International Financial Markets and Institutions 2 - Essay Example

The price at which the asset or a bond may be traded at expiration is called an exercise price or strike price. A call option is an option granting the right to buy an underlying asset. A call option on a bond would mean that the bond issuer has the option to buy back the bond at a certain price after the expiration of a certain time period. A put option is an option granting the right to sell an underlying asset. In this case, a bond investor has the right to sell back the bond at a certain price after the expiration of a certain time period.

(Chance, 2009) An option is generally considered to be in-the-money when exercising the option would result in a positive cash inflow. Therefore, call options are considered to be in-the-money for the bond investor when the value of the underlying asset exceeds the exercise price. This way, if the underlying bond is bought at the exercise price, it can be sold at the market value to make positive cash inflow if delivery is term of contract and be simply a positive settlement in case cash settlement is the term of contract.

A put option is considered to be in-the-money for the bond issuer when the value of the bond is lower than the exercise price. (Chance, 2009) There are three measures to calculate the yield of any bond with an attached option: yield to maturity, yield to call and yield to put. Yield to maturity measure assumes that the bond will be held to maturity and that any option on the bond will not be exercised. This means that the yield to maturity measure on a callable or putable bond is the same as the yield to maturity on a simple bond with no options.

The yield to maturity is, therefore, the ‘interest rate that will make the present value of a bond’s cash flows equal to its market price plus accrued interest’. Hence, the Internal Rate of Return (IRR) is calculated for all the expected positive cash flows (including interest and the face value of the bond receivable at maturity) and the negative cash flow (purchase price of the bond). This gives us the yield to maturity. ‘A callable bond may have a call schedule. The yield to call assumes that the issuer will call a bond on some assumed call date and that the call price is the price specified in the call schedule’ (Fabozzi, 2009).

You can use the yield to call concept to calculate the yield to first call or yield to next call or yield to first par call or a yield to refunding. The yield to call is calculated in the same way as any other yield. In this case we assume the call date to be the maturity date and then use the cash inflows and outflows to get the IRR and define the yield to call. The yield to put is the ‘interest rate that will make the present value of the cash flows to the first put date equal to the price plus accrued interest’ (Fabozzi, 2009).

Once again, this measure assumes that the bond will be put at the first put date. Therefore, the schedule is used to identify the value of bond at the put date and calculate cash inflows and outflows. These are then used to obtain the IRR or the yield measure. Question2 You have been appointed as the Business analyst at an international fund management firm. As part of your role, you are required to prepare a report covering the following areas: a. How the Internet, and technological advances in computing power and communications affects: I.

The provision of domestic and global banking products and services II. The degree of competition in the world’