The settlement values are worked out as above but now, as the
index has declined in value, the fund manager must pay the interest
value plus the value of the fall in the index.
This has the effect of making the impact on the portfolio similar to
what would have happened had the fund manager purchased the
stock. In quarter one, the interest that was received on the cash was
paid away; if the manager had purchased stock there would have
been no interest received by the fund. The manager received the
monetary value of the change in the index and so the portfolio has
reflected a gain just as it would have done had the stock been pur-
chased. A similar situation occurs each quarter.
The terms of the swap are of course negotiable between the fund
manager and the broker. For instance, the value of the index change
could have incorporated the dividend stream or the interest terms of
LIBOR –10 basis points (bps) may have been agreed to reflect a
notional dividend amount. Also the principal amount of £5 million
may remain constant and any balance settled as shown in the exam-
If the terms are that the principal amount rises or falls in line
with the index movement then in our example above, for the second
quarter the principal amount would have been £5 million plus the
net settlement and both the index value and the interest settlement
would have been based on that amount.
Over-the-counter options are often called ‘exotic’ because, unlike the
standardised exchange-traded product, they possess additional char-
acteristics that change the relatively simple Call and Put outcomes.
As the terms are negotiated they are of course very flexible.
Common OTC options include:
• Calls and Puts with specific amounts and duration, for example
a £1 million, two-year Call option on the FTSE 100 Index at a
strike of 6005.2 (exchange-traded FTSE 100 Index options on
Euronext.liffe are listed with nine-month duration and a fixed
unit of trading and strike prices).
• Interest Rate Guarantee (IRG) is an option on a FRA.
• Swaption is an option on a swap.
• European, American and Bermudan style options which have
different exercise characteristics, i.e. expiry, any time, specific
OTC products 103