Didier Joannas’s research while affiliated with Thomson Reuters and other places

We continue with options in this chapter, with a look at how options behave in response to changes in market conditions. To start we consider the main issues that a market maker in options must consider when writing options. We then review ‘the Greeks’, the measures by which the sensitivity of an option book is calculated. We conclude with a discussion on an important set of interest-rate options in the market, caps and floors.

For any application the discount rate that is used is the market-determined rate. This rate is used to value capital market instruments. The rate of discount reflects the fact that cash has a current value and any decision to forgo consumption of cash today must be compensated at some point in the future. So when a cash-rich individual or entity decides to invest in another entity, whether by purchasing the latter’s equity or debt, he is forgoing the benefits of consuming a known value of cash today for an unknown value at some point in the future. That is, he is sacrificing consumption today for the (hopefully) greater benefits of consumption later. The investor will require compensation for two things; first, for the period of time that his cash is invested and therefore unusable, and secondly for the risk that his cash may fall in value or be lost entirely during this time. The beneficiary of the investment, who has issued shares or bonds, must therefore compensate the investor for bearing these two risks. This makes sense, as if compensation was not forthcoming the investor would not be prepared to part with his cash.

Chapter 4 introduced the concept of the yield curve. The analysis and valuation of debt market instruments revolves around the yield curve. Yield curve or term structure modelling has been extensively researched in the financial economics literature; it is possibly the most heavily covered subject in that field. It is not possible to deliver a comprehensive summary in just one chapter, but our aim is to cover the basic concepts. As ever, interested readers are directed to the bibliography, which lists the more accessible titles in this area.

In certain countries there is a market in bonds whose return, both coupon and final redemption payment, is linked to the consumer prices index. Investors’ experience with inflation-indexed bonds differs across countries, as they were introduced at different times, and as a result the exact design of index-linked bonds varies across the different markets. This of course makes the comparison of issues such as yield difficult, and has in the past acted as a hindrance to arbitrageurs seeking to exploit real yield differentials. In this chapter we highlight the basic concepts behind the structure of indexed bonds and show how these differ from those employed in other markets. Not all index-linked bonds link both coupon and maturity payments to a specified index; in some markets only the coupon payment is index-linked. Generally the most liquid market available will be the government bond market in index-linked instruments.

This was the assessment of the IMF in their quarterly report of April 2007. Only three months later one of the deepest crises since the Great Depression of the 1930s broke out. The IMF quote was characteristic for its time. Many people continued to believe that we were living in a new era where unlimited credit supply was possible without creating excesses. However the ‘this-time-it-is-different’ view appeared not to be so different. Mainstream economists either did not acknowledge the build up of the asset price bubble or underestimated its impact.

In this chapter we introduce the basic concepts of securitisation and look at the motivation behind their use, as well as their economic impact. We illustrate the process with a brief hypothetical case study. We also describe the ‘in-house’ deal, a response by banks to the 2007–8 credit crunch.

The risks associated with holding a fixed-interest debt instrument are closely connected with the ability of the issuer to maintain the regular coupon payments as well as redeem the debt on maturity. Essentially the credit risk is the main risk of holding a bond. Only the highest-quality government debt, and a small number of supra-national issues, may be considered to be entirely free of credit risk. Therefore, at any time, the yield on a bond reflects investors’ views on the ability of the issuer to meet its liabilities as set out in the bond’s terms and conditions. A delay in paying a cash liability as it becomes due is known as technical default and is a cause for extreme concern for investors; failure to pay will result in the matter being placed in the hands of the court as investors seek to recover their funds. To judge the ability of an issue to meet its obligations for a particular debt issue, for the entire life of the issue, requires judgemental analysis of the issuer’s financial strength and business prospects. There are a number of factors that must be considered; and larger banks, fund managers and corporates carry out their own credit analysis of individual borrowers’ bond issues. The market also makes a considerable use of formal credit ratings that are assigned to individual bond issues by a formal credit rating agency. In the international markets the most influential ratings agencies are Standard & Poor’s Corporation (S&P), Moody’s Investors Service, Inc (Moody’s) and Fitch Investors Service, Inc (Fitch).

For market practitioners, zero-coupon rate curves are the basic tools used to value interest-rate based instruments. Curves are built using market data such as money market rates, swap rates, interest rates futures or bond prices as inputs. Despite the name, it is not in fact the ‘zero coupon’ rates that are the most important output from a curve fitting methodology, but rather a set of quantities known as discount factors. It is these that are crucial for the pricing of interest rate-based instruments.