Derivatives II

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This files has expired at 30-Jun-13
Derivatives II
Mapping to Curriculum
Reading 63: Option Markets and Contracts Reading 64: Swap Markets and Contracts Reading 65: Risk Management Applications of Option Strategies
This files has expired at 30-Jun-13 Expect around 6 questions in the exam from todays lecture
Neev Knowledge Management Pristine
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Key Concepts
Calls, Puts and their Payoffs Minimum And Maximum Value Of European And American Options Intrinsic And Time Value Of Option Covered Call, Protective Put Effect Of Variables On Option Pricing Option Price Sensitivities Interest Rate Caps, Floors, Collars This files has expired at 30-Jun-13 Swaps and their Termination
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Derivatives
Securities whose price is dependent upon or derived from one or more underlying assets.
The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset.
The most common underlying assets include stock, bonds, commodities, currencies, interest rates and market index.
This files has expired at 30-Jun-13 Most derivatives are characterized by high leverage.
Futures contracts, forward contracts, options and swaps are the most common types of derivatives
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Options
Options
Call Long Put
Put Short Put
Long Call
Short Call
The right to The right to The obligation to The obligation to files has expired at 30-Jun-13 Sell an option Buy an option This Sell the underlying Buy the underlying
Long options have rights Short options have obligations
Call Put
Buy Sell
Seller of an option is also called as option writer Option Premium: Price that the owner of an option is required to pay to acquire those rights
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Example: Options And Forward Payoff

Spot T=0 If the Spot price of a computer is $1000. Forward T=1
If the forward price at Time 1 is

In the Money
Payoff for the Payoff for Long forward position Call position 200 100 -100 -200 200 100
Payoff Forward profit and loss
1200 1100 1000 900 800

Profit/Loss of the Call
At the 0 0 This files has expired at 30-Jun-13 Money
Out of the Money
0 0
1000
S(T)
300
200 100
700 0 -50
800
900
1000 1100 1200
Terminal stock price ($) 1300
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Long Call
Profit from buying one European call option: option price = $5, strike price = $100, option life = 2 months
30
Profit ($)
20

10 70 80 90 100 110 120 Terminal stock price ($)
0
-5 130
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Short Call
Profit from writing one European call option: option price = $5, strike price = $100
Profit ($) 5 0 70 90 This80files 100 Terminal has expired at 30-Jun-13 stock price ($) 110 120 130
-10
-20
-30
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Long Put
Profit from buying an European put option: option price = $7, strike price = $70.
30
Profit ($)
20

10 0
Terminal stock price ($) 40 50 60 70 80 90 100
-7
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Short Put
Profit from writing an European put option: option price = $7, strike price = $70
Profit ($)
7 40 0 50 60
Terminal stock price ($)

-10
70
80
90
100
-20
-30
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Payoffs From Options
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Types Of Options
Financial Options:
Based on Equity, Indices, Bonds, interest rates, currencies Equity Options:
Most popular
Index Options:
European Style Settled in cash
Bond Options
Mostly traded OTC and only a few exchanges. This files has expired at 30-Jun-13 Liquidity of the Government Security market is much larger than the corporate bond market. Options almost always on Government Securities Can be either European or American Expiration date must be much before the underlyings maturity date since the price tends to be very close to par value at expiration. Else, it removes much of the uncertainty in its price.
Currency Options
A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate expressed as an exchange rate. Usually traded OTC, but there are a few exchanges trading them with low activity
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Types Of Options (Continued)

Options on futures:
Call => option to go long a future contract Put = > option to go short a future contract
Commodity Options:
Gives the holder the right to buy/sell the underlying commodity at the strike price
Real Options are options to be taken into account while doing NPV analysis
E.g. option to abandon a project before completion
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Question
Which of the following single option transaction can be most risky?

A. B. C. Writing a put Buying a put Writing a call
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Solutions
C.
As the stock price of the underlying increases above the exercise price of a call option, writer of the option faces unlimited risk whereas buyer of the option face unlimited gain in this situation.
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European & American Options
Options Type
European Options
American Options
Can be exercised Option Premium only at the end of This files has Is Lower its life
Can be exercised Option Premium at any time expired at before 30-Jun-13 is Higher or on expiration
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Minimum And Maximum Value Of European And American Options

Notations
c: p: S0 : X: T: : European call option price European put option price Stock price today Strike price Life of option Volatility of stock price C: American Call option price P: American Put option price ST : Stock price at option maturity D: Present value of dividends during options life r: Risk-free rate for maturity T with continuous compounding This files has expired at 30-Jun-13
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Minimum And Maximum Value Of European And American Options (Cont)

An American option is worth at least as much as the corresponding European option
Cc Pp
Type European Call
Lower Bound 0
Upper Bound St X / (1 + RFR)(T-t) X
This files has expired at 30-Jun-13 American Call 0 St

European Put American Put 0 0
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American Options, Lower Bounds, Early Exercise

American Options can be executed earlier than expiration which can have value. Hence, C0c0 P0 p0 There is no real reason to execute a call option early because:
This files has expired at 30-Jun-13 You lose interest on your money
You lose the insurance. Exceptions If there is a cash payment, like dividend payments For American Puts, there is always a possibility of early exercise Especially when the underlying price is low or in case of bankruptcy.
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Bounds Revised
Revised Table: Type European Call Lower Bound Max[0, St - X / (1 + RFR)T-t] Upper Bound St
Imp
American Call
European Put American Put
Max[0, St - X / (1 + RFR)T-t]
Max[0, X / (1 + RFR)T-t - St ] Max[0, X St ]
St
X / (1 + RFR)(T-t) X
American Put European Putfiles has expired at 30-Jun-13 This American Call European Call
Total Value of option
Intrinsic Value
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Example
Find lower bound for American and European put X = $45, stock is trading at $42, RFR = 6%, 3 months expiry
American: Max[0,45 - 42] = $3 European: Max[0, 45/1.063/12 42] = $2.34
Find lower bound for American and European call X = $45, stock is trading at $49, RFR = 6%, 3 months expiry
American=European: Max[0, 49 45/1.063/12 ] = $4.65
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Questions
1. Maximum value for European Put and American Put is if X is strike price, S is spot price, RFR is risk free rate and T is time to maturity of the contract
A. European Put: X/(1 + RFR)T-t, American Put: X B. European Put: X, American Put: X/(1 + RFR)T-t C. European Put: X, American Put: X
2. What are the minimum values of an American-style and a European-style 3-month call option with a strike price of $90 on a non-dividend-paying stock trading at $96 if the risk-free rate is 3%?
A. American: $6.00, European: $6.00 B. American: $6.00, European: $5.62 This files C. American: $6.62, European: $6.62
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3.
The minimum value of a American put option is:

A. Max[0, X St ] B. Max[0, St - X / (1 + RFR)T-t] C. Max[0, X / (1 + RFR)T-t - St ]
4.
Which of the following is closest approximation for the maximum value of a call option
A. The price of the stock minus the exercise price B. The exercise price times one plus the risk free return C. The price of the stock
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Questions
5. European and American options differ in the way that
A. B. C. American option can be exercised any time till expiry, European can not be exercised before expiry European option can be exercised upto 10 days before expiry, American can not be exercised before expiry European option can be exercised any time till expiry, American can not be exercised before expiry
6.
A European call option on an underlying asset has a strike price of $ 120 and a time to expiration of 0.25 years. Risk-free rate is 6 percent. If the underlying asset is trading at $140 then which of the following represents the lower bound for the call option:
A. $20 B. $21.74 C. $17.98
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Solutions
1. 2. 3. 4. 5. 6. A. C. A. C. A. B. Lower of a European call option = Max (0, S X/(1+RFR)T) = $21.74 This files has expired at 30-Jun-13
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Intrinsic And Time Value Of Option

Intrinsic value: It is amount by which the option is in-the-money Intrinsic value of a call option; C = max[ 0, S X ] Intrinsic value of a put option; P = max[ 0, X - S ] Example: If the stock price is say, $25, and the exercise price is $20. The intrinsic value of the option is $5. At-the-money and Out-of-the money options do not have any intrinsic value Time value of a option:
Portion of the option premium that is attributable to the amount of time remaining till maturity Thishigher files expired at 30-Jun-13 Longer the time to maturiy, is thehas time value of the option
Total Option Value = Intrinsic value + Time Value
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Moneyness Of An Option:
In-The-Money
At-The-Money
Stock price
Out-of-The-Money
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Call Option Profit & Losses

Consider a call option:
Premium = $5 Strike price = $50 Profit (p) = Max(0,ST-X) c0 Max Profit = Max Loss = c0
Profit
Long Call
+$5
0 Breakeven (X+ premium) Short Call

-$5
X= $50
$55
Stock Price
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Put Option Profit & Losses

Consider a put option:
Premium = $5 Strike price = $50 Profit (p) = Max(0,X-ST) p0 Max Profit = X-p0 Max Loss = p0
$45 Profit

0 -$5 Breakeven(X - Premium) Long Put
$5
Short Put
-$45 Stock price $45 X= $50
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Questions
1. If the owner of a call option with a strike price of $35 finds the stock to be trading for $42 at expiration, then the option:
A. Expires worthless. B. Will not be exercised C. Is worth $7 per share.
2. What is the option buyer's total profit or loss per share if a call option is purchased for a $5 premium, has a $50 exercise price, and the stock is valued at $53 at expiration?
A. ($5) B. ($2) C. $3
3. A put option with strike price of $20 has an option premium of $2. At expiry, underlying was traded at $22. Premium at expiry day would be
A. $2 B. $1 C. None of the above
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Questions
4. What is the worst-case profitability scenario for an investor who sold a call on the firm's stock for a premium of $10 and a strike price of $100?
A. $90 per share profit B. $0 per share profit (break-even) C. Unlimited losses
5. An investor buys a put on a stock selling for $80, with a strike price of $75 for a premium of $6. The maximum gain is :
A. $70 B. $69 C. $75
6. A person faces highest risk of maximum loss if he trades Write unprotected Call Buy unprotected Put Write unprotected put
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Solutions
1. 2. 3. 4. 5. 6.
.
C. B. C. C. B. The maximum gain is = $75(strike) - $6(premium) = $69 A
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Agenda
Option Markets and Contracts Risk Management Applications of Option Strategies Swap Markets and Contracts
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Covered Call = Long Stock + Short Call

Involves selling call options of stocks already owned or simultaneously bought Motivation
Earning a return from the underlying that is already owned Lowering the cost of acquisition of the underlying asset
Expectation
Moderate rise in the price of the underlying
Profit Potential
Maximum Profits when the options are exercised by the buyer
This files Premium received + Strike Price Spothas Price

More conservative than buying the stock only
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If the options are not exercised the trader gets to keep the premium, thus lowering the cost of acquiring the asset
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Covered Call = Long Stock + Short Call

Value at expiration: VT = ST Max(0,ST-X) Profit: p= VT - S0 + c0 profit Maximum Profit (loss) X S 0 + c0 Maximum Loss underlyin 0 g S 0 c0 price Breakeven S 0 c0 Buying the Underlying
profit (loss)
underlying price
Sell Call

profit (loss)
=
Neev Knowledge Management Pristine 34
underlying price
Covered Call spread
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Covered Call = Long Stock + Short Call (Cont)

If My Company(MC) trades at Rs33 and Rs35 calls are priced at Rs1, then an investor can purchase 100 shares of MC for Rs3300 and sell one (100-share) call option for Rs100, for a net cost of only Rs3200. The Rs100 premium received for the call will cover a Rs1 decline in stock price. The breakeven point of the transaction is Rs32/share. Upside potential is limited to Rs.300, but this amounts to a return of almost 10%. (If the stock price rises to Rs35 or more, the call option holder will exercise his option & the investor's profit will be Rs35-Rs32 = Rs3). If the stock price at expiry is below Rs35 but above Rs32, the call option will be allowed to expire, but the investor can still profit by selling his shares. Only if the price is below Rs32/share will the investor experience a loss. Stock price at expiration Rs.30
to 30-Jun-13 This files has Comparison expired at

Net profit/loss (200) simple stock purchase (300)
Rs.32
Rs.33 Rs.35 Rs.37
0
100 300 300
(100)
0 200 400
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Protective Put = Long Stock + Long Put

Involves buying put options of stocks already owned or simultaneously bought Motivation
Protection against loss in the value of stocks owned
Expectation
Rise in the price of the underlying
Advantage
Trader profits from the rise in price of the underlying albeit the amount of profit is reduced by the premium paid to purchase the put In case the price of the underlying goes has down, expired the trader is still to sell the underlying at the strike This files atable 30-Jun-13 price, thus insuring her profit
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Protective Put = Long Stock + Long Put

Profit
Protective Put Strategy: Long a Stock. Long a Put Option. The payoff diagram of this strategy would be look like a Long Call. Value at expiration VT = ST + Max(0,X ST) S This files Thas expired at 30-Jun-13 Profit: p = VT S0 p0 Maximum Profit = Maximum Loss
K
= S 0 + p0 X
Breakeven = S0 + p0
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Role of Arbitrage
Arbitrage refers to riskless profit Such profits are generally earned when securities are mispriced Example: Short-selling a stock which is mispriced high in one market and simultaneously buying it in another market where the same security is priced lower When several market participants enter arbitrage transactions, securities return to their fair values Arbitrage plays an important role in valuing securities Types:
Law of one price states that securities with Identical cash flows must have the same price Portfolio of securities (with uncertain individual returns) has a certain payoff ==> then the portfolio should give risk free rate of return
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Put Call Parity

Consider the Pay-off of a trader who has the following position:
A Call Option with a Strike Price of 5 and, A Bond with a maturity value of 5.
Share Price at Expiration 0-5 6 7 8 9 10 Call Pay-Off 0 1 Bond Value at Maturity 5 5
Strike Price 5 5
Bond + Call 5 6 7 8 9 10
This files has expired at 530-Jun-13 2 5

3 4 5 5 5 5 5 5 5
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Put Call Parity

Consider, now, the Pay-off of a trader who has :
A Put Option with a Strike Price of 5 and, An equivalent unit of the underlying asset
Stock Pay-off
0 1
Share Price at Expiration 0 1 2 3 4
Put Pay-Off (Exercise Price 5) 5 4
Stock+ Put
5 5 5 5 5
This files has expired at 30-Jun-13 3 2

2 1 3 4
5-10
5-10
5-10
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Put Call Parity

The Pay-offs are exactly the same
12 10 8 6
4
2
TotalPay-off
0
0 2 4 6 8
Share Price
10 12
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The Pay-offs Are Exactly The Same

Put Call parity provides an equivalence relationship between the Put and Call options of a common underlying and carrying the same strike price: It can be expressed as:
Value of call + Present value of strike price = value of put + share price.
1 RER
pS
Put Call Parity is valid only for European options, for American Options this relationship turns into an inequality
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Questions
1. Suppose an investor buys one share of stock and a put option on the stock. What will be the value of her investment on the final exercise date if the stock price is below the exercise price?
A. The value of two shares of stock B. The value of one share of stock plus the exercise price C. The exercise price
2. An investor shorts 100 shares of a company at $50 per share and at the same time writes a put option of the same company with a strike price of $48 for a price of $4 per share. If the spot price of the stock on the expiration date is $52. What is the maximum profit/loss to the writer of this covered put option?
A. 0 B. $200 profit C. $400 loss
3. An investor writes a covered call with the exercise price of $55 and the current value of the asset as $50.The premium charged for writing the call is $ 4. Then which of the following statements does not reflect the gain/loss of the investor.
A. Investor can a loss of $ 48. B. Investor can make a gain is $8 C. Investor can suffer a loss of $45
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Questions
4. An investor writes a covered call with the exercise price of $55 and the current value of the asset as $50.The premium charged for writing the call is $ 4. Then which of the following statements does not reflect the gain/loss of the investor.
A. Investor can a loss of $ 48. B. Investor can make a gain is $8 C. Investor can suffer a loss of $45
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Solutions
1. 2. C. B.
The put option would not be executed and the writer of the put gets the premium of $ 400. But since it is a naked call option, the investor has to buy the shares in the spot market at $52 and close his short position. In this transaction he makes a profit of $200 (5000+400-5200)
3.
A.
The breakeven value of the assets price for the investor is $46. The option will be exercised when the asset value moves above $55. So the investor can make any gain up to $9. If the asset price falls below $46 then the investor will make a loss but maximum loss can be $46 when the asset price is zero.
4.
A.
The breakeven value of the assets price for the investor is $46. The option will be exercised when the asset value moves above $55. So the investor can make any gain up to $9. If the asset price falls below $46 then the investor will make a loss but maximum loss can be $46 when the asset price is zero.
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Effect Of Variables On Option Pricing

(S-X) (X-S) (S-X)
Imp
(X-S)
Variable
S0 K T r D
+ + ? ? + + + has expired + +30-Jun-13 + This files at + + + +
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Questions
1. Which of the following will most likely increase the value of a European put option?
A. B. C.
Decrease in the exercise price Increase in volatility of an asset or interest underlying the option. Increase in the time to expiration.
2. The value of a European put option:
A. B. C.
Increases with an increase in both volatility and discount rate Increases with an increase in volatility but decreases an increase in discount rate This files has expired atwith 30-Jun-13 Decreases with increase in both volatility and discount rate
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Solution
1. B. A decrease in the exercise price of a put option( both American and European) decreases its value. We cannot positively state that the value of a European put will increase with longer maturity. However increase in the volatility of an asset or interest underlying the option will increase the value of both the American and European Call and Put options. 2. B.
The value of European put option is directly related to volatility and inversely related to the discount rate.
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Example: An Arbitrage Opportunity?

Suppose that
c=3 S0 = 20
T=1
X = 18
r = 10%
D=0
Is there an arbitrage opportunity?
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Questions
1. European put-call parity says the difference in price for call options less put options, both with exercise price E and time to maturity T, is equal to the stock price:
A. B. C. Minus the future value of the exercise price. Plus the future value of the exercise price. Minus the present value of the exercise price
2.
A stock is selling at $ 50; a 3 months call at $ 60 is selling for $2 whereas a 3 months put at $60 is selling for $ 14.The risk free rate is 6%. Considering these figures the gain which can be made through arbitrage is:
A. B. C. $2.87 $2 $ 0 ( No arbitrage possible)
3.
Which of the following is not a characteristic of a fiduciary call?

A. B. C. Consists of a combination of a call option and a pure-discount, riskless bond that pays the same amount as the exercise price of the call option. The payoff is equal to stock price of the underlying asset when the call is in money. It consists of a share of a stock together with a call option on the stock.
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Questions
4. A protective put is best described by:
A. Long European put on a stock + Long the stock B. Long European put on a stock + Short the stock C. Short European put on a stock + Long the stock
5. Which of the following statements is true?

A. For both calls and puts an increase in the exercise price will cause an increase in the option price B. For both calls and puts an increase in the time to maturity will cause an increase in the option price This files has expired at 30-Jun-13 C. For calls, but not for puts, an increase in the time to maturity will cause an increase in the option price
6. Which of the following statements are true:

A. Longer the time to maturity lesser is the value of the option. B. Call prices are directly related to the exercise price. C. The value of an option cannot be negative
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Questions
7. If the volatility of the underlying asset decreases, then the:
A. Value of the put option will increase, but the value of the call option will decrease B. Value of the put option will decrease, but the value of the call option will increase C. Value of both the put and call option will decrease
8.
Which of the following features increase(s) the value of a call option?

A. A high interest rate B. A highly variable stock price This files C. All of the above
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Solutions
1. C. 2. A.
If the put call parity equation does not hold true then there is a chance of arbitrage. The synthetic stock price is given by S = C-P +X/(1+RFR)T Where C = $2 P = $14 X =$60 RFR = 6% and T =0.25 years Synthetic Price S = 47.13 Since the stock is selling for $50 so youhas can immediately short for $50 and buy a synthetic for an This files expired ata share 30-Jun-13 immediate arbitrage profit of $2.87.
3.
C.
Fiduciary call consists of a combination of a call option and a pure-discount, riskless bond that pays the same amount as the exercise price(X) of the call option. The payoff is equal to stock price of the underlying asset when the call is in money, and equal to exercise price when the call is out of money.
4. 5. 6. 7. 8.
A. B C C C
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Agenda
Option Markets and Contracts Risk Management Applications of Option Strategies Swap Markets and Contracts
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Interest Rate Caps, Floors, Collars

Interest rate cap: Puts a cap on the maximum interest rate the floating rate borrower will have to pay in the event of increase in interest rates.
Series of call options Which have expiration dates corresponding to the reset dates of a floating rate loan Protects a floating rate buyer against an increase in interest rates Each component call option called a caplet
Interest rate floor: Specifies the minimum interest rate the floating rate lender will receive in the event of decrease in interest This rates. files has expired at 30-Jun-13
Series of put options Which have expiration dates corresponding to the reset dates of a floating rate loan Protects a floating rate lender against a decrease in interest rates Each component put is a floorlet.
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Interest Rate Collars

Interest Rate Collar is constructed by either
1. Long Cap and Short Floor 2. Short Cap and Long Floor
If their premiums offset each other, it is called a Zero-Cost Collar.
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Question
The pay off for which of the following is most likely equivalent to that of a series of put options?
A. Interest Rate Cap B. Interest Rate floor C. Interest Rate Collar
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Solution
B.
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Characteristics Of Swaps
A swap is an agreement to exchange cash flows at specified future dates according to certain specified rules:
Interest Rate Swaps Currency Swaps
Traded mostly OTC and are customized to suit the needs of the parties to the contract Subject to default risk. Netting Exchanging only the net amount owed from one party to the other. Netting payments decrease default risk. A swap has zero valueThis at the initiation the contract. files of has expired at 30-Jun-13
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Characteristics Of Swaps
Interest rate Swaps do not require the actual exchange of the notional amount of the contract Currency Swaps requires the exchange of principal in the respective currencies on initiation and termination of the contract Swaps act as a good hedge instrument. Settlement/Payment Date: Each date the party makes payments. Settlement Period: The time between Settlement Dates Termination Date: The final payment date Tenor: The original maturity of the swap.
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Termination Of Swaps
Ways to terminate the contract before maturity:
Mutual Termination Offsetting contract Resale of Swap to another party Swaption
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Plain Vanilla Interest Rate Swap

An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $10 million
Period 0 1 2 3 4 5 6 Libor rate Floating Leg Fixed Leg 4.20% 4.80% 5.30% 5.50% 5.60% This 5.90% 6.40% 210,000 240,000 265,000 275,000 280,000 files 295,000 320,000 Net Cash Flow (40,000) (10,000) 15,000 25,000 30,000 at 30-Jun-13 45,000 70,000
250,000 250,000 250,000 250,000 250,000 has expired 250,000 250,000
Net (For fixed rate payer) = (Swap fixed rate LIBOR) (No. of days/360) (Notional Principal)
Uses of an Interest Rate Swap Converting an investment return or liability from

Fixed rate to floating rate Floating rate to fixed rate
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Equity Swap
Equity Swaps: It refers to an arrangement where one party pays the returns received on the stock or a stock index in exchange for a return imitating a fixed rate or a floating rate bond It has two distinct features
The party paying fixed could also have to be paying variable. This is in the case where equity returns are negative Both the parties are uncertain about the payments they will receive untill the settlement date.
For some swaps, the equity returns may be comprised of both dividends and capital gains.
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Questions
1. For which of the following type of contracts is the payment due/receivable by the parties to the contract not netted against each other
A. Interest Rate Swaps B. Equity Swaps C. Currency Swaps
2. The unique feature of Floating for return Equity Swaps is that:

A. It involves exchange of return on equities B. It is very easy to value C. Both parties are uncertain the return will receive This about files hasthey expired at
30-Jun-13
3. Which of the following is least likely correct?

A. The notional principal is swapped at inception and at termination of a currency swap B. In an interest rate swap only interest rate is exchanged C. Only the net difference between the dollar interest and the foreign interest is exchanged in a currency swap.
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Questions
4. Bank A enters into a $10,000,000 million quarterly pay plain vanilla interest rate swap as the fixed rate payer at a fixed rate of 5% based on a 360 day year. The floating rate payer agrees to pay 90 day LIBOR plus 1% margin; 90 day LIBOR is currently 4%.90 day LIBOR 90 days from now is 5% and 180 days from now is 5.5%. What amount Bank A pays or receives?
A. $0 pay B. $50,000 pay C. $50,000 receive
5. Which of the following is most likely a characteristic of a plain vanilla interest swap in a single currency?
A. Notional principal is swapped at initiation. B. Interest payments are netted out and net amount is paid by one who owes it. C. At the term of the contract notional principals are netted out and the net amount is paid by the one who owes it.
6. An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $10 million. What is the net cash flow in period 3 if 6month LIBOR at start of period 3 is 5.5%?
A. $275,000 B. $250,000 C. $25,000
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Questions
7. Which of the following is least likely a characteristic of Swaps?
A. They are customized contracts B. They are traded in organized secondary market C. Most participants in swaps market are large institutions.
8. The major risk with Swaps is:

A. Liquidity risk B. Counterparty risk C. Market risk
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Solutions
1. C. 2. C. 3. C. 4. C.
Bank A pays = [0.05*(180/360) (0.05 + 0.01)(180/360)]*10,000,000 = - $50,000, so receives $50,000. In a plain vanilla interest swap in a single currency the following takes place: This files has expired at steps 30-Jun-13
Notional principal is generally not swapped at initiation in single currency swaps. Full interest payments are exchanged at each settlement date, each in a different currency Since a notional fund was not swapped, there is no transfer of funds.
5. C.
6. C. 7. C They are traded in organized secondary market. Swaps are customized contracts which are not traded in any organized secondary market. 8. B.
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Interest Rate Option Payoff

Payoff for other types of options is simple Example: For the holder of a call option, he will receive the amount by which the current stock price is higher than the exercise price on the expiry of the contract The payoffs in case of interest rate options is received not on expiry of the contract but on expiry of the period for which the notional amount is borrowed at the reference rate Example:
This has expired at principal 30-Jun-13 XYZ bought a 30-day call optionfiles on a 120-day LIBOR. The notional is $ 1,00,000 and the strike rate
is 6%. If the 120-day LIBOR on expiry is 7% on expiry of the option contract what is the payoff to XYZ. Solution: Interest Saved = (0.07 - 0.06) (1,00,000) (120/360)
= $333.33
But this amount will be received after 120 days after the expiry of the option contract
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Purpose Of Derivative Markets

Purpose of Derivatives: Risk Management: It is a process of identifying the desired level of risk, identifying the actual level of risk, & altering the latter to equal the former. Hedging & speculation are the two processes here
Hedging & speculation: is a process generally refers to the reduction, & in some cases the elimination of risk Hedging: involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset.
Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has This has expired at 30-Jun-13 Hedgers reduce their risk by files taking an opposite position in the market to what they are trying to hedge The ideal situation in hedging would be to cause one effect to cancel out another protect itself from any downside risk
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Purpose Of Derivative Markets (Cont)

Speculators: They make bets or guesses on where they believe the market is headed
Example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risk The main purpose of speculation is to profit from betting on the direction in which an asset will be moving
Price Information: Futures markets provide valuable information about the prices of the underlying assets on which futures contracts are based
files has expired at 30-Jun-13 Many of the assets This are traded in geographically dispersed regions, thus many different spot prices exist Price of contract with shortest time to expiration often serves as a proxy for the price of underlying asset Prices of all future contracts serve as prices that can be accepted by those who trade contracts in lieu of facing the risk of uncertain prices Forward contracts & swaps also allows users to substitute a single locked-in price for the uncertainty of future spot prices
Reduce transaction costs: Derivatives are characterized by relatively low transaction costs
Because derivatives are designed to provide a means of managing risks (thus, it serve as a form of insurance) Insurance cannot be viable if its price is too high relative to the value of insured asset Thus, derivatives must have low transaction costs otherwise they would not exist
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Criticism Of Derivatives
Criticism of Derivatives: They are very complex, sometimes the users dont understand them well Too risky (leverage)
Example: Margin trading -> using leverage form the broker to buy the securities
Mistakenly characterized as a form of legal gambling Important distinction between derivatives & gambling is:
Benefits of derivatives extent much further across society By providing the means of managing risk, they make financial markets work better
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Questions
1. Which of the following type of options gives the holder the right to buy/sell the underlying commodity at the strike price?
A. Real Options B. Commodity options C. Financial options
2. What is least likely to be true regarding financial derivatives

A. Derivatives create excess financial risk in the system B. Derivatives are used for speculation C. Derivatives helps in This price discovery of underlying files has expired A. Buy the stock and buy a call option. B. Sell the stock and buy a call option. C. Buy the stock and buy a put option.
at 30-Jun-13
3. Which combination of positions will tend to protect the owner from downside risk?
4. Which combination of positions is least likely to protect from risk of stock price going up down?
A. Buy the stock and buy a call option. B. Sell the stock and buy a call option. C. Buy the stock and buy a put option.
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Solutions
1. B. 2. A.
On the contrary derivatives are meant to transfer the risk on to a party, which is better equipped to handle and mitigate it. However derivatives are also used for speculation and they help in price discovery by increasing liquidity.
3. C. 4. A.
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Interest Rate Options Versus FRAs

Interest rate Option: It is an option which gives the holder the right to go long/short on a notional amount at the strike interest rate for a fixed period Combination of a long interest rate call option and a short interest rate put option will give the same payoff as a long position in an FRA
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Rate Options
LIBOR considered the best measure of an interest rate paid in dollars on a non governmental borrower. FRAs
Forward contracts that pays off based on the difference between the underlying rate and the fixed rate embedded in the contract when it is constructed. The payoff is discounted by the spot rate on a 180-day LIBOR to give the present value for the payoff as of the expiration date.
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Rate Options
Interest Rate Option
Has an exercise rate or strike rate It is the right, not obligation, to make one interest payment and receive another. Interest Rate Calls and Interest Rate Puts Settled in cash Mostly European but can be American too The money is not paid at expiration, but paid at a later date (no need to discount payment)
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Questions
1. Forward rate agreement (FRA) has the same payoff as a combination of:
A. B. C. Long interest call option and short interest put option Short interest call option and long interest put option Long interest call option and Long interest put option
2. Payoff of a long position in an FRA is the same as a combination of:

A. Long interest rate call option and a short interest rate put option B. Short interest rate call option and a short interest rate put option This files has expired at 30-Jun-13 C. Short interest rate call option and a long interest rate put option
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Solutions
1. A.
Forward rate agreement (FRA) has the same payoff as a combination of long interest call option and short interest put option.
2. A.
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Five Minute Recap

Type European Call American Call European Put American Put Lower Bound Max[0, St - X / (1 + RFR)T-t] Max[0, St - X / (1 + RFR)T-t] Max[0, X / (1 + RFR)T-t - St ] Max[0, X St ] Upper Bound St St X / (1 + RFR)(T-t) X Swap Termination before maturity: Mutual Termination Offsetting contract Resale of Swap to another party Swaption Call Put Parity X c pS 1 RER T
Swap Characteristics: Traded mostly OTC - customized Subject to default risk. This Usually Netted - decrease default risk. files has Zero value at the initiation of the contract. Interest rate Swaps - do not require the actual exchange of the notional amount Currency Swaps - requires the exchange of principal in the respective currencies on initiation and termination of the contract Equity Swaps Fixed paying might need to pay floating in case of a negative equity return,
Interest Rate Collar is constructed by either expired at 1. Long Cap30-Jun-13 and Short Floor 2. Short Cap and Long Floor
Variable S0 K T r D
(S-X) c
(X-S) p
(S-X) C
(X-S) P
Swap Terminology Settlement/Payment Date: Each date the party makes payments. Settlement Period: The time between Settlement Dates Termination Date: The final payment date Tenor: The original maturity of the swap.
+ + +
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Derivatives II

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This files has expired at 30-Jun-13

Neev Knowledge Management Pristine

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Call Long Put

Put Short Put

Long options have rights Short options have obligations

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Example: Options And Forward Payoff

If the forward price at Time 1 is

Payoff Forward profit and loss

1200 1100 1000 900 800

At the 0 0 This files has expired at 30-Jun-13 Money

Out of the Money

1000 1100 1200

Terminal stock price ($) 1300

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Terminal stock price ($) 40 50 60 70 80 90 100

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Terminal stock price ($)

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Payoffs From Options

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Types Of Options (Continued)

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Which of the following single option transaction can be most risky?

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European & American Options

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Minimum And Maximum Value Of European And American Options

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Minimum And Maximum Value Of European And American Options (Cont)

Type European Call

Upper Bound St X / (1 + RFR)(T-t) X

This files has expired at 30-Jun-13 American Call 0 St

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American Options, Lower Bounds, Early Exercise

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American=European: Max[0, 49 45/1.063/12 ] = $4.65

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The minimum value of a American put option is:

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Intrinsic And Time Value Of Option

Total Option Value = Intrinsic value + Time Value

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