Embedded Financing: The Unsung Virtue of Derivatives

Abstract

In theoretical derivatives pricing models, such as those for equity options, the interest rate is often simply specified as r, a fixed constant rate on a “bond” with no default risk. Rates must be treated as stochastically time varying for interest rate derivatives, but still, little attention is paid to the “financing rate.” Tuckman points out that this oversimplifies what happens in the real world. The proper financing rate to use in pricing a given derivative, and especially in setting up an arbitrage trade against the underlying, depends on the specific market practices the trader will face regarding collateral requirements, securities lending terms, and the availability of long-term financing markets (or lack of them). In theory, buying a bond in the cash market and “putting it out on repo” should yield the same payoff as a forward contract on the bond. But this requires financing the bond over the lifetime of the trade, which is rarely possible at a rate that is fixed ex ante for the whole period. The cash market transaction, financed by rolling over short-term repo loans, entails financing risk that the equivalent forward contract does not have. Embedded financing is an important, and frequently overlooked, benefit of derivatives.

TOPICS: Options, fixed income and structured finance