Another Misuse of Financial Derivatives

Just like any financial derivatives that were initially designed for risk management purposes, interest rate swaps are an effective tool for managing and transferring interest rate risks as long as those risks are well understood.  But as banks and financial institutions are constantly trying to invent new financial products to sell to their consumers, sometimes the risks of those products are not well understood and disclosed.

This is what happened with the interest rate swap market in New Zealand where banks sold interest rate swaps to farmers in order for them to hedge the fluctuation in the mortgage rates.  However, the banks only emphasized the advantages of the interest rate swaps, and they did not discuss the potential downside in detail.

Swaps are enormously complicated and risky financial derivatives. They are used - mostly by big businesses or international dealing rooms - to hedge against interest rate moves.

But in the period 2005-2008, New Zealand banks aggressively sold swaps to farmers as a supposedly less risky alternative to fixed interest loans, and a way for farmers to protect themselves from hikes in their mortgage repayments if interest rates went up.

When the financial crisis hit, and the interest rates went down, farmers started losing money. Many were forced to sell their farms, and some of them committed suicide.

Walker estimates up to 2000 New Zealand farmers lost up to $1 billion on swaps. They lost farms they had inherited from their fathers and planned to pass onto their children. Too many committed suicide. Walker spent the three years following the Farmers Weekly survey doggedly researching banks' sales of swaps to New Zealand farmers. And then she went to see the regulators.  Read more

The problem is not in the financial derivative itself, but it is that the risks were not well understood and explained to the customers.

Banks will be asking what are the lessons, what do we need to change to make sure going forward we don't have this happen with a different product. It's not so much just about the swaps but how do we make this not happen in the future.

Article Source Here: Another Misuse of Financial Derivatives

Accounting for Convertible Debt

Convertible debt is a type of loan that can be converted back to stock after some specified future date. When making an investment in convertible debt, both the issuer and investor are clear that there is a possibility of debt being converted into stock in the future. International Account Standard 32 deals with accounting for convertible debt.

A convertible debt instrument is an alternative financing solution, normally used by companies to finance their operation or working capital. The peculiar thing about this arrangement is that both parties can be on the same page regarding an eventual conversion of convertible debt into common stock of the company. In other words, both the issuer and the holder can convert the debt into equity at a future date. However, the former (i.e. the forced conversion) is rare, while the latter (conversion by the holder) is more common.

Sometimes, it is not easy for the company to issue convertible debt because the shareholder may oppose this management decision. This is due to the fact that upon conversion of the debt to equity, the shareholders’ stock values will decline because of the share dilution. Therefore management needs to pursue by performing a cost-benefit analysis as to why the issuance of convertible debt is beneficial to the company and its shareholders at the same time.

An example of a convertible debt

Normally, the company issues the bond at par, but sometimes it can offer a discount to investors in convertible debts as an incentive. For example, Mr. A purchased a convertible bond on January 01, 2020, for $500,000 at $500 each, whereas the par value of the bond is $550. Why has the company offered a discount on the issuance of the bond?  It is because investors will be likely to convert their debts into equities.

Why offering a discount?

Debt is senior to equity in terms of payback at times of liquidation. So if an investor is willing to forgo his debt right for equity, then obviously the company has to offer some incentive in order to keep its investment.

Moving forward in the above-mentioned example, if the maturity of the bond is December 31, 2024, this means that after 5 years, the investor can convert and the company can reduce its debts leverage and issue its stocks in place.

Why is issuing a convertible bond good for the company?

A company at times is in need of financing, but they don’t want to increase their debt leverage, therefore they offer a discount to investors for investing in their convertible debt instruments. Once the investment has been made, the company can save itself from a debt burden.

Why is purchasing a convertible bond good for investors?

Often times it is worthwhile to invest in a company’s stock but for some reason, the investor does not want to invest in equity immediately. Therefore a better way is to go for convertible debt and then convert it into equity at a future date. This way, the investor will be in the position of a shareholder. In addition, as discussed above, the investor can be offered a discount as an incentive for investing in convertible debt.

How to account for the convertible debt:

As both the company and investors have the same understanding that after a defined period of time they can convert the debt into common stocks, therefore as per IAS-32, when accounting for the convertible debt, the company has to recognize the issuance of convertible debts as a compound instrument.

Every year the interests accrued on the debt portion of the convertible debt shall be recognized in the profit and loss statement, and at the maturity of that instrument, all the loan shall be converted into equity at par and will be recognized in the capital of the company.

Post Source Here: Accounting for Convertible Debt

Valuing European Options Using Monte Carlo Simulation-Derivative Pricing in Python

In a previous post, we presented a methodology for pricing European options using a closed-form formula. In this installment, we price these options using a numerical method. Specifically, we will use Monte Carlo simulation.

Recall that,

• A call option gives the buyer the right, but not the obligation to buy an agreed quantity of the underlying from the seller at a future time for a given price. The payoff of the call option at expiration is max(S_T-K,0),
• A put option gives the buyer the right, but not the obligation to sell an agreed quantity of the underlying to the seller at a future time for a given price. The payoff of the put option at expiration is max(K -S_T,0),

where S_T  denotes the stock price at expiration and K is the strike price.

To price these options, we first simulate the price paths using the following Stochastic Differential Equation:

where

• S_t is the stock price at time t,
• σ denotes the stock volatility,
• µ is the drift which equals the risk-free rate, and
• dW_t represents the standard normal random variable.

The simulation is carried out until the options’ maturity. We then apply the terminal payoff functions and calculate the mean values of all the payoffs. Finally, we discount the mean values to the present and thus obtain the option values.  For a more detailed presentation of the Monte Carlo method, see Reference [1].

The picture below shows the call and put option prices using 100000 simulations. All other parameters are the same as in the previous post.

We compare the above results to the ones obtained by using a third-party software and notice that they are in good agreement.

In the next installment, we will present a methodology for pricing American options using Monte Carlo simulation.

References

[1] Glasserman, Paul; Monte Carlo Methods in Financial Engineering, Springer; 2003

 

Follow the link below to download the Python program.

Originally Published Here: Valuing European Options Using Monte Carlo Simulation-Derivative Pricing in Python