Home, first-time buyers, mortgages

The Deed as Evidence of Ownership

admin — Wed, 27 May 2009 08:52:13 +0000

A deed represents evidence of ownership of real estate. Thus, it is the instrument by which a real estate owner acknowledges transfer of the property to a new owner. There are two kinds of deeds that are customarily used in conveying land: warranty deeds and quitclaim deeds.
•    Warranty    Deeds. A warranty deed usually contains the phrase, “and warrants the title thereto.” Such a deed contains covenants (assurances or guarantees) of title that impose contractual liability upon the grantor (person transferring title). Typical covenants are: 1) that the seller had an estate free of adverse claims in fee simple with the right and power to convey, 2) that the property was free from encumbrances of liens except those listed on the deed, and 3) that the buyer will have quiet and peaceable possession and the seller will defend title against all persons lawfully claiming it. A warranty deed actually conveys no more title than does a quitclaim deed. However, if a warranty deed is used, the grantor may be held liable if the title is limited, defective, or encumbered. For example, if the property being conveyed by warranty deed is mortgaged and the deed is not made subject to the mortgage, then the grantor may be personally liable for any damages suffered by the grantee (person receiving the title). Such liability of the grantor may even extend beyond the grantee to subsequent grantees. The warranty deed also assures the grantee that if the grantor did not have title at the time of delivering the deed, but should later acquire title, then the grantee will thereby receive all of such title.
• Quitclaim    Deed. A quitclaim deed indicates that the seller is conveying whatever rights he possesses in the property to the buyer but does not promise that the seller owns anything. Such a deed does not obligate the grantor beyond his present ownership. If the grantor has no interest in the property, none will be conveyed. A quitclaim deed contains the words “and quitclaim” as a usual term in the granting clause of the deed. It is possible to insert in the quitclaim deed an additional clause by which the grantor obligates himself to convey all interest, if any, which he may thereafter acquire in the land. This would accomplish one of the additional protections of a warranty deed but would not help the buyer if the seller never acquired title.
• Purpose    of    Recording    a    Deed. Deeds should be recorded, not for the purpose of giving them validity, but to give notice of their contents and effects to all the world. To be recorded, the deed should be acknowledged with a declaration that the grantor personally appeared before a public officer, such as a notary public, and certified that the deed was voluntarily signed by the grantor. Deeds are recorded in the County Clerk’s office of the county in which the land is located.
• Importance    of    Delivery. Sometimes a grantor will sign a deed covering land which he or she wants to keep until death expecting the deed to be the method by which title to the land is transferred. Instead of delivering the deed directly to the grantee, the owner places the deed in a safety deposit box or among private papers. Undelivered deeds like these are commonly called “dresser drawer deeds.” Such deeds are invalid because they were not delivered to the grantee or his or her agent during the lifetime of the grantor. Delivery    is    necessary    to    accomplish    a    conveyance    by    deed.
Unless the deed is drawn and executed in the form of a will (which would be extraordinary and unusual), it could not become legally effective without delivery of the deed to the grantee or his agent. One alternative for handling this problem is for the grantor to retain a life estate for himself and transfer a remainder interest to the person he wants to own the property after death. At death, the property would automatically pass to the remainder-man. This may, however, present problems in terms of potential conflicts between the life tenant and remainderman regarding management of the property.
The deed could also be delivered to an escrow holder, who acts independently of both the grantor and grantee, with instructions that the escrow holder is to deliver the deed to the grantee upon the completion of certain acts or the happening of a certain event. In such a case, the law regards the date when the deed was delivered to the escrow holder as the effective date of the delivery, which makes the deed valid. The law would not pay any attention to the date when the deed was physically delivered to the grantee and, therefore, it would not make any difference if the grantor were dead at the time when the grantee received the deed. Escrow transactions are frequently used to overcome the risk of a grantor’s death pending the closing of a prolonged real estate transaction or one involving installment payments extending over many years.
The key to effective delivery of a deed is that the grantor must presently transfer legal control over the deed to the grantee or an independent third party. If the grantor retains a right to change his mind, then control has not been presently transferred. Because of the potential legal problems that may arise in using this type of device in estate planning, it is especially important to obtain legal advice. An alternative planning tool may better meet your needs with less risk of legal challenge.
If a mortgage covers the property to be transferred, the grantor (transferor) should keep in mind that liability for the debt remains unless a release from the lender is obtained.

New floor

admin — Tue, 19 May 2009 20:48:20 +0000

This time I would like to share something more personal with you. Finally, after too much time I left my family nest, bought a decent flat and started living on my own. Things are going just great. Nobody bothers me and I can do whatever i want. The flat is cosy and that’s enough for now. However, I have a small problem with the floor in my living room and so I think that the best idea would be to buy a new one. I’m considering Carpet One’s Laminate flooring as it seems to be the best value for the money. Moreover, it is very aesthetic and seems quite durable. So what say you? would that be a good idea?

Co-ownership

admin — Tue, 19 May 2009 08:51:23 +0000

One piece of property can also have two or more present owners, rather than being owned by just one individual. Co-ownership can be for real property as well as personal property. In legal language, it is owned “in undivided interests.” There are three types of such co-ownership: tenancy-in-common, joint tenancy with the rights of survivorship, and tenancy by the entirety. The type of co-ownership affects:
1. Who will inherit property
2. How it will be taxed for estate tax purposes
•    Tenancy-in-Common. Tenants-in-common have undivided interests in the same land. Two or more persons may be owners in undivided interests as tenants-in-common. Tenancies-in-common are frequently created by the laws of inheritance. For example, if a widow with two children owns a farm and dies without a will, the two children will each own an undivided one-half interest as tenants-in-common.
There is no right of survivorship between tenants-in-common. Each tenant-in-common can sell or devise (will) his share. For example, if two married brothers own 320 acres as tenants-in-common and one brother dies, his one-half interest would pass to his heirs and be included in his estate for estate tax purposes. It would only pass to the surviving brother if he were an heir designated to receive the property.
If two or more persons own property jointly, it is normally presumed that they own as tenants-in-common unless the deed or title documents clearly indicate that a right of survivorship was intended.
•    Joint    Tenancy. The owners are called “joint tenants.” The joint tenants do not have to be husband and wife. When one joint tenant dies, his or her undivided interest is distributed equally among the surviving joint tenants. This is the characteristic peculiar to joint tenancy, and is referred to as “right of survivorship.”
Under Oklahoma law3 a joint tenancy can be created by the present owner deeding property to himself or herself and another as joint tenants or by a third party transferring property to two or more persons in a deed that specifies they will own as joint tenants. Use of words “and/or” alone is insufficient to create joint tenancy. Since some institutions or firms do not rigidly follow the law in this respect, it is best to review and decide with your legal counsel how titles should be held for bank accounts, savings and loans, bonds, stocks, insurance policies, and automobiles. Inadequate or improper wording may result in unnecessary litigation or additional estate taxes. A common abbreviation designating joint tenancy, as used here, is “J.T.W.R.O.S.,” meaning joint tenancy with rights of survivorship.
A joint tenant can sell or mortgage their interest, but cannot dispose of it by will. If a husband and wife own real property as joint tenants and the husband dies, the wife takes full ownership to the exclusion of the children. It is possible for the joint tenancy to be broken by one joint tenant conveying his or her interest outside the existing joint ownership.
For estate tax purposes, generally the entire value of joint tenancy property is included in the estate of the first joint tenant to die, but it may be reduced by the proportionate value contributed by the survivors.4 There is an exception for gifts of joint tenancy property to a spouse which occurred after December 31, 1976. See post “Taxing Joint Tenancy Property.”
•    Tenancy    by    the    Entirety. Tenancy by the entirety is a type of joint tenancy between husband and wife that is characterized by the fact that neither party can sever it without the consent of the other. Upon the death of one, the survivor acquires title to the property. This type of ownership is similar in nature to joint tenancy. Therefore, it is recommended that the deed or contract specifically refer to tenancy by the entirety if this type of co-ownership is desired.

PREVAILING RISK ATTITUDES

admin — Thu, 14 May 2009 20:47:56 +0000

An efﬁcient mental risk-return calculus is a critical component for business success under uncertainty.
. . . the overall risk perception held by the public is often worse than reality. Risk management can assist you in making more proﬁts in areas where over-conservative investors stay out. The upside is that, if risk is really low, your rivals will be over-valuing the risk. The downside is that, if risk is really higher than you think, you will stand to pay the price of the risk hazard or damage.
The efﬁcient portfolio theory and mainstream mathematical models only set a basic foundation for analysis; they do not represent the risk management goal itself. Thus, they can become inclined to set a level of return that is not proportionate to an acceptable level of risk. We have seen that investors and managers often inadvertently end up being risk-seeking.
Sophisticated ﬁnancial modelling can lead companies into a false sense of security where theory has not been adequately back-tested to check if it conforms to reality. Thus:

they have lower assessment of the risk probability and impact;
the impact of worst-case scenario is less dramatic than imagined;
the maximum return is potentially higher than thought;
such phenomena of risk misperceptions are often observed in practice, but not always admitted.

Weak banks and companies that are more prone to failure have inherent shortcomings such as a CEO and board that are likely to embark on unsuitable strategic missions. Reputation and prestige of the guilty party, as we have seen in the Credit Lyonnais case, may be enough to stop adequate risk management exercises taking off in the ﬁrst place.
Furthermore, the internal checks and balances offered by the oversight board may have been overidden, so defects in the company’s structure are prevalent.
At the lower organisational level, there will be risk management weaknesses that allow major errors to occur. The Leeson or Rusnak cases are examples of a failure to incorporate suitable control elements. Financial modelling errors are examples of less glaring unintentional mistakes in risk management.
Setting up a departmental risk management function will monitor a risk hazard, and train staff. Under the trend of short-termisim in career and instant gratiﬁcation, there are limits to how much passive personnel watching can achieve.
It is traditionally incumbent upon the industry watchers and regulators to monitor the operations and losses on a “watch list”, then to sound alarm bells. Yet, this corporate warning is too late for many shareholders. The auditors are meant to perform a regular ﬁnancial health-check, as is done before a merger or acquisition.

CHECKING CORPORATE FUNDAMENTALS

admin — Fri, 08 May 2009 20:46:03 +0000

We can revisit the traditional series of steps of the investment processes that extend from the John and Mary Smiths, to the bankers and fund managers, i.e. every reasonable investor. The diagram of investment project parties involved is used as a building block for demonstrating how the stakeholders interact in a basic model. In the orthodox models, the steps of managing business investment decisions are sequential. We can insert reality checks that focus upon risk to keep our risk-return view balanced, put back in question at every phase, leading if necessary to a complete revision of investment projects. Let us see these phases in turn:
1. Formulate a business plan.
2. Match the risk appetite to the risk offer.
3. Due diligence, not least to manage reputation risk.
4. Risk support and methodology.

INSTINCT VERSUS ABILITY

admin — Mon, 04 May 2009 20:43:21 +0000

The ﬁnance industry’s basic instinct focuses on hiring the best performing stars, and that may include closing eyes to certain work or character defects. One error is that the “star” bank trader or fund manager is really a shooting-star, one that burns up and disappears from sight. Empirical results show that there is only a tiny core of fund managers who are truly stars. These stars are surrounded by the ephemeral satellites who will slip down the market performance stakes. Hiring these satellites at their peak is to risk underperformance, and even fund losses. Reputational risk is once again means sticking your neck on the block. Banks that realise this stand a better chance of succeeding because their risk perception is correct. Investment banks that held on to a large staff with high salaries and higher bonuses in a down- turn put their balance sheets on the line. Those that shed staff and cut payroll fast put their reputation at danger, being seen as a “bank with a problem”, but their ﬁnancial strength remains.
Mortgage banks that lend money out at low interest rates and high leverage are in this market risk scenario on a different playing ﬁeld. The fact that the loan is secured on collateral (the property) may be irrelevant – the real estate value can have dived disastrously. “No problem, we can always redo the property.”
The American early 1980s S&L banking failures underlined the danger of such lax risk perception. We have to adopt realistic risk attitudes about the ﬁnance game.
The use of RAROC to test individual lines comes across as a good start to justify the investment. RAROC enables a company to ask if it is really making an acceptable return for the risk from each particular business line. It is a fundamental question that is worth asking whether to:

remove (reduce capital)
reinforce (more capital)
stay in the business line
or get out of the business.

The ﬁnancial regulatory authorities hope that Basel II will eventually force banks and ﬁnancial companies to report real trading losses. RAROC and similar tools are designed to develop richer proﬁt and loss accounts, not cosmetic trading ﬁgures to appease the regulators and shareholders.
One of the problems that bedevil banks and funds is the uneven standards of institutional practices. The media have tended to focus so far on fraud and rogue trading, even when this is in the minority of losses. The FSA and London Stock Exchange warns that “previous performance is not a guarantee of future . . . ”
Yet, we are constantly faced with inspecting the value of the track record; poor traders or managers continue where they are protected by the mantra of their previous performance. These professionals have prided themselves upon their skill in recruitment and due diligence, their greater ability to sift out between good and unacceptable customers or staff. Unfortunately, banks’ hiring and due diligence errors have subjected them and their shareholders to signiﬁcant operational and reputational losses that have ﬁnancial costs. The Basel Committee reported deﬁciencies in international banking due diligence know-your-customer (KYC) policies. KYC policies in some countries have signiﬁcant gaps and in others they are non-existent. Even among countries with well-developed ﬁnancial markets, the extent of KYC robustness varies.
Thus, the Western economies with a long history of developed banking sectors also have large room or exposure for due diligence errors. This risk needs to be rectiﬁed.

The Move Towards Paper-based (Fiat) Money

admin — Fri, 01 May 2009 20:41:57 +0000

What do gunpowder and pasta have in common? According to the Chinese both of these were invented in China long before they appeared in the West. It is generally accepted that the earliest use of paper money was in China more than 1000 years ago towards the end of the Tang dynasty. These were issued by private banks but backed by the state. The use of the paper currency reduced the need to transpor t silver to make payments. This paper was effectively a form of negotiable IOU or promissor y note. The holder of the note could present it to the issuer and receive the stated weight of silver in return.
While Italians may dispute this version of histor y as it relates to pasta they can at least claim to have laid the foundations for the modern banking system in the sixteenth centur y. This was the perfect scam because while the per petrators proﬁted no-one was obviously hurt through their system provided it worked as intended. The per petrators were respected (or at least rich) goldsmiths.
Goldsmiths had to keep quantities of gold on their premises in the form of raw material, work-in-progress and ﬁnished products. This gold had to be kept in a secure place and yet be readily accessible. This allowed them to provide a ser vice to rich merchants and landowners to store their gold. They were able to offer one of the earliest safekeeping, or custody, ser vices to their customers. Customers would deliver their gold, usually in the form of coins, to the goldsmith who would issue a receipt for the gold. The receipt represented a claim on this stored gold. The goldsmith would return the gold when this receipt was presented.
A merchant who had to pay a supplier would present his receipt to the goldsmith, take the gold and then make the payment. The supplier would then take the gold back to the goldsmith for safekeeping and receive a receipt in turn. Over time customers realized that it was safer and more convenient to make large payments using these receipts as the medium of exchange. Two issues had to be resolved. The ﬁrst was that the receipts presented were genuine and represented real claims. The second was that the goldsmith would, and could, honor these claims. The ﬁrst issue was resolved through the use of wax seals. The second issue depended largely on the reputation of the goldsmiths and perceptions of their integrity and solvency. Over time the gold receipts increasingly displaced gold coins for the settlement of large payments. Coins continued to be used to settle smaller transactions and to make up any difference between the value of the receipts and the required payment. As an aside, these early forms of paper money can be viewed as an asset backed bearer security but by convention it is usually referred to as cash.
These developments led to the adoption of the equivalent of paper money but it did not involve either the creation of money or the establishment of a banking system. These required a leap of imagination. It is difﬁcult to believe this innovation emerged from a committee but the name of the original visionary has been lost in the mists of time. As will become clear goldsmiths had ever y incentive to keep the workings of this system to themselves.
On any given day the amount of actual gold withdrawn by customers was normally only a very small propor tion of the gold that had been deposited with the goldsmith. It became clear that some of this stored gold could be lent out without the knowledge of the depositors. The latter were not concerned whether the coins they received on presentation of their receipt were those initially deposited – only that their value (weight) was the same.
The borrowers rarely withdrew gold itself but instead were issued receipts that acted as a negotiable currency just as those issued to the actual depositors did. The goldsmiths agreed terms and conditions for these loans with the borrowers. The latter paid interest on these loans. The nominal value of receipts circulating in the economy exceeded the value of the gold held by the goldsmiths. In this way money was created.
The system had two potential weaknesses. The ﬁrst was that the goldsmiths might get greedy and lend out too high propor tion of the gold they held leading to a high level of receipts circulating in the system. This in turn could result in people star ting to question whether the goldsmiths could meet their claims. If enough people with a claim on the goldsmith presented his or her receipts at the same time the goldsmith would be unable to meet all of the claims. The system only worked if depositors were conﬁdent that their claims would be met.
The second weakness arose from borrowers who took their loans in the form of gold and subsequently defaulted. This was a real risk when borrowers included kings using such loans to ﬁnance wars and merchants buying goods abroad to be shipped home for resale. Members of the ﬁrst group were at risk from losing their war or being held for ransom, the second of their ship sinking or being attacked by pirates and losing their cargo.
The banking system created by the goldsmiths was unregulated, there were no legal reser ve or capital adequacy requirements, for example. There was no form of depositor protection provided by the likes of the US Federal Deposit Insurance Cor poration (FDIC). It also still relied on the backing of a commodity (gold) with an intrinsic value.
We now have the basis for the modern money system but we need to get rid of the convertibility into gold. We have already discussed some of the practical problems with using gold as a currency such as the tying up of resources to produce and store it that could be better used elsewhere. This is not the major problem, however, which lies in the realm of macroeconomics. By linking the domestic currency to gold a countr y’s money supply is effectively constrained by gold supply. Although there have been periods when gold supply has risen much faster than the real economy, such as happened in Spain, the supply of gold is relatively ﬁxed. In an expanding economy an insufﬁcient level of money supply growth will lead to disinﬂation, higher unemployment and a lower level of real output. This link can be broken by prohibiting gold withdrawals. This would effectively mean that no-one would know whether the gold was there or not! Policy makers could then determine money supply as deemed necessar y by economic conditions.
These problems are, however, ampliﬁed by trade when countries have their own currencies linked to gold. This results in the adoption of what is known as the gold standard and results in a ﬁxed exchange rate system. If holders of sterling were entitled to exchange a £100 note for one ounce of gold and the holders of US dollars could exchange $200 for one ounce this would force a ﬁxed exchange rate of £1 for $2.
Under a gold standard countries with a trade deﬁcit (where the value of their expor ts in terms of gold was less than the value of their impor ts) settle this difference by transferring gold to those countries with a trade sur plus. The outﬂow of gold leads to a fall in money supply in those countries with a deﬁcit and lower prices making expor ts more competitive as a result. Inﬂows of gold at creditor nations result in increased money supply, higher prices and less competitive expor ts. As a result of these two pressures the trade balance tends to equilibrium. Higher trade levels result in higher overall output and trade has expanded much more rapidly than economic output since the time of the industrial revolution. The demand for exchange currency has hence grown much faster than the supply of gold. The only way for this demand to be satisﬁed is for prices to fall, and again leads to higher unemployment and a lower output level than would otherwise be the case.
A gold standard puts policy makers into a straitjacket with no effective means to determine or inﬂuence money supply other than through trade tariffs and other barriers that reduce the level of trade. The last attempt to operate using a global ﬁxed exchange rate system failed in 1974 and today few seriously countenance the return to either a ﬁxed exchange rate system or a gold standard.

PUBLIC STANDARDIZED TRANSACTIONS

admin — Tue, 28 Apr 2009 11:52:59 +0000

A private transaction is not generally reported in the news or to any price-reporting service. Forward contracts are private contracts. Just as in most legal contracts, the parties do not publicly report that they have engaged in a contract. In contrast, a futures transaction is reported to the futures exchange, the clearinghouse, and at least one regulatory agency. The price is recorded and available from price reporting services and even on the Internet.’ We noted that a futures transaction is not customized. In a forward contract, the two parties establish all of the terms of the contract, including the identity of the underlying, the expiration date, and the manner in which the contract is settled (cash or actual delivery) as well as the price. The terms are customized to meet the needs of both parties. In a futures contract, the price is the only term established by the two parties; the exchange establishes all other terms. Moreover, the terms that are established by the exchange are standardized, meaning that the exchange selects a number of choices for underlyings, expiration dates, and a variety of other contract-specific items. These standardized terms are well known to all parties. If a party wishes to trade a futures contract, it must accept these terms. The only alternative would be to create a similar but customized contract on the forward market.
With respect to the underlying, for example, a given asset has a variety of specifications and grades. Consider a futures contract on U.S. Treasury bonds. There are many different Treasury bonds with a variety of characteristics. The futures exchange must decide which Treasury bond or group of bonds the contract covers. One of the most actively traded commodity futures contracts is oil, but there are many different types of oil.’ To which type of oil does the contract apply? The exchange decides at the time it designs the contract. The parties to a forward contract set its expiration at whatever date they want. For a futures contract, the exchange establishes a set of expiration dates. The first specification of the expiration is the month. An exchange might establish that a given futures contract expires only in the months of March, June, September, and December. The second specification determines how far the expirations go out into the future. For example, in January of a given year, there may be expirations of March, June, September, and December. Expirations might also be available for March, June, September, and December of the following year, and perhaps some months of the year after that. The exchange decides which expiration months are appropriate for trading, based on which expirations they believe would be actively traded. Treasury bond futures have expirations going out only about a year, Eurodollar futures, however, have expirations that go out about 10 years.3 The third specification of the expiration is the specific day of expiration. Many, but not all, contracts expire some time during the third week of the expiration month.
The exchange determines a number of other contract characteristics, including the contract size. For example, one Eurodollar futures contract covers $1 million of a Eurodollar time deposit. One U.S. Treasury bond futures contract covers $100,000 face value of Treasury bonds. One futures contract on crude oil covers 1,000 barrels, The exchange also decides on the price quotation unit. For example, Treasury bond futures are quoted in points and 32nds of par of 180. Hence, you will see a price like 104 21/32, which means 104.65625. With a contract size of $100,000, the actual price is $104,656.25.
The exchange also determines what hours of the day trading takes place and at what physical location on the exchange the contract will be traded. Many futures exchanges have a trading floor, which contains octagonal-shaped pits. A contract is assigned to a certain pit. Traders enter the pits and express their willingness ta buy and sell by calling out and/or indicating by hand signals their bids and offers. Some exchanges have electronic trading, which means that trading takes place on computer terminals, generally located in companies’ offices. Some exchanges have both floor trading and electronic trading; some have only one or the other.

A BRIEF HISTORY OF FUTURES MARKETS

admin — Sat, 25 Apr 2009 11:51:47 +0000

Although vestiges of futures markets appear in the Japanese rice markets of the 18th century and perhaps even earlier, the mid-1800s marked the first clear origins of modem futures markets. For example, in the United States in the 1840s, Chicago was becoming a major transportation and distribution center for agricultural commodities. Its central location and access to the Great Lakes gave Chicago a competitive advantage over other U.S. cities. Farmers from the Midwest would harvest their grain and take it to Chicago for sale. Grain production, however, is seasonal. As a result, grain prices would rise sharply just prior to the harvest but then plunge when the grain was brought to the market. Too much grain at one time and too little at another resulted in severe problems. Grain storage facilities in Chicago were inadequate to accommodate the oversupply. Some farmers even dumped their grain in the Chicago River because prices were so low that they could not afford to take their grain to another city to sell.
To address this problem, in 1848 a group of businessmen formed an organization later named the Chicago Board of Trade (CBOT) and created an arrangement called a “to-arrive” contract. These contracts permitted farmers to sell their grain before delivering it. In other words, farmers could harvest the grain and enter into a contract to deliver it at a much later date at a price already agreed on. This transaction allowed the farmer to hold the grain in storage at some other location besides Chicago. On the other side of these contracts were the businessmen who had formed the Chicago Board of Trade.
It soon became apparent that trading in these to-arrive contracts was more important and useful than trading in the grain itself. Soon the contracts began trading in a type of secondary market, which allowed buyers and sellers to discharge their obligations by passing them on, for a price, to other parties. With the addition of the clearinghouse in the 1920s, which provided a guarantee against default, modem futures markets firmly established their place in the financial world. It was left to other exchanges, such as today’s Chicago Mercantile Exchange, the New York Mercantile Exchange, Eurex, and the London International Financial Futures Exchange, to develop and become, along with the Chicago Board of Trade, the global leaders in futures markets.

Premiums and Values of Traded Options

admin — Mon, 20 Apr 2009 19:58:42 +0000

The asymmetric nature of returns with regard to the price of the underlying instrument, and mirror image of returns to the holder and the writer, mean that options have a value to the holder even if the current stock price is below the call option’s strike price or above the put option’s strike price. The holder of such an option should be able to sell the option for a cer tain amount to a third par ty. This is referred to as the option’s premium. The price of a traded option can be broken into two par ts, its intrinsic value and its life or time value:
Intrinsic value. The intrinsic value is simply the proﬁt that would be realized if the option was in-the-money and exercised. The intrinsic value is zero when the option is either at-the- money or out-of-the-money.
Life or time value. In addition to the price of the underlying instrument there are three factors that determine the value of an option’s premium, the volatility of the price of the underlying instrument, time to expiration and the level of interest rates.
Time. The longer the exercise period the greater the value of the option’s value. This is pretty obvious. If the option is out-of-the-money and expires next week there is less oppor tunity for the bond’s price to rise above that of the strike price than if it expires in six months.
Volatility. The value of the bond will var y with changes in the yield cur ve. The more volatile that interest rates are the more volatile will be the bond’s price. Higher volatility is good for option holders due to the asymmetric nature of returns relative to the bond’s price. If the bond price falls below the strike price it doesn’t matter if it falls a little or a lot as we won’t exercise the option in any event. If the bond’s price rises a lot our proﬁt on exercise will be much greater than if it only rises a little.
The writer (or seller) of an option is paid a premium by the holder (buyer) of the option. This price may be lower or higher than the value implied from option valuation models.
The option’s premium also varies with the level of interest rates but this is far less signiﬁcant as a factor than either time or volatility. Its effect is also far more subtle and difﬁcult to explain simply. For our pur poses it is sufﬁcient to note that the level of interest rates does affect an option’s value and leave it at that for now.
The ﬁrst of the following two char ts shows the traded and intrinsic values of the above call option plotted against bond price. The following characteristics are wor th noting:
The value of the premium falls as the option moves deep into or out-of-the-money.
When the option is either deep in-the-money or deep out-of-the-money its value varies with that of the bond’s price.
The second char t shows the rate of change in percentage terms of the option’s traded value against the bond’s price. In the context of this chapter this has little signiﬁcance but we will be picking up on this in Par t III when we look at trading strategies and risk management. This has the following impor tant characteristics:
The rate of change of the option’s value does not var y in a linear way with bond price.
The rate of change is greatest when the option is close to being at-the-money and
The rate of change reverses direction at a par ticular bond price. Char ts of the ﬁrst form, which plot the price of one instrument against a single factor (in this case bond price), are sometimes referred to as delta char ts. Risks resulting from changes in the price against this factor are referred to as delta risk.