Outline

„ Review of derivative products

Hedging and investing with futures
Derivatives „

„ Hedging and investing with options

Hedging and Investing

Hedging risk Forwards

„ A forward is the simplest of derivatives where
a contract is entered today for a
„ The only perfect predetermined exchange price F at a date, T,
hedge is in a Japanese in the future.
garden. „ Payoff is therefore ST-
ST-F.
„ Long is to buy a forward, ie will pay an
agreed amount for the asset at time T.
„ Short is to sell forward, ie will accept the
agreed sum and give up the asset at T.

Payoffs to Long Forwards

Payoffs to short forwards
Payoff Payoff

Payoff is ST - F Payoff is ST - F

ST ST
F F

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 Futures Options
„A series of one day forwards - margin „ A call option gives the buyer the right but not
account. the obligation to purchase an asset at a
predetermined price (X) at time T.
„ Through a clearing house.
„ A put option gives the buyer the right but not
„ Payoff at expiry is the same but in day to
the obligation to sell an asset at a predetermined
day there are cash adjustments from the
price (X) at time T.
margin account.
„ X is the exercise price of the option.

Options 2 Call Payoffs

„ A call option requires the seller (the writer) to
Payoff
sell an asset at a predetermined price at time T if
called on to do so.
Max {0,ST-X}
„ A put option requires the seller (the writer) to
buy an asset at a predetermined price at time T X
ST

if called on to do so.

Put payoffs Options

„ Stocks
Payoff
„ Index
Max {0, X-ST} „ Commodity and stock
ST
„ Futures options
X
„ Currency options
„ Interest rate options

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 Using options to invest Option strategies
„ Buy stock „ Put floor
„ Buy call options „ Covered call
„ Buy call options and invest in rf. „ Straddles
„ Options offer leverage because offer higher rates „ Spreads
of return „ Collars – especially with interest rates
„ Also offer risk management

Exotic options Asian options

„ Combination options
„ a package of options to construct a given payoff
„ path dependent payoffs rather than just based
on the spot at maturity
„ e.g. Asian options; barrier options etc
„ These are average rate options.
„ Pay off depends on average price of the underlying
over a fixed time up to maturity.
„ Averaging overcomes problems of manipulating the
underlying price on a particular day.
„ E.g., call on sterling gives right to receive zero or the
arithmetic daily exchange rate averaged over a period of
time minus the strike.

Basket options Barrier options

„ A result of Asian option.
„ Options on a basket of currencies
„ e.g. Australian fund manger with exposures to Yen,
ringgat, US dollar would use these.
„ Often cheaper than total value of options on
individual assets.
„ These are of various kinds.
„ Main effect is to reduce the price of the option to the
buyer.
„ The barrier is some value in the underlying during
the life of the option. E.g. a knock out option where
once the barrier is touched the option ceases to have
value.
„ Greater the probability that will hit barrier the cheaper the
premium.

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 Forwards futures Stock index futures
„ Basis risk „ Asset allocation
„ Difference between futures and spot price - at „ Hold contracts long
maturity this must be zero „ Invest in t-
t-bills to cover future price at maturity
„ However before maturity can diverge causing
risk on early liquidation.

Index arbitrage Swaps

„ Futures price too high short futures and long stocks.
„ Program trading
„ Triple witching believed to create volatility
„ Expiration day effect.
„ Stagger closing times – market on open orders
„ Namura
„ First in 1981 to exchange the balance of two
cash flows.
„ Back to back in a single package rather than two
separate loans.
„ Who packages an intermediary bank for a
suitable commission!
„ They are off balance sheet.

Types Why swaps

„ Currency „ Persistent or temporary arbitrage opportunities are
„ Exchange cash flows denominated in 2 different created by institutional effects.
currencies. „ E.g. Japanese market in the early 90s.
„ Interest rate 1. Ministry of Finance limited the amount of nonyen bonds
held by Japanese companies.
„ Same currency but different rates. E.g. floating
2. A duel currency bond issued in yen with yen interest and
versus fixed. principal in foreign was a yen bond.
„ Combined currency and interest rate 3. Zero coupon bonds were taxed as non income generating
„ Largest share of the swap market. Eurobond issues assets.
are swapped. „ Complete markets with new securities. A long term
forward.

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 Long & Short Hedges (F&F)
„ A long futures hedge is appropriate when you
know you will purchase an asset in the future
& want to lock in the price
„ A short futures hedge is appropriate when you
know you will sell an asset in the future &
want to lock in the price
Example
„ Basis risk is spot minus futures price of contract.
„ If basis = 0 which it should at T then perfect
hedge.
Interest rate Derivatives
„ A futures contract on as asset whose price is
dependent solely on the level of interest rates.
Basis Risk
„ Basis is the difference between spot & futures
„ Basis risk arises because of the uncertainty about the
basis when the hedge is closed out.
„ The issues in futures are:
„ The asset match
„ The date bought or sold
„ If you close out before expiry
Choice of Contract
„ Choose a delivery month that is as close as
possible to, but later than, the end of the life of
the hedge.
„ When there is no futures contract on the asset
being hedged, choose the contract whose
futures price is most highly correlated with the
asset price.
„ There are then 2 components to basis.
Pricing : T bills
„ Quoted as the discounted price:
„ FV – yield*days to maturity
„ Eg 180 day bill issued today at 6%:
100 – 6*180/360 (US convention)
100 – 6*180/365 (Aust convention)
„ US price is 97 Aust price is 97.04
„ At delivery short trader gives t bills and buyer gives FV
less interest accrued,
„ this is the invoice amount
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 Non parallel shifts Option Hedging Example
„ In practice short term rates are more volatile „ A bank has sold for $300,000 a European call option
than long term on 100,000 shares of a nondividend paying stock
„ In fact short and long appear uncorrelated „ S0 = 49, X = 50, r = 5%, σ = 20%,
„ Sometimes they can move in opposite T = 20 weeks, μ = 13%
directions. „ The Black-
Black-Scholes value of the option is $240,000
„ Hedge by dividing yield curve into segments and „ How does the bank hedge its risk?
isolating them.
„ GAP management.

Naked & Covered Positions Stop-Loss Strategy

„ Naked position „ This involves:

„ Buying 100,000 shares as soon as price
„ Take no action
reaches $50
„ Covered position „ Selling 100,000 shares as soon as price falls
„ Buy 100,000 shares today below $50

„ Both strategies leave the bank exposed to „ This deceptively simple hedging strategy
significant risk does not work well

The Greeks Critical points

„ Delta is the partial derivative of option price wrt
stock price.
„ Gamma is the second partial derivative wrt stock
price
„ Theta is the partial wrt time
„ Vega is the partial wrt volatility
„ Rho is the partial wrt riskless interest rate
„ It is important to remember that calculus derivatives
are only exact for infinitesimally small changes in the
variables that effect option prices.
„ Partials assume nothing else changes when the variable
of interest changes.
„ The difference between a partial derivative and total
derivative can be the difference between success and
bankruptcy!

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 Delta Delta Hedging

„ (Δ) is the rate of change of the option

Delta (Δ
price with respect to the underlying „ This involves maintaining a delta neutral
portfolio
Option
price „ The hedge position must be frequently
rebalanced
„ Delta hedging a written option involves a “buy
Slope = Δ high, sell low”
low” trading rule
B
A Stock price

Example Delta hedging

„ S = 125.9375 X = 125 r = 0.0446, T = 0.0959 s „ In BS world this must be done continuously.
= 0.83 „ This is called delta neutral
„ Delta = N (d 1)e– qt „ For example
„ however q = 0 here so N(d1)
„ Buy 569 shares and sell 10000 calls. If stock
price falls by say 0,01 loose 5.69
„ d1 = [ln(So/X) + (r + σ2/2)T] / (σ
(σ T1/2) „ But gain 0.00569*1000 on options or 5.69
„ 0.17422
„ What if doesn’
doesn’t change by a small amount?
„ This leads to gamma

Gamma Gamma Addresses Delta Hedging

Errors Caused By Curvature
„ Gamma (Γ (Γ) is the rate of change of delta (Δ
(Δ)
with respect to the price of the underlying Call
asset price
„ The larger the gamma the more sensitive is
the delta to stock price change and harder to C’’
maintain delta neutral hedge. C’

„ Gamma is always positive and largest when C

near exercise price of a call Stock price
S S’

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 Example Gamma hedging
„ A delta neutral portfolio of options is „ Need another option.
–10,000. If there is a change of +2 or –2 in the „ It is impossible to be gamma and delta neutral
asset over a short period of time there is an with only stock and option.
unexpected decrease in the portfolio of around: „ Quite a complex procedure
„ $20,000 However doesn’
„ doesn’t deal with volatility changes
which is the next letter.

Managing Delta, Gamma, &

Vega V Vega
„ Vega (V) is the rate of change of the value of „ Delta, Δ, can be changed by taking a position in
a derivatives portfolio with respect to the underlying asset
volatility. „ Usually cant be gamma neutral and vega neutral.
To hedge delta gamma and vega need three
V=S0√TN’
„ V=S TN’(d1) „
instruments at least.
„ Most options highly sensitive to volatility!
„ Only accurate for very small moves.

Hedging in Practice Scenario Analysis

„ Traders usually ensure that their portfolios are A scenario analysis involves testing the effect on
delta-
delta-neutral at least once a day the value of a portfolio of different assumptions
„ Whenever the opportunity arises, they improve concerning asset prices and their volatilities
gamma and vega
„ As portfolio becomes larger hedging becomes
less expensive

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 Hedging vs Creation of an
Option Synthetically
„ When we are hedging we take positions
that offset Δ, Γ, ν, etc.
„ When we create an option synthetically
we take positions that match Δ, Γ, & ν
Portfolio Insurance
„ In October of 1987 many portfolio managers
attempted to create a put option on a
portfolio synthetically
„ This involves initially selling enough of the
portfolio (or of index futures) to match the Δ
of the put option
Portfolio Insurance
The strategy did not work well on October 19,
1987...