Financial Derivatives

Paper Summary:

This paper explains that the Black-Scholes method is a very famous method for the valuation of an equity share and other variables related to the value of an equity share in the future months. The author points out that the key characteristics needed for the Black-Scholes formula are the price and price volatility of the underlying stock, coupled with the available rate of return on a risk free stock, under the assumption that trading in the concerned stock, along with the ability for exercise of the option, is continuous and unrestricted. The paper relates that credit derivatives are mechanisms for the credit institutions to separate the credit risk from their loans and treat market risk as a separate category so that their pricing efficiency could be more competitive and the concerned organizations could be more competitive in the market.

From the Paper:

"One can even buy securities at low prices on a forward basis. Generally, these are used in a manner similar to bonds which have a benchmark of comparable maturity. Thus, a bank may buy from an investor an option on the credit spread of a BBB-rated corporate bond which has a maturity after 5 years. For this, a premium will have to be paid. At the same time, the bank will have the right to sell the bond to the investor at a certain strike price. This strike price is in terms of a difference with treasury notes, and if the actual spread on the date of maturity of the deal, is more than the strike rate specified, then the option will not be used. If the actual difference is higher, then the bond may be purchased."

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