DERIVATIVES

AGENDA

1. Derivative Market and Instruments

2. Basis of Derivative Pricing and Valuation
3. Risk Management Application of Option Strategies
REVIEW

A derivative: is a security that derives its value from the value or return of another asset or security
(underlying asset)
Spot price (cash price): is the price for immediate purchase of the underlying asset
Derivative contract initiates on a certain date and terminates on a later date.
is an agreement between 2 parties in which each does something for the other
REVIEW

Derivative contracts: are created on exchange traded and over the counter (OTC)
- Exchange traded contracts: have standard terms and features and are traded on
an organized derivatives trading facility
- OTC contracts: are any transactions created by two parties anywhere else
Derivative contracts: Forward commitments
Contingent claims
1. BASIC CONCEPTS
Present value of an asset
( )
0 = + PV Benefits PV(Costs)
(1++ )

Where:
0 : The current spot price (present value) of the asset
( ): The expected value of the asset at time T
Benefits: any benefit of owning the asset such as stock dividend, bond coupon or convenience yield of
holding physical asset.
Costs: cost of owning the asset, par example: storage cost, insurance cost, opportunity cost, etc.
Cost of carry: the net cost of holding the asset by taking into account both holding costs and benefits.
NO ARBITRAGE CONDITION

Arbitrage refer to a transaction where the speculator purchase asset A (or portfolio of assets) at price
and simultaneously sell that has price > regardless of future events, realizing a risk-free gain
on the transaction.
No arbitrage assumption: because of transaction cost and supply-demand equilibrium.
REPLICATION

If we invest in T-bonds with the Face value = K , PV= (1+)

What if we invest in a portfolio, which includes: An asset (with price 0 ) and the short position in a forward contract with the price K?

Pay-off Time T=1

Long Asset
Short position in Fw contract K-
Total pay-off K

The PV of portfolio :
(payoff on the asset at time T + pay off on the short forward at time T)
Asset position at time 0 + short position in a forward contract at time 0 = =
(1+) (1+)

>> For both case, we obtain K at T=1 >> REPLICATION

>> Hedge strategy
I. FORWARD CONTRACT

A forward contract is: an agreement between two parties in which one party, the buyer, agrees to buy
from the other party, the seller- agree to sell an underlying asset or other derivative, at a future date at
a price established at the start of the contract.
When a contract expires, there are 2 possible arrangements:
1. Delivery: The long will pay the agreed-upon price to the short, and the short will deliver the asset
2. Cash settlement: The long and short will pay the net cash value of the position on the delivery date.
TYPE OF FORWARD

Equity forward
Forward contract on Individual stock
Forward contract on Stock portfolio
Forward contract on stock indices
Bond and Interest rate forward contracts
Forward contracts on Individual bonds and bond portfolio
Forward contracts on Interest rates: Forward Rate agreements
Currency forward contracts
(And others)
FORWARD CONTRACT VALUATION
Consider : no storage costs, and no benefits to holding the security >> the net cost of carry is
simply the opportunity cost of the invested funds ( risk-free rate)
With a Forward contract that will expire at time T, with the price 0 . The spot price is 0; we
have the formula: 0 = 0 (1 + )
What if :
1st : 0 + >> Arbitrageur take a short position in the forward contract and buy the asset at 0.
What happens at time T ?
2nd: 0 - >> Arbitrageur take short selling at 0 and take a long position in the forward contract
What happens at time T ?
VALUING THE FORWARD CONTRACT

0
Assume that there is no-arbitrage. The value of forward contract is : =
1+
0
So, at T=0 (initiation): 0 = 0 =0
1+

During the life of the contract, at time t <T, the value of forward contract is the
0
=
1+

Value of the contract at the expiration:

0
= = 0
1+
1 The price of a forward or futures contract:
A. is typically zero at initiation
B. is equal to the spot price at expiration
C. remains the same over the term of the contract

2. For a forward contract on an asset that has no costs or benefits from holding it to have zero value at
initiation, the arbitrage-free forward price must equal:
A. the expected future spot price
B. the future value of the current spot price
C. the present value of the expected future spot price
FORWARD RATE AGREEMENT (FRA)

Company A needs a six-month $1 million loan, but doesnt need it until six months in the future.
A is worried that interest rates will rise, and thus wants to lock in the current interest rate of 6%.
Banks X sells a 6% FRA to ABC. Under the FRA, if in six months time interest rates are above 6%, X will
pay the difference on notional amount to A. If interest rates are lower, A will pay the difference to X.
For example, if in six months the interest rate is 7%, then XYZ pays the difference of 1% interest for six
months on the notional value of $1 million to A. This amounts to a payment of $5,000.
FORWARD RATE AGREEMENT (FRA)

Eurodollar: is a dollar deposited outside the United States.

LIBOR (London Interbank Offer Rate): is the rate at which London banks lend dollars to other London
banks
Example of Eurodollar time deposit: Nat West banks need to borrow $10mil for 30 days. It obtains a
quote from Royal Bank of Scotland for a rate of 5.25% => 30-day LIBOR is 5.25%. If Nat West take a deal,
30
it will owe: $10mil *(1+ 0.0525 ) = $10,043,750 in 30 day.
360
FORWARD RATE AGREEMENT (FRA)

Forward rate agreement is a forward contract that has future interest rate as underlying asset.
The contract covers a notional amount but only interest rate payments on that amount are considered
The purpose of entering a FRA is to lock in a certain interest rate for borrowing or lending at some
future date.
One party will pay the other the difference between the interest rate specified in FRA and the market
interest rate at contract settlement.

LIBOR (London interbank Offered rate) is most often used as the underlying rate.
Use FRA to hedge risk of (remove uncertainty about) borrowing and lending they intend to do in the
future
 LONG A 30 DAYS FRA ON 90-DAY LIBOR

> Position
Long position in FRA: Pay fixed and receive floating
Short position in FRA: Pay floating, receive fixed
30 days FRA: 30 days to loan start date
90-day LIBOR: Reference data
FRA PAYOFF FORMULA

(From the perspective of the party going long)

( )(
360
= Notional principal ( )
1+ ( )
360

Where:
Forward contract rate: the rate that 2 parties agree will be paid
Days in underlying rate: the number of days to maturity of the instrument on which the underlying rate
is based
 To avoid confusion, the FRA market use a special type of terminology that converts the number of days
to months:

Notation Contract Expires in Underlying Rate

1x3 1 month 60-day LIBOR
1x4 1 month 90-day LIBOR
1x7 1 month 180-day LIBOR
3x6 3 months 90-day LIBOR
3x9 3 months 180-day LIBOR
6x12 6 months 180-day LIBOR
12x18 12 months 180-day LIBOR
 In case, a party wants a contract expires in 37 days on 122-day LIBOR => consider as the exception to
the standard, called off the run
EXERCISE 1

Dealer quotes a rate of 4% on this instrument and end user agrees. He is hoping that rates will increase.
Expiration is in 90 days.
The notional amount is $ 5 million.
The underlying interest rate is the 180 LIBOR time deposit.
In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.
=>>
5,000,000 x ((0.05 - 0.04) (180/360)) = $ 47,600
1 + 0.05 (180/360)
 Consider an FRA expiring in 90 days for which the underlying is 180-day LIBOR.
Suppose the dealer quotes this FRA contract at a rate of 5.5%.
The end user is essentially long the rate and will benefit if rates increases. The dealer is essentially short
the rate and will benefit if rate decrease.
The 180-day LIBOR= 6%
The contract covers a given notional principal=$10mil
>> Calculate the payment that party long the FRA will receive?
EXERCISE 2

The treasurer of Company A expects to receive a cash inflow of $15.000.000 in 90 days. The treasurer
expects short-term interest rates to fall during the next 90 days. In order to hedge against this risk, the
treasurer decides to use an FRA that expires in 90 days and is based on 90-day LIBOR. The FRA is quoted
at 5%. At expiration, LIBOR is 4.5%. Assume that the notional principal on the contract is $15.000.000
A. Indicate whether the treasurer should take a long or short position to hedge interest rate risk?
B. Using the appropriate terminology, identify of FRA used here
C. Calculate the gain or loss to Company A as a consequence of entering the FRA
EXERCISE 3

Suppose that a party wanted to enter into an FRA that expires in 42 days and is based on 137-day LIBOR.
The dealer quotes a rate of 4.75% on this FRA. Assume that at expiration, the 137-day LIBOR is 4 percant
and the notional principal is $20 mil.
1. What is the term used to describe such nonstandard instruments?
2. Calculate the FRA payoff on a long position?
CURRENCY FORWARD CONTRACT

Example: Microsoft has a European subsidiary that expect to send It 12mil in 90 days >> Mircrosoft
need to sell Euro and buy Dollar >> A currency forward contract is useful to enable to lock the exchange
currency rate >> Microsoft needs long euro and short dollar position
JP Morgan Chase propose a rate of $0.925 which enable Microsoft sell euro and buy Dollar at this rate
in 3 months => The converted money of Microsoft = 12mil * 0.925 = $11.100.000
3 months later, the spot rate for euros is $0.920 >> Microsoft is pleased !
But if the spot rate increase, Microsoft still have to deliver Euro and accept the rate=0.925
EXERCISE 4

Assume Sun Microsystem expect to receive 20mil in 90 days. A dealer provides a quote of $0.875 for
currency forward contract to expire in 90 days. Suppose that at the end of 90 days, the rate is $0.90.
Assume that settlement is in cash.
Calculate the cash flow at expiration if that company enters in to a forward contract expiring in 90 days to
buy dollars at $0.875
II. FUTURE CONTRACT

Is agreement between two parties, in which one party, the buyer agrees to buy from the other party,
the seller, an underlying asset or other derivative, at a future date at a price agreed on today; is public
transaction that takes place on an organized future exchange
Gains and losses on each partys position are credited and charged on a daily basis >> called: daily
settlement or making to market.
TRADING PROCESS

1. People enter into a future contract by establishing their long or short position
2. When the agreement is established, each party deposits a small amount of money called the
margin with clearinghouse.
# A party has opened a long position collects profits or incurs losses on a daily basis. At some point in the
life of the contract prior to expiration, that party may wish to re-enter the market and close out the
position >> offsetting ( selling previously purchased stock or buying back a stock to close the short
position)
# Noted that: when a party offset a position, it does not necessary do so with the same counterparty to
the original contract.
TYPES OF FUTURE CONTRACTS

Short-term interest rate future contracts

Treasury Bill Futures: in which the underlying is $1,000,000 of a US treasury Bill
Eurodollar Futures: in which the underlying is $1,000,000 of a Eurodollar time deposit
Intermediate and Long-term interest rate future contracts
Treasury bond future contracts: in which the underlying is $100,00 of a US Treasury bond with a minimum 15-
year maturity
Stock Index Future contracts: the underlying is well-known index (S&P500, etc)
Currency Future contracts
CLEARINGHOUSE, MARGINS AND PRICE LIMIT

Margin: Margin in Future market is different from Stock market.

>> Margin in Future market: describe the amount of money that must be put into on account by a party
opening up a futures position.
>> When a transaction is initiated, a futures trader puts up a certain amount of money to meet the initial
margin requirement, however the remaining money is not borrowed.
>> Each day, clearinghouse conducts daily settlement > will result a gains or losses each day >> The
holder position must maintain balances above the level called maintenance margin requirement.
>>Maintenance margin requirement < Initial margin requirement
>> The margin balance end of the day: taking previous balance + all gain/loss + Money added or withdraw
EXERCISE 5
Assumption that the future price is $100 when the transaction opens. The initial margin requirement is
$5, the maintenance margin requirement is $3.
Trader takes a long position of 10 contracts on day 0, depositing $50 (for each contract is $5).
Assume that the settlement price is as in the table.
Complete the table for both holder of long position and short position

Day Beginning balance Funds deposited Settlement price Future price change Gain/loss Ending balance

0 0 50 100 50

1 99.2

2 96

3 101

4 103.5

5 103

6 104
EXERCISE 6
Consider a futures contract in which the current price is $212. the initial margin requirement is $10. And
the maintenance requirement is $8. You go long 20 contracts and meet all margin calls but do not
withdraw an excess margin.
A. When could there be a margin call?
B. Complete the table below

Day Beginning balance Funds deposited Settlement price Future price change Gain/loss Ending balance
0 212

1 211

2 214

3 209

4 210

5 204

6 202
SWAP CONTRACTS
A swap is an agreement between two parties to exchange series of future cash flows

There are: long and short party.

> Long position: receive floating rate

> Short position: receive fixed rate

When a swap is initiated, neither party pays any amount to the other >> swap contract has Zero value at the start
of the contract
 Each date on which the parties make payments : settlement date / payment date

The time between settlement dates : settlement period

A swap always has a termination date = the date of the final payment

If the payments are made in the same currency, the payments are usually netted
TYPE OF SWAPS

Currency swaps

Interest rate swap

Equity swaps

Commodity and other types of swaps

 CURRENCY SWAP
In currency swap, each party makes interest payment to other in different currencies

Considering the following situation:

~ Company A in US want to open a new store in Germany and need 9 mil for initial operations => issue a
fixed-rate euro-denominated bond with face value of 9mil. But, A is not very well known in Europe.

~ Deutsche bank, advice company A to issue the bond in US dollar and use a swap to convert it into euros

~ Suppose A issues a five-year US$10mil bond at the rate=6%

Enter into a swap in Deutsche bank, who will make payment to A in US dollars at fixed rate = 5.5%

A will make payments to DB in Euro at fixed rate = 4.9%

The transaction will be on each 15 March and 15 Sept, for 5 years

 Thus, the swap is composed of the following transaction:

15 Sep:

- DB pays A 9mil

- A pays DB $10 mil

=> A has 9mil to begin the expansion

Each March and 15 Sep for 5 year

- DB pays A= $10mil * 5.5%(180/360) = $275,000

- A pays DB = 9mil*4.9%(180/360) = 220,500

15 Sep 5 years since initiation:

- DB pays A $10 mil

- A pays DB 9mil
 15
$10 mil

Company A D. bank

9mil

$10 mil

Net effect: A has 9mil for the expansion

As bondholder
 15 15
220,500

Company A D. bank

$ 275,000

$300,00

As bondholder
15 Sept, 5 years later
9mil

Company A D. bank

$ 10 mil

$10 mil

Net effect: A pays off its bondholder and terminates its swap

As bondholder
EXERCISE

Consider a currency swap in which the domestic party pays at fixed rate in the foreign currency, the
British pound, and the counterparty pays a fixed rate in U.S. Dollar. The notional principal are $50mil
and 30mil.
The fixed rate are 5.6% in $ and 6.35% in . Both sets of payment are made on the basis of 30 days per
month and 365 days per year. The payment are made semiannually
A. Determine the initial exchange of cash that occurs at the start of the swap
B. Determine the semiannual payment
C. Determine the final exchange of cash that occurs at the end of the swap
INTEREST RATE SWAPS

A plain vanilla swap: is an interest rate swap in which one party pays a fixed rate and the other pays a
floating rate, with both sets of payments in the same currency.
EXERCISE

Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms:
Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional
principal of $20 million. The one-year LIBOR was 5.33%.
Calculate the amount that company A and P pays for each other for the interest rate swap contract
EXERCISE

Determine the upcoming payments in a plain vanilla interest rate swap in which the notional
principal is 70mil. The end user makes semiannual fixed payments at the rate of 7% and the
dealer makes semiannual floating payments at Euribor, which is 6.25% on the last settlement
period. The floating payments are made on the basis of 180 days in the settlement period and
360 days in a year.

Payment are netted, so determine which party pays which and what amount.
EQUITY SWAPS

In equity swap, the rate is the return on a stock or stock index

# Different from other kinds of swap
#1: Make a variable payments based on the equity return: The return of a stock could be (+) or (-). If the
return is (+), the dealer will receive the return. But if the return is (-), the dealer has to pay for the user
#2: The payment is not know until the end of the settlement period.
EXERCISE

A mutual fund has arranged an equity swap with the dealer. The swaps notional principal is $100
mil, and payments will be made semiannually. The mutual fund agrees to pay the dealer the
return on a small-cap stock index, and the dealer agree to pay the mutual fund based on one of
the two specifications given below. The small-cap index starts off at 1,805,2. Six months later, it is
at 1,796.15
A. The dealer pays a fixed rate of 6.75 percent to the mutual fund, with payments made on the
basis of 182 days in the period and 365 days in year. Determine the first payment for both
parties and, under the assumption of netting, determine the net payment and which party
makes it
B. The dealer pays the return on a large-cap index. The index starts off at 1155.14 and six months
later is at 1148.19. Determine the first payment for both parties and , under the assumption of
netting, determine the net payment and which party makes it.
III. OPTION MARKETS AND CONTRACTS
Owning an option contract, holder has the right , not the obligation, to buy or sell an underlying asset.
An option is a financial derivative contract that provides a party the right to buy or sell an underlying at
fixed price by a certain time in the future.
A call option: granting the right to buy the underlying
A put option: granting the right to sell the underlying
To obtain this right, the option buyer pays the seller a sum of money called option price or Option
premium. This is paid when the option contract is initiated.
# The right to buy or sell is held by option buyer >> called Long or option holder
# The right to buy or sell is held by option seller >> called Short or Option writer
BASIC CHARACTERISTICS FOR OPTIONS

The fixed price at which the option holder can buy or sell the underlying is called exercise price / strike
price / striking price / strike
The use of the right to buy or sell the underlying is called exercise the option / exercise
The expiration date: When the expiration date arrives, an option that is not exercise simply expires
Cash settlement is possible
Option holder exercising a call receives the difference between: the market value of the underlying and the
exercise price from the seller in cash
Option holder exercising a put receives the difference between the exercise price and the market value of the
underlying asset in cash
 2 style of option:
American style: Holder can exercise on any day through the expiration day
European style: Holder can only exercised on its expiration day
For OTC option, 2 parties decide each of the terms through negotiation
For Exchange, the contract is standardized, the exchange establishes each term, except the price which
is negotiated by the 2 parties
In OTC option, only the buyer face the counterparty risk. In Exchange-listed option, the clearinghouse
guarantees payment to the buyer.
TYPE OF OPTION

Stock options
Index options
Bond options
Interest Rate Options
Currency Options
EXAMPLE OF OPTIONS
Closing price of Selected Options on SUNW, 13 June
Exercise Price July calls October Calls July Puts October Puts
15.00 2.35 3.30 0.90 1.85
17.5 1.00 2.15 2.15 3.20
Note: Stock price is $16.25; July options expire on 20 July; October Option expire on 18 Oct.

- July call:
- With price of $2.35, we obtain the Call option for the exercise price of $15
- With the lower price $1, we obtain the call option for the exercise price of $17.5
- July Put:
- With price of $0.9 , we obtain the Put option for the exercise price of $15
- With the lower price $2.15, we obtain the put option for the exercise price of $17.5
# The price of Option in July is cheaper than the price of Option in October: Buyer expects
For longer period, the change in the price could move as the buyer wants >> Willing to pay more
This means:
- Call options have a lower premium have the higher exercise price
- Put options have a lower premium have the lower exercise price
- Both call and put options are cheaper have the shorter time to expiration
CONCEPT OF MONEYNESS OF AN OPTION

Concept of moneyness refers to the relationship between the price of an underlying asset (S) and the
exercise price (K)

In-the-money: Positive payoff. For call option: S-K > 0, For Put option: K-S > 0
Out-of-the-money: negative payoff. For call option: S-K < 0, For Put option: K-S <0
At-the-money: neither gain or loss: is when S=X
EXERCISE

Consider a July 40 call and a July 40 put, both on a stock that is currently selling for $37/share. Calculate
how much these options are in or out of the money?
# Note: A July 40 call: a call option with an exercise price of $40 and an expiration date in July
PRINCIPLE OF OPTION PRICING

An option has a positive value at the start; The buyer must pay money and the seller receive money to
initiate the contract
Prior to expiration, the option always has positive value to the buyer and negative value to the seller
The option price is the option value
# Assume that: All market participants in the market behave in a rational manner (do not throw away
money , take advantage of arbitrage opportunities). As such, we assume that markets are sufficiently
competitive that no arbitrage opportunities exist.
WE CALL
0 , = Price of the underlying asset at time 0 and time T (expiration)
X = Exercise price
r= Risk-free rate
T= Time to expiration = No. of days to expiration / 2365
0, = Price of European call today and at expiration
0, = Price of American call today and at expiration
0, = Price of European put today and at expiration
0, = Price of European puttoday and at expiration
PAYOFF VALUES
An options value at expiration is called Payoff
# At expiration: a call option is worth either Zero of the difference between the underlying price (S) and
the exercise price (X), whichever is greater:
= Max (0, )
= Max (0, - X)

# At expiration: A put option is worth either Zero or the difference between the exercise price (X) and the
underlying price (S)
= (0, )
= (0, )
Types of Option Payoff Call Payoff Put
contract
Stock option Max (0, - X) (0, )

Index option Max (0, - X) * Index contract multiplier (0, ) *Index contract
multiplier

Bond option Max (0, - X) *Face value Max (0, - X) *Face value

Interest rate option (Notional principal)* Max (0, - X) * (Notional principal)* Max (0, )

( ) *( )
360 360

Currency option Max (0, - X) *Currency value Max (0, - X) *Currency value
Option values at Expiration, Assume X= 50
Option Value = 52 = 48

European Call = Max (0, )

American call = Max (0, - X)

European Put = (0, )

American Put = (0, )

LONG CALL

Value
5

2 Value

0
0 50 51 52 53 54
SHORT CALL

Short call / Long put / Short put ?

EXERCISE

Determine the payoff of calls and puts under the conditions given
1. The underlying is a stock index and is at $5601,19 when the option expire. The multiplier is 500. The
exercise price is:
A. 5500
B. 6000
2. The underlying is a bond and is at $1,035 per $1 par when the option expire. The contract is on
$100.000 Face value of bonds. The exercise price is:
A. $1.00
B. $1.05
3. The underlying is a 90-day interest rate and is at 9% when the option expire. The notional principal is
$50 mi. The exercise rate is:
A. 8%
B. 10.5%
4. The underlying is the Swiss Franc and is at $0.775 when the options expire. The options are on SF
500,000. The exercise price is:
A. $0.75
B. $0.81
5. The underlying is a future contract and is at 110.5 when the options expire. The options are on a future
contract covering $1 mil of the underlying. These prices are percentages of par. The exercise price is:
A. 110
B. 115
BOUNDARY CONDITIONS

# Minimum and Maximum value

Minimum value of any option is zero. No option can sell for less than 0, because if the option <0,
means: the writers have to pay for the buyer
The maximum value of a call : is the current value of the underlying
The maximum value of a European put: is the present value of the exercise price
The maximum value of an American put is the exercise price
FILL THE TABLE
Option values at Expiration, Assume X= 50, S=52, r= 5%, T = year

Option

European Call

American call

European Put

American Put
 LOWER BOUND
Lower bound of a European call: is constructed by a portfolio consisting of a long call and risk-free
bond and a short position in the underlying asset >> produce a non-negative value at expiration, so at
current value, it should be non-negative
The new Max-Min of an European call is : 0= Max (0, 0 /(1 + )^)
Lower bound for American call is alike European call

A lower Bound combination for European Calls

Transaction Current Value < >
Buy call 0 Not exercise = 0
Sell short -0 - -
underlying
Buy bond X/(1-r)^T X X
Total =sum of 3 above X- >0 0
 The new Max-Min of an European put is : 0= Max (0, /(1 + )^- 0)
The lower bound for American put is: 0 = (0, 0)

A lower Bound combination for European Puts

Transaction Current Value < >

Buy put 0 Exercise=X- Not exercise =0
Buy underlying 0

Issue bond -X/(1-r)^T -X -X

Total =sum of 3 above 0 >0
EXERCISE

Consider call and put options expiring in 42 days, in which the underlying is at 72 and the risk-free rate
is 4.5%. The underlying makes no cash payments during the life of the options.
A. Find the lower bounds for European calls and puts with the exercise prices of 70 and 75
B. Find the lower bounds for American calls and puts with the exercise price of 70 and 75
PUT-CALL PARITY

The derivation of put-call parity for European options is based on the payoffs of portfolios
combination:
Fiduciary call and protective put
Synthetics
An Arbitrage Opportunity
 A fiduciary call: is a combination of a call with exercise price W and a pure-discount, riskless bond that
pays X at maturity (option expiration). The payoff for fiduciary call = X at the expiration if the call is out-
of-the-money. IF the call is in-the-money, payoff= X+(S-X)
Is called a fiduciary call because: it allows protection against downside losses and is thus faithful to the
notion of preserving capital

Transaction Current Value < >X

Buy call 0 0 X

Buy bond X/(1+r)^T X X

Total 0+ X/(1+r)^T X
 A protective put: is a share of stock together with a put option on the stock. The expiration date payoff
for a protective put is (X-S)+S=X when the put is in the money, or = S if the put is out of the money

Transaction Current Value < >X

Buy put - 0

Buy underlying
asset
Total = + X
 Transaction Current Value < >X

Buy call 0 0 X

Buy bond X/(1+r)^T X X

Total 0+ X/(1+r)^T X
Transaction Current Value < >X
Buy put - 0

Buy underlying
asset
Total = + X

+ X/(1+r)^T = +
CALL AND SYNTHETIC CALL
+ X/(1+R)^T = + = + - X/(1+R)^T
Value at expiration
Transaction Current Value < >X
Call
Buy call 0 -X
Synthetic call
Buy put - 0

Buy asset

Issue bond -X/(1+r)^T -X -X

Total + - X/(1+r)^T 0 -X
PUT AND SYNTHETIC PUT
+ X/(1+R)^T = + = + X/(1+R)^T-

Value at expiration
Transaction Current Value < >X
Put
Buy put X-St
Synthetic put
Buy call St-X
Short asset -

Buy bond X/(1+r)^T X X

Total + X/(1+r)^T- X-St
 ALTERNATIVE EQUIVALENT .
+ X/(1+R)^T = + <<
Strategy Consisting of Worth = Strategy Consisting of Worth

Fiduciary call Long call + X/(1+r)^T = Protective put Long put +

Long bond Long underlying
Long call Long call = Synthetic call Long put + - X/(1+r)^T
Long underlying
Short bond
Long put Long put = Synthetic put Buy call + X/(1+r)^T-
Short asset
Buy bond
Long underlying Long underlying = Synthetic Long call + X/(1+r)^T-
underlying Long bond
Short put

Long bond Long bond X/(1+r)^T = Synthetic bond Long put + -

Long u.asset
Short call
AN ARBITRAGE OPPORTUNITY

Considering the following situation involving call options:

- The exercise price is $100, expiring in a half year. Risk free rate is 10%. The call is price at $0.75, and
the put price is at $4.25. The underlying price is $99.
>> Recall: + X/(1+r)^T = + < = > left side: 0.75 + 100/(1+10%)^0.5 = 102.85
right side: 5.25 + 99 = 103.25
The protective put is overpriced, and the other is underpriced.
THE STRATEGY
Now, we sell the put and sell short the underlying to obtain: $103.25, then, buy the fiduciary call, pay=
$102.85 =>> Nets in cash inflow = $0.40
What happens at expiration?

Transaction > <100

Protective put
Short put 0 100
Short underlying - -
Fiduciary call
Long call 0

Long bond 100 100

Net effect 0 0
EXERCISE

The put-call option with an exercise price of 45 expire in 115 days. The underlying is priced at 47 and
makes no cash payments during the life of the options. The risk-free date is 4.5%. The put is selling for
3.75 and the call is selling for 8.00
1. Identify the mispricing by comparing the price of the actual call with the price of the synthetic call
2. Based on your answer in part A, demonstrate how an arbitrage transaction is executed? (hint: sell the
call and buy the synthetic call)
THE END