FO CASE Q

The exercise of employee stock options usually leads to new shares being issued by thecompany and sold to the employee. This changes the amount of equity in the capitalstructure. When a regular exchange-traded option is exercised no new shares are issued andthe company’s capital structure is not affected

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A protective put consists of a long position in a put option combined with a long position

in the underlying shares. It is equivalent to a long position in a call option plus a certain

amount of cash. This follows from put–call parity:

A bear spread can be created using two call options with the same maturity and different

strike prices. The investor shorts the call option with the lower strike price and buys the call

option with the higher strike price. A bear spread can also be created using two put options

with the same maturity and different strike prices. In this case, the investor shorts the put

option with the lower strike price and buys the put option with the higher strike price

A butterfly spread involves a position in options with three different strike prices (K1, K2,

and K3). A butterfly spread should be purchased when the investor considers that the

price of the underlying stock is likely to stay close to the central strike price, K2.

A subprime mortgage is a mortgage where the risk of default is higher than normal.

An ABS is a set of tranches created from a portfolio of morgages or other assets An ABS CDO is an ABS created from particular tranches of a number of diferent abs

Agency cost is a term used to describe the costs in a situation where the interests of two parties are not perfectly aligned. There were potential agency costs between the originators of mortgages and investors. And employees of banks who earned bonuses and the banks themselves.

Typically an ABS DO is created from the BBB-rated tranches of an aBS. This is because it is difficult to find investors in a direct way for the BBB-rated tranches of an ABS.

A moderately high default rate will wipe out the tranches underlying the ABS CDO so that the AAA-rated tranche of the ABS CDO is also wiped out. .A moderately high default rate will at worst wipe out only part of the AAA-rated tranche of an ABS.

If the initial spread between the five-year Treasury note and the two-year Treasury note were 2% (i.e., 6% - 4% = 2%), and you expected it to widen, then your strategy should be to buy the spread (expecting it to rise) by selling the five-year Treasury note (hoping its price would fall) and purchasing the two-year Treasury note (hoping its price would rise). 

If the spread between the five-year Treasury note and the two-year Treasury note rose to 3% (i.e., 5% - 2% = 3%), then you would earn net profits on the trade, regardless of whether the yield curve rose or fell. Because of the 1% decline in yield on the five-year Treasury note (i.e., from 6% to 5%), the price of this note would rise, thereby incurring losses on your short position. As a result of the 2% decline in the two-year Treasury note yield (i.e., from 4% to 2%), the price of this note would rise, thereby creating profits on your long position. Net gains would result from the spread position because the gains from the price increase caused by the 2% decline in the two-year Treasury note yield would more than offset the losses from the price increase caused by the 1% decline on the five-year Treasury note yield.