Ebook Derivatives markets (3rd edition): Part 2
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Ebook Derivatives markets (3rd edition): Part 2
PARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2and-alone financial claims. In the next three chapters we will see that these claims can be used as financial building blocks to create new claims, and also see that derivatives pricing theory can help us understand corporate financial policy and the valuation of investment projects.Specifically, in Ebook Derivatives markets (3rd edition): Part 2 Chapter 15 we see how it is possible to construct and price bonds that make payments that, instead of being denominated in cash, are denominated in sEbook Derivatives markets (3rd edition): Part 2
tocks, commodities, and different currencies. Such bonds can be structured to contain embedded options. We also see how such claims can be used for riPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2atives are important, including corporate financial policy, compensation options, and mergers. Chapter 17 examines real options, in which (he insights from derivatives pricing are used to value investment projects.Financial Engineering and Security DesignTT1 orwards, calls, puts, and common exotic o Ebook Derivatives markets (3rd edition): Part 2ptions can be added to bonds or otherwise JL combined to create new securities. For example, many traded securities are effectively bonds with embeddeEbook Derivatives markets (3rd edition): Part 2
d options. Individual derivatives thus become building blocks—ingredients used to construct new kinds of financial products. In thischapter we will sePARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2ngineering15.1 THE MODIGLIANI-MILLER THEOREMThe starting point for any discussion of modern financial engineering is the analysis of Franco Modigliani and Merton Miller (Modigliani and Miller. 1958). Before their work, financial analysts would puzzle over how to compare the values of firms with simi Ebook Derivatives markets (3rd edition): Part 2lar operating characteristics hut different financial characteristics. Modigliani and Miller realized that different financing decisions (for example,Ebook Derivatives markets (3rd edition): Part 2
the choice of the firm’s debt-to-equily ratio) may carve up the flrm’s cash flows in different ways, but if the total cash flows paid to all claimantPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2alue, profltable arbitrage would exist. Using their famous analogy, the price of whole milk should equal the total prices of the skim milk and butterfat that can be derived from that milk.1The Modigliani-Miller analysis requires numerous assumptions: For example, there are no taxes, no transaction c Ebook Derivatives markets (3rd edition): Part 2osts, no bankruptcy costs, and no private information. Nevertheless. the basic Modigliani-Miller result provided clarity for a confusing issue, and itEbook Derivatives markets (3rd edition): Part 2
created a stalling point for thinking about the effects of taxes, transaction costs, and the like, revolutionizing finance.All of the no-arbitrage prPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2contract Using options, a call option using a forward contract, bonds, and a put. and so forth. In Chapter 10 we saw that an option could also be synthetically created from a position in the stock and borrowing or lending. If prices of actual claims differ from their synthetic equivalents, arbitrage Ebook Derivatives markets (3rd edition): Part 2 is possible.I.sundafd corporate finance texts offer a more detailed discussion or die Modigliani-Miller results. The original paper (Modigliani and MEbook Derivatives markets (3rd edition): Part 2
iller. 1958) is a classic.437438 Chapter 15. Financial Engineering and Security DesignFinancial engineering is an application of the Modigliani-MillerPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2he sum O1 the pieces combined to create it. When we create a new instrument in this fashion, as in the Modigliani-Miller analysis, value is neither created nor destroyed. Thus, financial engineering has no value in a pure Modigliani-Miller world. However, in real life, the new instrument may have di Ebook Derivatives markets (3rd edition): Part 2fferent lax. regulatory, or accounting characteristics, or may provide a way for the issuer or buyer to obtain a particular payoff at lower transactioEbook Derivatives markets (3rd edition): Part 2
n costs than the alternatives. Financial engineering thus provides a way to create instruments that meet specific needs of investors and issuers. To iPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2lowing questions when you confront new financial instruments:•What is the payoff of the instrument?•Is it possible to synthetically create the same payoffs using some combination of assets, bonds, and options?•Who might issue or buy such an instrument?•What problem does the instalment solve?We begin Ebook Derivatives markets (3rd edition): Part 2 by discussing structured notes without and with options. We then tun) to examples of engineered products.15.2 STRUCTURED NOTES WITHOUT OPTIONSAn ordiEbook Derivatives markets (3rd edition): Part 2
nary note or bond has interest and maturity payments that are fixed at the time of issue.2 3 A structured note has interest or maturity payments that PARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2rencies, and the payoffs may or may not contain options.We first discuss bonds that make a single payment and then bonds that make multiple payments (such as coupon bonds), all without options. In the next section we will introduce structures with options.Single Payment BondsA single payment bond is Ebook Derivatives markets (3rd edition): Part 2 a financial instalment for which you pay today and that makes a single payment at lime 7? The payment could be $1. a share of stock, an ounce of goldEbook Derivatives markets (3rd edition): Part 2
, or a bushel of corn. A single payment bond is equivalent to a prepaid forward contract on the asset or commodity.Because the price of a single paymePARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2 This interpretation will play an important role in our discussion.The most basic financial instrument is a zero-coupon bond that pays Si at maturity. As in Chapter 7, let r,(f. T) represent the annual continuously compounded interest rate2We will use the terms "bond" and "note" interchangeably, tho Ebook Derivatives markets (3rd edition): Part 2ugh in common usage ii note has a medium time to maturity <2-10 years) and a bond has a longer maturity.3In earlier chapters we referred to this instrEbook Derivatives markets (3rd edition): Part 2
ument as a zero-coupon bond. In this chapter, “zero-coupon bond" will mean a single payment bond that pays in cash15.2 Structured Notes without OptionPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as sta Ebook Derivatives markets (3rd edition): Part 2 book of Islam, prohibit the payment of interest. By scholarly interpretation, the Qur'an also requires that business transactions must both pertain to real assets and have an ethical purpose. These restrictions and requirements have given rise to a practice known as Islamic Finance. The primary ele Ebook Derivatives markets (3rd edition): Part 2ments of Islamic Finance are•No interest or usury•No gambling•No speculationPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as staPARTFinancial Engineering and Applications11» (he preceding chapters we have focused ơn forwards, swaps, and options (including exotic options! as staGọi ngay
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