at shareholder meetings and be able to claim dividends.
There are a standard set of financial transactions where the underlying entity is equity. So we can buy futures, options and swaps on equities. These are described in this chapter for those products. The fact that the underlying entity is equity does not change the cashflows of these trades. The only difference is that at the end of, say, a physical equity option, one may be left holding equity and at that point the dividend cashflows will apply. Whereas, had the option been on silver, one may be left holding silver and there would not be any dividends.
3.8 Bond spot
For a fuller description of bonds, see section 4.4. As for equity, we need to distinguish from whom we are buying the bond.
If we buy it from someone other than the issuer, it is a standard spot trade. We receive a bond and can redeem the coupons on the bond for cash from the issuer (but not from the counterparty).
We are therefore going to examine the cashflows when we purchase a bond directly from the issuer. The various parameters of a bond which determine the time and size of its cashflows are set by the issuer at the time of issuance. It is possible to create a huge variety of different bonds by varying these parameters, but there are some characteristics common to all bonds. If we purchase a bond, we give up some cash (the purchase price) and receive a financial instrument that obliges the issuer to pay us cash (by redemption of a coupon) at a time or various times in the future. Bonds have a:
■ notional amount – this is used to determine the size of each coupon
■ schedule of coupon dates
■ redemption – this is the final cash amount we receive (aside from any coupons) at the maturity of the bond.
We have restricted the illustration of cashflows to three common types: a fixed coupon bond (Figure 3.10), a floater (Figure 3.11), and a zero coupon bond (Figure 3.12).
Figure 3.10 Cashflows on fixed bond
Figure 3.11 Cashflows on floating bond
Figure 3.12 Cashflows on zero coupon bond
Perhaps the simplest type of bond is one that pays fixed coupons. Here all the cashflows are known at the outset of the trade. We give the issuer the purchase price at the start of the trade and they pay fixed coupons at periodic intervals until the bond reaches maturity. At that time, they pay the last, fixed coupon plus the redemption amount which is set at 100 by convention.
A floating coupon bond (also known as a floater) pays a coupon based on a reference entity. The coupon is fixed just prior to the due date in the same manner as swap fixings described above. Hence we know the time when coupons will be due, but we do not know the amounts until just before payment.
A zero coupon bond pays no coupons. We pay the purchase price at the start and receive the redemption at the end so there are just two, fixed cashflows.
3.9 Option
Options are discussed in section 5.2. Here we shall discuss the cashflows related to the purchase of an option. Remember that the value of an option is very different from the cashflows. The value diagrams are also in section 5.2.
The basic mechanics of purchasing an option are the payment of a fixed premium at the start of the trade and the possibility of a payout at some future time, depending on how market prices change relative to an agreed fixed price, known as the strike.
A European option can, by definition, only be exercised at one time in the future. This means the time of the payout cashflow is known from the start. Whether there will be any payout at all and the size of the payout, cannot be known until the exercise date.
American options can be exercised at any time up to the final exercise date (effectively the close of the trade). Therefore both the time and the size of the payout cashflow are completely unknown. The buyer can exercise at any time or not exercise at all.
Options can be either physical or cash. Figure 3.13 shows the payout in black, representing a physical return should the option be exercised. A cash option would calculate the value of the physical underlying entity at payout and convert that amount to cash, so nothing other than cash would be exchanged.
Figure 3.13 Cashflows on an American option trade
Note that options can be applied to most asset classes. For example, a physical equity option, if exercised, would pay out in shares. A physical commodity option would pay out in some commodity, such as cocoa beans or palladium. This is a good example of how a financial product transcends the asset class and has the same features and cashflows across all asset classes.
3.10 Credit default swap
A credit default swap (CDS) is a contract between two parties referencing an entity or asset: a buyer of protection, also known as the seller of risk; and a seller of protection also called the buyer of risk.
A simple example would be:
JPMorgan buys protection from Banco Santander referencing Ford Motor Credit (Ford Motor Credit is the reference entity). The contract would have a specific term, say five years; an agreed notional amount, say USD 10m; a pre-agreed premium, typically called the ‘CDS spread’, say 800bp = 800 basis points = 8 % per annum – so the annual premium is approximately 10m × 800/10,000 = USD 800,000 per annum; an agreed list of ‘credit events’; and other details including payment method on a credit event.
A credit event triggers the termination of the contract and a capital payment. Typical credit events include bankruptcy, failure to pay, or restructuring of outstanding debt. In the context of credit derivatives, the term ‘default’ is often used to mean ‘credit event’ (in contrast, ‘default’ for bond assets typically only means failure to pay).
When a credit event occurs, the seller of protection pays either:
■ physical settlement: USD 10m in return for USD 10m notional of Ford Motor Credit debt; or
■ cash settlement: a net sum representing USD 10m less the value of Ford Motor Credit debt in the marketplace.
In summary, a CDS is an insurance policy. Generally the purchaser of insurance pays a sum of money at regular periods and these payments are known as premiums.
The seller (or writer) of a CDS will only pay out in the event of a default which is determined by a legally defined event or events. Once default has been triggered the whole trade ceases and no more premiums are paid. That is why only the first premium is shown as a solid line in Figure 3.14 because it is bound to occur, while the others are depicted as dotted lines.
Figure 3.14 Cashflows on CDS
The amount and time of payment are impossible to know at the start of the trade hence the striped rectangle of possible times and amounts.
