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Derivative Notes

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Definitions

A. Option Contract- Obtain rights in exchange for

monetary transfer

a. Call- right to purchase underlying security at a

specific price

b. Put- right to sell

c. American vs. European Option

d. Writer- seller of option contracts.

B. Futures Contract

a. Delivery of a specified good by the seller for

payment of an agreed amount at some fixed future

date.

b. Both sides of an obligation

c. Cash does not change hands between buyer and

seller until delivery.

C. Option on futures Contract- Option to buy or sell a

futures contract. Allows for standardization of underlying

asset.

D. Swaps- Exchange of cash flows between two parties.

Generally fixed for flexible.

E. Arbitrage-Simultaneously purchase and sell the same

good at different prices. Forces prices to converge.

Why these markets are valuable

a. Modification of risk-return opportunity set.

a. Hedging- reduces risk of holding the underlying

asset

b. Speculation- highly levered portfolio that is

easily obtainable.

displayed in an organized market.

c. Provides for more efficient markets by creation of

arbitrage opportunities.

Variables that describe an options contract.

1. Type (put, Call)

2. Underlying asset (IBM, GE etc)

3. Exercise or strike price

4. Expiration date

5. Example IBM March 85 call

1.

2.

3.

4.

Stock Index Options (15%)

Commodity Options (5%)

Futures Options (5%)

1. Options traded in 3-month cycles with up to 2 adjacent

months.

2. Generally 3 to 5 dates traded at one time

Need choices for spreads and various risk trade-offs.

Also want liquidity.

3. Strike prices in $2.50 increments till $25/share then $5.00

increments

4. New strikes prices open up as prices change.

5. 100shares/option

Open Interest

2. Up if both buyer and writer are establishing new

position.

3. No change if either side is liquidating position

4. Down if both sides are liquidating position

5. example

Market Mechanics

1. Exchange Floor participants

a. Floor brokers- Commission traders who cannot

trade for own acct.

b. Market makers- Trades only for own account

c. Order Book Official- Keeps track of all limit orders

2. Clearing house

a. Matches buyers and sellers each day.

b. Assigns writer in delivery process.

c. Serves regulatory function (sets position limits,

guarantees writer performance etc.)

3. Exercise procedure

a. Buyer has right to exercise.

b. Writer is assigned obligation from clearing house

c. Options expire on 3rd Friday of delivery month.

All outstanding options with value are exercised

at that time.

d. Opening rotation - starts earliest month low

strike to high. May take as long as 10 minutes to

establish prices.

Introduction to Valuation

Terminology

1. Intrinsic value

a. Call = Security Price minus Exercise Price

if positive otherwise 0.

b. Put = Exercise Price Security Price if

positive otherwise zero.

2. Time value = Observed option price minus its

intrinsic value.

3. In-the-money = option with positive intrinsic

value

a. Stock price > exercise price for calls

b. Stock price < exercise price for puts.

4. Out-of the money = intrinsic value is zero.

5. At expiration an Option is always worth its

intrinsic value.

Graphical depiction.

1. Maximum value for put but not for call

2. Minimum value zero for both given limited

liability of option.

3. See graph

Notation to be used

1. S = Stock price

2. E = Exercise or Strike Price

3. T = Time till Expiration

4. i = Risk Free interest rate.

5. C = Call Price

6. P = Put Price

7. PV( ) = Present Value of whats in Parenthesis

Assumptions

1. Call options will be considered first

2. More is preferred to less

3. No taxes or transactions costs

4. American Option unless otherwise specified.

5. No Dividends

Proposition 1.

C > 0 this is the minimum call price

Proof:

Since there is limited liability for the option

it can never be worth less than zero at

expiration. Therefore it cant be worth less

than zero today.

Proposition 2.

C > Max (S-E ,0) Call must be worth its intrinsic

value.

Proof:

If not buy option and exercise.

Example

S = 25 E = 20 C = 4

Buy Option -4 Must pay for the option

Exercise

-20 Must pay for the stock

Sell Stock +25 market price

Profit

+1

Graph of new boundary

Proposition 3.

C(E1) > C(E2) given E1 < E2. Lower exercise

price worth at least as much as higher exercise

price all else equal.

Proof:

Consider a portfolio of buying E1 option and

selling E2 option.

Look at all possible portfolio values at

expiration.

1

S* < E1 < E2 E1

C(E1) = 0

= S* - E1

C(E2) = 0

= S* - E2

Port = 0

2

3

< S* < E2 E1 < E2 < S*

C(E1) = S*- E1

C(E1)

C(E2) = 0

Port = S*- E1

C(E2)

Port =

E2 E1

Therefore since portfolio will never have

negative value at expiration it cant have

negative value today which it would if C(E1) <

C(E2). If it did you could buy the portfolio today

collect the cash flow and never have to pay it

back.

Also since the maximum value of the port at

expiration is E2-E1, the maximum difference is

price has to be the present value of E2 E1. If

bank. Bank value at expiration will be greater

than E2 E1, which is the most you will have to

pay at expiration.

Show on Graph.

Proposition 4.

C(T2) > C(T1) given T2 >T1. Options with a

longer time to expiration cannot have less value.

Proof:

At expiration time T1, C(T1) = max S*- E or 0

and from Prop 2. C(T2) must be worth at least

the same so it has to be worth at least the same

today.

Proposition 5.

C<S

Proof:

Stock can be considered an option with infinite

time to expiration and zero expiration price.

From Prop 3 and 4 its must be worth at least as

much as any option.

Proposition 6.

its discounted intrinsic value.

Proof:

Consider two portfolios:

Port A: Own a Call

Port B: Own stock

Borrow PV(E)

Compare all possible values of each portfolio at

expiration

S<E

S >E

Port A

C =0

C= S*- E

Port B

S= S*

S=S*

Must pay back E

Must pay

back E

S*- E <0

S*- E

Port A more valuable

Portfolios have

equal value

Therefore, since at expiration Portfolio A will

always be worth at least as much as Portfolio B,

it must be worth at least as much today.

Example of an arbitrage situation:

C = 3, S =55, E = 50, PV(E) = 49

Call is below discounted intrinsic value which is

$5.

Buy Call 3 (Buy Port A) today

Sell Stock +55 and Lend $49 = -49 (Sell Port B)

today

Positive cash flow of 55-49-3 = $3 today.

Since we know the call will be worth at least the

other two at expiration we keep the $3 and

maybe more if S*<50.

Implications

1. longer time to maturity implies higher

lower boundary since PV(E) is smaller i.e

S- PV(E) larger.

2. higher interest rate implies higher lower

boundary.

Same reasoning.

4. both shift lower boundary to the left in graph.

Variables determining Intrinsic Value

1. Exercise Price

Negatively related to call price

2. Stock Price

Positively related to call Price

Time Value

3. Interest rate

Positively related to Call price

Think of owning a call as not having to purchase stock

till some future date. Therefore higher interest rate

implies larger savings.

4. Volatility

Positively related to Call Price

Profit on gain but limited liability on loss.

5. Time to maturity Positively related to Call price

Better chance to profit on gain and more savings by not

having to buy till later.

Show relationship movements on Graph.

Proposition 7:

Given on Dividends, never exercise an American Call early.

Proof:

If exercised buyer receives intrinsic value i.e. Max(0, S-E)

However before expiration from Prop 6

C > Max (0, S PV(E)) which is greater than intrinsic

value. Therefore never exercise early.

Hence American Call price = European Call Price

positive time value before expiration and exercising foregoes

that value.

Proposition 7:

If Stock pays dividend an American Call may be exercised

early.

Proof :

Stock price falls on ex-dividend by the amount of the

dividend. However, since option holder is not stockholder, he

does not receive Dividend. Therefore, if dividend is greater

then time value left in the option, he is better off exercising

right before ex- dividend since lost time value will be less

than lost intrinsic vale from stock price decline.

Example:

S = 52 E =50 Company will pay $1 dividend tomorrow.

There is $.50 of time premium left in option.

If not exercised option will be worth $1.50 tomorrow.

Therefore, better off getting $2.00 today.

If Time premium was $1.25 no need to exercise since option

is worth $2.25.

Put Propositions

Proposition 1:

P>0

Proof: Do to limited liability cannot be worth less than zero

at expiration.

Proposition 2:

P > Max (E-S, 0) Put must be worth its intrinsic value.

Proof:

If worth less buy option and exercise.

Example

S = 22 E = 25 P =2

Buy Put

-2

Buy Stock

-22

Exercise

+25 buy delivering stock

Profit

+1

Graph boundary

Proposition 3:

P(E1) < P(E2) given E1 < E2

Same as call example by forming portfolio of buying P(E2)

and Selling P(E1).

Look at all possible portfolio values at

expiration.

1

2

3

S* < E1 < E2 E1 < S* < E2

E1 < E2

< S*

P(E1) = -(E1- S*) P(E1) = 0

P(E1) =

0

P(E2) = E2 - S*

P(E2) = E2- S*

P(E2)

=0

Port = E2 - E1

Port = E2- S*

Port =

Therefore since portfolio will never have

negative value at expiration it cant have

negative value today which it would if P(E1) >

P(E2). If it did you could buy the portfolio today

collect the cash flow and never have to pay it

back.

Also since the maximum value of the port at

expiration is E2-E1, the maximum difference is

price has to be the present value of E2 E1. If

not sell P(E2) buy P(E1) and put proceeds in

bank. Bank value at expiration will be greater

than E2 E1, which is the most you will have to

pay at expiration.

Show on Graph.

Proposition 4:

P(T2) > P(T1) given T2 >T1. Options with a

longer time to expiration cannot have less value.

(American options only.)

Proof:

At expiration time T1, P(T1) = max E - S* or 0 and from

Prop 2. P(T2) must be worth at least the same so it has to be

worth at least the same today.

Proposition 5:

P < (E) Put cannot be worth more than its exercise price.

Proof:

Since stock minimum is zero maximum put intrinsic value is

E. Therefore it cannot be worth than E at expiration or worth

more than the Present value of E today. (American Option).

Graph.

Proposition 6:

P > Max ((PV(E) S) , 0)

Proof:

Consider Two portfolios

Portfolio A : Own a put

Lend PV(E) amount of cash

Compare all possible values of both portfolios at expiration

S<E

S >E

Port A

P = E S*

P= 0

Port B

Stock = -S*

same as before

Gets E back

E S* for both

Port A more

valuable

Since 0 > E-S*

Show graph

This boundary is less restrictive then intrinsic

value boundary. Proposition shows a negative

component to the time value of a put.

Implications

1. longer time to maturity implies lower

boundary since PV(E) S* is smaller than

E-S*.

2. higher interest rate implies lower

boundary.

Same reasoning.

both shift lower boundary to the left in

graph.

Variables used to determine the Put Price

Variables determining Intrinsic Value

1. Exercise Price

Positively related to Put price

2. Stock Price

Negatively related to Put Price

Time Value

3. Interest rate

Negatively related to Put price

Think of owning a call as not having the proceeds from

selling the stock until some future date. Therefore

higher interest rate implies larger foregone income.

4. Volatility

Positively related to Put Price

Profit on gain but limited liability on loss.

5. Time to maturity

related to Put price

Better chance to profit on gain but more foregone

income buy not selling stock till later.

Proposition 7:

An American Put may be exercised early.

Proof:

If (E S)(FV) > E-S* then you are better off

exercising today because value at expiration is

greater than max value on Put.

Doesnt hold for call since max value does not

exist.

negative component of time value dominates to

positive component. This happens if there is

certainty that E S* will occur at expiration. In

this case owning a put will always give you the

same payout as selling stock and lending so its

better to get the funds today.

Show on graph

For European options

P = C S +PV(E)

Proof:

Consider the following Portfolios

Portfolio A: Own a Put

Portfolio B: Own a Call

Sell Stock

Lend PV(E)

Consider all possible portfolio values at

expiration

S* < E

Port A:

Port B

P = E S*

C= 0

S = -S*

Get E back

Port B value E - S*

Both Ports same value

same value

S*>E

P=0

C = S* -E

S = -S*

Get back E

Port B = 0

Both Ports have

then they must be worth the same today. If not

buy port with less value and sell one with higher

value.

Implications

1. If S=E Call will be worth more than Put.

Both options only have time value and

Call value is higher.

2. May not hold for American options. Why?

Index Options

Underlying Asset

1. Consists of a portfolio of securities

2. Gives purchaser to right to purchase an

amount of dollars equal to the index value

multiplied by some multiplier.

3. Example

a. S &P 500

b. Nasdaq 100

4. Exercise procedure consists of cash settlement

as determined by multiplying the intrinsic

value at the close of trading by a given

multiplier.

a. Example

b. OEX 450 Call with S* = 456.50. Cash

settlement would be $6.50 * 100 = $650.

c. Can be difficult to create cash position in

an arbitrage.

Extra Risks with cash settlement

1. Timing risk Writer doesnt know of exercise

till the following day.

i. Cash settlement in effects liquidates

position in the market.

ii. Buyer can announce intent to deliver for

about a half hour after the market closes.

iii. Therefore, if news comes out after the

close buyer has option to liquidate

position before the opening the next day.

iv. Not true with stock options since stock is

received upon exercise

v. Example

1. Index value = 246 a 240 C = 7 at

the close of trading.

2. Bad news comes out on the market

and the Index value is expected to

go down 2 points on the open.

3. Can liquidate now and get $6 will

only be worth about $5 or so

tomorrow ($4 of I.V. $1 T.V.)

so you still take the loss.

2. Early exercise risk during trading hours.

i. Option may trade below its intrinsic value

during trading hours without pure

arbitrage available.

ii. Because intrinsic value is not determined

till the end of trading that day.

iii. Example

Price

Beginning assumptions

1. Perfect capital markets (no taxes, transactions

costs, etc)

2. No dividends

3. Risk free interest rate known and constant

4. Distribution of stock price movements known

5. European option

6. Two possible outcomes for every period in

time

Steps in determining no arbitrage option price

1. From portfolio theory since options and stock

are perfectly correlated a risk free portfolio

can be created.

2. Buy stock and sell calls or buy stock and buy

puts.

3. Assume there is one-period till expiration

a.

Observe possible stock and option

combos at expiration that yields the same

value for both states of nature. (Sell calls

and buy puts)

b.

Let S + - C+ = value if Stock price rises

c.

Let S - - C- = value if Stock price falls

d.

Find share of stock purchased per call sold

to equate both states. (Delta)S + - C+ =

(Delta)S - - Ce.

Delta = (C+ - C-)/(S+ - S-) Will always be

between zero and one.

f.

g.

can be discounted at risk free rate to find

portfolio value today.

Given stock price is known today can

solve for option price today.

4. Example

a.

S0 = $50, E = $50 Prices will rise or fall

50% next period. Risk free rate = 25%.

b.

Delta = (25 0)/ (75- 25) =

c.

Own one stock and sell 2 calls.

d.

Portfolio values at expiration are

i. 75 2(25) =25 or

ii. 25 2(0) = 25

iii. worth $25 no matter what state occur

e.

Value today is $25/(1 + .25) = $20

f.

$20 = S 2C =$50 2C or C =$15

g.

show one period tree

5. A pure arbitrage exists today if call does not

equal $15

a.

Say C=$10 then buy two calls sell stock

and lend $20.

b.

To

T1- T1+

i. Buy 2 calls -20

0

+50

ii. Sell stock +50 -25 -75

iii. Lend $20 -20 +25

+25

iv. Value

+10 0

0

v. Keep $10 for all states

c.

Do Opposite if C > $15

6. Observations

a.

Two assets can be combined to make a

third, therefore arbitrage forces

deterministic price.

b.

No investor risk preferences needed.

c.

Stock price is the only random variable

market risk does not matter.

d.

Probability of up and down movement not

used.

e.

Hedge ratio always between 0 and 1.

f.

Show graph from example.

7. Call price depends on the following variables

a.

Size of stock price movement (Vol ) S+

=80 and S- = 20 implies C = 17

b.

E = 60 implies C = 7

c.

Int rate = 20% implies C = 14.58

d.

Longer time to expiration (must look at

two period model)

8. Two- Period Model.

a.

Must start at expiration and work

backwards for each state of nature

b.

Show two period tree and example.

c.

Hedge ratio must be adjusted each period

9. One Period Put

a.

Combo is for purchase of stock and put

b.

From example S+ + P+ = (Delta) S- + Pc.

Delta = (P+ - P-)/ (S+ - S-)

d.

Delta = -25/50 = -1/2. Buy 1 stock and 2

puts

e.

Value at expiration is $75 in both states

f.

$75/(1.25) = $60 = S + (2)P = 50 =2(P)

g.

P = $5

11. General formula for n period binomial

a.

C = S x F(a,n,p) E x f(a,n.p)/(1 + r)n

b.

Where

i. F = binomial distribution function

ii. n = number of periods till expiration

iii. a = lowest # of up moves for call to

be in the money at expiration

iv. p = size of the up or down move

v. f(a,n,p) = hedge ration to be

readjusted each period.

Black- Scholes Formulation

Added assumption to binomial

1. Market operates continuously

2. Stock price movements are also continuous

3. Stock Price follows a log normal distribution

due to limited liability on the downside.

4. show graph

Value of a call is the Present value of expected cash

flows from holding option.

1. Find the expected area under the curve from

log normal distribution.

2. If cash flows can be evaluated at some end

point with specific boundary conditions then

the differential equation can be solved.

3. Relate to graph

e-rt .N ( d2)

1.

2.

3.

4.

5.

6.

7.

d1 = (log(S/E) + (r + .5 . var) (T))/ (Stand Dev. .

T1/2)

d2 = d1 ((s.d.) . T1/2)

T = Time to maturity in a fraction of a year

r = risk free rate

N (1.00) implies .8413 is Prob of a

standardized variable (z- stat) is under 1.00.

Show in graph

Interpretation of Equation

1. As variance goes to zero, N(d1), and N(d2)

approach one since Z score up.

C = S E e-rt

No volatility premium only time value of

money

Show on graph

2. N(d1) = hedge ratio or delta of position =

C/S

This is the slope of the line on graph.

Changes in S, T, or will change delta

i. S up implies delta up since N (.) up.

down depending on in or out of the

money

iii. up implies same could be up or

down

iv. r up implies delta up.

c. Rule of thumb is that delta is approximately .5

around PV(E).

3. Gamma = Delta / Stock price

Measure of portfolio stability

Positive gamma implies that delta up

when stock price up

Largest when stock price is around

exercise price.

Also becomes larger when Time to

expiration is shorter and stock price

around exercise price.

Becomes smaller when time to expiration

is shorter and stock price is not around

exercise price.

See graph.

4. Theta = C/T Also known as time decay

Multiply change in time by theta to get

price change

Considered negative for calls since calls

lose value over time.

Also not linear. Theta increases as

expiration approaches.

Most negative at the money.

5. Kappa = C/

price goes up

Also greatest at the money.

Put Valuation

1. Black-Scholes Model

a. P = C S + PV(E)

b. P = E . e-rt . (1- N ( d2)) - S . (1 -N (d1))

2. Put Delta = N(d1) 1

a. Same as call delta 1

b. Always negative

c. Call delta + absolute value of put delta

always equals one.

3. Put Gamma

a. Same as call gamma.

b. Always positive and largest at-the-money

4. Put Theta

a. Could be positive or negative.

b. Depends on the various time value

components

5. Put Kappa same as for calls

Other Uses of B/S Valuation model

1. Can get implied volatility of stock given option

price

volatility

3. Delta or Hedge ratio important to arbitrage

mispriced options.

Show real world examples of option characteristics

Problems with B/S in practice

1. Can only be used if life of option known

a. Problems with puts and calls with

dividends

b. Multi-period Binomial may be a more

accurate model

2. Must take dividends into account

a. Substitute S PV(div) for S into B/S

equation

b. Dividend must be known

c. Option must not be exercised early

3. Must continuously adjust hedge ratio to stay

risk free if arbitrage appears available.

4. What is true measure of Volatility?

Strategies

Background

1. Types of positions

a. Naked Purchase or sale of a single type

of option

b. Hedged- Portfolio of both underlying asset

and option

c. Spread- Purchase of one option and sale

of another

d. Combination- Portfolio containing both put

and call options

2. Profit graphs

a. Look at profits at expiration for various

potential stock prices

b. Profit on vertical axis Stock price on

horizontal.

c. Example Stock ownership

3. Analyze components before expiration (delta,

gamma, theta, kappa)

Naked Positions

1. Call Buying

a. Show expiration graph

b. Example S =49, E = 50 C = 3 Delta =.45

Gamma = .04

i. Max loss = 3

ii. Breakeven at expiration is S* = 53

c. Positive Delta, gamma, Kappa

money over time

e. Show todays graph

f. Which option to pick (exercise price and

time to exp.)

i. Lower exercise price implies less

leverage, more stable delta.

ii. Longer time implies greater premium

iii. Graph of different exercise prices

2. Call Writing

a. limited profit, relatively unlimited

downside

b. Show graph and previous example for

writer

c. Negative Delta, Gamma and Kappa.

d. Positive Theta i.e. the position makes

money over time.

e. I-t-m vs. o-t-m

3. Put Buying

a. Maximum loss, limited profit

b. Example E= 50 S = 49 P = 2 Delta = -.55

Gamma =.04

c. Show expiration day graph

d. Negative delta, Positive Gamma, Neg

Theta (Generally), Positive kappa.

e. Show todays graph

f. Time premium lower with puts.

g. In-the-money vs. out-of-the-money.

4. Put Writing

a. limited profit, relatively unlimited

downside

writer

c. Positive Delta, Negative Gamma and

Kappa.

d. Positive Theta i.e. the position makes

money over time.

5. Buying Stock

a. Show graph

b. Delta is always positive one, gamma is

zero theta is zero.

Synthetic Positions

1. Synthetic Long Stock

a. Buy call + sell put

b. Combine individual graphs

c. Example E = 50 S = 49 C = 2 P =2

i. Deltas must add to one

ii. Graph example

d. Smaller investment for synthetic

i. Implies must have smaller profit at

expiration

ii. Position will lose money over time.

Losses should equal the interest lost

on buying stock relative to buying

synthetic stock.

iii. Call premium is greater than put

premium.

2. Synthetic Short Stock

a. Sell Call + buy Put

b. Delta always equals 1.

shorting stock.

d. Graph

3. Synthetic Puts and Calls

a. They follow from Put-Call parity.

b. Buy Put = Buy Call and Sell Stock

i. Max loss is the premium on Call plus

(E-S)

ii. Example E= 50 S = 48 C=1

1. max loss is three at expiration

2. breakeven is at S = 47

iii. Difference between synthetic put and

actual is the interest earned on

selling the stock to create put.

iv. Show graph

c. Buy Call = Buy put + Buy stock

i. From above example maximum price

must the put be?

ii. Synthetic Call will be more expensive

since you have to borrow to buy

stock.

iii. Show graph

Hedged Positions

1. Covered Call Write (Write Call against Stock

Ownership)

a. Gives downside protection but limits

upside gain

b. Show expiration day graph

c. Example E=50 S=51 C=4 Delta = .55

i.

Breakeven is S =47

ii.

Go through example in detail.

d. Delta of position = Stock Delta (+1) Call

Delta

i. Delta goes from 1 to zero as stock

price rises

ii. What will of position do over time?

e. Gamma of position is negative since delta

down as stock price rises.

i. Position gets more bearish as prices

rise and more bullish as prices fall.

ii. Dont want a lot of movement

f. Theta is positive

i. Position makes money over time

ii. This is because we sold time

premium on the call.

g. Different exercise prices

i. O-t-m

1. higher max profit (allows stock to

appreciate)

2. higher breakeven ( Collect

smaller premium)

3. Example E= 55 S =51 C =1

4. Max profit = 5 B.E. is 50

h. Check volatilities to find best option

2. Protective Put (Put Buying with Stock

Ownership)

a. Limited liability with no Maximum profit

b. Show expiration graph

c. Example E = 50 S = 51 P = 1 Delta =

-.45

i. Maximum loss is 2

ii. Breakeven is S = 52

d. Delta of Position = stock Delta + put

Delta

i. Always positive between zero and

one

ii. .55 from example

e. Gamma is Positive (As stock price rises

put delta falls therefore position delta

rises).

f. Graph with todays position

g. Theta is negative

i. Position loses money over time

ii. Bought option so lose value over

time.

h. I-t-m vs. o-t-m same as for calls

3. Comparing Covered Calls and Protective

puts

a. Graphical comparison

b. From example can determine under what

various stock price each strategy

dominates

i. Calls max profit is 3 and Put max loss

is 2

ii. Therefore Calls will dominate

between S =44 and and S = 55

Puts otherwise

iii. Calls better for small movements

Puts better for large movement

iv. What happens as volatility of Stock

rises? Does it change your opinion?

Complex Hedges

a.

b.

a. Sell more than one Call against

stock ownership

b. Advantages and disadvantages over

simple covered call

i. Adds more premium income therefore

increase downside protection

ii. Creates exposure on upside because of

uncovered short call position

c. Construct expiration day graph for 2/1 ratio

i. Max Profit occurs where E = S

ii. Breakeven points for both upside and

downside

d. Example S = 49 C = 3 E = 50 Delta of Call

= .45

i. Max profit = 7 Downside breakeven

=43 upside Breakeven = 57

ii. Profits eared over a range

e. Delta of 2/1 position

i. Delta goes from +1 to negative one.

Near +1 if options are way out of

money. 1 if way I-t-m.

ii. From example the delta of position is

zero i.e. delta flat.

iii. Position becomes bearish as stock

prices rise and bullish as stock prices

fall.

f. Gamma

i. Negative since as stock prices rise delta

falls.

ii. Dont want movement in stock.

iii.

covered call since there are more

options

g. Theta is positive position makes money

over time

h. What happens with higher ratios?

2. Variable Ratio Write

a. Sell Calls with two different exercise prices

b. Maximum profit occurs over a range

between the exercise prices.

c. More stable than ratio write since gamma

is smaller especially around exercise

prices. Lower max profit since one option is

in-the-money and one is out.

d. Example and graph.

4. Ratio Put write

a. Sell stock and sell more puts

b. Same graph as ratio call write

c. Therefore same characteristics

d. Graph and example

5. Reverse Ratios have exactly opposite

characteristics

sale of another

1.

a. Buy low E sell high E

b. Always a debit transaction

c. Bull spread because it makes profit if

prices rise

d. Max profit and max loss

e. Example Buy C45 = 3 and Sell C50 = 1 S

=45

i.

Max gain = 3 and Max loss = 2

ii.

show graph

f.

Delta is Positive to neutral since lower E

has higher delta. ( Put deltas on

example position)

g. Gamma is neutral goes from slightly

positive to slightly negative

h. Theta also can be positive or negative.

Depends on whether low E or high E

option dominates

i.

O-t-m spreads more aggressive max

profit higher but need more movement

for profits. Delta is more positive.

2.

A.

Buy low E and sell

high E

B.

Credit transaction

C.

Same

characteristics as bull call spread

D.

Show graph

3.

Bear Spreads

a. Sell low strikes and buy high strikes

b. Profits if stock price fall

c. Cash inflow for calls outflow for puts

d. Graph

e. Delta negative, all others similar as bull

spreads.

4.

Butterfly Spreads

a. Uses three exercise prices

b. Combines a bull and bear spread

around the middle price

c. Buy low strike, sell 2 middle strikes and

buy high strike

d. Show basic graph

e. Example of call butterfly S =49 , C45 = 6

C50 = 3 C55 = 1

i.

Max loss at S = 45 is 6

6 + 1 =1

ii.

Max profit at S= 50 is 1

+ 6 1 =4

iii.

Graph example

f.

Delta is relatively flat. Goes from

slightly positive to slightly negative.

g. Gamma is also relatively flat

h. Theta depends on location

i.

Risk is low with limited profits. May

have high commission

j.

Reverse ratio buy middle E sell outsides

a. Buy Low E Calls and sell more high E Calls

transaction.

c. Graph

i. Below Low E keep proceeds

ii. Between low and high E keep

premium from high E and get return

on low E.

iii. Above High E, lose on uncovered call.

d. Example

e. Buy C50 = 5 and Sell two C55 = 2 where S =

54

i. Max loss at E =50 is 5 + 4 = 1

ii. Max gain at E = 55 is 0 + 4 = 4

iii. Draw graph

f. Delta of position goes from Positive to

negative

i. From example what is Delta/

ii. What is smallest delta from example

g. Gamma is negative for most of the

position

i. As long as neg delta from sales are

greater than delta from purchase

ii. When is gamma positive?

g. Theta is positive over most of the position

h. What happens as ratio increases?

i. Ratio spread vs. ratio write

i. No downside risk with spread

ii. No premium with stock so higher max

profits with ratio write

iii. No dividend with Spread.

7. Ratio Put Spread

a. Buy high E sell more low E

b. Graph position

c. Similar characteristics to Ratio Call spread

8. Reverse Ratio spreads (Backspreads)

a. Sell low E buy more high E

b. Maximum loss is at high E

c. Can flip example above

d. Graph

e. Characteristics are opposite to ratio

spreads.

f. Watch out for early exercise on in the

money options that are sold especially

with puts.

9. Time Spread

a. Sell Nearby option and buy Option with

longer time to maturity.

b. Cash outflow since longer term has higher

price.

c. Example E = 50 S=48 C(t1) = 2 C(t2) = 5

i. Max loss at T1 is equal to initial

investment since worst case is all

options have zero value

ii. Max Profit is uncertain because price

of C(T2) is not certain at T1.

d. Graph at expiration of nearby option

i. Max profit takes place at S* = E.

1. Since at prices below E keep

premium on nearby while

deferred increases in value as S

increases.

2. While at prices above E the

position loses dollar for dollar on

delta on deferred.

ii. Max losses at the tails

e. Delta could be positive or negative

f. Gamma is generally negative except in

the tails

g. Theta is generally positive except again in

the tails.

Combination Positions

a.

b.

1. Straddle

a. Buy a Put and a Call with the same

characteristics.

b. One will be in-the-money and one will be o-tm.

c. Max loss is S* = E since neither option will

have any value.

d. Example E = 45 S = 44 P =2 C = 2

i. Max loss is 4 at 45

ii. Show graph

e. Delta could be positive or negative. From

example?

f. Gamma Positive, Theta Negative, Kappa

Positive

2. Strangle

a. Different Exercise Prices of Put and Call

b. Less initial investment if both o-t-m but

max loss is greater.

c. Example of o-t-m strangle S= 37 C40 = 2,

P35 = 2

P40 = 4

40 since both options are worthless.

iii. Breakeven is at 31 and 44.

iv. Show graph

d. Example of I-t-m strangle S= 37 C35 = 4,

i. max loss between S* = 35 to 40 is $8

(initial Investment) - $5(value of put

plus call) = $3.

ii. Breakevens are 32 and 43.

iii. Show graph

iv. Compare the two.

Arbitrage Positions

1.Conversion (Buy stock and buy put, sell

call)

a. Position is simultaneously buying and

selling stock.

b. Profit if cost of position is less than the

present value of the exercise price.

c. Example S = 53 C50 = 5 P50 = 1

i. Cost of position is 53 5 +1 = 49

ii. At expiration position is always

worth 50

1. S* > 50 implies S* - (S*- 50) + 0

= 50

2. S* < 50 implies S* - 0 +(50- S)

= 50

expiration it must be worth the

present value of E today.

iv. Otherwise but position finance and

collect 50 at expiration for arbitrage

profit.

2.Reversal (Sell stock, sell put and buy

call)

a. Profit if credit from position is greater

than the present value of E.

b. Position will cost E at expiration for all

states of nature. Therefore if the credit

today plus interest on the credit held till

expiration is greater than E an arbitrage

profit exists.

c. Example

3.Debit Box Spread (Buy Bull call spread

and Bear Put Spread)

a. Buy low E and sell High E Call, and Sell

low E and Buy high E put.

b. Position must be worth the difference in

exercise prices at expiration. Therefore it

must be worth the present value of the

difference today. If less, then buy borrow

and collect value at expiration for a

profit.

c. Proof. Buy C50 ,Sell C60 , Sell P50 , Buy P60

i. If S*>60 call spread worth 10 Put

spread worth 0 at expiration

ii. If S* < 50 Call spread worth 0, Put

spread worth 10 at expiration.

two spreads worth 10 at expiration.

iv. Therefore position must be worth

the present value of 10 today. If less

than buy spread and borrow. Will

pay back less than 10 at expiration

and collect 10 for position.

4.Credit Box Spread (Buy Bear call Spread

and Bull Put spread)

a. Sell low E and buy High E Call, and buy

low E and Sell high E put.

b. Position must cost the difference in

exercise prices at expiration. Therefore it

must be worth the present value of the

difference today. If more , then buy lend

credit and collect value at expiration for

a profit.

c. Proof. Sell C50 ,Buy C60 , Buy P50 , Sell P60

i. If S*>60 call spread cost 10 Put

spread worth 0 at expiration

ii. If S* < 50 Call spread worth 0, Put

spread costs 10 at expiration.

iii. If 50 < S* < 60 then the sum of the

two spreads costs 10 at expiration.

iv. Therefore position must be worth

the present value of 10 today. If

more than buy spread and lend

credit. Will be worth more than 10 at

expiration and repay 10 for position.

I. Assumptions

A. Pure discount Bonds issued

B. No Dividends

C. Capital Structure Unimportant

D. Other B/S Assumptions apply

E. Let Vo = So + Bo

1.

Where Vo is the value of the

firm today

2.

So is the value of equity

today

3.

Bo is the value of debt

today

A.

B.

C.

D.

A. Consider equity an option with Exercise being

the face value of the debt and the time to

expiration the maturity date of the debt.

B. Intrinsic Value of So > ( V* - Bd , 0) Where Bd is

face value of debt.

C. Graph

D. Price today can be obtained from Black/Scholes

model.

1. So = Vo * N(d1) - Bd e-rt * N(d2)

2. Same characteristics as call option

3. Delta positive, Gamma Positive, Theta

Negative, Kappa Positive.

III. Value of Debt

A.

Intrinsic value of B = Min (Bd , V*) Either the

bond gets paid off or the debt holders get the

firm.

B.

Graph at expiration

C.Bond purchase could be considered as buying

the firm and writing a covered call to sell it back

at the face value of the debt.

D.

Can find Bo from total value and B/S

equation.

Bo = Vo - So

a.

= Vo - (Vo * N(d1) - Bd e-rt

b.

* N(d2))

= Vo * N(-d1) + Bd e-rt *

c.

N(d2)

E.Delta is Positive, Gamma negative Theta

Positive, Kappa Negative.

F. Show todays graph

IV. Implications

A. V* up implies B up and S up.

B. Vol up implies B down and S up.

i.

Especially around the exercise price

ii. Limited liability for stockholder, Max Profit

for bond holder.

iii. Shifts value from bondholder to stockholder

C. T down implies B up and S down

D.i up implies B down and S up.

V. Convertible Bonds

I.

Definitions

A.

by the seller for payment of an agreed

amount at some fixed future date.

1)

Both sides have an

obligation

2)

Everything but price fixed by

exchange

3)

Cash does not change hands

till delivery

B.

1)

Individual Agreement vs.

Organized Exchange

2)

Implies only futures markets

are standardized contracts.

3) Clearinghouse settles al futures contracts

4) Security Deposit vs. Marked-to-market

a. Must pay initial margin (1% to 10%)

b. Profits and losses marked-to-market

every day

C. Marked-to-market example and price paid at

delivery

1) Buy a futures contact promising to pay

$98,000 for $100,000 face value worth of

T-bonds.

2) Tomorrow value of contract becomes

worth $99,000

account. Seller has $1,000 debited.

4) If prices dont move again buyer pays

$99,000 at delivery. But costs $98,000

due to intermittent cash flow.

5) This procedure allows every contract to

be interchangeable. You dont have to buy

from original seller.

D. Margins

1) Initial is 1 to 10 percent

2) Maintenance margin is 60 to 80% of

original

3) Margins set by exchange and can change

E. Terminology

1. Long vs. short

2. Nearby vs. deferred contract

3. Basis (futures price minus the spot price)

F. Characteristics for a successful contract

1. Non- Perishable underlying asset

2. Standardizable quality

3. Large and widely held deliverable supply

4. Competitive cash market

5. Large number of potential hedgers

G. Types of contracts

1. Agricultural Goods (Only contracts till

1973)

2. Industrial and Precious metals

3. Financial

a. Foreign exchange

b. Government securities

c. Eurodollars

d. Stock Indexes

4. Raw materials (Heating Oil)

II. Mechanics

A. Participants

1. Hedgers Have or will have a spot

market position and wish to reduce the

uncertainty about futures prices.

2. Speculators No spot position

a. Scalpers (in and out of positions in a

few minutes)

b. Day traders (hold position

throughout the day)

c. Position traders

B. CFTC (Regulatory Body)

1. Evaluates new and existing contracts

2. Protect against market manipulation

Buy futures contract

a.

b. Own the deliverable supply

C. Clearinghouse

1. Matches buyers and sellers each night

2. Marks positions to market each night

3. Guarantees no defaults

4. Inspects and certifies the deliverable

supply

D. Primary markets

1. CME

2. CBT

4. COMEX

5. London International Futures Exchange

III. Economic Justification

A. Provides Information: Futures price conveys

info about expected Supply/demand

Conditions

B. Risk shifting through hedging

1. Separates price risk from operating risk

2. Shifts risk from hedger to speculator

a. Holder of spot is sell futures contracts

b. Want to hold later will buy futures

contracts

C. Increases market efficiency

1. No price risk implies firms can lower profit

margin

2. Reduces search costs for information

Valuation of Futures Contracts

I.

1. The value of futures and forward contracts

are initially

zero.

2. Price is some observable number used as a

benchmark to determine future value.

B. Value of a forward contract

1. At expiration time T, the forward price is

equal to the spot price.

F = the price of forward contract when

purchased.

3. Prior to Expiration: Vt = PV( Ft F) which is

the present value of the change in price

discounted by time to expiration.

C. Value of Futures Contract

1. At Expiration

a. Price is equal to spot price f t = St

b. Value = 0 as soon as daily mark-tomarket occurs.

2. Before expiration value reset to 0 after

daily m-t-m.

D. Forward vs. Futures Differences

1. No difference 1 day prior to expiration.

2. Otherwise difference is function of

movements in futures prices relative to

interest rate movements.

a. If interest rate is constant Forwards =

Futures

b. Otherwise relative prices depend on

correlation between movement in interest

rates and futures prices.

c. If Int rates and futures price are positively

correlated then futures are worth more

d. If opposite then futures are worth less.

e. Example

II. Pure Cost of Carry Model

Expiration

1. Storage Costs

2. Financing Costs (Interest charges on

Purchasing and holding asset till expiration)

3. Possible Transportation costs

4. Insurance costs

B. Cash to futures pricing relationship

1. f0,t < S0 ( 1 + Ct )T where

a. f0,t is the futures price today with

expiration time t

S0 is the spot price today

Ct are all carrying costs/period with T

periods till expiration.

b. Otherwise arbitrage from buying spot,

financing and selling futures contract

c. Example S0 = $400 (say gold)

C = 10%/ year

Six months till expiration

Futures contract = $440

Cost is $400 + 20 = $420 get $440

make $20

2. Similarly f0,t > S0 ( 1 + Ct )T must hold

a. Opposite presents arbitrage (buy f, sell

spot, lend)

b. Example if futures contract is $410

Assumes no restrictions on short sale

and can invest funds.

3. Therefore

f0,t = S0 ( 1 + Ct )T must hold

4. Similar relationship for relative futures

contracts

1. Bid-ask Spread and other direct transaction

costs

a. Pay the ask for buying spot, get bid for

selling spot

b. Forms a wider no-arbitrage boundary

condition.

S0 (1-Tr) ( 1 + Ct )t < f0,t < S0 (1+Tr) ( 1

+ Ct ) t

Where Tr = Transactions costs

c. Discuss inequality

2. Unequal Borrowing and Lending rates

a. Let CL = lending rate and CB = borrowing

rate

b. then S0 (1-Tr) ( 1 + CL )t < f0,t < S0 (1+Tr)

( 1 + CB)t

3. Short Selling Restrictions

a. May preclude arbitrage of f0,t < S0 (1+Tr)

t

( 1 + CB)

b. due to use of funds, no short selling or

availability of spot asset.

c. Widens no-arb lower bound for futures

price

4. Limitations to Storage

a. Pure carry model assumes storability

b. Effects upper bound

c. S0 (1-Tr) (1 + CL )t < f0,t may not hold

since cant buy spot and deliver in future.

5. Example

a. Spot gold = $400, CB= 10%/ year, CL=

8%/year

Tr = 1% on bid-ask spread, 1%

commission and storage costs

b. No-arb becomes

400(1.04)(.98) < f0,t < 400(1.05)(1.02)

407.68 < f0,t < 428.40

c. Different costs for different traders

III. Breakdowns in Carry Model

A. Convenience Yield: Futures trade at less than

full carry.

1. Buy futures and sell spot is not done

2. Return for holding physical product.

3. Physical Asset in Short Supply

a. Not enough traders willing to sell spot

and buy back later

b. Need commodity (seasonal

supply/demand conditions) with limited

storage) or short selling restriction

B. Backwardation: Cash price exceeds futures

price or nearby exceeds deferred futures

prices

IV. Futures Prices and Risk Premia

A. With no premium futures price = E[S]

B. Risk premium may exist if all speculators are

on one side of market.

C. Keynes Theory of Normal backwardation

1. Assumes speculators are net long and

hedgers net short

take on risk therefore, f< E[S] to give

speculators expected return

D. Opposite of hedgers are net long. A

Contango market may exist.

T-Bill Contract

1. Spot Commodity Characteristics

A. Pure Discount instrument

B. Issued in $10,000 Face Value

Demoninations

C. Maturities of 91 and 182 days issued every

Tuesday

D. Price quotes

i. P = ( 1 dt(n/360))(Face Value)

ii. n = days to Maturity

iii. Example dt = 5% N= 90 days FV =

$10,000

1. P = (1- .05(.25))(10,000) = 9,875

2. Futures Contract Specs

A. $1 Mil Face Value for 90,91 or 92 day T-Bills

B. March, June, Sept December delivery

months

C. Expiration date is the third Wed of the

delivery month.

i. Deliverable only exists for three months

prior to expiration

ii. Is created by the six month T-bill auction

3 months before expiration

1. Example yield of 5.20% P = 94.80

2. Easy to know what yield is being traded

3. Actual delivery price is (1- .05(.n/360))

(1,000,000)

4. Minimum move is (.0001)(90/360)(1 mil)

= $25

E. Margin is approx $1500 initial, $1000

maintainance

F. Uses of short term futures contracts

1. Speculate on short term movements in

interest rates

2. Sell futures to hedge against rising

interest rates

a. Companies who may issue S. T. debt in

the future

b. Underwriter protection against short

term security

sale.

3. Buy futures to protect against fall in short

term rates

a. Investor wants to purchase short term

securities

b. Offset lower proceeds from variable

rate loans

Eurodollar Contract

I. Definition - U.S. Deposits held in a

commercial bank Outside the U.S.

Interbank offer rate)

B. Contract $1mil in U.S. Deposits held in

foreign banks

with 90 days to

Maturity.

C. Quotes are the same as with T-bill contract

D. Differences with T-Bill contract

1. Cash Settlement

2. Libor is determined by mean of a sample

found over two points within the last 90

minutes of trading from a random

selection of 12 reference banks.

3. Yield is add-on vs. discount yield for

Bills

Add-on = (discount amount/ price)

(365/N)

N = days to maturity

Example T-bill = 6% discount

amount is $15,000

Add-on =

(15,000/985,000)(4) = 6/09%

E. Largest volume of any short term

instrument

T-Bond Contract

I.

102-05

Spot Market

A. Auctions with maturities in Feb, May, Aug.

and Sept.

B. Pays principle at maturity, interest Semiannually

C. Quoted in 32nds of a % of par example

interest.

A.I. = N (coupon amt/365)

N = days since last payment

Dec.

A. $100,000 face value of 6% coupon bond

with at least 15 years to maturity

B. Price quote in 32nds with 100 face value

C. Delivery dates March, June, Sept and

month

E. Can delivery other than 6% coupon bond

but must be the same issue on entire

amount

F. Conversion Factor adjusts for delivery off

other than 6% coupons

1. price of the bond if it had a 6% y-t-m/

price

10% y-t-m.

formula

2. example

a. 20 years to maturity 10% and

b. Price if 6% yield = 146. 23 Show

G. Finding the cheapest to Deliver

1. Multiply conversion factor times

futures price.

2. The invoice price is this amount plus

A.I.

3. Compare cash market price to (C.F.)

( F.P)

greatest relative amt.

5. see example

$31.25

I. Spot Market

A. Price weighted - (DJIA)

B. Value Weighted (S&P 500, Nasdaq etc)

C. Equal Weighted (Russell 2000, Value

line)

II. Futures Contracts - There are many recently.

A. Most have both regular and mini contracts

B. The minis are traded electronically, regulars on

open outcry C. All contracts are cash settled

D. S&P 500 Specs

1. Regular contract size = 250 * Index Value

2. Minis are 50* Index value

3. March, June Sept and Dec delivery months

with expiration being Thursday before the

third Friday.

4. Settlement base on closing pot price on last

day.

5. Contract movement min is .10 *250 = $25

on Reg.

6. Margin approx 10% initial and 70% of initial

for maintenance

E. Uses

1. Adjust portfolio exposure for little cost

2. Short term substitute for an equity

position

3. Highly leveraged way the speculate on

market.

Hedging

I. Definitions

A. Short Hedge Holder of position worried about

falling prices.

B. Long hedge- Holder of position worried about

rising prices.

C. Direct Hedge Hedger offsetting deliverable

asset

D. Cross Hedge- Hedger not offsetting

deliverable asset

1. Many more cash assets than futures

contracts

2. Limited number of expiration dates on

futures contract

3. Limited size of each contract.

1. Basis Risk Especially for cross hedges

a. Random shocks do not always have an

equal effect on both cash and futures

prices.

b. Trend movement since carry gets

smaller over time

c. More predictable basis implies more

effective hedge

d. Find the best contract for a given asset

1. horizon- futures contract should expire

near end of hedging period but must also

be liquid.

2. May need to rollover nearby contract

3. Must find the best hedge ratio.

2. Margin risk

a. Provision of funds for Marking-to-themarket

b. Do not want to have to close futures

position early

c. Adequate reserve depends on Volatility

and contract

type

3. Quantity risk

II. Basic Nave Hedge hedging example Hedge dollar

for dollar

A. In one month you will have $1mil to invest

B. Interested in a 6.5% y-t-m t-bond maturing in

20 years

C. Current price = 104-08

D. What is the concern?

2. Need to buy futures contracts

E. Buy 10 June T-bond futures contracts at P =

98-10

F. Suppose interest rates fall

1. Cash price becomes 107-30

2. Futures price becomes 101-00

3. Made 2-22 on futures but lost 3-22 on cash

4. Hedge did not eliminate risk because the

basis narrowed.

III. Determining the best hedge ratio to eliminate

price risk.

A. Portfolio Theory Hedge ratio. (Minimum

Variance Hedge)

1. Consider a two asset portfolio (futures and

spot holdings)

2. sf2(f) + 2Cov(sf)*f

Where f= number a futures contracts per 1 spot

holding This follows from Portfolio theory

3. Want to find the minimum variance portfolio

a. Take the derivative with respect to change

in the number of futures contracts held and

set to zero

b. 2*(f(f)) + 2*cov(sf) = 0

or f = - Cov/(f) is the risk minimizing hedge

ratio

c. This is also Beta from the regression:

1. s = a + B(f)

2, show plot

4. A measurement of hedging effectiveness

a. 1- (var(h)/var(u) =effectiveness

b if var (h) =0 perfectly effective 1-0 =1

1=0

futures per spot held.

6. Problem is one of stability

a. what if optimal Beta changes over

time?

may not be

optimal

applicable in future

7. If Beta =1 is optimal nave hedge is

A. Duration: Weighted Ave. time to maturity of the

PV of all

Cash flows

1. D = ( (T)*((Coup)/(1 +i)t )/ (Price of bond)

2. D approximates ( i)/ i)

Which is the price sensitivity of a change in

interest rates

3. Example

4. (= -Dur * (i / (1 + i))

5. -Dur * (i / (1 + i)) * B

6. From example

$

7. Higher duration implies more price sensitivity

to int rate

change

1. f-Durf * (if / (1 + if)) * f

2. Therefore Nf = f = (Durb / Durf) (B/f) ((1

+ if)/ (1 + i)

3. Example

C. Problems

1. Assumes yield curve constant over hedging

period.

Otherwise durations change.

2. Must estimate relative changes in yields if

there are any

Hedging Examples

I. Corporate borrower- Borrows a variable rate loan

A. Borrows $2 million at prime rate + 1%

Payable quarterly for next three quarters

B. Borrower is worried about rates rising

C. Sells futures contracts over life of loan

D. If rates rise losses offset by futures gains

E. Want to hedge using Eurodollar contract Sell

2 contracts

F. Currents conditions

1. Prime rate = 7%

2. Spot Eurodollar = 5%

3. June Eurodollar futures contract = 95.00 or

5%

Sept Eurodollar futures contract = 94.5 or

5.5%

Dec. Eurodollar futures contract = 94 or

6%

4. If prime rate is stable at Eurodollar = 2%

expected

$42,500

Payments are:

June = 8% or (2mil)(8%)(1/4) = $40,000

Sept = 8.5% (2mil)(8.5%)(1/4) =

Dec = 9%

(2mil)(9%)(1/4) = $45,000

Total expected interest expense =

$127,500

G. Assume in June Prime rate goes up to 8% but

basis

remains the same.

1. Spot Euro = 6% loan payment is 9%

2. June payment = (2mil)(9%)(1/4) =

$45,000

June Futures Contract = 94 since euros at

6%

Profits are (100)($25)(2) = $5,000

3. The hedge was successful since the basis

didnt move.

H. Have to go through it two more times to

complete hedge.

A. Interested in a 4% coupon 7- year note

selling at par

B. Concerned rates will fall

C. Buys 10 10-year note futures contracts.

Currently yielding 4%

Price = 116-11 (116,351) Show on board

D. In one month rates rise to 4.5%

1. Cash bond only costs $97,026

10 year note)

3. Made 100,000 97,026 or

$2,974/$100,000 on spot

4. Lost 116,351 111,351 or $

4,378/contract on futures

5. Net loss is $1,404 * 10 or $14,040 on

investment

E. Needed to buy less futures contracts since

duration of

futures was greater than cash.

(Use price sensitivity hedge ratio)

(Durb / Durf) (B/f) = Nf

Strategies

A. Let P(t1) and P(t2) be the price of discount

bonds paying

$1 at times t1 and t2 respectively

B. Let t1 be the expiration date of a t-bill futures

contract and

Let t2 be the maturity date of Bill delivered at

t1.

C. Compare the following portfolios

1. Buy time t1 security

HPR = (1- P(t1))/P(t1)

2. Buy time t2 security and sell Futures

contract

HPR = (fp P(t2)/ P(t2)

3. Since both portfolios held for same time

HPRs must

be the same

4. Setting them equal and solving for fp

fp = P(t2)/P(t1)

D. Also one can substitute

1. 1/(1 + it1 ) = P(t1) therefore

fp = P(t2)( 1 + it1 )

2. This is the pure carry model carrying the

deliverable

to expiration.

E. if fp > P(t2)( 1 + it1 ) In this case the yield

from holding

2 period bill is higher than return on one

period bill and

Futures contract therefore,

1. sell futures contract

2. Buy P(t2) bill

F. if fp < P(t2)( 1 + it1 )

1. Buy futures

2. Sell P(t2) bill

3. Buy P(t1) bill

II. T-Bond Futures Contract Price Determination

A. f*(CF) = B( 1 + it1 - ib)

1. if f*(CF) > B( 1 + it1 - ib)

Sell futures contract

Buy cash bond and finance at rate it1

2. if f*(CF) < B( 1 + it1 - ib)

a. Buy futures contract

Sell bond and lend proceeds

b. This arbitrage presents some unique

problems since

Short initiates delivery proceed

1. What is the holding period? Delivery

can take

Place anytime throughout the month

2. What bond will be delivered?

B. Special options for short in T-bond contract

1. Quality option short delivers cheapest

bond

2. Timing option delivers anytime

throughout the month

3. Wild card option Gets till 9:00 p.m to

deliver

4. End of month option Can deliver after

contract expires

1. f*(CF) > B( 1 + it1 - ib) appears to be

the norm

2. Again t-bill holder is better off buying

bond

and selling futures contract.

2. There is some reinvestment rate risk to be

considered

III. Stock Index Futures

A. f = S(1+ i d)

Where d = dividends paid over holding

period

B. Index arbitrage and program trading

1. Computer directed index arbitrage

2. Since inception could trade index via DOT

a. Designated Order Turnaround

b. Can be used to by S&P index with one

trade

c. $5 mil minimum

d. Reduced the potentially large

transaction costs

3. Could have caused crash in 1987

a. Futures < spot plus carry

b. Used DOT to buy futures and sell cash

c. Helped to push cash down further

d. Eventually spiraled out of control

e. As a result DOT turned off after large

move

C. Problems with arbitrage

1. Transactions costs have been reduced

dramatically

options

2. Short sales on spot

3. Cash settlement must leg out position like

1. P = C + (E f)/ (1 + 1)t

2 . Consider two portfolios

Port A: Own a put

Port B: Own a call

Sell futures contract at f

Lend (E f)/ (1 + 1)t

0

At E

if S* < E

Port A

E- S*

If S* > E

Port A

Port B

0 (S* -f) + (E-f) = E S*

Port B

1

(S* -E) +(E-S*) = 0

Spreading Strategies

I. Types of spreads

A. Intermarket- Same Commodity, Different

Exchange

Pure arbitrage doesnt happen very often

B. Intercommodity

2. Usually same maturity but could be different

markets

3. Example expect the yield curve to steepen

a. interest rates on t-bills will fall relative to

t- notes

b. Buy t-bill futures and sell t-note futures

4. Other common spreads S & p vs. small cap

index

Gold vs. Silver etc.

C. Intramarket

1. Same commodity different maturities

2. Better if non-perishable

3. example gold contracts should equal cost of

carry

If you think rates will narrow buy nearby

sell differed

rate.

1. T-Bond Spread gives an implied forward

contract

3. If not buy one and sell the other

I. Definition Option to buy or Sell a Futures Contract

A. Last day of trading in month prior to expiration

of futures

contract.

B. For T-Bonds- 5 days prior to first notice day of

futures cont.

C. Exercised Commodity is a futures contract at E.

1. Clearinghouse creates long position for

buyer, short for

Seller.

2. Credits and debits must be made upon

exercise

3. Example T-Bond

a. Strikes are offered at 1% of par i.e 101,

102 ect.

b. Options traded in 64ths of 1%

c. Say futures contract is at 101

d. The June 100 call may be selling today

for 2-32

thats $2.50/100 or $2,500/ $100,000

e. if at expiration f = 101 option buyer gets

$1,000 credit

and option writer owes $1,000

II. Economic Rationale

A. Expands to set of hedging opportunities

1. Suppose you are a money manager who

may or may

not purchase T-bonds in 3 months

2. With futures only how do you hedge

it.

commodity

C. Lets futures market speculators reduce some

risk of holding

position

III. Valuation

contracts.

A. Both puts and call may be exercised early

B. Consider deep-in the money call.

a. if f* > E is assured then delta of option is 1.

Then

both assets move dollar for dollar

b. No money tied up in futures contract

however there is a

premium paid on call option

c. if exercised investor has the same profit

opportunities with

no cost

d. not the same with stock options, must

commit funds upon

exercise.

C. Example

1. T-Bond futures option E = 101 with f = 107

2. Will get a $6,000 credit if exercised

identical why not.

V. Binomial formulation

1. Riskless hedge consists of a position in the

futures option and an opposite position in the

underlying futures contract.

2. Similar to equities except that the value of

the futures contract is zero at time zero

3. No initial investment required in futures

contract.

4. No foregone income from holding put or

savings from holding call.

5. Therefore, interest rate term not needed in

finding hedge ratio.

6. Example

7. General B/S equation

a. C = F . N (d1) E . e-rt .N ( d2)

b. However no interest rate term in N (d1)

or N ( d2) terms

Exotic Options

I.

future but paid for now. Generally at-the

money when the life begins. Often used for

executive compensation.

A.3 dates to consider

1. Valuation date t(o)(todays date)

begins

3. Expiration date (T = time to expiration)

B. When life begins, Option has T- t(g) time

left. T(o) t(g) life gone

C. Value from B/S

1. Time to expiration in model is T-t(g)

2. C = F . N (d1) E . e-r(T-t(g)) .N ( d2)

3. Value today is C . e-r(t(g)-t(o))

D. Example

II. Compound Options The underlying asset is also

an option.

A. Buy the right to pay X for an option with

Strike Price E.

B. Let E and t(2) be the exercise price and

expiration date of the underlying option.

C. Let t(1) be the expiration date of the

compound option.

D. Pricing is from the date of expiration of the

compound option

1. From t(1) to t(2) option pricing is as

before.

2. Must decide at t(1) whether or not to

exercise.

3. at t(1) C = max (Cu X, 0 )

4. Will exercise if S at time t(1) implies Cu >

X

5. Need a bivariate cumulative normal

distribution since two events must occur.

6. Show example

and put underlyings)