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Explore the credit cycle more closely

Sunday, March 21st, 2010

23Rather than simply hoping the partnership delivers what it’s capable of achieving, I use a structured process that helps me manage the outcomes. This process is called the Plan–Do–Check–Act cycle, also known as the Shewhart cycle or the Deming cycle.

Walter A. Shewhart, a statistician at Bell Telephone Laboratories in New York, developed a technique to reduce process variation in tasks that workers performed. He developed this planning cycle to improve the output of his processes and bring them under what he called “statistical” control. Later Dr. W. Edwards Deming referred to the Shewhart cycle as the Plan–Do–Check–Act cycle. Deming introduced it to the Japanese to help rebuild their economy after World War II. This cycle has been a cornerstone of the Japanese economic miracle ever since the 1960s and is still used today. In fact, the Japanese call it the Deming Cycle of Quality. The Plan–Do–Check–Act (PDCA) cycle is as useful in developing relationships as it is in managing statistical control or performing a task. I use this simple tool repeatedly throughout the partnering process. Let’s explore the cycle more closely.

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Credit options on liquidity traded assets

Friday, March 12th, 2010

1However, since options are nonlinear derivatives, the delta itself will change with every move of the underlying asset;  i.e. the hedger must adjust the hedge amount dynamically, in order tocorrectly mimic the option to be replicated. Since in reality it is not possible to continuously adjust the hedge, the hedger is exposed to the risk of the delta changing quickly. The hedger with the delta position is always one step behind the true actual delta. The risk of unanticipated changes in the delta is called the gamma risk. In other words, the gamma is the sensitivity of the delta with respect to the underlying asset. If a trader wants to hedge gamma risk in addition to delta risk, he or she needs a security with a nonlinear payoff depending on the same underlying asset in addition to the underlying asset itself. By just using the underlying asset (which is an instrument with a linear payoff) the trader could never hedge gamma risk (which arises only in nonlinear payoffs). Similarly, option price sensitivities with respect to volatility (called vega), to interest rates (called rho) and to net yield can be calculated and used as a hedge measure for a change in the respective parameter. These sensitivities, which were developed for options on liquidly traded assets (e.g. equity), will generally be appropriate for property options as well.

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Loans and dividend payments

Wednesday, March 10th, 2010

Just as for forward and futures contracts, the holder of an option is not entitled to earn any yield on the underlying asset before the option is exercised and the underlying asset is owned directly. The yield on a directly owned asset is called the convenience yield. On the other hand, the option holder does not need to bear the cost that is related to the storage or maintenance of the underlying asset, called cost-of-carry. A large yield such as a big dividend payment can make it worthwhile to exercise an option early. Suppose a stock pays a dividend of 5% tomorrow and an investor holds a deep in-the-money call option (i.e. the option is highly likely to be exercised) that matures next week. If the investor could exercise the option today, he or she would need to put down the strike price today but would capture the dividend. If he or she were to wait until maturity, there would only be a need to pay the strike price in a week but the dividend payment would be missed. Clearly, the possibility of an early exercise can be valuable if the underlying asset provides a yield. In that case, an American-style option is worth more than a European-style option.

The net yield can be directly observed in the market (announced dividend payments) or estimated from related markets.

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What’s the intrinsic value of a loan

Wednesday, March 10th, 2010

The time to maturity is determined in the option contract. Generally, the longer the time to maturity, the more valuable is the option. The reason for this relation is straightforward for the American-style option: the holder of the option can always exercise the option prior to maturity. In addition, there is the possibility to wait and exercise the option at a later point in time. The longer the time to maturity, the greater is the value of the possibility to wait.

For European-style options, the relation of time to maturity and option price needs further explanation. A start is made by showing that an early exercise does not make much sense. Assume that an investor holds a call option with a strike at US$ 100 and a two-year maturity on a nondividend paying stock. The price of the underlying stock is currently at US$ 90. Obviously, an early exercise makes little sense, since the out-of-the money option would be worth zero immediately. Suppose the stock rises to US$ 110 over the next year. If the investor were to exercise the option now, he or she would need to put down US$ 100 (the strike price) and get the stock worth US$ 110. The difference between the actual stock price and the strike price of US$ 10 would have been gained, called the intrinsic value.

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