Derivatives and Risk Management

SWAPS are valued in terms of Bonds

Bfix =

; B fl = ( L + K* ) *

Floating rate Vswap = Bfix Bfl

; em que:

; L=notional ; K=coupon ; r*=Libor

Fixed rate Vswap = Bfl Bfix Forward Rate Agreement (FRA) Forward today = Spot

Currency swaps Vswap = BD S0BF (domestic is received and foreign is paid) Vswap = S0BF BD (domestic is paid and foreign is received)
(1) Option Price/Stock Price = premium ; (2) Strike Price/Stock Price -1 = % of price today ; implicit cost yearly = (1)*(2)*2
Naked call option is written the margin is the greater of: 1) 100% proceeds + 20% underlying share price - amount (if any) by which the option is out
of the money 2) 100% proceeds of the sale + 10% of the underlying share price For other trading strategies there are special rules.
T -> The longer I hold the option, more valuable it will be. In a put option, we dont know the relation between p and T, because it depends on interest
rates all the time.; -> as I have an insurance, when volatility goes up, the price goes up to.
st

D , 1 minus -> if the company is cutting the dividends, that is a bad sign. But on the side of a call, now we dont have a cost. Every time I can exercise
the option, because I bought the right to have the dividend.
American Option is worth at least as much as the corresponding European. It cannot be lower than the European. C >=c American options provide
insurance, since it prevents the holder from S0 <K. Once the option is exercised, K is exchanges for S and the insurance vanishes. Time value of money,
the later the holder pays K, the better.
Put call parity:

. if I have dividends I have to discount it from S, eg. D=1 -> (S-1)

Early exercise: 1) call: compare income collected/financial cost + prob (price going down) ; 2) put: compare degree of ITM of the option. If it is deeply
ITM makes sense to exercise the option. If it is +/-, it depends on the risk profile of the investor.
; value of the portfolio today is: (

Value of the portfolio at time T is:

(

) (

)
) ; Fu=Max(0;So*u-K); Fd=Max(0;So*d-K)

Riskless portfolio when

(
) (
); f=[p*fu + (1-p)*fd]*e^(-rT)at maturity the value of the option is equal to its intrinsic value
F0 > S0*e^(r-q)T , an arbitrageur buys the stocks underlying the index and sells futures F0 < S0*e^(r-q)T, an arbitrageur buys futures and shorts or sells
the stocks underlying the index
American put: every node choose the max between: i) Max(0;K-St) ii) [p*fu + (1-p)*fd]*e^(-rT)

u= ; d=1/u=
It can be optimal to exercise an American put option on a non-dividend-paying stock early. Indeed, at any given time during
its life, the put option should always be exercised early if it is sufficiently deep in the money. American put option is always worth more than the
corresponding European put option. Max(Ke^rT-St;0). Note that a call option will be S-K
Rf = ln ( 1 + rf x t/12)^(12/t) continuous in months
Black-Scholes:

ST

); d1=

( ) (

Payoff

; d2=

( ) (

= d1-

Profit

Long Put 1

Short Put 2

Total

K1 - ST

ST - K2

K1 - K2

K1 - K2 + (-p1 + p2)

K1 < ST K2

ST - K2

ST - K2

ST - K2 + (-p1 + p2)

ST > K2

(-p1 + p2)

ST K1

ITM
ATM
OTM

Call
St > K
St = K
St < K

Put
St < K
St = K
St > K

Speculation in futures markets: pure gambling. It is not in the public interest to allow speculators to trade
on futures exchange Speculators:important market participants who add liquidity into it. However, contracts
must be useful for hedging as well as speculation. Because regulators generally only approve contracts when
they are likely to be of interest to hedgers as well as speculators.American Opt worth at least as much as a
European Opt on the same asset with the same strike price and exercise date.Holder of an American opt has
same rights as the europ. It must be worth at least as much. If it were not, an arbitrageur could short the
European opt and take a long position in the American opt. As much as its intrinsic value. Holder of an amer
has the right to exercise it immediately. The ame opt must be worth at least as much as its intrinsic value. If it were not an arbitrageur could lock in
profit by buying the option and exercising it immediately.The early exercise of an amer put is a tradeoff between the time value of money and the
insurance value of a put. An American put when held in conjunction with the underlying stock provides insurance. It guaranteed that the stock can be
sold for the strike price, K. if the put is exercised early, the insurance ceases. option holder receives strike price, earns interest on it.