34 lines
2.2 KiB
Plaintext
34 lines
2.2 KiB
Plaintext
602 Part V: Index Options and Futures
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COMPUTING THE VALUE OF THE IMBEDDED CALL WHEN
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THE UNDERLYING IS TRADING AT A DISCOUNT
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Can we compute the value of the imbedded call when the structured product itself
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is trading at a discount to its guarantee price? Yes, the formulae presented earlier can
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always be used to compute the value of the imbedded call.
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Example: Again using the example of JEM, the structured product on the Nikkei
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index, recall that it was trading at 8. 75 with a guaranteed price of 10, with maturity
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40 months hence. Assume that the risk-free interest rate at the time was 5.5%.
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Assuming continuous compounding, $8.75 invested today would be worth $10.51 in
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40 months.
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Money in the bank = 8. 75 x ert
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where r = 0.05 and t = 3.33 years (40 months)
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Money in the bank= 8.75 x e0-055 x 3-333 = 10.51
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Since the structured product will be worth 10 at maturity, the value of the call
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is 0.51.
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There is another, nearly equivalent way to determine the value of the call. It
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involves determining where the structured product would be trading if it were com
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pletely a zero-coupon debt of the underwriting brokerage. The difference between
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that value and the actual trading price of the structured product is the value of the
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imbedded call.
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The credit rating of the underwriter of the structured product is an important
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factor in how large a discount occurs. Recall that the guarantee price is only as good
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as the creditworthiness of the underwriter. The underwriter is the one who will pay
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the cash settlement value at maturity - not the exchange where the product is listed
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nor any sort of clearinghouse or corporation.
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THE ADJUSTMENT FACTOR
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In recent years, some of the structured products have been issued with an adjustment
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factor. The adjustment factor is generally a negative thing for investors, although the
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underwriters try to couch it in language that makes it difficult to discern what is going
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on. Simply put, the adjustment factor is a multiplier (less than 100%) applied to the
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underlying index value before calculating the Final Cash Value. Adjustment factors
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seemed to come into being at about the time that index option implied volatility
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began to trade at much higher levels than it ever had (1997 onward). |