THE MINDMAP

THE MINDMAP

1. Rates

   • Prime rate
     • for short-term loans & creditworthy customers
   • Bank rate
     • Bank of Can.-> commercial banks overnight
   • Call money rate
     • Brokerage firms pay for call money loans, for customers on margin loans
   • Commercial paper
     • short-term unsecured debt by largest firms
   • Bankers acceptance
     • postdated check with guaranteed payment
   • Certificate of deposit
     • Deposits>$100k at comm. banks
   • London Eurodollars
     • Cert. of Dep. in USD in London
   • LIBOR
     • Overnight eurodollar loans
   • T-Bills
     • short-term federal government debt instrument

2. Different way that money market interest rates are quoted:

   • Bank discount basis
     • Current price=Face value * (...)
   • Bonds equivalent yields
     • =(365*Discount yield)/360-...
   • Annual percentage rates
   • Effective annual rates
   • Canadian T-Bill
     • Bill price=1.000/(1+(Bond eq. * Days)/365)
     • Bond eq. yields= (1000-price/price)*(365/Days)
   • Seperate Trading of Registered Interest and Principle of Securities
     • Face value / (1+YTM/2)^2M
   • Current Yield=
     • Face value ($100) / Bond price (P0)

3. Explaining the term structure

   • Expectations Theory: The term structure of interest rates reflects the financial market beliefs about future short-term interest rates
   • Fisher Effect: interest rates depend on two factor rnom = rreal + EP , rnom = nominal short-term interest rates, rreal = real interest rate, EP= expected inflation Upward sloping yield curve: future short-term rate↑ due to rreal ↑ or EP↑ AND C.p.
   • Maturity Preference Theory: Lenders prefer short-term loans to avoid tying up funds for long periods of time. Long-term interest rates contain a maturity premium necessary to induce lenders into making longer term loans.
   • Market Segmentation Theory: Debt markets are segmented by maturity, and interest rates for various maturities are determined separately in each segment. For example, insurance firms tend to invest in long term bonds and banks tend to lend short-term loans. Therefore, interest rates tend to be determined by supply and demand in each segment.

4. Interest rate risk

   • Interest Rate Risk is the possibility that changes in interest rates will result in losses in the bond’s value.
   • (1) price risk, the bond may be sold before maturity and the price may differ from the face value;
   • (2) reinvestment risk, coupons received over time may be reinvested at a rate different from YTM. Therefore, realized yield, ie., the yield actually earned on a bond, is almost never exactly equal to YTM due to changes in interest rates. To gain insight into the determinants of interest rate risk, we plot the % change in bond price corresponding to changes in YTM for bonds that differ in maturity, coupon levels and initial YTM.

5. Trading strategies

   • Protective Put
     • Firstly, you own a a share. Then you purchase a put. You can protect yourself against a price decline. Two szenarios: Stock stays at strike price = you would not exercise it and rather loose your put option ($2). OR Stock falls below strike price, nevertheless you would exercise your put and would get strike price because of your guarantee to receive the price for a share of stock.
   • Covered Call
     • Firstly, you own a share, then you sell a call option, with a strike price of the same value and a call option of $3. If the stcok stays below the price, it is going to be worthless and you collect the $3 premium you received from selling the call option. If the stock price rises you have to deliver the stock for the original price. Therefore, the worst thing that could happen is to sell the stock at exercise price, because you already own the stock.
     • Naked Call = selling call options on stock you do not own. Unlimited potential losses.
   • Spreads
     • Option trading strategy involving two or more call options OR two or more put options.
   • Straddle = Combination

6. Strengths of the BS-Model

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