Loans with Rights of Notice

In order to valuate loans with rights of notice, you must create them as generic transactions.

An example could be a loan with an original term of 15 years on which notice can be given after 10 years with a notice period of 6 months.In order to valuate the loan, you must split it into two transactions: A long loan and a European short call on the loan with the term end date 10.5 years in the future.The term start date is 01/01/2002, the currency is EUR.The Prerequisite and Example sections demonstrate how to create the generic transaction.

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This division is not completely correct from a business perspective, as it assumes that no right of notice exists after 10.5 years, although legally the right could still exist.The option price determined from this division is therefore only the lower limit of the actual price of the right of notice.The upper limit for the right of notice could be determined by moving the exercise date for the option to the final due date of the loan.

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You use the Complex OTC Option elementary transaction in order to depict the loan with a right of notice as a generic transaction.The system currently supports only European-style exercise for this option.It is not currently possible to accurately calculate the price of this kind of option with American-style exercise.

Note that as from Release EA-FINSERV 200 you have the option of modeling notice options as exercise opportunities (Bermuda option) within a generic transaction.

Prerequisite

In order to create the generic transaction, you must have created the disbursed loan in Treasury and the corresponding financial object must exist.For more information, see Creating a Loan Contract and Editing Financial Objects .

Procedure

The following hierarchy of elementary transactions is required in order to depict the loan with a right of notice as a generic transaction.

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Create the hierarchy as follows:

Create a new generic transaction.See Editing Generic Transactions for the procedure.

In the dialog structure, select the first elementary transaction and assign to it transaction form 200 (complex financial transaction).

Select the elementary transaction again.The system displays a tab page.

Enter the start of the term of the underlying loan in the Start of term field.

Create a transaction with transaction form 401 (reference to ID number) under the Complex Financial Transaction elementary transaction.To do this, select the Complex Financial Transaction elementary transaction in the dialog structure and choose Create Elementary Trans. on Next Level . Select the new elementary transaction and assign to it transaction form 401.

The system displays a tab page.

Enter the object number of the underlying loan in the Original Trans . field.You can use input help to select the loan.

Create a transaction with transaction form 62 (OTC option) under the Complex Financial Transaction elementary transaction.(Proceed as for step 3).

The system displays three tab pages.

Enter the following information on the Header Information tab page:

Start of term field.

Start date of term of loan.

Notification By/End Date of Term field

Earliest possible date for giving notice on the loan.

Purchase/Sale field

Set the indicator to sale (option is a short call).

On the Options Information tab page, flag the option as a standard option with European exercise and, in particular, as a call option.Enter the following information:

Strike Currency field

Currency of loan.

Delivery of Underlying field

Earliest possible date for giving notice on the loan.

Quotation of Underlying field

Percentage quoted.

You do not need to make any entries on the Cash Flow tab page.

Create a transaction with transaction form 401 (reference to ID number) under the Complex OTC Option elementary transaction.(Proceed as for step 3).

The system displays a tab page.

Enter the object number of the underlying loan in the Original Trans . field.You can use input help to select the loan.

Choose Back and then Save .

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Note that, once you have created the generic transaction, two financial objects may exist for the loan: One for the original transaction and one for the loan with the right of notice as a generic transaction.You must deactivate either the analysis parameters (RM) in the financial object for the original transaction, or the analysis parameters (RM) in the financial object for the generic transaction.

Result

You have created the loan with a right of notice as a generic transaction.

Example

You would enter the following data for the generic transaction for the loan in the example.The tables below show what entries need to be made in the individual fields for each elementary transaction.

Complex Financial TransactionElementary Transaction

Tab Page	Field	Example of Contents	Comment
Header Information	Start of Term	01/01/2002	The term start of the underlying loan

Complex OTC OptionElementary Transaction

Tab Page	Field	Example of Contents	Comment
Header Information	Start of Term	01/01/2002	The term start of the underlying loan
Header Information	Notification By/End Date of Term	07/01/2010	Notice can be given on the loan after ten years and six months (notice period) at the earliest.
Header Information	Purchase/Sale	200	Sale
Options Information	Option Category	001	Standard option
Options Information	Exercise Type	1	European exercise
Options Information	Put/Call Indicator	2	Call
Options Information	Strike Currency	EUR	Currency of loan
Options Information	Delivery of Underlying	07/01/2010	In our model, the underlying is delivered on the exercise date. This is the earliest possible date on which notice can be given – after ten years and 6 months.
Options Information	Quotation of Underlying	1	Percentage-quoted

This graphic is explained in the accompanying text.

The tab pages may also contain other fields.You do not need to make entries in fields that are not included in this table as they are not relevant for valuating the generic transaction.