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Financial derivatives
Financial derivatives are a powerful tool used in business
today. They are so named because their values are derived
from underlying assets.
These instruments can be used for two very distinct
management objectives:
1
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practice
The June 2005 Mexican peso futures contract has a price of
$0.08845. You believe the spot price in June will be $0.09500.
What speculative position would you enter into to attempt to
profit from your beliefs?
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Standardizing Features
Contract size
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Maturity date
Third Wed of Jan, Mar, Apr, Jun, Jul, Sep, Oct, Dec.
Commissions
2
3
96
97
pay 2 receive 1
pay 97
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LIFETIME
HIGH LOW
OPEN
INT
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Moneyness
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practice
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Currency
Australian dollar
British pound
Canadian dollar
Euro
Japanese yen
Swiss franc
Contract size
AD50,000
31,250
CD50,000
e62,500
U6,250,000
SF62,500
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You just bought a Dec GBP call option with an exercise price
of $1.20/. At expiration, the value of the call option is
1
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You just bought a Mar EUR put option with an exercise price
of $1.35/e. At expiration, the value of the put option is
1
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Profit
Long 1 call
ST
c0
E + c0
E
Out-of-the-money
In-the-money
loss
Profit
c0
ST
E + c0
E
loss
Out-of-the-money
In-the-money
short 1
call
Profit
E p0
ST
p0
E p0
long 1 put
E
loss
In-the-money
Out-of-the-money
Profit
p0
ST
E p0
E
short 1 put
E + p0
loss
Profit
Example
Long 1 call
on 1 pound
ST
$0.25
$1.75
$1.50
loss
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Profit
For a contract
Long 1 call
on 31,250
ST
$7,812.50
$1.75
$1.50
loss
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Profit
$42,187.50
ST
$4,687.50
$1.35
$1.50
Long 1 put
on 31,250
loss
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practice
From the perspective of the writer of a put option written
on e62,500. If the strike price is $1.25/e, and the option
premium is $1,875, at what exchange rate do you start to lose
money?
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R
L
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1 + i 1 + i$
Using a similar portfolio to replicate the upside potential of a
put, we can show that:
E
St
Pe Max
,0
1 + i$ 1 + i
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F
E
Ce Max
,0
1 + i$ 1 + i$
E
F
Pe Max
,0
1 + i$ 1 + i$
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Ca > Ce ; and
Ca Max[St E, 0].
Pa > Pe ; and
Pa Max[E St , 0].
This must be true. And we can find a tighter bound...
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A tighter bound...
St
E
Ca Max
, St E, 0
1 + i 1 + i$
E
St
Pa Max
, E St , 0
1 + i$ 1 + i
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Put-Call parity
No arbitrage relationship;
links the common strike price of $/, dollar prices of
European-style put and call options at that strike price, and
the U.S. interest rate.
F = E + (C P ) [1 + i$ ]
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practice problem
It is Thursday, Sep 16, and we have the following information:
Spot rate: $0.7142/SF
90-day forward rate: $0.7114/SF
U.S. dollar interest rate: 3.75% p.a.
Swiss franc interest rate: 5.33% p.a.
Option data for December contracts ($/SF):
strike
0.70
call
0.0255
put
0.0142
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$1.80
e
$15, 000@
@
@
@
RS1d
$1.20
e
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C0
@
@
@
@
R$6, 000 $6, 000
= $0 = C1d
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eie
e1.00
e i$
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uS
Cu
S@
C@
@
@
@
@
RdS
@
@
RCd
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= eif T
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(2)
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Risk-Neutral Pricing
(id if )T
ue
C = eid T [p Cu + (1 p )Cd ]
(id if )T
ud
as
(3)
(4)
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Lets verify
What is the ?
What is the B?
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Lets verify
What is the p ?
What is the C0 ?
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