Option

In finance, an option is a derivatives financial instruments that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike).The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to full fil the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stocks, a bond, a currency or a future

contract) plus a premium based on the time remaining until the expiration
of the option. Other types of options exist, and options can in principle be created for any type of valuable asset.

Types of Option
Exchange-traded options
It is(also called "listed options") are a class of exchange traded derivatives. Exchange traded options have standardized contracts, and

are settled through a Clearing House with fulfillment guaranteed by

the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include: Stock Option, Bond Option and Other Interest Rate Option Stock Market Index Option or, simply, index options and

Over the Counter Option

It is(OTC options, also called "dealer options") are traded between

two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: interest rate options currency cross rate options

Other option types

Another important class of options, particularly in the U.S., are employee stock option, which are awarded by a company to their

employees as a form of incentive compensation. Other types of options

exist in many financial contracts, for example real estate option are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Types of Option Styles

European option an option that may only be exercised on expiration.

American option an option that may be exercised on any trading day

on or before expiry. Bermudan option an option that may be exercised only on specified

dates on or before expiration.

Barrier option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. Exotic option any of a broad category of options that may include complex financial structures.[7] Vanilla option any option that is not exotic.

Hedging risk with Derivatives

Review of equity options Review of financial futures Using options and futures to hedge portfolio risk Introduction to Hedge Funds

Options -- Contract
Calls and Puts Underlying Security (Number of Units) Exercise or Strike Price Expiration date Option Premium

American, European, Asian, etc.

Options -- Markets
1 Buyer + 1 Seller (writer) = 1 Contract Examples of Price Quotations Premium = Intrinsic Value + Time Prem Options available on Equities Indicies Foreign Currencies Futures

Options -- Basic Strategies

Buy Call Sell (write) Call Buy Put Sell (write) Put

Options -- Advanced Strategies

Straddle Strips and Straps Vertical Spreads Bullish Bearish

Options - Determinants of Value

Value of Underlying Asset Exercise Price Time to Expiration VOLATILITY Interest Rates Dividends

Options -- Black Scholes Option Pricing Model

C = SN(d1) - Xe-rTN(d2) ln(S/X) +(r+s2/2)T d1 = --------------------------sT1/2

d2 = d1 - sT1/2
Put-Call Parity: P = C + Xe-rT - S

Futures Contract
Agreement to make (sell) or take (buy) delivery of a prespecified quantity of an asset at an agreed upon price at a specific future date. ex. S&P 500 Index Futures: Price: 1126.10; Delivery month: June

Buyer agrees to purchase a portfolio representing the S&P 500 (or its cash equivalent) for $1126.10 x 250 = $281,525 on Thursday prior to 3rd Friday in June. (Buyer is locking in the purchase price for the portfolio.)
Seller agrees to deliver the portfolio described above. Note: since this is a cash settled contract, if the price was 1116.10 on the delivery date, the buyer would pay the seller $2,500 (= 10 x 250). If the price was 1136.10, the seller would pay the buyer $2,500

Futures Contract: Marking to Market

Marking to market: Price of Futures contract is reset every day Gains/Losses versus previous day are posted to buyer and seller margin accounts Futures = a bundle of consecutive 1-day forward contracts If futures held to expiration, effective delivery price is same as when contract initiated

Futures Contract: Marking to Market example (C$ contract)

11/2 11/3 11/4 11/5 11/8 11/9 11/10 $0.7483 $0.7490 $0.7480 $0.7472 $0.7422 $0.7430 $0.7432 +$70 -$100 -$80 -$500 +$80 +$20 $2000 $2070 $1970 $1890 $1390 $2080 $2100 Add $610

Index Futures Market

Speculators often sell index futures when they expect the underlying index to depreciate, and vice versa.

April 4
1. Contract to sell S&P @ 1126.1 ($281,525) on June 17.

June 17
2. Buy S&P @ 1106.1 ($276,525) on spot market and deliver @ 1126.1 3. Profit = $5,000

Index Futures Market

Index futures may be sold by investors to hedge risk associated with securities held.

April 4
1.Contract to sell S&P @ 1126.1 ($281,525) on June 17.

June 17
2. Market falls to 1106.1.Gain =$5000

3. Gain offsets (approx.) loss of $5000 on securities held

Index Futures Market

Most index futures contracts are closed out before their settlement dates (99%). Brokers who fulfill orders to buy or sell futures contracts earn a transaction or brokerage fee in the form of the bid/ask spread.

Hedging with Derivatives

Basic option strategies Covered call Protective put Synthetic short Basic futures strategies Using interest rate futures to reduce risk

Covered Call
Sell call on stock you own. (Long stock, short call) Good:
As value of stock falls, loss is partially offset by premium received on calls sold. Essentially costless since hedge generates a cash inflow

Bad:
Maximum inflow from call = premium; Hedge is less effective for large drop in stock price If stock price rises, call will be exercised; Investor transfers gains on stock to holder of call.

Protective Put
Buy put on stock you own. (Long stock, long put) Good:
As value of stock falls, loss is partially offset by gain in value of put. Gain from put continues to grow as stock price falls. If stock price rises, maximum loss on put = premium; Investor keeps all stock gains less fixed put premium.

Bad:

More expensive to hedge with put

Synthetic Short
Sell call and buy put on stock you own. (Long stock, short call, long put) Good:
As value of stock falls, loss is offset by gain in value of put. Gain from put continues to grow as stock price falls. If stock price rises, gain is offset by loss on call. Loss from call continues to grow as stock price rises. Very effective hedging device Can be self-financing (premium received on put sold offsets premium paid on call purchased)

Bad:

Often more expensive than simply shorting the stock itself.

Delta Hedging with Options

Call Delta = DC= dC/dS From Black-Scholes model,
DC = N(d1) Ex.: If S=74.49, X=75, r=1.67%, s =38.4%, t=0.1589 yrs. Then, C = 4.40 and N(d1) = 0.5197 If S increases by $1, C increases by $0.5197 Hedge Ratio = H = 1/DC = 1/0.5197 = 1.924 Sell 1.924 calls per share of stock held to hedge!

Example of Call Hedge Held to Expiration, 1000 share stock position

IBM 90 Profit S 15,510 Profit C -20,140 Combined -4,630

85
80 75 74.49

10,510
5,510 510 0

-10,640
-1,140 8,360 8,360

-130
4,370 8,870 8,360

70
65 60 55

-4,490
-9,490 -14,490 -19,490

8,360
8,360 8,360 8,360

3,870
-1,130 -6,130 -11,130

Delta Hedging - Puts

Put Delta = DP= dP/dS From Black-Scholes model and Put-Call Parity,
DP= DC 1 =N(d1) - 1 Ex.: If S=74.49, X=75, r=1.67%, s =38.4%, t=0.1589 yrs. Then, C = 4.40, P = 4.71, N(d1) = 0.5197, and N(d1) -1 = -0.4803 If S increases by $1, P decreases by $0.4803 Hedge Ratio = H = 1/D = 1/0.4803 = 2.082 Buy 2.082 puts per share of stock held to hedge!

Example of Put Hedge Held to Expiration, 1000 share stock position

IBM 90 Profit S 15,510 Profit P -9,891 Combined 5,619

85
80 75 74.49 70 65 60 55

10,510
5,510 510 0 -4,490 -9,490 -14,490 -19,490

-9,891
-9,891 -9,891 -8,820 609 11,109 21,609 32,109

619
-4,381 -9,381 -8,820 -3,881 1,619 7,119 12,619

Delta Hedging with Options

Delta changes over time! S changes Time declines Other factors (r, s) may change

True Delta Hedging Adjust hedge when S changes

Scenarios 1 & 2:
IBM stock drops by $1 to $73.49 ==> Loss of $1000 Call options also drop by $0.5197 ==> Gain of $1037.97 ==>Net change $37.97 IBM stock rises by $1 to $75.49 ==> Gain of $1000 Call options also rise by $0.5193 ==> Loss of $1037.97 ==> Net change ($37.97)

True Delta Hedging Adjust hedge when t changes

Scenario 3: One week passes, IBM stock at $71.49 ==> Loss of $3000 Call options now worth $2.73 ==> Gain of $3173 ==>Net change $173 New call delta = 0.4029 New hedge ratio = 1/0.4029 = 2.482 ==> Sell 5 more contracts! Scenario 4: One week passes, IBM stock at $77.49 ==> Gain of $3000 Call options now worth $5.82 ==> Loss of $2698 ==> Net change ($302) New call delta = 0.6238 New hedge ratio = 1/0.6238 = 1.603 ==> Buy 3 contracts!

True Delta Hedging Adjust hedge when S changes

Scenarios 1 & 2:
IBM stock drops by $1 to $73.49 ==> Loss of $1000 Put options also rise by $0.4803 ==> Gain of $1008.63 ==>Net change $8.63 IBM stock rises by $1 to $75.49 ==> Gain of $1000 Put options also fall by $0.4803 ==> Loss of $1008.63 ==> Net change ($8.63)

True Delta Hedging Adjust hedge when t changes

Scenario 3: One week passes, IBM stock at $71.49 ==> Loss of $3000 Put options now worth $6.06 ==> Gain of $2835 ==>Net change ($165) New put delta = 0.4028 1 = -0.5972 New hedge ratio = 1/0.5972 = 1.674 ==> Sell 4 contracts! Scenario 4: One week passes, IBM stock at $77.49 ==> Gain of $3000 Put options now worth $3.15 ==> Loss of $3276 ==> Net change ($276) New put delta = 0.6238 1 = -0.3762 New hedge ratio = 1/0.3762 = 2.658 ==> Buy 5 more contracts!

Delta Hedging with options

Delta represents response of call (or put) price with change in the stock price Delta changes as stock price, time to expiration, interest rates, volatility change It is too expensive to hedge individual stock positions with matching options. It is more common to hedge a portfolio with index options (cross hedging) Most managers monitor delta itself to decide when to rebalance.

A True Protective Put

Puts can be used to build a floor under the value of a long position Buy 1 put per long share Ex.: Long 1000 shares of IBM at $74.49 Buy 1000 puts at $4.71 Puts guarantee a value of $75 per share This is insurance, not a hedge!

A True Protective Put

IBM 90 Profit S 15,510 Profit P -4,710 Combined 10,800

85
80 75 74.49 70 65 60 55

10,510
5,510 510 0 -4,490 -9,490 -14,490 -19,490

-4,710
-4,710 -4,710 -4,200 290 5,290 10,290 15,290

5,800
800 -4,200 -4,200 -4,200 -4,200 -4,200 -4,200

Hedging with Futures (example from May 2001)

There are futures on the S&P500. Suppose I have a portfolio that is currently worth $1,117,672. The portfolio has a beta of 1.3. June S&P500 futures are at 1430.70 ==> contract is worth 500 x 1430.70 = $715,350 Hedge ratio = (Value of portfolio / Value of Futures contract)(Portfolio Beta)

= (1,117,672/715,350)(1.3) = 2.031 ==> Sell 2 Contracts !

Hedging with Futures (example from May 2001)

S&P Spot in June 1573.75 1502.25 1430.7 1359.15

% ch an ge

Port. in June

% cha nge 6.5% 0.0% -6.5%

Profit Portf olio 72,649 0 -72,649

Profit Futur es -71,550 0 71,550

Combine d $2,247 1,099 0 -1,099

10% 1,262,969 5% 1,190,321 0% 1,117,672 -5% 1,045,023

13.0% 145,297 -143,050

1287.65

-10%

972,375 -13.0%

145, 297

143,050

-2,247

Adjusting Systematic Risk with Futures

PM may choose to adjust systematic exposure up or down to reflect investor desires expectations of market movements About index futures: Represents contract to make/take delivery of a portfolio represented by the index Since index itself may be non-investable, most index futures contracts are cash-settled example: S&P500 futures CME contract value = 250 x index Initial margin: $6K for spec, $2.5K for hedgers.

Adjusting Systematic Risk with Futures

I have an $11 million stock portfolio with b=1.05. I want to increase b to 1.2. Value of Futures = 1314.50 x 250 = $328,625 bf = 1.0. Target b = contribution from portfolio + contribution from futures 1.2 = (1.0)(1.05) + [(F x 328,625)/$11,000,000](1.0) F = (bT - Wsbs)(Vs/VF) F = 5.02 => buy 5 contracts What have we done? Used futures contracts to leverage holdings and increase exposure to market risk

Adjusting Systematic Risk with Futures

Suppose target b = .90 0.90 = (1.0)(1.05) + [(F x 328,625)/$11,000,000](1.0) F = (.90 - 1.05)(33.4728)(1.0) = -5.02 contracts (sell)

We have shorted futures to reduce systematic exposure.

Hedging with Interest Rate Futures

How do you reduce duration for a bond portfolio? Sell high D, buy low D Sell bonds, buy Tbills Sell interest rate futures Interest rate futures: agreement to make/take delivery of a fixed income asset on a particular date for an agreed upon price ex: Sept Tbond futures contract $100K FV US Treas bonds with 15-years to maturity and 8% coupon (what if they don't exist?) Price: 99-27 = 99 27/32 % of $100,000 = $998,437.50 (Tick = $31.25) D = 8.64 years

Hedging with Interest Rate Futures

I own an $11,000,000 face value portfolio of high grade US corporate bonds with an aggregate value of 101-08 (or $11,137,500) and a duration of 7.7 years. I expect rates to rise. How can I immunize my portfolio? Target D = contribution of bond port + contribution of fut. 0 = (1.0)(7.7) + [(F x 998,437.50)/11,137,500](8.64) F = (0.0 - (1.0)(7.7))(11,137,500/998,437.50)/8.64 F = -9.94 contracts => short 10 Tbond futures contracts

This is the weighted average duration approach