Engineering New Risk Management Products Option-Related Derivatives II

Engineering New Risk Management Products Option-Related Derivatives (II) Dr. J. D. Han King’s College, UWO

1. Straight Options: “Vanilla” • USD call/JP Yen put “Face values in dollars = $10, 000 Option call/put = USD call or JPY put Option Expiry = 90 days Strike = 120. 00 Exercise = European” The buyer of this option has a right to buy USD $10 million by delivering JP Y 1, 200 millions (USD call); He has a right to sell his JP Y 1, 200 million for USD $1 (JPY put). This option will be exercise only when the actual price of a US dollar in terms of Yen goes above 120. 00. 2

2. Creating New Products • Combining existing instruments • Restructuring existing instruments • Applying existing instruments to new markets 3

3. Combining Options with Forwards • Allows hedge against unfavorable outcome • Allows retention of possible benefits • Three types of forward options are common – Break forwards – Range forwards – Participating forwards Most common in Foreign Exchange Markets 4

1) Break Forwards • Modifies forward to have features of a call • Premium is paid “implicitly” • Owner can “break” or unwind the forward position at a price below the contract price 5

Break Forward Payoff Diagram Standard Forward Break Forward Typical Forward Contract Rate 1. 40 1. 45 1. 50 1. 55 1. 60 $/£ Contract Rate Price where owner may break (unwind) 6

2) Range Forward • A forward contract with limited gain & loss • Major merit: Low Cost • Also known as – A flexible forward – Forward band • a long position in a currency put plus a short position in a currency call 7

3) Participating Forward • • Way to eliminate the “up-front” premium Combine short forward position with Long out-of-money call Short fraction of in-money put 8

Participating Forward Diagram V Buy 1 Call Resulting Exposure P Combined Option Payoff Sell 1/2 Put Inherent Risk 9

• • • 3. Combining Options with Options: ‘Synthetic Options’- Mainly Tools for Speculators Straddle Strangle Butterfly Condor Spread Cylinder = Collar 10

1) Long “Straddle” Use: Betting on an Increased Price Volatility Construction: Long Call and Long Put at the same Strike Price 11

2) Long ‘Strangle’ Use: the same as ‘Straddle’ but a lower premium Construction: long call and long put at different strike prices 12

3) Long ‘Butterfly’ 13

4) Long ‘Condor’ 14

5) Spread: ‘Low or Zero Cost Options’ (1) Bull Spread Buy Call at X 1 and Sell Call at X 2 X 1 X 2 Sell call option and use the premium to buy another call option at a lower strike price: X 1 > X 2 15

(2) Bear Spread: Buy Put at X 1 and sell Put at X 2 Short put X 1 X 2 Use the premium from short Put in order to buy another Put at a higher strike price Long put 16

6) Collar = Cylinder =Range Forward A kind Long Put S 1 Short Call 17

Another kind of Collar Which one to choose depends on the Initial FX risk of the hedger. 18

• A collar is an interesting strategy that is often employed by major investment banks and corporate executives. • This position is made by selling a call option at one strike price and using the proceeds to purchase a put option at a lower price. The cost to the investor to make this trade, therefore, is low or close to zero. • It is called Cylinder = Option fence = collar = range forward. 19

• When this collar or cylinder is used for a long position of any asset(FX), then the net wealth position of the combination of initial FX risks and hedging looks like a ‘Spread’. • That is the upside potential modified because of the cost saving actions. 20