CALL OPTION : It gives right to the owner (buyer) of the call option to buy an asset

at a specified price that is called Strike price or X at a certain date or exchange the
difference b/w Strike price and the price of asset at time T.

The Seller of the option has an obligation to sell the asset at the strike price.

Question We buy the call with the exercise price of 2000 for 8 1.75. Consider
values of the index at expiration of 1900 and 2100. For ST = 1900,

Answer The formula to calcuate profit = π = max(0,ST - X) - co

Here π is the profit, ST is the asset value at time T, X is the exercise price, c0 is the value
of call option . The formula simply says that whatever the maximum, 0 or ST-X will be
Taken and then we deduct the cost of the call option we have paid

1) if the strike price is $2,100 then the call option is in the money and the profit
π= Max(0, 2100 - 2000) - 87.75 = 18.25

2) if the strike price is 1900 the the option is out of money so the profit would be
II = max (0, 199 - 2000) - 87.75 = -87.75 or a Loss of 87.75

Breakeven price is the price of the asset at which the buyer of the call option has
neither profit nor loss that is π = Max(0, ST - X) - co = 0 and that is possible if
Strike price rise enough to cover the cost of the call option in the above example
π = max(0, 2087.75 - 2000) - 87.75 = 0. So the breakeven price of asset is 2087.75

Maximum profit of a Call Option is unlimited as the price of asset can go up at any
level where as Maximum Loss of a call option is the cost of the call option or co.

COVERED CALL : It is a position in which you own the asset and sell a call
The value of the position at time 0 is the cost of the underlying asset minus
the proceed from the sale of the call option. That is V0 = S0 - co. Why we deduct the
value of call option because we invested in the asset and we got back some of
our investment by selling the call so our actual value of investment at time 0 is S0 - co.

The profit from this strategy is the VT - V0 or the value of this portfolio at the end
less value at the start

If the Call option is out of money ( ST <= X) then simply the VT = ST and profit is
VT - V0 or (S0 - ST )+co

If the option is in the money then VT = X and profit = (S0 - X )+c0

Suppose in the above example the A manager buys the asset at $2000 and sold a
call option for 59.98 at a strike price of 2050. Suppose the value of asset at time T
 is 2100 then the option is in the money and the manger has to deliver the asset and
get 2050 plus 59.98 = 2109.98. At the start the value of this protfolio was 2000 - 59.98
= 1940.02 and at time T the value of 2050 so a gain of 2050 - 1940.02 = 109.98

if the price of the asset at time T is 1900 the call option will be out of money and
the manager has a value of 1900 + 59.98 so a loss of $2000 - $1900 + $59.98 = $40.02

selling a call without owning the stock exposes the investor to unlimited loss potential.
But selling a covered call-adding a short call to a long position in a stock reduces the overall risk.

Coverd Call not only reduces the risk but also reduces the expected return compared with
simply holding the underlying

Question Consider a bond selling for $98 per $100 face value. A call option selling for $8 has
an exercise price of $105. Answer the following questions about a covered call.
A. Determine the value of the position at expiration and the profit under the following
outcomes:
i. The price of the bond at expiration is $1 10.
ii. The price of the bond at expiration is $88.
B. Determine the following:
.i. . The maximum profit 11. The maximum loss
C. Determine the breakeven bond price at expiration

Solution i) Here S0 = $98

co =$8
X = $105
ST = 110 Since the Strike price is above exercise price therefore the option
in the money so the the holder of the option will get $105 plus $8 the price of option
and VT = $105+8 = 113 and profit is 98-105 +8 = $15
The maximum profit in Covered Call is equal to the difference of exercise price less the
underlying initial price plus the value of the call that is X - S0 + c0 Why because the upside
potential of the underlying asset is sold to the option buyer. If price goes up the strike
price the seller of the option will only get the exercise price plus the value of the call

ii) if the strike price or ST is $88 the option is out of money therfere the option is useless
for the buy of option therefore the value of the portfolio or VT = $88 +8 = $96
and the profit = 88 - 98 + 8 = - 2 or loss of $2
The Maximum loss is $98 - $8 = $90. If the value of the asset become Zero the holder of the
bond will lose $98 but gain the value of call option that he has sold so total maximum loss
is 98 - 8 = 90
breakeven is if strike price goes up to S0 - co that is 98-8 = 90. at the price of the $90 the
call option would be out of money and the value of the asset would be $90 + 8 = 98 which
is equal to V0 when the asset was bought at $98
 PROTECTIVE PUT Holding an asset and a BUY a put on the asset is a protective put strategy.
buying a put to add to a long stock position is much better than selling a call because it keeps
open the upside potential of the underlying asset but give downside protection.
protective put is often viewed as a classic example of insurance.

The value this portfolio at Time 0 is value of asset plus the cost of the put option that is S0 + p0
The Value at the expiration of option
if Option is in the Money that is ST <= X
VT = ST + (X - ST) = X and the profit is π = X - (S0+P0)

If Option is out of money that is ST > X then VT = ST and profit is π= ST - (S0 + P) )

Question Suppose the price of an underlying at Time 0 is 2000 and a Put is bought at exercise price of
1950 with a premium of 56.01. If the value of underlying at expiration is 2100 then

V0 = S0+P0 = 2000+56.01 2056.01

VT = ST = 2100
π = VT - V0 = 2100 - 2056.01 = 43.99

If the value of underlying at expiration is 1900 then

VT = ST + (X-ST) = 1900 +(1950-1900) = 1950
profit = VT - V0 = 1950 -2056.01 =-106.01

The maximum profit is unlimited as the upside is open the maximum loss is S0-X-p0 that is
2000 - 1950 - 56.01 = 6.01
The breakeven = S0 + p0 that is 2000+56.02 the price of the underlying must go at this level
so that the total cost of purchasing under lying and the put option can be recovered.

Question Consider a currency selling for $0.875. A put option selling for $0.075 has an exercise
price of $0.90. Answer the following questions about a protective put.
A. Determine the value at expiration and the profit under the following outcomes:
i. The price of the currency at expiration is $0.96.
ii. The price of the currency at expiration is $0.75.
B. Determine the following:
i. The maximum profit
ii. The maximum loss
C. Determine the breakeven price of the currency at expiration
A (i) since the put option is out of money therefore VT = ST
Profit = S0 - p0 = 0.96 - .875 - 0.075 = 0.01
The V0 = S0 + p0 = 0.875 + 0.075 = 0.95
profit = VT - V0 = 0.96 - 0.95 = 0.01

A(ii) Since the option is in the money therfore VT = X

profit = VT - V0 = 0.90 - 0.95 = -0.05
B (i) The maximum profit this portfolio can earn depends on the underlying price
The maximum profit in the situation in A(i) = 0.96 - .875 - .075 = 0.01.

B (ii) Maximum Loss = S0 - X - p0 = .875 - 90 - .075 = 0 .05

C Break even = S0 + p0 = 0.0875 + 0.075 = 0.95

BULL SPREAD
In this strategy we combine a long position in a call with one exercise price and a short position
in a call with a higher exercise price. Let X1 be the exercise price of Long call and X2 be the exercise
price of short call the c1 is value of long call at time 0 and c2 be the value of short call at time 0
Since we are long in c1 therefore we paid the value of c1 and we are short in c2 so we have received
the value of c2 as premium therefore the value of this portfolio at time 0 =
V0 = c1-c2

VT = max(0,ST-X1) - max(0, ST - X2)

profit = max(0,ST-X1) - max(0, ST - X2)-(c1 - c2)

Now there can be three situations i) both options are in the money ii) both options are out of money iii)
one option is in the money and 2nd is not

if ST <= X1 then it means the the underlying price is lower then the lower exercise price so c1 is out of
money and therefore ST is lower then X1 therefore it is also lower then X2 because X2 was higher then
X1 so if ST is lower then X1 then it must also be lower then X2 so both the options are out of money therefore
VT = 0 - 0 = 0

If First long call is in the money but short call is out of money that is X1 < ST < X2 then value of portfolio at time T
VT = ST - X1 - 0 = ST - X1

IF the underlying price at time T that is ST is greater or equal to X2 then the short call is in the money then
value of portfolio at time T
VT = ST - X1 - (ST - X2) = X2 - X1

Question Supose exercise price X1 = 1950 and X2 = 2050, c1 = 108.43 and c2 = 59.98. if asset price at expiration is
2100, 2000, and 1900 then determin the VT and profit

i) Suppose asset price ST is 2100 then both the options are in the money The value of the portfolio at time T

VT = 2100 - 1950 - (2100 - 2050) = 150 - 50 = 100

so the V0 was (c1 - c2) = 108.43 - 59.98 = 48.45
so the profit = VT - V0 = 100 - 48.45 = 51.55

ii) If the asset price at atime T = 2000 then long call is in the money but short coll is not
VT = ST - X1 - 0 = 2000 - 1950 = 50
 Porfit = VT - V0 = 50 - 48.45 = 1.55

iii) If the asset price at time T = 1900 then both the long and short call are out of money therefore VT =
VT = 0 - 0 = 0 and profit = 0 - 48.45 = - 48.45 or loss

A bull spread has some similarities to the covered call. With

a covered call, the long position in the underlying "covers" the short position in the call. In
a bull spread, the long position in the call with the lower exercise price "covers" the short
position in the call with the higher exercise price. For both strategies, the short call can be
viewed as giving up the gains beyond its exercise price.

BEAR SPREAD
If one uses the opposite strategy, selling a call with the lower exercise price and buying a
call with the higher exercise price, the opposite results occur. This strategy is called
a bear spread. The more intuitive way of executing a bear spread, however, is to use puts.
Specifically, we would buy the put with the higher exercise price and sell the put with the
lower exercise price

The value of this position at expiration would be VT = max(0,X2 - ST) -max(0,X1 - ST)

In the example, we again use options with exercise prices of 1950 and 2050. Their
premiums are pl = 56.01 and p2 = 107.39. We examine the three outcomes we did with
the bull spread: ST is 1900, 2000, or 2100

The value of this portfolio at time 0 = p2-p1 = 107.39 - 56.01 = 51.38. NOTE we put P2 price
first because we sold p2 for a higher price.

i) Since the ST is below both the exercise price therefore both options are in the money
VT = max(0, 2050-1900) - max( 0, 1950 - 1900) = 150 - 50 = 100
Profit = VT - V0 = 100 - 51.38 = 48.62

ii) At this asset price the long put is in the money while the short put is out of money
VT = max(0,2050-2000) - max(0, 1950-2000) = 50 - 0 = 50
Porift = VT - V0 = 50 - 51.38 = -1.38

iii) Since the underlying value is higher then both the strike prices therefore both the
options are out of money.

VT = max(0, 2050 - 2100) - max(0, 1950 - 2100) = 0 - 0 = 0

Profit = VT - V0 = 0 - 51.38 = -51.38

Breakeven = X2 - p2+p1

Question Consider two put options on a bond selling for $92 per $100 par. One put has an
 exercise price of $85 and is selling for $3. The other put has an exercise price of $95
and is selling for $1 I. Both puts expire at the same time. Answer the following questions
about a bear spread:
A. Determine the value at expiration and the profit under the following outcomes:
i. The price of the bond at expiration is $98.
ii. The price of the bond at expiration is $9 1.
iii. The price of the bond at expiration is $82.
B. Determine the following:
i. The maximum profit
ii. The maximum loss
C. Determine the breakeven bond price at expiration

We will buy the put with higher exercise price so X2 = 95 and p2 = $11. we sell the
put at a premium of $3 with exercise price of $85 so X1 = $85 and p1 = $3

A(i) if the ST is $98 both the put options are out of money because asset price is higher then
both the exercise prices.
V0 = 3 - 11 = -8
VT = max(0,95 - 98) - max(0, 85 - 98) = 0 - 0 = 0
profit = -8 - 0 = -8

A(ii) Since the asset price or ST is lower then X2 therefore the long option is in the money. Since
ST is still higher then X1 that is 85 therefore it is out of money
so VT = max(0,95-91) - max(0, 85-91) = 4 - 0 = 4
profit = 4 - 8 = -4

A(iii) Here the underlying price (asset price) is even lower then both the exercise prices therefore
both the options are in the money.
VT = max(0,95 - 82) - max(85 - 82) = 13 - 3 = 10
profit = 10 - 8 = 2

B The maximum profit in this strategy is X2 - X1 +p1-p2 = 95 - 85 + 3 - 11 = 2

maxmimum loss will occurs when both the options are out of money and portfolio has a value of -8
that is the premium difference paid and received.

C Breakeven is X2 - p2 + p1 = 95 - 11 + 3 = 87

BUTTERFLY SPREAD
The butterfly spread combines a bull and bear spread.
for a butterfly spread to be an appropriate strategy, the
user must believe that the underlying will be less volatile than the market expects. If the
investor buys into the strategy and the market is more volatile than expected, the strategy
is likely to result in a loss.
we buy the calls with exercise prices of 1950 and 2050 and sell two calls with
exercise price of 2000. So, X1 = 1950, X2 = 2000, and X3 = 2050. Their premiums are
cl = 108.43, c2 = 8 1.75, and c3 = 59.98. Let us examine the outcomes in which ST =
1900, 1975, 2025, and 2100. These outcomes fit into each of the four relevant ranges.

X3 = 2050 c3 = 59.98
X2 = 2000 c2 = 81.75
X1 = 1950 c1 = 108.43

V0 = (81.75x2) - 59.98 - 108.43 = -4.91

VT = MAX(0, ST - X3) + MAX(0,ST-X1) - 2MAX(0,X2 - ST)

If ST = 1900 then VT = max(0, 1900-2050) + max(0, 1900-1950) - 2max(0, 1900-2000 ) = 0 + 0 - 0 = 0

Profit = VT - V0 = -0 - 4.91 = -4.91

IF ST = 1975 then VT = max(0,1975-2050) + max(0, 1975 - 1950) - 2max(0,1975-2000)

VT = 0 + 25 - 0 = 25
profit = 25 - 4.91 = 20.09

IF ST = 2025 then
VT = max(0,2025-2050) + max(0, 2025 - 1950) - 2max(0,2025-2000) = 0 + 75 - 50 = 25
profit = 25 - 4.91 = 20.09

IF ST = 2100 then
VT = max(0,2100-2050) + max(0, 2100 - 1950) - 2max(0,2100-2000) = 50 + 150 - 200 = 0
profit = 0 - 4.91 = -4.91

Hint = Since all four options are call options therefore when the ST is higher then
the highest exercise price then all the four options will be in the money. Similarly
when the ST is lower then the lowest exercise price then all the option will be
out of money.

BreakEven price = lower exercise price of long option mius the total net premium
lower exercise price of long option is X1 that is 1950 and net premium is -4.91 so
since the net premium is in negative therefore the breakeven price should be 1954.91

SELLING BUTTERFLY SPREAD STRATEGY

If the investor expects the market to be more volatile than he
believes the market expects, the appropriate strategy could be to sell the butterfly spread.
Doing so would involve selling the calls with exercise prices of X1 and X3 and buying two
calls with exercise prices of X2.
 SHORT BUTTERFLY SPREAD OR SANDWICH SPREAD
To implement this strategy we buy the puts with exercise prices
X1 and X3 and sell two puts with exercise price of X2

QUESTIONConsider three put options on a currency that is currently selling for $1.45. The exercise
prices are $1.30, $1.40, and $1.50. The put prices are $0.08, $0.125, and $0.18,
respectively. The puts all expire at the same time. Answer the following questions
about a butterfly spread.
A. Determine the value at expiration and the profit under the following outcomes:
i. The price of the currency at expiration is $1.26.
ii. The price of the currency at expiration is $1.35.
iii. The price of the currency at expiration is $1.47.
iv. The price of the currency at expiration is $1.59.
B. Determine the following:
i. The maximum profit
ii. The maximum loss
C. Determine the breakeven currency price at expiration.

X1 = 1.30 P1 = 0.08
X2 = 1.40 P2 = 0.125
X3 = 1.50 P3 = 0.18

i) The value of this portfolio at time 0 = 2x0.125 - 0.08 - 0.18 = .01

The VT = max(0, X1 - ST) - 2max(0, X2 -ST) + max(0,X3 - ST)
VT = max(0,1.30 - 1.26) - 2max(0, 1.40 - 1.26) + max(0,1.50 - 1.26) = .04 - .28 + .24 = 0
profit = 0 - .01 = -0.01

ii) if ST = 1.35
VT = max(0,1.30 - 1.35) - 2max(0, 1.40 - 1.35) + max(0,1.50 - 1.35) = 0 - .10 + 0.15 = 0.05
profit = .05 - 0.01 = 0.04

iii) if ST = 1.47
VT = max(0,1.30 - 1.47) - 2max(0, 1.40 - 1.47) + max(0,1.50 - 1.47) = 0 - 0 + 0.03 = 0.03
profit = .03 - 0.01 = 0.02

iv) if ST = 1.59
VT = max(0,1.30 - 1.59) - 2max(0, 1.40 - 1.59) + max(0,1.50 - 1.59) = 0 - 0 + 0 = 0.0
profit = 0.0 - 0.01 = -0.01

maximum profit X3 - X2 - net premium = 1.50 - 1.40 - 0.01 = 0.09

maximum loss = 0.01
Breakeven = hightest strike price - net premium = 1.50 - 0.01 = 1.49
COLLARS
A collar is a modified version of a protective put and a covered call and requires different
exercise prices for each. Let the put exercise price be X1 and the call exercise price be X2.
With X1 given, it is important to see that X2 is not arbitrary. If we want the call premium
to offset the put premium, the exercise price on the call must be set such that the price of the
call equals the price of the put. Then the call exercise price is selected by determining which
exercise price will produce a call premium equal to the put premium. Although the put can have
any exercise price, typically the put exercise price is lower than the current value of the underlying
call exercise price then must be above the current value of the underlying.

Although it is not necessary that the call premium offset the put premium, and the
call premium can even be more than the put premium, the typical collar has the call and
put premiums offset. When this offsetting occurs, no net premium is required up front. In
effect, the holder of the asset gains protection below a certain level, the exercise price of
the put, and pays for it by giving up gains above a certain level, the exercise price of the
call. This strategy is called a collar. When the premiums offset, it is sometimes called a
zero-cost collar. This term is a little misleading, however, as it suggests that there is no
cost to this transaction. The cost takes the form of forgoing upside gains. The term "zerocost"
refers only to the fact that no cash is paid up front.

Suppose we use the put with exercise price of 1950.

Its premium is 56.01. So now we need a call with a premium of 56.01. The call with exercise
price of 2000 is worth 81.75. So to get a lower call premium, we need a call with an
exercise price higher than 2000. By trial and error, we insert higher and higher exercise
prices until the call premium falls to 56.01, which occurs at an exercise price of about
2060.17 So now we have it. We buy the put with an exercise price of 1950 for 56.01 and sell
the call with exercise price of 2060 for 56.01. This transaction requires no cash up front.
Using our example where XI = 1950, pl = 56.01, X2 = 2060, c2 = 56.01, and So = 2000,
we obtain the following values at expiration:
IF ST = 1900
IF ST = 2000
IF ST = 2100

So there will be no upfront cash outflow but we are long in asset which has a value of S0 = 2000
VT = max(0, X1 - ST) - max(0, ST - X2) = max(0, 1950 - 1900) - (max(0, 1900 -2060) = 50
Profit = 1950 - 2000 = -50
Because no premium involve the price of asset is now 1900 so we had a $100 loss but $50 is covered
from the put option that is in the money so now our asset value of 1950 and we have a loss of $50.

if the ST = 2000. the situation will be that our call option we sold remain out of money where as the
put option we bought is also out of money as there is no change in the asset price and no net premium
involved therefore out V0 and VT both remain 2000 and there is no profit no loss.

IF ST is = 2100
 The put option we bought is out of money but our call option is in the money since the price of the asset
is above the exercise price so we will sell our asset for 2060 and our profit is $60.

Question The holder of a stock worth $42 is considering placing a collar on it. A put with an exercise price of $40
costs $5.32. A call with the same premium would require an exercise price of $50.59.
A. Determine the value at expiration and the profit under the following outcomes:
i. The price of the stock at expiration is $55.
ii. The price of the stock at expiration is $48.
iii. The price of the stock at expiration is $35.
B. Determine the following:
i. The maximum profit
ii. The maximum loss
C. Determine the breakeven stock price at expiration

A i) Since net premium is zero therefore V0 will be S0 which $42. So at ST = $55

VT = max(0, 40 - 55) - max(0, 55- 50.59 ) = 0 + 4.41
profit = 42 - 50.59 = 8.59

A(ii) VT = max(0, 40 - 48) - max(0, 48- 50.59 ) = 0 + 0

profit = 48 - 42 = 6.00

VT = max(0, 40 - 35) - max(0, 35- 50.59 ) = 5 + 0 = 5

profit = 42 - 40 = -2

B(i) maximum profit is can only occurs when the asset price goes up to 50.59 so at this price
maximum profit will be 50.59 - 42 = 8.59
maxmum loss is 40 - 42 = 2
Breakeven when asset price does not move that is ST = S0 or $42

STRADDLE
If an investor believes the market will be volatile but does not feel particularly strongly about the
direction. Suppose the investor buys both a call and a put with the same exercise price on the same
underlying with the same expiration. This strategy enables the investor to profit from upside or
downside moves. Its cost, however, can be quite heavy. In fact, a straddle is a wager on a large
movement in the underlying.

The initial value of the straddle is simply Vo = co + po.

The value of a straddle at expiration is the value of the call and the value of the put:
VT = max(0,ST - X) + max(0,X - ST).

let X = 2000. Then co = 81.75 and po = 79.25

If ST = 2100, the put will be out of money and call in the money so VT = 2100 - 2000 = 100.
If ST = 1900, Put is in the money and call out of money so VT = 2000 - 1900 = 100
If ST = 2100, the profit is II = 100 - 81.75 - 79.25 = -61.
 If ST = 1900, the profit is II = 100 - 8 1.75 - 79.25 = -61.

Question Consider a stock worth $49. A call with an exercise price of $50 costs $6.25 and a
put with an exercise price of $50 costs $5.875. An investor buys a straddle.
A. Determine the value at expiration and the profit under the following outcomes:
i. The price of the stock at expiration is $61.
ii. The price of the stock at expiration is $37.
B. Determine the following:
i. The maximum profit
ii. The maximum loss
C. Determine the breakeven stock price at expiration.

A(i) if ST = $61 VT = max(0, 50 - 61) + max(0, 61 - 50) = 0 + 11 - 12.125 = -1.125

The value of portfolio at time 0 = 6.25+5.875 = 12.125

A(ii) If ST = 37 VT = max(0, 50 - 37) + max (0, 37-50) = 13 - 12.125 = .875

B(i) maximum profit if ST goes below exercise price is is $1. If ST is above exercise price of of
$50 then the greater the ST above $50 the greater the profit so upper side is open

B(ii) The maximum loss is where ST does not move much and remain below the exercise price.
so both the option will be out of money and maximum loss is the total premium paid that is 12.125
C. The breakeven is where price does not move. X + V0 = 50+12.125 = 62.125

BOX SPREAD
A box spread is a combination of a bull spread and a bear spread.
A box spread can also be used to exploit an arbitrage opportunity but it requires that
neither the binomial nor Black-Scholes-Merton model holds, it needs no estimate of the
volatility, and all of the transactions can be executed within the options market, making '
implementation of the strategy simpler, faster, and with lower transaction costs.

Suppose we buy the call with exercise price X1 and sell the call with exercise price X2. This
set of transactions is a bull spread. Then we buy the put with exercise price X2 and sell the
put with exercise price XI. This is a bear spread. Intuitively, it should sound like a combination
of a bull spread and a bear spread would leave the investor with a fairly neutral position,
and indeed, that is the case.The value of the box spread at expiration is:

VT = max(0,ST - X1) - max(0, ST - X2) + MAX(0,X2 -ST) + MAX(0, X1 - ST)

initial value V0 = c1 -c2 + p2 - p1
Profit = X2 - X1 - c1+c2 - p2 + p1
Maximum profit = (same as profit)
Maximum loss = (no loss is possible, given fair option prices)
Breakeven: no breakeven; the transaction always earns the risk-free rate, given fair
 option prices.

In each case, two of the four options expire in-the-money,

and the other two expire out-of-the-money. In each case, the holder of the box spread ends
up buying the underlying with one option, using either the long call at X1 or the short put
at XI, and selling the underlying with another option, using either the long put at X2 or the
short call at X2. The box spread thus results in buying the underlying at X1 and selling it
at X2. This outcome is known at the start.

Question Consider a box spread consisting of options with exercise prices of 75 and 85. The
call prices are 16.02 and 12.28 for exercise prices of 75 and 85, respectively. The put
prices are 9.72 and 15.18 for exercise prices of 75 and 85, respectively. The options
expire in six months and the discrete risk-free rate is 5.13 percent.
A. Determine the value of the box spread and the profit for any value of the underlying
at expiration.
B. Show that this box spread is priced such that an attractive opportunity is available.

Buy call at X1 = 75 at a premium of -16.02

sell call at X2 = 85 at a premiym 0f +12.28

Buy put at X2 = 85 at a premium 0f -15.18

sell put at X1 = 75 at a premium of+ 09.72
Net premium -9.2

If we solve this without formula then At ST of $100, both the put will be out of money and
both calls will be in the money so the payoff will be 85-75 = 10 and profit = 10-9.2 = 0.80

if ST = $80 then both long call & long put will be in the money & payoff of long call will be
80 - 75 = 5 & you will be able to sell at 85 so get 85-80 = 5 total payoff 10 & profit 10-9.2 = 0.80

if ST = $60 both Calls are out of money & two put calls arein the money. You buy the asset at
75 paying 60-75 = -15 & sell it at 85 getting 85-60=25 so payoff = 25-15 = 10 profit = 10-9.2 = 0.80

the diffrece in both exercise prices = 10 at riskfree rate of 5.13 it s PV= 10(1.0513) 0.5 = 9.75
whereas the cost of this box spread strategy is -9.2 thefore it is underpriced.

INTEREST RATE OPTIONS

FRAs are forward contracts that pay off based on the difference B/W the underlying rate
and the fixed rate embedded in the contract when it is constructed.
 For example, consider a 3 X 9 FRA. This contract expires in three months. The underlying rate
is six-month LIBOR. Hence, when the contract is constructed, the underlying Eurodollar
instrument matures in nine months. When the contract expires, the payoff is made
immediately, but the rate on which it is based, 180-day LIBOR, is set in the spot market,
market, where it is assumed that interest will be paid 180 days later. Hence, the payoff on an
FRA is discounted by the spot rate on 180-day LIBOR to give a present value for the payoff as
of the expiration date

Just as an FRA is a forward contract in which the underlying is an interest rate, an

interest rate option is an option in which the underlying is an interest rate. Instead of an
exercise price, it has an exercise rate (or strike rate), which is expressed on an order of
magnitude of an interest rate. At expiration, the option payoff is based on the difference
between the underlying rate in the market and the exercise rate. Whereas an FRA is a
commitment to make one interest payment and receive another at a future date, an interest
rate option is the right to make one interest payment & receive another. And just as there are
call and put options, there is also an interest rate call and an interest rate put

INTEREST RATE CALL

An interest rate call is an option in which the holder has the right to make u known
interest payment and receive an unknown interest payment. The underlying is the unknown
interest rate. If the unknown underlying rate turns out to be higher than the exercise rate at
expiration, the option is in-the-money and is exercised; otherwise, the option simply expires

INTEREST RATE PUT

An interest rate put is an option in which the holder has the right to make an
unknown interest payment and receive a known interest payment. If the unknown underlying
rate turns out to be lower than the exercise rate at expiration, the option is in-the-money
and is exercised; otherwise, the option simply expires

All interest rate option contracts have a specified size, which, as in FRAs, is called the notional
notional principal. An interest rate option can be European or American Style, but most tend
to be European style. Interest rate rate options are settleed in cash.

Example Consider options expiring in 90 days on 180-days LIBOR. The option buyer specifed whatever
exercise 90 days on 180-day LIBOR. The option buyer specifies an exercise rate of 5.5% and a
notional principal of $10 million. Suppose that at expiration the 180-day LIBOR is 6%

Since at the expiration the LIBOR rate is above the exercise rate of 5.5% therefore the option
is in the money & buyer of this option will receive $10,000,000(.06 - 0.55) (180/360) = $25,000
Unlike an FRA This amount will not be paid at expiration but it will be paid after 180 days.
because these instruments are commonly used to hedge floating-rate loans in which the rate
is set on a on a given day but the interest is paid later.
The general formula for Interest rate call is as under:
(Notional Principal) max(0, Underlying rate at expiration - Exercise rate) (Days in underlying rate/360)
For a Interest rate put option the formula is:
(Notional Principal) max(0, Exercise rate- Underlying rate at expiration) (Days in underlying rate/360)

Borrowers use interest rate call options to hedge the risk of rising rate on floating -rate loans
Lenders use interest rate put options to hedge the risk of falling rate on floating-rate loans

INTEREST RATE CAP AND FLOOR

A combination of interest rate calls is called an interest rate cap or sometimes just a cap
A combination of interest rate puts is called an interest rate floor or sometimes just a floor
an interest rate cap is a series of call options on an interest rate, with each option expiring at
the date on which floating loan rate is reset, & with each option havinag the same exercise rate

USING INTEREST RATE CALL WITH SHORT TERM BORROWING

On 14 April, Global Computer Technology GCT is anticipating to take a $40 million loan on
20 August at LIBOR plus 200 basis point. The loan will be for 180 days and will be fully paid
on 16 February. GCT would like protection against higher interest rates, so it purchases an
interest rate call on 180-day LIBOR to expire on 20 August. GCT chooses an exercise rate
of 5 percent. This option gives it the right to receive an interest payment of the difference
between the 20 August LIBOR and 5 percent. If GCT exercises the option on 20 August,
the payment will occur 180 days later on 16 February when the loan is paid off. The cost of the
call is $100,000, which is paid on 14 April. LIBOR on 14 April is 5.5% and on 20 August 8%

14-Apr 20-Aug 16_February

GCT buys call Call expirs Loan paid off
Loan received after and Call Payoff
adjusting for PV of made
call premium

Step 1Since the $100,000 which is the call premium not normally paid at the start therefore
at the expiry of call when loan is received its PV is adjusted. We here will use the LIBOR rate
on 14 apr plus 200 bps so
100,000 (1.075)(128/360) = 102,667

Step 2 : On 20 August the compnay receives loan of 40 million less the adjusted value of the
premium of call therefore = $40,000,000 - 102,667 = 39,897,333

Step 3 : On 16 February, Since the interest rate on 20th august was 8% therefore GCT will pay
8% + 200 bps = 10% interest along with the principal amount of $40 million so
$40,000,000 X 10% X 180/360 = 2,000,000

Step 4 : Since the call was in the money therefore the company at 16 February will receive the
difference of underlying interest rate on 20 august and the exercise price of 5% so
$40,000,000 X (8% - 5%) X (180/360) = $600,000
 So Finally company will pay $40,000,000 + $2,000,000 - $600,000 = $41,400,000

The effective rate company paid on this loan = (41,400,000/39,897,333) 365/180 - 1 = .07785 = 7.79%

Question On 10 January, ResTex Ltd. determines that it will need to borrow $5 million on 15
February at 90-day LIBOR plus 300 basis points. The loan will be an add-on interest
loan in which ResTex will receive $5 million and pay it back plus interest on 16
May. To manage the risk associated with the interest rate on 15 February, ResTex
buys an interest rate call that expires on 15 February and pays off on 16 May. The
exercise rate is 5 percent, and the option premium is $10,000. The current 90-day
LIBOR is 5.25 percent. Assume that this rate, plus 300 basis points, is the rate it
would borrow at for any period of up to 90 days if the loan were taken out today.
Interest is computed on the exact number of days divided by 360.
Determine the effective annual rate on the loan for each of the following outcomes:
i. 90-day LIBOR on 15 February is 6 percent.
ii. 90-day LIBOR on 15 February is 4 percent.

The current rate at January 10 is 5.25 plus 300 pbs = 8.25% . The company bought
a Call for $10,000 the premium will be paid on 15 febuary so the value of the
premium on 15 feb = 10,000(1.0825 X 36/360) = 10082.5

On Feb 15 the company will receive $5,000,000 - 10082.5 = 4,989,917.5

On 16 may the company will repay its loan plus interest on it. The LIBOR on 15 Feb
was 6% so company will pay interest at the rate 9%
5,000,000 X 9% X 90/360 = 112,500 So the total payment will be 5,112,500
Since the 90-Day LIBOR rate on 15 Feb was above the strike rate of 5% therefore
the Call Option is in the money so the company will get back the difference
5,000,000 X (6% - 5%) X 90/360 = 12,500 . Therefore the net payment
On 16 may The net payment = 5,112,500 - 12,500 = 5,100,000

Effective rate = (5,100,000/4,989,917)365/90 -1 = 0.0912 or 9.25%

ii) If the 90-Day LIBOR is 4% on 15 February then on 16 May the company will pay
interest at 7% along with the principal amount that is
5,000,000 X 7% X 90/360 = 87,500 and company wll pay 5,087,500
Since the 90-Day LIBOR rate at 15 February is below the Strike rate of 5% therefore
the call is out of money and no payoff will occur on 16 May
Effective rate = (5,087,500/4,989,917)365/90 - 1 = 0.0817 or 8.17%

USING INTEREST RATE PUT WITH LENDING

Interest rate options pay off if LIBOR is below the exercise rate at expiration. If LIBOR
 is above the exercise rate at expiration, the option expire unexercised and the
lender benefits from the higher rate on the loan.

Question ABInc makes a commitment on 15 March to lend $50 million at 90-day LIBOR plus 2.5%
on 1 May, which is 47 days later. Current LIBOR is 7.25%. It buys a put with an exercise
rate of 7% for $62,500. Assume that the opportunity cost of lending in the LIBOR market
is LIBOR plus a spread of 2.5 percent. Therefore, the effective cost of the premium
compounded to the option's expiration is
$62,500 (1+ (0.0725 + 0.025) ( 47/360) = $63,296

When it lends on 1 May, it effectively has an outlay of $50,000,000+$63,296=$50,063,296

The loan rate is set on 1 May and the interest, paid 90 days later on 30 July, is LIBOR on
1 May plus 250 basis points
$50,000,000 (LIBOR on 1May plus 250 basis points (90/360)

The PUT payoff = $50,000,000 Max(0, 0.07 - LIBOR on 1st May) (90/360)

The Effective Rate = (Principal + Effective Interest)/50,063,296 - 1

Suppose LIBOR on 1 May is 6%. The Put is in the money since 6% is below the strike
rate of 7% The company will receive interst payment plus principal that is equal to
50,000,000 (8.5%) (90/360) = 1,062,500 so total amount it receives back = 51,062,500
plus the payoff of the option that is $50,000,000 (7% - 6%) (90/360) = 125,000
The Net payment the company will receive = 51,062,500 + 125,000 = 51,187500

The effective Rate = (51,187,500/50,063,296 )365/90 - 1 = 0.0942 or 9.042%

Question State Bank and Trust (SBT) is a lender in the floating-rate instrument market,
Recently SBT has made a commitment to make a loan of $100m to be made in 65
days at 180-day LIBOR plus 100 basis points. The loan will be paid back 182 days
after being taken out, and interest will be based on an exact day count and 360 days
in a year. Current LIBOR is 7.125 percent, which is the rate it could borrow at now
for any period less than 180 days. SBT considers the purchase of an interest rate put
to protect it against an interest rate decrease over the next 65 days. The put will have
an exercise price of 7 percent and a premium of $475,000.
Determine the effective annual rate on the loan for the following outcomes:
i. 180-day LIBOR at the option expiration is 9 percent.
ii. 180-day LIBOR at the option expiration is 5 percent.

(i) The current LIBOR rate is 7.125% so this is the opportunity cost for SBT. It has bought
PUT for $475,000 which has effective value of $475000 X 1.07125 X 65/365 = 481,111

After 65 days SBT lend $100 million plus 481,111 = 100,481,111

The Loan is paid pack with interest after 182 days and 180-day LIBOR is 9%
 so for company it will be 9% + 1% = 10%
$100,000,000 X 10% X 182/360 =5,055,555 = Total = 105,055,555

Since the 180-Day LIBOR was 9% which is above the strike rate of 7% therefore
the PUT option is out of money and there is no payoff

The effective Rate = (105,055,555/100,481,111 )365/182 - 1 = 0934 = 9.34%

(ii) If After 65 days 180-day LIBOR is 5% the interest rate for SBT is 5% + 1% = 6%
So After 182 days the company will get back
$100,000,000 X 6% X 182/360 = 3,033,333 the total SBT getback = 103,033,333
Since the Put Option is in the money the payoff is
$100,000,000 X (7% - 5%) X 182/360 = 1,011,111
so total SBT get 103,033,333 + 1,011,111 = 104,044,444

Effective Rate = (104,044,444/100,481,111)365/182 - 1 = 07239 0r 7.24%

USING INTEREST RATE CAP WITH A FLOATING RATE LOAN

An interest rate cap is a series of call options on an interest rate, with each option
expiring at the date on which floating loan rate is reset, & with each option
havinag the same exercise rate. many corporate loans are floating-rate
loans & require periodic interest payments in which the rate is reset on a regularly
scheduled basis. Because there is more than one interest payment, there is
effectively more than one distinct risk. If a borrower wanted to use an interest
rate call to place a ceiling on the effective borrowing rate, it would require more
than one call option expiring on each interest rate reset date.

A combination of interest rate call options designed to align with the rates on a loan
is called a cap. The component options are called caplets. Each caplet is distinct in
having its own expiration date, but typically exercise rate on each caplet is the same.

Measure Technology (MesTech), which borrows in the floating-rate loan market. It

usually takes out a loan for several years at a spread over LIBOR, paying the interest
semiannually and the full principal at the end. On 15 April, MesTech takes out a
$10 million three-year loan at 100 bps over 180-Day LIBOR from a bank. Current
180-day LIBOR is 9% which sets the rate for the first 6 months at 10%. Interest
payments will be on the 15th October and 15th April for three years. This means
that the day counts for the six payments will be 183, 182, 183, 182, 183, and 182.

To protect against increases in interest rates, MesTech purchases an interest rate cap
with an exercise rate of 8%. The component caplets expire on 15 October, the following
15 April, and so forth until the last caplet expires on a subsequent 15 October. The
loan has 6 interest payments, but because the first rate is already set, there are only
five risky payments so the cap will contain five caplets. The payoff of each caplet will be
determined on its expiration date, but the caplet payoff, if any, will actually be made
on the next payment date. This enables the caplet payoff to line up with the date on
which the loan interest is paid. The cap premium, paid up front on 15 April, is $75,000

8.50 percent on 15 October

7.25 percent on 15 April the following year
7.00 percent on the following 15 October
6.90 percent on the following 15 April
8.75 percent on the following 15 October

The first interst rate payment is certain as it is already known to be 9% so with

100 bps it would be 10%
10,000,000 X 10% X 183/360 = 508,333 since no cap for 1st payment so no payoff

On 15 october of ist year the Cap is in the money as LIBOR is 8.5%

the interest paymnet = 10,000,000 x 9.5% X 182/360 = 480,278
The payoff = 10,000,000 X ( 8.5% - 8%) X 182/360 = 25,278

On 15 Apr of 2nd year the CAP is out of money so no payoff

the interest paymnet = 10,000,000 x 8.25% X 183/360 = 419,375

On 15 October of 2nd year the CAP is out of money so no payoff

the interest paymnet = 10,000,000 x 8.00% X 182/360 = 404,444

On 15 Apr of 3rd year the CAP is out of money so no payoff

the interest paymnet = 10,000,000 x 7.90% X 183/360 = 401,583

On 15 Octber of 3rd year the CAP is in the money

the interest paymnet = 10,000,000 x 9.75% X 182/360 = 492,917
Payoff = 10,000,000 X (8.75% - 8%) X 182/360 = 37,917

CashFlows Cap Cap Net cashflow

Premium Payoff
- 10,000,000 75,000 - - 9,925,000
508,333 - - 508,333
480,278 25,278 455,000
419,375 - 419,375
404,444 - 404,444
401,583 401,583
10,492,917 37,917 10,455,000
NPV 2,718,735
IRR = 0.046
Annualized IRR =(1.046)2 1.094 9.4%
 USING INTEREST RATE FLOOR WITH FLOATING RATE LOAN
A lender is normally concerned about falling interest rates.
It could therefore, buy a combination of interest rate put options that expire on the
various interest rate reset dates. This combination of puts is called a floor, and the
component options are called floorlets.

Example Take from prevous example Suppose SenBank a lender, buy a floor with floorlets expirng
on the interest rate reset dates & with exercise rate of 8%. The premium is $72,500.

Loan amount: $10,000,000

Underlying: 180-day LIBOR
Spread: 100 basis points over LIBOR
Current LIBOR: 9 percent
Interest based on: actual days1360
Component floorlets: five floorlets expiring 15 October, 15 April, etc.
Exercise rate: 8 percent
Floor premium: $72,500

Shown below is one particular set of outcomes for LIBOR:

8.50 percent on 15 October
7.25 percent on 15 April the following year
7.00 percent on the following 15 October
6.90 percent on the following 15 April
8.75 percent on the following 15 October

Following is a summary of each floorlet outcome and interest payment

DATE 180-LIBOR Loan Days in Interest FloorLet Effective

Rate Period Due Payoffs Interest
15-Apr Yr 1 0.0900 0.1000
15-Oct Yr 1 0.0850 0.0950 183 $508,333
15-Apr Yr 2 0.0725 0.0825 182 $480,278 $0 $480,278
15-Oct Yr 2 0.0700 0.0800 183 $419,375 38,125 $457,500
15-Apr Yr 3 0.0690 0.0790 182 $404,444 50,556 $455,000
15-Oct Yr 3 0.0875 0.0975 183 $401,583 55,917 $457,500
15-Apr Yr 4 182 $492,917 $0 $492,917

Question Capitalized Bank (CAPBANK) is a lender in the floating-rate loan market. It uses
fixed-rate financing on its floating-rate loans and buys floors to hedge the rate. On
1 May 2002, it makes a loan of $40 million at 180-day LIBOR plus 150 basis points.
Interest will be paid on 1 November, the following 5 May, the following 1 November,
and the following 2 May, at which time the principal will be repaid. The exercise
rate is 4.5 percent, the floorlets expire on the rate reset dates, and the premium
will be $120,000. Interest will be calculated based on the actual number of days in
the period over 360. The current 180-day LIBOR is 5 percent.
Determine the effective interest payments CAPBANK will receive if LIBOR on the
following dates is as given:
1 November: 4.875 percent
5 May: 4.25 percent
1 November: 5.125 percent

DATE 180-LIBOR Loan Days in Interest FloorLet Effective

Rate Period Due Payoffs Interest
1-May-02 0.05000 0.06500
1-Nov-02 0.04875 0.06375 184 1,328,889 0 1,328,889
5-May-03 0.04250 0.05750 185 1,310,417 0 1,310,417
1-Nov-03 0.05125 0.06625 180 1,150,000 50000 1,200,000
2-May-04 182 1,339,722 0 1,339,722

Note there is a one day differnce b/w 01-nov-03 and 02-may-04 because of leap year. I made
adjustment to reconcile it with the book.

USING INTEREST RATE COLLOR WITH A FLOATING RATE LOAN

Borrowers normally use caps because they protect against rising interest rates but they have
to pay premium on caps. So in order to reduce the premium they sell floors so that preimum
is offset. A collar combines a long position in a cap with a short position in a floor. The sale of
the floor generates a premium that can be used to offset the premium on the cap. Although it
is not necessary that the floor premium completely offset the cap premium, this arrangement
is common. The exercise rate on the floor is selected such that the floor premium
is precisely the cap premium. The sale of the floor results in the borrower giving up any gains
from interest rates below the exercise rate on the floor. Therefore, the borrower pays for
the cap by giving away some of the gains from the possibility of falling rates.

Consider the $10 million three-year loan at 100 basis points over LIBOR. The payments are made
semiannually. Current LIBOR is 9 percent, which means that the first rate will be at 10 percent.
Interest is based on the exact number of days in the six-month period divided by 360. MesTech
selects an exercise rate of 8.625 percent for the cap. Generating a floor premium sufficient to offset
the cap premium requires a floor exercise rate of 7.5 percent. The caplets and floorlets will
expire on 15 October, 15 April of the following year, and so on for three years, but the payoffs
will occur on the following payment date to correspond with the interest payment based on
LIBOR that determines the caplet and floorlet payoffs. Thus, we have the following information:
Loan amount: $l0,000,000
Underlying: 180-day LIBOR
Spread: 100 basis points over LIBOR
Current LIBOR: 9 percent
 Interest based on: actual days/360
Component options: five caplets and floorlets expiring 15 October, 15 April, etc.
Exercise rate: 8.625 percent on cap, 7.5 percent on floor
Premium: no net premium

180-LIBOR rate on subsequent Dates

8.50 percent on 15 October
7.25 percent on 15 April the following year
7.00 percent on the following 15 October
6.90 percent on the following 15 April
8.75 percent on the following 15 October

DATE 180-LIBOR Loan Days in Interest Caplet FloorLet Effective

Rate Period Due payoff 8.625% Payoffs 7.5% Interest
15-Apr 0.0900 0.1000
15-Oct 0.0850 0.0950 183 508,333 508,333
15-Apr 0.0725 0.0825 182 480,278 0 0 480,278
15-Oct 0.0700 0.0800 183 419,375 0 -12708 432,083
15-Apr 0.0690 0.0790 182 404,444 0 -25278 429,722
15-Oct 0.0875 0.0975 183 401,583 0 -30500 432,083
15-Apr 182 492,917 -6319 0 486,597

Question Exegesis Systems (EXSYS) is a floating-rate borrower that manages its interest rate
risk with collars, purchasing a cap and selling a floor in which the cost of the cap
and floor are equivalent. EXSYS takes out a $35 million one-year loan at 90-day
LIBOR plus 200 basis points. It establishes a collar with a cap exercise rate of 7 percent
and a floor exercise rate of 6 percent. Current 180-day LIBOR is 6.5 percent.
The interest payments will be based on the exact day count over 360. The caplets
and floorlets expire on the rate reset dates. The rates will be set on the current date
(5 March), 4 June, 5 September, and 3 December, and the loan will be paid off on
the following 3 March.
Determine the effective interest payments if LIBOR on the following dates is as
given:
4 June: 7.25 percent
5 September: 6.5 percent
3 December: 5.875 percent

DATE 90-LIBOR Loan Days in Interest Caplet FloorLet Effective

Rate Period Due payoff 7% Payoffs 6% Interest
5-Mar 0.06500 0.08500
4-Jun 0.07250 0.09250 91 752,014 0 0 752,014
5-Sep 0.06500 0.08500 93 836,354 22604 0 813,750
3-Dec 0.05875 0.07875 89 735,486 0 0 735,486
 3-Mar 90 689,063 0 10938 700,000

DELTA HEDGE
An option dealer who has taken short position in a call has an open ended risk because at time T the
asset price can go anywhere upside. To layoff this risk the dealter can take the opposite position of
buying a call with a cheaper price which is difficult to find. Another way is to go long with underlying
by issuing a zero coupon bond(or borrow). This hedge is called static hedge because no change in the
position is required as time passes.

Practically both the hedging techniques are difficult to apply. Next best alternative, dealers delta hedge
their positions using an available and attractively pricedinstrument. The dealer is short the call and will
need an offsetting position in anotherinstrument. An obvious offsetting instrument would be a long
position of a certain numberof units of the underlying. The size of that long position will be related to
the option's delta. By defination a Delta is the Ratio of change in option price/Change in underlying price

Delta expresses how the option price changes relative to the price of the underlying. Technically,
we should use an approximation sign (≈) in the above equation, but for now we shall assume the
approximation is exact. Let ∆S be the change in the underlying price and ∆c be the change in the
option price. Then Delta = ∆c / ∆S

Delta usually lies between 0.0 and 1.0. Delta will be 1.0 only at expiration and only if the option expires
in-the-money. Delta will be 0.0 only at expiration if the option is out of money. So most of the time, the
delta will be b/w 0.0 and 1.0. Hence, 0.5 is often given as an "average" delta, but one must be carefull
because even before expiration the delta will tend to be higher than 0.5 if the option is in-the-money
If we construct a portfolio of Ns units of underlying & N, call options, then the value of portfolio is :
V = NsS + Nc C and the change in value of portfolio = ∆V = Ns∆S + Nc ∆C The final equation is :
Nc/Ns = - 1/( ∆c/ ∆S)
The ratio of calls to shares has to be the negative of 1 over the delta. Thus, if the dealer
sells a given number of calls, say 100, it will need to own 100(De1ta) shares
Suppose we sell call options on 200 shares and the delta is 0.5. We would, therefored, needs to bold
200(.5) = 100 shares. If the underlying falls by $1 then we lose $100 on our position in underlying. If the

delta is accurate, the option should decline by $0.50. By having 200 options, the loss in vlaue of the
options collectively is $100. Because we short the options, the loss in value of the options is actually
a gain. Hence, the loss on the underlying is offset by the gain on the options. If the dealer were
long the option, it would need to sell shrot the shares.

The delta hedging example above seems a simple solution but there are three complicating issues.
One is that delta is onlyan approximation of the change in the call price for a change in the underlying.
A secondissue is that the delta changes if anything else changes. Two factors that change are the
price of the underlying and time. When the price of the underlying changes, delta changes,
which affects the number of options required to hedge the underlying. Delta also changes
as time changes; because time changes continuously, delta also changes continuously.
Although a dealer can establish a delta-hedged position, as soon as anything happens-the
underlying price changes or time elapses-the position is no longer delta hedged. In some
cases, the position may not be terribly out of line with a delta hedge, but the more the underlying
changes, the further the position moves away from being delta hedged. The third issue
is that the number of units of the underlying per option must be rounded off, which leads to
a small amount of imprecision in the balancing of the two opposing positions.

DynaTrade is an options trading company that makes markets in a variety of derivative instruments.
On 18 Nov DynaTrade has just sold 500 call options on a stock currently priced at $125,75. The call has an
exercise price of $125, 60 days until expiration, a prince of $10.89 and a delta of 0.5649. DynaTrade will

delta-hedge this transaction by purchasing an appropriate number of shares. Any addiotnal transactions
required to adjust the delta hedge will be executed by borrowing or leding at the continuously
compounded risk-free rate of 4%
DynaTrade has begun delta hedging the option. Two days later, 20 Nov, the following information applies
Stock price: $122.75
Option price: $9.09
Delta: 0.5 176
Number of options: 500
Number of shares: 328
Bond balance: -$6,072
Market value: $29,645
-- --
A. At the end of 19 November, the delta was 0.6564. Based on this number, show
how 328 shares of stock is used to delta hedge 500 call options.
B. Show the allocation of the $29,645 market value of DynaTrade's total position
among stock, options, and bonds on 20 November.
C. Show what transactions must be done to adjust the portfolio to be delta hedged
for the following day (2 1 November).
D. On 21 November, the stock is worth $120.50 and the call is worth $7.88. Calculate
the market value of the delta-hedged portfolio and compare it with a
benchmark, based on the market value on 20 November.

A) On 19 November the delta is 0.6564 so for 500 calls DynaTrade needs 500(0.6564) = 328.20 shares
so rounding this value the company has same no of shares.

B) Value of Shares = 328* 122.75 = 40,262

value of options = -500*9.09 = -4,545
value of Bond -6,072
$29,645
C) On 21 Nov the new delta is 0.5176 so for that delta the company needs -500(0.5176) = 258.8 shares
It has 328 shares so 328-259 = 69 shares to be sold @ 122.75 getting = 69* 122.75 = 8470 and lend it at
 riskfree rate of 4%.

D) the portfolio of 20 Nov will grow by 4% continous rate to 29645 e(.04/365) = 29,648
Now company owns 269 shares which are worth 259 * 120.50 = 31,210
Call options worth 500 * 7.88 = -3,940
Bond worth = 8470 e(.04/365) = (bond value increased by.26 ) 2,398
Total portfolio vlaue on 21 Nov 29,668 29,668
The portfolio value on 21 Nov is worth more by $20

Question Consider the following information:

Stock price: $46
Exercise price of call options: $45
Call premium: $5
Delta: 0.5420
Number of calls sold: 1,000
Delta at the end of the previous day: 0.64
Continuously compounded risk-free rate: 4.5 percent.
A. How many shares of stock are needed to delta hedge the call position at the end
of the previous day?
B. Suppose that at the end of the previous day, we had a loan balance of $3,000. What
is the market value of the portfolio today using the new information given above?
C. Show what transactions would need to be done to adjust the portfolio to be delta
hedged for the following day.
D. On the following day, the stock is worth $45.50 and the call is worth $4.71. Calculate
the market value of the delta-hedged portfolio and compare it with a benchmark,
based on the market value computed in Part B above.

A = 1000(.64) = 640 shares

B Value of shares = 640*46 = 29440
Value of Call options 1000*5 = -5000
Loan balance -3000
21440

C Since Delta has changed so company need 1000(.542) = 542 shares it already have 640 shares so it has
to sale 640-542 = 98 shares at a value of 98*46 = 4508. So the new loan balance = -3000+4508 = 1508

D Value of Stock = 542 * 45.5 = $24,661

Option Value = -1000*4.71 = -$4,710
Loan value = 1508 e(0.045/365) = $1,508
21,459
PV of Previous day value 21440e(.045/365) = 21,443

The portfolio value increased by = 21549-21443 16

π
2100

2050
2025
2000

1950

1900
 bruary
paid off
all Payoff
OPTION STRATEGIES V0

COVERED CALL
BUY AN ASSET AND
SALE A CALL a Call for $5 at Strike price of $110 100+5 = 105
PAOFF IF ST > EXERCISE PRICE VT Profit

PAYOFF= MAX(0, ST - X) X+c0 X+c0 - S0

if ST = 120 payoff = max(0, 120,110) = $10 110+5 = 115 X+c0 - S0 = 110+5-100 = 15

if ST = 105 payoff = max(0, 105,110) = 0 105+5 = 110 ST+c0 -S0= 105-5-100 = 10
maximum profit Maximum Loss Breakeven

X+c0-S0 = 110+5 -100 = 15 S0-c0 = 100-5=95 S0-c0 = 100-5 = 95

TYPES OF FORWARD CONTRACTS
EQUITY FORWARD CONTRACT
An equity forward is a contract calling for the purchase of an individual stock, a stock
portfolio, or a stock index at a later date. The contract can be structrued requiring actual
delivery of stocks or cash settelment.

FORWARDC ONTRACTSO N INDIVIDUBOANLD S AND BOND PORTFOLIOS

There is a similarity b/w forward contracts on equity and on bond that individual stock,
stock portfolio or stock index give Dividend. In case of bond the individual bond or
bond index give Coupon. But unlike the forward contract on equity the bond matures
at a certain date the the forward contract on Bond must expires before bond matuirty.
Unlike Equity stocks, bonds often have many special features such as calls and convertibility
And finally unlike stocks, bond carry default risk.

FORWARD CONTRACTS ON INTEREST RATES :FORWARD RATE AGREEMENTS

FRAs are contracts in which the underlying is simply an interest payment
FRA mature in a certain number of days and are based on a rate that applies to an instrument
maturing in a certain number of days measured from the maturity of the FRA. Thus,
there are two day figures associated with each contract. Our example was a 90-day
contract on 180-day LIBOR. To avoid confusion, the FRA markets use special terminology
that converts the number to months, Like 3 X 9 FRA which reflects the fact that the contract
expires in three months and that six months later, or nine months from the contract
initiation date, the interest is paid on the underlying

CURRENCY FORWARD CONTRACTS

Currency forwards are widely used by banks and corporations to manage foreign exchange
risk. Suppose Microsoft is expecting to receive 1,200,000 Euro from its Euoropian Office in
3 months. Microsoft will go to a delear and ask for a forward quote for 1.2 million Euro for
3 months. Initially Microsoft will go long on euro because altimately it has to sell Euro.

PRICING AND VALUATION OF FORWARD CONTRACTS

A forward price is the spot price compounded at the risk free interest rate. Suppose spot
price of an asset at time 0 is $100 and riskfree rate is 5% then one year forward price of the
the contract is simply F(0,T) = S0(1+RF) T or F(0.T) = $100(1+5)1 = $105

The transaction is risk free and should be equivalent to investing S0 dollars in a riskfree
asset that pays F(0,T) at time T. Thus, the amount received at T must be the
future value of the initial outlay invested at the risk-free rate

The spot price is $72.50, the risk-free rate is 8.25 percent, and the contract is for 5 years.
The forward price would be F(0,T) = F(0,5) = 72.50(1.0825) 5 = 107.76
 No money changes hands at the start of a forward contract, meaning that the value of a
forward contract at its start is zero. A contract in which the initial value is intentionally
set at a nonzero value is called an off-market FRA. In such a contract, the forward price is set
arbitrarily in the process of negotiation between the two parties. Given the chosen forward
price, the contract will have a nonzero value

Theorotically The value of a Forward contract at Time 0 is 0 and at time T is forward price but
if for any reason we want to determine the value of a forward contract during the lifetime of
a contract or at time t then: Vt(0,T) = St - F(0,T)/(1+r)(T-t)

Suppose 3 months in the above example we want to know the value of the forward when asset
pice is or St = $102 then value of forward contract = V t(0,T) = 102 - 105)/(1+5)(1-.25) = $0.7728

The company who has bought this forward contract is Long in this position that means it
has purchased the asset at a forward price and at the expiration the asset will be deliverd
to it. The company also has a liabilitiy to pay $105 at the expiration. so to know the value
of this forward contract we deducted from the current value of the asset the present value
of the liability. Tha tis 102 - 105/(1.05) .75 = 102 - 101.2272 = $0.7728

Forward contract value is the asset price minus the PV of the exercise price

Question An investor holds title to an asset worth €125.72. To raise money for an unrelated
purpose, the investor plans to sell the asset in nine months. The investor is concerned
about uncertainty in the price of the asset at that time. The investor learns about the
advantages of using forward contracts to manage this risk and enters into such a contract
to sell the asset in nine months. The risk-free interest rate is 5.625 percent.
A. Determine the appropriate price the investor could receive in nine months by
means of the forward contract.
B. Suppose the counterparty to the forward contract is willing to engage in such a
contract at a forward price of € 140. Explain what type of transaction the investor
could execute to take advantage of the situation. Calculate the rate of return
(annualized), and explain why the transaction is attractive.
C. Suppose the forward contract is entered into at the price you computed in Part A.
Two months later, the price of the asset is € 118.875. The investor would like to
evaluate her position with respect to any gain or loss accrued on the forward contract.
Determine the market value of the forward contract at this point in time
from the perspective of the investor in Part A.
D. Determine the value of the forward contract at expiration assuming the contract
is entered into at the price you computed in Part A and the price of the underlying
asset is €123.50 at expiration. Explain how the investor did on the overall
position of both the asset and the forward contract in terms of the rate of return.

A F(0,T) = S0(1+r)T = 125.72(1.05625)0.75 = 130.99

B The investor definitely go with the contract at the forward price of $140. After
9 month he will deliver the asset and get 140 so his profit = 140=125.72 = 14.28
This is rate of retun = 14.28/125.72 = .113586 & for 9 month = (1.113586) 12/9 = 15.42%
C Vt(0T) = St - F(0,T)/(1+rf)(T-t) 118.875 -130.99/(1.05625)(9-2) = 118.875 - 126.87 = -$8

D At the expiration of contract the asset price is 123.50. so the party who was long in
the contract will get the asset and pay 130.99 to investor has a total loss of
130.99-123.50 = 7.49. The investor who was short in the contract will get 130.99 and
deliver the asset which had a cost of 125..72 so his gian is only 130.99-125.72 = 5.27
which is actually the interest he earned on his investment of 125.72. to check this
5.27/125.72 = 0.041919 annualize it to (1.041919) (12/9) = 1.056279 and that is the
riskfree rate.

PRICING AND VALUATION OF EQUITY FORWARD CONTRACTS.

Equity forward contracts are priced and valued much like the generic contract
with one important additional feature. Many stocks pay dividends, and the effects
of these dividends must be incorporated into the pricing and valuation process.
our concern is with the dividends that occur over the life of the forward contract,
but not with those that may come after the contract ends. , we assume that these
dividends are known or are a constant percentage of the stock price.

The simple idea is that is dividends are accuring during the lifetime of a forward
contract simply deduct the present value of these dividends from the asset price
of the asset at time 0. Or alternatevly DEDUCT the future value of the dividends
from the forward price of the asset.

consider a stock priced at $40, which pays a dividend of $3 in 50 days. The riskfree
rate is 6%. A forward contract expiring in six months (T = 0.5) would have a price of
F(0,T) = (S0 - PV of Dividend )/(1+rf)T PV of Div = $3/(1.06)(50/365) = 2.976
So F(0.T) = ($40 - $2.976)(1.06)0.50 = 38.12

If the stock had more than one dividend, we would simply subtract the PV of all
dividends over the life of the contract from the stock price at time 0

Suppose The risk-free rate is 4% and the forward contract expires in 300 days and
is on a stock currently priced at $35, which pays quarterly dividends according to
the following schedule:

Days to Ex-Dividend Date Dividend

10 $0.45
102 $0.45
193 $0.45
283 $0.45
 First of all we will calcuate the present value of all dividend payments
Days to ex
Dividend Dividend PV factor PV
$0.45 10 0.99893 $0.450
$0.45 102 0.98910 $0.445
$0.45 193 0.97947 $0.441
$0.45 283 0.97005 $0.437
Total PV $1.772

Now we plug in the figure in the formula

F(0,T) = ($35 - $1.772)(1.04)(300/365) = 33.228 * 1.032761 = $34.32

Another approach is to DEDCUT Future Value of Dividends from Future price

To calcuate Future value of dividend dedcut the days to ex-dividend date
from the total life of the forward contract which si 300 days.
Days to Ex- Days to
Dividend DDividend Expiration FV factor FV
10 $0.45 290 (1.04)290/300 $0.4642
102 $0.45 198 (1.04)198/300 $0.4597
193 $0.45 107 (1.04) 107/300
$0.4552
283 $0.45 17 (1.04)17/300 $0.4508
Total Future Value $1.8299

Now simply calucate the future price = $35(1.04) (300/365) = 36.14665

Now dedcut the Future value of Dividends = $36.14665 - $1.8299 = $34.32

Question An asset manager anticipates the receipt of funds in 200 days, which he will use to
purchase a particular stock. The stock he has in mind is currently selling for $62.50
and will pay a $0.75 dividend in 50 days and another $0.75 dividend in 140 days.
The risk-free rate is 4.2 percent. The manager decides to commit to a future purchase
of the stock by going long a forward contract on the stock.
A. At what price would the manager commit to purchase the stock in 200 days
through a forward contract?
B. Suppose the manager enters into the contract at the price you found in Part A.
Now, 75 days later, the stock price is $55.75. Determine the value of the forward
contract at this point.
C. It is now the expiration day, and the stock price is $58.50. Determine the value
of the forward contract at this time.

A To calculate the F(0,T) we first calcuate the present value of the dividends
1st Dividend $0.75 After 50 days 0.994380 $0.7458
2nd Dividend $0.75 After 140 days 0.984343 $0.7383
$1.4840
 F(0,T) = ($62.5 - $1.484)(1.042)(200/365) 61.02 X 1.0228 = 62.41

B After 75 days, first dividend has been paid and only 2nd is outstanding which is
65 days away from payment. The present value of last dividend = $0.74
The value of the stock minus the PV of dividend = 55.75-0.74 = $55.01
The PV of the forward price at time t = 62.41/(1.042) (125/365) = 61.54
The value of the contact = 55.01 - 61.54 = -6.53
The long is in the loss of 6.53 because the PV of the forward price is 61.54 and
at time t the asset is available for 55.01.
C At expiration the long will get the asset which is worth 58.5 and he would be
paying 62.41 so he is in loss of 58.5-62.41 = -3.91 He has this losss because

He paid Interest on (S0-PV of div) = 61.02 X0.042 X (200/365) -1.404

Asset price droped from 61.02 - 58.5 = -2.516
the difference of 0.01 is rounding difference. -3.92

VALUATION OF EQUITY FORWARD WITH CONTINOUS COMPUNDING

Stock, portfolio, or index pays dividends continuously at a rate of δ'. By specifying
the dividends in this manner, we are allowing the dividends to be uncertain and
completely determinedby the stock price at the time the dividends are being paid.
In this case, the stock is constantly paying a dividend at the rate δ.

Because we pay dividends continuously, for consistency we must also compound

the interest continuously. The continuously compounded equivalent of the discrete
risk-free rate r will be denoted rc and is found as rc = ln(1 + r).

In case of continuously compounded dividend and risk free rate the formula for
Forward price = F(0,T) =( S0e-δcT)ercT
The term in parentheses, the stock price discounted at the dividend yield rate, is equivalent
to the stock price minus the present value of the dividends. This value is then compounded
at the risk-free rate over the life of the contract, just as we have done in the other versions

Some people attach significance to whether the forward price is higher than the spot
price. It is important to note that the forward price should not be interpreted as a forecast
of the future price of the underlying. This misperception is common. If the forward price
is higher than the spot price, it merely indicates that the effect of the risk-free rate is greater
than the effect of the dividends. In fact, such is usually the case with equity forwards. Interest
rates are usually greater than dividend yields.

As an example, consider a forward contract on France's CAC 40 Index. The index is

at 5475, the continuously compounded dividend yield is 1.5 percent, and the continuously
compounded risk-free interest rate is 4.625 percent. The contract life is two years. With T
= 2, the contract price is, therefore,
F(0,T) = (5475 X e-0.015(2))e0.04625(2)) = 5313.189 e0.04625(2) = 5828.11

In case we have to value this forward contract in the middle of the lifetime of the contract
we use following formula

Vt(0,T) = Ste-δ(T-t) -F(0,T)e-rc(T-t)

FORWARD CONTRACTS ON FIXED INCOME SECURITIES

Forward contracts on fixed-income securities are priced and valued in a virtually identical
manner to their equity counterparts. We can use the above formulas if St represents the
bond price at time t and Di represents a coupon paid at time ti. We denote Bc as a coupon
bond and then use notation to draw attention to those coupons that must be included in the
forward contract pricing calculations. We will let B,C(T + Y) represent the bond price at
time t, T is the expiration date of the forward contract, Y is the remaining maturity of the
bond on the forward contract expiration, and (T + Y) is the time to maturity of the bond
at the time the forward contract is initiated.

Converting the formula for a forward contract on a stock into that for a forward contract
on a bond and letting CI be the coupon interest over a specified period of time, we have
Forward price of F(0,T) = [ B0c (T+Y) - PV(CI,0,T)]/(1+r)T
where PV(CI,O,T) is the present value of the coupon interest over the life of the forward
contract. Alternatively, the forward price can be obtained as
F(0,T) = [ B0c (T+Y) ] (1+r)T - FV(CI,0,T)

Just like Forward contracts on Stocks the PV of coupon can be deducted at the price of
bond at time 0 or FV of coupons can be deducted from the Forward price of bond.

Vt (0,T) = Btc(T+Y) - PV(CI,t,T) - F(0,T)/(1+r)(T-t)

Only remaining coupons as of time t until expiration of the forward contract are relevent.

Consider a bond with semiannual coupons. The bond has a current maturity of 583
days and pays four coupons, each six months apart. The next coupon occurs in 37 days,
followed by coupons in 219 days, 401 days, and 583 days, at which time the principal is
repaid. Suppose that the bond price, which includes accrued interest, is $984.45 for a
$1,000 par, 4 percent coupon bond. The coupon rate implies that each coupon is $20. The
risk-free interest rate is 5.75 percent. Assume that the forward contract expires in 310 days.
Thus, T = 3 10, T + Y = 583, and Y = 273, meaning that the bond has 273 days remaining
after the forward contract expires. Note that only the first two coupons occur during
the life of the forward contract.
After PV factor PV of coupon
 PV of first two Coupons = $20 37 days 0.994349 $19.89
$20 219 days 0.967012 $19.34
$39.23
F(0,T) = (984.45 - 39.23 )(1.-0575)(310/365) = $945.22 X 1.048629 = 991.18

Now assume it is 15 days later and the new bond price is $973.14. Let the risk-free
rate now be 6.75%. The new PVs of Coupons are as follows:

After PV factor PV of coupon

PV of first two Coupons = $20 22 days 0.996071 $19.92
$20 204 days 0.964151 $19.28
New PV of coupons $39.20

Vt(0,T) = 973.14 - 39.20 - 991.18/(1.0675) 295/365) = $933.94 - 940.21

Vt(0,T) = 976.34 - 950.21 = $26.13. The long is in loss The asset he is going to get
is worth 933.94 Where as the PV of the liability he has to pay is 950.21 so he is
in loss of $933.94 - 940.21 = -6.27

Question An investor purchased a bond when it was originally issued with a maturity of five
years. The bond pays semiannual coupons of $50. It is now 150 days into the life of
the bond. The investor wants to sell the bond the day after its fourth coupon. The
first coupon occurs 181 days after issue, the second 365 days, the third 547 days,
and the fourth 730 days. At this point (150 days into the life of the bond), the price
is $1,010.25. The bond prices quoted here include accrued interest.
A. At what price could the owner enter into a forward contract to sell the bond on
the day after its fourth coupon? Note that the owner would receive that fourth
coupon. The risk-free rate is currently 8 percent.
B. Now move forward 365 days. The new risk-free interest rate is 7 percent and the
new price of the bond is $1,025.375. The counterparty to the forward contract
believes that it has received a gain on the position. Determine the value of the
forward contract and the gain or loss to the counterparty at this time. Note that
we have now introduced a new risk-free rate, because interest rates can obviously
change over the life of the bond and any calculations of the forward contract
value must reflect this fact. The new risk-free rate is used instead of the old rate
in the valuation formula.

A First the PV of the coupon

coupon Days After PV factor PV
$50 31 Days 0.993485 $49.67
$50 215 Days 0.955679 $47.78
$50 397 Days 0.919699 $45.98
$50 580 Days 0.884888 $44.24
$187.69
 F(0,T) = ($1010.25 - $187.69 )(1..08)(581/365) = 822.56 X 1.1303 = $929.76

B Now that 365 Days of Bonds life has been passed but only 215 days of Forward
Contract has been passed (Contract starts at 150 days of bonds life

coupon Days Left PV factor PV

$50 32 Days 0.994086 $49.70
$50 215 Days 0.96093 $48.05
$97.75

Ft(0,T) = (1025.375 - 97.75 ) - 929.76/(1.07) (216/365) = 927.62 - 893.27 34.35

The counterpary has a profit of 61.55 because the Present value of the their liability
is only 893.27 and the asset they are going to receive has a value of 927.62

(VERY IMPORTANT QUESTION, MUST BE REPEATED )

PRICING AND VALUATION OF FORWARD RATE AGREEMENTS (FRAs)
de
 31
0 ----------------------------------------------------t-------------------------------T
150 515
0 | 182 365 547 730
coppon 1 coppon 2 coppon 3 coppon 4
912