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Financial Engineering principles - Beaumont P.H.

Beaumont P.H. Financial Engineering principles - Wiley publishing , 2004. - 318 p.
Download (direct link): financialengineer2004.pdf
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PRODUCTS, CASH FLOWS, AND CREDIT
For example, a settlement that is agreed to be next day means that the securities will be exchanged for cash on the next business day (since settlement does not occur on weekends or market holidays). Thus, for an agreement on a Friday to exchange $1,000 dollars for euros at a rate of 1.10 using next day settlement, the $1,000 would not be physically exchanged for the ˆ 1,100 until the following Monday.
Generally speaking, a settlement day is quoted relative to the day that the trade takes place. Accordingly, a settlement agreement of T plus 3 means three business days following trade date. There are different conventions for how settlement is treated depending on where the trade is done (geographically) and the particular product types concerned.
Pretty easy going thus far if we are willing to accept that the market’s judgment of a particular asset’s spot price is also its value or true worth (valuation above or below the market price of an asset). Yes, there is a distinction to be made here, and it is an important one. In a nutshell, just because the market says that the price of an asset is “X” does not have to mean that we agree that the asset is actually worth that. If we do happen to agree, then fine; we can step up and buy the asset. In this instance we can say that for us the market’s price is also the worth of the asset. If we do not happen to agree with the market, that is fine too; we can sell short the asset if we believe that its value is above its current price, or we can buy the asset if we believe its value is below its market price. In either event, we can follow meaningful strategies even when (perhaps especially when) our sense of value is not precisely in line with the market’s sense of value.
Expanding on these two notions of price and worth, let us now examine a few of the ways that market practitioners might try to evaluate each.
Broadly speaking, price can be said to be definitional, meaning that it is devoid of judgment and simply represents the logical outcome of an equation or market process of supply and demand.
Let us begin with the bond market and with the most basic of financial instruments, the Treasury bill. If we should happen to purchase a Treasury bill with three months to maturity, then there is a grand total of two cash flows: an outflow of cash when we are required to pay for the Treasury bill at the settlement date and an inflow of cash when we choose to sell the Treasury bill or when the Treasury bill matures. As long as the sale price or price at maturity is greater than the price at the time of purchase, we have made a profit.
A nice property of most fixed income securities is that they mature at par, meaning a nice round number typically expressed as some multiple of $1,000. Hence, with the three-month Treasury bill, we know with 100 percent certainty the price we pay for the asset, and if we hold the bill to maturity, we know with 100 percent certainty the amount of money we will get in three months’ time. We assume here that we are 100 percent confident
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Cash Flows
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that the U.S. federal government will not go into default in the next three months and renege on its debts.1 If we did in fact believe there was a chance that the U.S. government might not make good on its obligations, then we would have to adjust downward our 100 percent recovery assumption at maturity. But since we are comfortable for the moment with assigning 100 percent probabilities to both of our Treasury bill cash flows, it is possible for us to state with 100 percent certainty what the total return on our Treasury bill investment will be.
If we know for some reason that we are not likely to hold the three-month Treasury bill to maturity (perhaps we will need to sell it after two months to generate cash for another investment), we can no longer assume that we can know the value of the second cash flow (the sale price) with 100 percent certainty; the sale price will likely be something other than par, but what exactly it will be is anyone’s guess. Accordingly, we cannot say with 100 percent certainty what a Treasury bill’s total return will be at the time of purchase if the bill is going to be sold anytime prior to its maturity date. Figure 2.1 illustrates this point.
Certainly, if we were to consider what the price of our three-month Treasury bill were to be one day prior to expiration, we could be pretty confident that its price would be extremely close to par. And in all likelihood
3-month Treasury bill
Maturity date.
Cash flow known with 100% certainty.
Purchase date. Cash flow known with 100% certainty.
FIGURE 2.1 Cash flows of a 3-month Treasury bill.
'If the government were not to make good on its obligations, there would be the opportunity in the extreme case to explore the sale of government assets or securing some kind of monetary aid or assistance.
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PRODUCTS, CASH FLOWS, AND CREDIT
the price of the Treasury bill one day after purchase will be quite close to the price of the previous day. But the point is that using words like “close” or “likelihood” simply underscores that we are ultimately talking about something that is not 100 percent certain. This particular uncertainty is called the uncertainty of price.
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