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Author: Bill Campbell
Bear Spread
If you haven’t read the article on option strategies in general, that’s a good place to start, then return here. In particular, if you haven’t read the warning about calculating profit that appears at the end of that article, you should go read it now; the way I’m calculating the profit here is correct, but…
Bull Spread
If you haven’t read the article on option strategies in general, that’s a good place to start, then return here. In particular, if you haven’t read the warning about calculating profit that appears at the end of that article, you should go read it now; the way I’m calculating the profit here is correct, but…
Option Strategies
Candidates seem to have a tremendously difficult time with option strategies: how to construct various spreads, how to compute the payoffs on those spreads, how to compute the profits on those spreads, how to compute the breakeven underlying prices on those spreads, and why they would employ a particular spread. I’m here to tell you…
Interest Rate Caps and Floors
Interest rate caps and floors are, essentially, collections of interest rate options: each option has a positive payoff when it expires in the money and a zero payoff when it expires out of the money. The individual options are called, respectively, caplets and floorlets. Note that caps and floors are commonly based on LIBOR or…
Equilibria: Stable and Unstable
In economics, as in physics, an equilibrium is a point at which all opposing forces net to zero: once you’re there, there’s nothing that will drive you away. Do not assume that this means that all equilibria are created equal. Far from it. What matters is not what the forces do when you’re at an…
Present Value of Growth Opportunities (PVGO)
Most companies don’t remain the same size (i.e., have the same amount of earnings, net income) forever; with a soupçon of luck, a company’s earnings will grow, year after year. The value of a company’s opportunities to grow in the future is known, with no great originality, as the present value of growth opportunities (PVGO). …
Binomial Pricing Trees (for Options)
Binomial trees are used in a variety of contexts in finance: Calculating probabilities for Bayes’ Formula type problems Calculating the value of options on stocks, commodities, and so on (you are here) Calculating the option-adjusted spread (OAS) for bonds Calculating the value of bonds with embedded options Calculating the value of floating-rate bonds Calculating the…
Valuing Bonds with Embedded Options
Bonds can be sold with a variety of embedded options, for example: Call options Put options Prepayment options Conversion options In this article, we will concentrate on callable bonds and putable bonds, although we’ll mention prepayable and convertible bonds as well. The common method of valuing a callable or putable bond is to use a…
Yield Spreads
A yield spread is an amount of interest that is added to another interest rate (or rates) to achieve some specific goal. For example, a yield spread might be added to the yield to maturity (YTM) of a risk-free bond to arrive at the YTM for a given risky bond of the same maturity. Or…
Valuing Floating-Rate Bonds
Some floating-rate bonds are easy to value: if the coupon resets to the market rate, then the value of the bond will reset to par. (Of course, this assumes that by “the market rate” we mean the rate appropriate for a given bond, which may have to include risk premia above the Treasury rate. If…