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Classification of Financial Instruments

Written by Andreas Lindberg

Paper category

Master Thesis


Business Administration>Finance




Master Thesis: Fair value hierarchy explanation As mentioned in the introduction, the fair value hierarchy consists of three levels, which correspond to the input levels used in the valuation method. From level 1 (price is considered the most accurate for fair value) to level 3, where fair value is based on inputs that are not directly observable, which may result in less accurate fair value. Since financial entities strive to report at the highest level in the hierarchy, the decision tree provided is very general. It is a product of loosely defined supervision and because the valuation of different financial instruments varies with the input parameters used. Must be Each tool category draws more different boundaries. 4.2 Pricing methods and financial products reviewed In this paper, the financial instruments investigated and their respective main valuation techniques are introduced below. The instruments considered are bonds, floating rate notes, interest rate swaps, total return swaps, currency swaps, futures/forwards, ordinary European options, automatically redeemable structured products and Asian options. 4.2.1 A bond is an issued product that can be paid by one or the issuer to the buyer in several sums. The fair value price of a bond can most easily be described as the sum of all discounted cash flows [10]. Therefore, the price can be calculated, where BP is the present value of the bond, ck is the cash flow of time step k (usually equal to the face value of the bond at the last payment iek=n), and dki is the discount factor corresponding to a specific time. It can be obtained from the market The observed zero interest rate rk calculates the discount factor as the expiry time of the specified observation. 4.2.2 Floating rate notes Floating rate notes (FRN), or bonds that pay variable coupons, are an advantageous tool because they have limited interest rate risk. Quote margin. The general bond price is calculated according to the above formula 4.1, in which the coupon is paid each time according to changes in future interest rates. Future interest rates or also known as forward interest rates can be derived from market data by interpolating between given interest rates for different periods. The forward interest rate F(Tt;T) between the maturities Tt and T can be continuously compounded from the interest rate (0;Tt) and r(0;T) as the spot interest paid on the face value of the bond in each accrual period. The payment is made on the payment day, and the final payment is the face value payment. Therefore, the present value of the bill can be calculated using Equation 4. 4.2.3 Interest rate swaps Interest rate swaps usually trade floating interest rates and fixed interest rates (fixed for floating), or very common, floating for floating interest rate swaps. As mentioned in Section 4.2.2, floating interest rates will change over time, so the present value of swaps will change with changes in interest rates [6]. The present value VPV of the fixed-to-floating swap of the party paying the floating interest rate can be expressed as [6] VPV=BfixedBFloat. In the case of two floating interest rates, the floating-to-float is expressed as [6] VPV=BFloat1BFloat2 Bond price according to formula 4.1 Calculate, using a discount factor obtained through a fixed interest rate or a floating interest rate. 4.2.4 Currency swap Currency swap between parties is a common method for hedging risks or exchanging favorable conditions between parties who wish to borrow from parties in different markets. Their respective markets and the advantages of local companies in the local market. The most commonly used pricing method for this agreement is based on the local zero interest rate, and in the initial agreement, the value of the swap is usually zero unless it is in a possibly different OTC swap. The present value of ordinary currency swaps can be regarded as the difference between the bonds on the exchange market and the bonds converted into the corresponding currency at the current exchange rate. The following is the present value of fixed-for-fixed swaps, including foreign payments and local payments [6]. VPV=BFY0BL and Y0=CurrFCurrL where BF is the bond value of foreign currency cash flow, BL is the bond value of the local currency, and Y0 is the current spot exchange rate between currencies, so the present value of the formula is based on the foreign market. 4.2.5 Futures/forward futures or forward contracts are agreements between the two parties to buy or sell commodities at a specific price in the later stage[6]. If the contract includes an asset that pays dividends, the future price is calculated as F0=S0ert, which will produce a price described as F0= (S0I)ert: where I is the sum of future dividend payments discounted during the contract period, if there is a continuous dividend formula Expressed as F0=S0e(rq)t where qi is the continuous compound interest dividend yield, S0 is the current price of the commodity, and F0 is the current futures price. For a long forward contract, the price can be calculated as f= (F0K)ert, and for a short forward contract, it can be calculated as f= (KF0)ert where Kwould is the execution price (that is, the agreed buying price and selling price )short). .2.6 Total Return Swap A total return swap is a swap between two parties in which one party pays the total return on assets (such as stocks or indexes, including the income generated and any capital gains), and the other party pays a fixed or floating interest rate return . For financial entities that are interested in asset returns but do not directly want to own assets, swaps may be of interest. Read Less