1. Debt OPTIONS

2. Options on Treasury Securities: T-Bill Options Options on T-Bills give the holder the right to buy a T-Bill with a face value of $1M and maturity of 91 days. Exercise price is quoted in terms of the IMM index and the following formula can be used to determine X: The option premium is quoted in terms of annual discount points (PT). The actual premium is

3. Options on Treasury Securities: T- Bond Options Options on T-Bonds give the holder the right to buy a specified T-Bond with a face value of $100,000. Exercise price is quoted as a percentage of par (e.g. IN = 90). If the holder exercises, she pays the exercise price plus the accrued interest: The option premium is quoted in terms of points (PT). The actual premium is

4. Fundamental Strategies There are six fundamental strategies: –Call Purchase –Naked Call Write –Covered Call Write –Put Purchase –Naked Put Write –Covered Put Write There are six fundamental strategies: –Call Purchase –Naked Call Write –Covered Call Write –Put Purchase –Naked Put Write –Covered Put Write

5. Profit Graph Option Strategies can be evaluated in terms of a profit graph. A profit graph is a plot of the option position’s profit and security price relation at expiration or when the option is exercised. Option Strategies can be evaluated in terms of a profit graph. A profit graph is a plot of the option position’s profit and security price relation at expiration or when the option is exercised.

6. Figure 17.3-1: Call Purchase Buy T-Bond call: X = $100,000, C = $1000

8. Figure 17.3-2: Naked Call Write Sell T-Bond call for: X= 100,000, C=1000.

10. Figure 17.3-3: Covered Call Write Long T-Bond at 100,000, short 100 T-Bond call at 1.

12. Figure 17.3-4: Put Purchase Buy T-Bond put: X=100,000, P = 1000

14. Figure 17.3-5: Naked Put Write Sell T-Bond put: X =100,000, P = 1000

16. Figure 17.3-6: Covered Put Write Short T-Bond at 100,000, short 100 T-Bond put at 1.

18. Other Strategies

19. Figure 17.4-1: Straddle Purchase Buy 100 T-Bond put for 1 and buy 100 T-Bond call for 1:

21. Figure 17.4-2: Bull Spread Buy 100 T-Bond call for 1 and sell 101 T-Bond call for.75:

23. Hedging

24. Table 17.8-4: Hedging the Cost of a September T-Bill Purchase with a T-Bill Call

25. Table 17.8-5: Hedging a Future T-Bond Sale with a T-Bond Put

26. Futures Options on Treasury Securities Futures options give the holder the right to take a futures position: –Futures Call Option gives the holder the right to go long. When the holder exercises, she obtains a long position in the futures at the current price, ft, and the assigned writer takes the short position and pays the holder ft - X. –Futures Put Option gives the holder the right to go short. When the holder exercises, she obtains a short position at the current futures price, ft, and the assigned writer takes the long position and pays put holder X - ft. Futures option on Treasuries: Options on T-Bill Futures, T-Bond Futures, and T-Note Futures.

27. Exhibit 17.9-1: Futures Options on Treasury Securities Call on T-Bill Futures: X = IMM 90 or X = $975,000 PT =.5 or C = $1,250 Futures and options futures have same expiration.

28. Exhibit 17.9-2: Futures Options on Treasury Securities Put on T-Bill Futures: X = IMM 90 or X = $975,000 PT =.5 or P = $1,250 Futures and options futures have same expiration.

29. Table 17.9-1: Put-Call-Futures Parity

30. Hedging Cases

31. Exhibit 18.2-2: Hedging $5M CF in June with June T-Bill Futures Call

32. Managing the Maturity Gap with T-Bill Put Case: In June, a bank makes a $1M loan for 180 days which it plans to finance by selling a 90-day CD now at the LIBOR of 8.258% and a 90-day CD ninety days later (in September) at the LIBOR prevailing at that time. To minimize its exposure to market risk, the bank buys a T-Bill put at X = IMM = 90 for $$1250.

33. Maturity Gap Hedged with T-Bill Puts

34. Hedging future T-Bond Sale With T-Bond Puts Case: Three months from the present (.25 of year), a bond manager plans to sell a T-Bond with maturity of 15.25 years, F = $100,000, and coupon rate = 10%. Manager hedges the sale against interest rate increases by buying one put option on a T-Bond with a current maturity of 15.25 years and face value of $100,000. The put has an expiration of T =.25 years, exercise price of X = IN = 95 or X = $95,000, and is trading at P = 1 - 5 or P = [1.15625/100]($100,000) = $1156.

35. Hedging future T-Bond Sale With T-Bond Puts Hedge T-Bond Sale:

36. Hedging Future Bond Portfolio Sale With T-Bond Puts Case: Three months from the present (.25 of year), a bond manager plans to liquidate a bond portfolio consisting of AAA, AA, and A bonds. The portfolio currently has a WAM of 15.25 years, F = $10M, WAC = 10%, and has tended to yield a rate 1% above T- Bond rates. Manager hedges the sale against interest rate increases by buying put options on a T-Bond with a current maturity of 15.25 years and face value of $100,000. The put has an expiration of T =.25 years, exercise price of X = IN = 95 or X = $95,000, and is trading at P = 1 - 5 or P = [1.15625/100]($100,000) = $1156. To hedge, the manager buys 105.26316 T-Bond puts for $121,684:

37. Hedging Future Bond Portfolio Sale With T-Bond Puts Hedge Bond Portfolio Sale:

38. Interest Rate Options

39. Interest rate call option gives the holder the right to a payoff if an interest rate (e.g., LIBOR) exceeds a specified exercise rate; interest rate put option gives the holder the right to a payoff if an interest rate is less than the exercise rate. Interest rate options are written by commercial banks in conjunction with a future loan or CD investment.

40. Interest Rate Call Option Case: A company plans to borrow $10M in sixty days from Sun Bank. The loan is for 90 days with the rate equal to LIBOR in 60 days plus 100 BP. Worried that rates could increase in the next 60 days, the company buys an interest rate call from the bank for $20,000. Terms: Exercise Rate = 7%; call premium plus interest will be paid at the maturity of the loan; any interest rate payoff will be paid at the loan’s maturity. See Chapter 17.

41. Interest Rate Put Option Case: A company plans to invest $10M in sixty days in a Sun Bank 90-day CD. The CD will pay the LIBBER. Worried that rates could decrease in the next 60 days, the company buys an interest rate put from the bank for $15,000. Terms: Exercise Rate = 7%; put premium plus interest will be paid at the maturity of the CD; any interest rate payoff will be paid at the CD’s maturity. See Chapter 17

42. Caps: Series of Interest Rate Call Options A Cap is a series of interest rate calls that expire at or near the interest rate payment dates on a loan. They are written by financial institutions in conjunction with a variable rate loan. Case: A company borrow $50M from Commerce Bank to finance its yearly construction projects. The loan starts on March 1 at 8% and is reset every three months at the prevailing LIBOR. Cap: In order to obtain a maximum rate while still being able to obtain lower rates if the LIBOR falls, the company buys a Cap from the bank for $100,000 with exercise Rate = 8%. See Chapter 17

43. Floor: Series of Interest Rate Put Options A floor is a series of interest rate puts that expire at or near the payment dates on a loan. They are purchased by financial institutions in conjunction with a variable rate loan they are providing. Case: Commerce Bank purchases a floor with an exercise rate of 8% for $70,000 from another institution to protect the variable rate loan it made. See Chapter 17

44. Table 17.8-1: Profit and Interest Rate Relation from Closing a Long 94 T-Bill Call Purchased at 1

45. Table 17.8-3: Profit and Interest Rate Relation from Closing a Long 94 T-Bond Put Purchased at $1000

46. Table 17.8-2: Profit and Interest Rate Relation from Closing a Long 94 T-Bill Put Purchased at 1