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On Investment Banking

What are Options in The World of Finance?

22/1/2013

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Options are financial products that derive their value from a change in the value of another underlying product. Options can be bought on many underlying products including but not limited to:

  • A share price (i.e. the market value of a company)
  • An interest rate
  • An exchange rate
  • A corporate or government bond
  • Real commodities, e.g. oil, gold, wheat, pork bellies

An option is a type of derivative. A derivative derives its value from a change in the value of another underlying product. All options give the buyer the right but not the obligation to do a given thing at a given time. 

Essentially, options can be viewed as insurance contracts. You get paid if a certain undesirable event happens. The price or cost of an option is called the premium.

Extracted from To Become an Investment Banker

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What are financial derivatives?

12/7/2012

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The very word "derivative" makes some people start running for the hills. It sounds scary, complicated, brain numbing. However, if you take the time to read a little about them, the majority of derivatives are easy to understand, particularly derivatives that are designed to hedge specific financial risks. Speculative derivatives can get a lot more complicated.

A derivative is a financial product whose value depends on the change in the value of some other underlying product. 

Derivatives are primarily used for:
  • Hedging: to protect a company against an adverse move in the market price of an input (costs) or an output (prices). To Become an Investment Banker focuses on explaining hedging. It's an important concept to understand because a lot of big companies undertake hedging activities.

  • Speculation: to benefit from an expected change in market prices.

  • Arbitrage: to take advantage of a perceived mispricing(s) in the market.

Understanding derivatives will a) help you decide what sort of products you might enjoy covering and b) it will give you a better feel for some of the key concerns that companies have to consider. 

In the equity capital markets, the simplest derivative is an equity call option and in the debt capital markets the simplest derivative is an interest rate swap. So read:

What is LIBOR? (it's an important variable in derivatives pricing)
What is an interest rate swap (or IRS)?  
What is a call option or an equity call option?

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What is a call option? or an equity call option?

10/7/2012

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An equity call option gives the buyer the right to buy a given number of shares in a given company at a given price on a given date (European-style option) or at any point with a given period of time (American-style option). Only the option buyer can exercise the option.

To buy a call option is called going long a call and selling a call option is going short a call. 

Example
Whilst Apple shares are trading at about $80 a share in late 2006 you decide to buy a call option that gives you the right to buy 1,000 shares in Apple Inc. at $200 anytime between 1 Jan 2010 and 31 Dec 2010.

Buying out-of-the-money call options is much cheaper than actually paying the money to buy the shares outright.

The call options are referred to as being out-of-the-money because the strike price, $200, is higher than the current share price of $80. If you buy this contract, you would be expressing the view that you believe in the company so much that you expect the share price to more than double over a four year period. This view would be the basis for buying the right to buy the shares at $200 in four years time, though the current value is only $80.

If at any point in 2010 Apple shares exceeded the option strike price of $200, you could exercise your right to buy the shares at $200 and immediately sell them to lock in a profit. Let’s say each option cost you $1, this means you would pay a premium of $1,000 for this option contract.

In Dec 2010, the Apple share price went over $320.
  • You decide to exercise the option when the market price is at $320.

  • You would pay $200,000 to exercise the equity call option contract: $200 strike price multiplied by 1,000 shares.

  • You would then immediately sell all those shares at the market price of $320, locking in an immediate profit of $119,000:
    $320,000 current market value of 1,000 shares
    minus $200,000 option contract value received on sale (when you exercise the contract)
    minus $1,000 premium paid to enter into option contract 
    = $119,000 
In summary, buying equity call options implies the buyer believes the share price will go up and they want to profit if this does happen. The higher the share price is above the strike price, the higher the profit as seen below.

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Excerpt from To Become an Investment Banker

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What is an interest rate swap or IRS?

5/7/2012

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The interest rate on money borrowed at a variable rate of interest, e.g. LIBOR, rises as the rate rises and falls as the rate falls. If interest rates are expected to rise, it is possible to hedge against the rise by entering into an interest rate swap (IRS) so that the floating rate is converted to a fixed rate.

An interest rate swap (IRS) is an agreement between two parties to exchange interest flows. 

One party pays a variable rate (normally LIBOR, but it can be another rate, e.g. a government base rate) whilst the other party pays a fixed rate as set on the date that the IRS is executed (i.e. when it is entered into).

The LIBOR payments are referred to as the ‘floating leg’; the fixed rate interest payments are referred to as the ‘fixed leg’.

The diagram below shows an interest swap between a book seller, Blissful Books United (BBU) and a bank. BBU pays a fixed rate to the bank and receives LIBOR.

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Excerpt from To Become an Investment Banker
The maturity of interest rate swaps varies widely, they can be very short-dated e.g. 3 or 6 months or very long dated e.g. 30 or even 60 years. Very short-dated IRS and very long-dated ones are not very common. Maturities of 3-, 5- and 7 years are common amongst corporate entities.

The amount on which interest is calculated is called the ‘notional’ amount because this value isn’t paid upfront by either party involved in the swap. What would be the point of exchanging the same amount of the same currency?

Payment dates occur periodically, typically every 3 or 6 months. On each payment the amount of interest due to be paid by each party is calculated and only the net amount is paid.

For example, assume the fixed rate that Blissful Books United pays on the IRS is 1.50% and that Libor turns out to be 1.725% for a given period, who pays and how much do they pay? Assume a notional amount of $10m:

  • BBU is meant to pay: 1.500% * USD10m * 0.5years = $75,000
  • 'Bank' is meant to pay: USD LIBOR of 1.7250% * USD10m * 0.5years = $86,250
  • Therefore, the bank pays a net amount of $11,250.

Normally, no upfront payment is required from either the bank or the non-bank counterparty to enter into an interest rate swap. Any costs and profits to the bank are incorporated into the periodic payments.

To Become an Investment Banker goes into a little more detail on how the rates are arrived at, terminology and what an IRS term sheet looks like. If you want one-on-one coaching on interest rate swaps, please book a coaching package.

In the week of June 25th 2012, the UK's financial services regulator the FSA claimed that some banks had mis-sold interest rate swaps to small businesses. Apparently, some small business claimed that they did not understand the risks that IRSs poised.

Who is Girl Banker® and how can she help you?

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    Girl Banker®

    I created my investment banking blog in 2012 as soon as I resigned from i-banking & published my book, To Become An Investment Banker.

    Initially published at girlbanker.com, all posts have now been subsumed into my personal website under katsonga.com/GirlBanker.

    These blog posts make it as straight-forward for you as possible to get into a top tier investment bank. 


    I have 7 years of front office i-banking experience from Goldman Sachs and HSBC, in both classic IBD (corporate finance) and Derivatives (DCM / FICC).

    ​I'm also a CFA survivor having passed all three levels on the first attempt within 18 months - the shortest time possible. 
    ​
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