Abstract
The chapter starts by discussing the valuation of single stock forwards and futures before extending the discussion to cover index futures. This provides a stepping stone to equity swap valuation before the final and longest section, that of equity options.
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Notes
- 1.
These desks typically create products that leave the banks structurally short calls and long puts, which means they will suffer a mark to market loss if the underlying price rises. In order to hedge this exposure these desks will buy futures. Structured products are considered in more detail in Chap. 12.
- 2.
A short forward position can be replicated by borrowing and then shorting a basket of shares. The proceeds of the short sale are placed on deposit to earn LIBOR but the investor will have to pay back to the lender any dividends and a securities lending fee (i.e. a repo rate). If the repo rate is negative the borrower is paid to borrow the shares.
- 3.
A worked example similar to this is detailed in Chap. 9.
- 4.
See Chap. 9.
- 5.
The example ignores taxation and assumes the investor funds at LIBOR.
- 6.
As a point of clarification, an ‘increase in the absolute value of the spread component of the LIBOR cash flow’ is defined as a situation where the floating cash flow moves from LIBOR—15 to LIBOR—25. This would mean of course that the magnitude of the LIBOR cash flow has decreased.
- 7.
A full derivation of the rates is beyond the scope of this book. Interested readers are referred to Schofield and Bowler (2011).
- 8.
An OIS is a fixed-for-floating swap in which the floating payment is based on compounding at an overnight interest rate.
- 9.
The validity of this assumption will be considered in greater detail in Chap. 6.
- 10.
The equation presented by Tompkins does not include a value for equity repo rates but this can be accommodated for by making an adjustment to the dividend yield parameter.
Bibliography
Barclays Capital (2010) Dividend swaps and futures Barclays Bank research
Combescot, P. (2013) Recent changes in equity financing Presentation to the Society of Actuaries
Nashikkar, & Amrut. (2011) Understanding OIS discounting Barclays Capital
Risk Magazine (2013) Inventory pressures August
Schofield, N.C., & Bowler, T. (2011) Trading, the fixed income, inflation and credit markets: a relative value guide Wiley Finance Series
Tompkins, R. (1994) Options explained 2 Palgrave Macmillan
UBS (1999) Options: the fundamentals UBS
Vasan, P. (1998) Foreign exchange options Credit Suisse First Boston
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Schofield, N.C. (2017). Valuation of Equity Derivatives. In: Equity Derivatives. Palgrave Macmillan, London. https://doi.org/10.1057/978-0-230-39107-9_4
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DOI: https://doi.org/10.1057/978-0-230-39107-9_4
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