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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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The change in the underlying credit asset

Thursday, March 11th, 2010

130Since options depend on a number of input factors, they must change in value when an input factor changes in value. The strike price as well as the maturity date are deterministic; i.e. once they are set, they do not change any more. The other input factors, price of the underlying asset, volatility, interest rate and net yield, can change over time. For  example, the impact of a change in volatility on the option price, all else being equal, is the sensitivity of the option price to volatility.

Most important and obvious, the option price is sensitive to a movement in the underlying asset. The change in the option value divided by the change in the underlying asset is called the delta. The delta of a call option is between zero and one while the delta of a put option is between minus one and zero. The delta is an important parameter with regard to the replicating portfolio.

Since it measures the price change of an option due to a price change in the underlying asset, the delta actually is the exact number of underlying assets that must be held in the replicating portfolio. Somebody who intends to hedge an option should therefore hold a delta amount of underlying assets. This procedure is called delta hedging.

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Option value and volatility value of a credit

Wednesday, March 10th, 2010

Alternatively, the investor could wait another year (i.e. to maturity of the option), and observe where the stock price has gone. If the stock price has gone down to, say, US$ 80, he or she would be happy to have waited since a loss would have been avoided. If, on the other hand, the stock rose further to, say, US$ 130, the investor could still exercise the option and put down the strike price of US$ 100. If he or she had exercised earlier, a stock worth US$ 130 would be held. However, the later the strike price needs to paid, the more interest can be earned on that money. Therefore, also in this scenario, it was wiser to wait as long as possible, i.e. until maturity. It follows that a longer maturity is more valuable, i.e. results in a higher option price, even if the option cannot be exercised before maturity.

As just seen, the remaining time to maturity is valuable. Consequently, the option price must be worth more than the intrinsic value (i.e. the US$ 10 that are collected in the above example if exercised immediately). That additional value is related to time to maturity and volatility. Higher volatility makes it more valuable to wait and see, i.e. to have the chance of avoiding a large loss by not exercising early. This difference between the option value and its intrinsic value is thus often called the time or volatility value.

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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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