Fixed Income Derivatives: Forwards, Futures, and Swaps
Introduction to Fixed Income Derivatives
1. Introduction
A derivative is a security whose value depends on the value of another security. Hedgers include oil producers, farmers, and other commodity producers.
2. Over-the-Counter Markets (OTC)
A decentralized market where dealers are connected through telephone, the internet, and proprietary electronic trading systems (for forwards and swaps).
- Advantages: Terms of contracts are privately negotiated.
- Disadvantages: Counterparty risk.
3. Exchange-Traded Markets
A
Read MoreInvestment Decisions: NPV, IRR, and Discounted Cash Flow
Chapter 8: NPV and Other Investment Criteria
NPV = PV – Initial Investment
A positive NPV means that the project is expected to add value to the firm and, therefore, will increase the wealth of the owner. Accept a project if NPV > 0.
IRR: The project’s expected return. If the cost of capital (required return) equals the IRR (expected return), the NPV = 0. A project’s IRR is the discount rate that makes its NPV = 0. Accept the project if the IRR is greater than r (the project’s cost of capital).
Read MoreStock Returns, Risk, and Portfolio Management
Stock Returns and Risk Premium
1. Calculating Percentage Return on a Stock
What is the percentage return on a stock that was purchased for $50.00, paid a $3.00 dividend after one year, and was then sold for $49.00?
Formula: % Return = (Capital Gain + Dividend) / Initial Share Price
= ($49.00 – $50.00) + $3.00 / $50.00
= 4.00%
2. Calculating Inflation Rate
If a share of stock provided a 14.0% nominal rate of return over the previous year while the real rate of return was 6.0%, then the inflation rate was:
Read MoreEurocurrency, Forex, EMS, Derivatives, and Options
Eurocurrency and the Eurodollar
A Eurocurrency is a claim (e.g., time deposit) in that currency held by a nonresident of the currency’s country of origin. Since the Eurodollar is the major Eurocurrency, it is a U.S. dollar claim arising from a dollar‑denominated deposit, note, or bond held by a nonresident of the United States.
The LIBOR (London Interbank Offer Rate) fixing is the base rate in the Eurocurrency market. (Offer Rate = Ask Rate) It represents the average rate at which leading multinational
Read MoreUnderstanding Bonds, ETFs, and the 1929 Stock Market Crash
Understanding Bonds and ETFs
Bond Fundamentals
Bonds Above Par: A bond sold on the secondary market with a market value higher than its face value.
Bonds Below Par: A bond with a market value below its face value.
Bonds vs. Certificates of Deposit: Both bonds and certificates of deposit (CDs) pay investors interest over the contract’s life. However, bonds are debt instruments, whereas CDs are savings certificates.
Corporate Bonds: These bonds typically offer higher yields due to the higher risk involved.
Read MoreUnderstanding Different Types of Market Participants and Transactions
Akihiko’s Forecasting Model
Akihiko has designed a sophisticated forecasting model, which predicts the movements in the overall stock market, in the hope of earning a return in excess of a fair return for the risk involved. He uses the predictions of the model to decide whether to buy, hold, or sell the shares of an index fund that aims to replicate the movements of the stock market. Takabe would best be characterized as an information-motivated trader.
James Beach’s Investment Strategy
James Beach
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