Corp. will make regular payment to SS Bank of the premium and if Danger Corp. defaults on its debts, the BB Corp. will receive one time payment and CDS contract is terminated. 8.2.4 Settlement of CDS Broadly, following are main ways of settlement of CDS. (i) Physical Settlement - This is the traditional method of settlement. It involves the delivery of Bonds or debis of the reference entity by the buyer to the seller and seller pays the buyer the par value. For example, as mentioned above suppose Danger Corp. defaults then SS Bank will pay $ 10 Million to BB Corp. and BB Corp will deliver $10 Million face value of Bonds to SS Bank (ii) Cash Settlement- Under this arrangement seller pays the buyer the difference between par value and the market price of a debt (whatever may be the market value) of the reference entity. Continuing the above example suppose, the market value of Bonds is 30%, as market is of belief that bond holder will receive 30% of the money owed in case company goes into liquidation. Thus, the SS Bank shall pay BB Corp. $ 10 Million - $3 million (100% - 30%) = $ 7 Million. To make Cash settlement even more transparent, the credit event auction was developed. Credit event auction set a price for all market participants that choose to cash settlement. (G9, REAL OPTIONS Real Options methodology is an approach to capital budgeting that relies on Option Pricing theory to evaluate projects. Insights from option-based analysis can improve estimates of project value and, therefore, has potential, in many instances to significantly enhance project management. However, Real options approach is intended to supplement, and not replace, capital budgeting analyses based © The Institute of Chartered Accountants of Indiaay ADVANCED FINANCIAL MANAGEMENT ‘on standard Discounted Cash Flow (DCF) methodologies that has been discussed at Intermediate Level. 9.1 How Real Option is different from Financial Option Before we further discuss the various aspects of Real Option it is important to first understand How Real Option is different from Financial Option which is as follows: The following isa list of options that may exist in a capital budgeting project. Long call: © Right to invest at some future date, at a certain price, © Generally, any flexibility to invest, to enter a business, to expand a business. Long put: © Right to sell at some future date at a certain price. © Right to abandon at some future date at zero or certain price. © Generally, any flexibility to disinvest, to exit from a business. Short call: © Promise to sell if the counterparty wants to buy. © Generally, any commitment to disinvest upon the action of another party Short put: © Promise to buy if the counterparty wants to sell. © Generally, any commitment to invest upon the action of another party. © The Institute of Chartered Accountants of IndiaDERIVATIVES ANALYSIS AND VALUATION WEIR: 9.2 Valuation of Real Options The methods employed to valuation of real options are same as used in valuation of Financial Options. However, sometimes it becomes difficult to identity the value of certain inputs. The various type of cash flows associated with Real Option can be analysed with cash flows involved in financial options and methods used in financial options can be employed easily. Broadly, following methods are employed for Valuation of Financial Options. (2) Binomial Model (0) Risk Neutral Method (c) Black-Scholes Model Note: Above 3 methods have been discussed in detail in earlier section. 9.3 Type of Real Options Following are broad type of Real Options: 9.3.1 Growth Options Sometimes it may be possible that some projects have a negative or insignificant NPV even then managers may be interested in accepting the project as it may enable companies to find considerable profitability and add values in future. This case of real option is like European Call Option. Some of the examples of such options are as follows: © Investment in R&D activi s © Heavy expenditure on advertisement ‘© Initial investment in foreign market to expand business in future © Acquiring making rights * Acquisition of vacant plot with an intention to develop it in futur. The purposes of making such investments are as follows: * Defining the competitive position of firm hence it is called strategic investments. * Gaining knowledge about project's from profitability © Providing the manufacturing and making flexibility to the firm. Mlustration 4 ‘ABC Ltd. is a pharmaceutical company possessing a patent of a drug called ‘Aidrex’, a medicine for aids patient. Being an approach drug ABC Ltd. holds the right of production of drugs and its marketing. The period of patent is 15 years after which any other pharmaceutical company produce the drug with same formula. It is estimated that company shall require to incur $ 12.5 million for © The Institute of Chartered Accountants of India