Derivative Markets 2nd Edition- Robert L.Mcdonald

Chapter3Insurance,Collars,andOtherStrategiesCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-2BasicInsuranceStrategies•OptionscanbeUsedtoinsurelongpositions(floors)Usedtoinsureshortpositions(caps)Writtenagainstassetpositions(sellinginsurance)Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-3InsuringaLongPosition:Floors•Aputoptioniscombinedwithapositionintheunderlyingasset•Goal:toinsureagainstafallinthepriceoftheunderlyingassetCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-4InsuringaLongPosition:Floors(cont’d)•Example:S&RindexandaS&Rputoptionwithastrikepriceof$1,000togetherBuyinganassetandaputgeneratesapositionthatlookslikeacall!Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-5InsuringaShortPosition:Caps•Acalloptioniscombinedwithapositionintheunderlyingasset•Goal:toinsureagainstanincreaseinthepriceoftheunderlyingasset(whenonehasashortpositioninthatasset)Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-6InsuringaShortPosition:Caps(cont’d)•Example:short-sellingtheS&RindexandholdingaS&Rcalloptionwithastrikepriceof$1,000Aninsuredshortpositionlookslikeaput!Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-7SellingInsurance•Foreveryinsurancebuyertheremustbeaninsuranceseller•StrategiesusedtosellinsuranceCoveredwriting(optionoverwritingorsellingacoveredcall)iswritinganoptionwhenthereisacorrespondinglongpositionintheunderlyingassetiscalledcoveredwritingNakedwritingiswritinganoptionwhenthewriterdoesnothaveapositionintheassetCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-8CoveredWriting:CoveredCalls•Example:holdingtheS&RindexandwritingaS&Rcalloptionwithastrikepriceof$1,000Writingacoveredcallgeneratesthesameprofitassellingaput!Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-9CoveredWriting:CoveredPuts•Example:shortingtheS&RindexandwritingaS&Rputoptionwithastrikepriceof$1,000Writingacoveredputgeneratesthesameprofitaswritingacall!Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-10SyntheticForwards•AsyntheticlongforwardcontractBuyingacallandsellingaputonthesameunderlyingasset,witheachoptionhavingthesamestrikepriceandtimetoexpirationExample:buythe$1,000-strikeS&Rcallandsellthe$1,000-strikeS&Rput,eachwith6monthstoexpirationCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-11SyntheticForwards(cont’d)•DifferencesbetweenasyntheticlongforwardcontractandtheactualforwardTheforwardcontracthasazeropremium,whilethesyntheticforwardrequiresthatwepaythenetoptionpremiumWiththeforwardcontract,wepaytheforwardprice,whilewiththesyntheticforwardwepaythestrikepriceCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-12Put-CallParity•Thenetcostofbuyingtheindexusingoptionsmustequalthenetcostofbuyingtheindexusingaforwardcontract•Call(K,t)–Put(K,t)=PV(F0,t–K)Call(K,t)andPut(K,t)denotethepremiumsofoptionswithstrikepriceKandtimetuntilexpiration,andPV(F0,t)isthepresentvalueoftheforwardprice•Thisisoneofthemostimportantrelationsinoptions!Copyright©2006PearsonAddison-Wesley.Allrightsreserved.3-13SpreadsandCollars•Anoptionspreadisapositionconsistingofonlycallsoronlyputs,inwhichsomeoptionsarepurchasedandsomewrittenExamples:bullspread,bearspread,boxspread•Acollaristhepurchaseofaputoptionandthesaleofacalloptionwithahigherstrikeprice,withbothoptionshavingthesameunderlyingassetandhavingthesameexpirationdateExample:zero-costcollarCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-14Spreads•Abullspreadisaposition,inwhichyoubuyacallandsellanotherwiseidenticalcallwithahigherstrikepriceItisabetthatthepriceoftheunderlyingassetwillincreaseBullspreadscanalsobeconstructedusingputsCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-15Spreads(cont’d)•Abearspreadisapositioninwhichonesellsacallandbuysanotherwiseidenticalcallwithahigherstrikeprice•AboxspreadisaccomplishedbyusingoptionstocreateasyntheticlongforwardatonepriceandasyntheticshortforwardatadifferentpriceAboxspreadisameansofborrowingorlendingmoney:Ithasnostockpricerisk•Aratiospreadisconstructedbybuyingmcallsatonestrikeandsellingncallsatadifferentstrike,withalloptionshavingthesametimetomaturityandsameunderlyingassetRatiospreadscanalsobeconstructedusingputsCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-16Collars•Acollarrepresentsabetthatthepriceoftheunderlyingassetwilldecreaseandresemblesashortforward•Azero-costcollarcanbecreatedwhenthepremiumsofthecallandputexactlyoffsetoneanotherCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-17SpeculatingonVolatility•Optionscanbeusedtocreatepositionsthatanondirectionalwithrespecttotheunderlyingasset•ExamplesStraddlesStranglesButterflyspreads•Whowouldusenondirectionalpositions?Investorswhodonotcarewhetherthestockgoesupordown,butonlyhowmuchitmoves,i.e.,whospeculateonvolatilityCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-18Straddles•Buyingacallandaputwiththesamestrikepriceandtimetoexpiration•Astraddleisabetthatvolatilitywillbehighrelativetothemarket’sassessmentCopyright©2006PearsonAddison-Wesley.Allrightsreserved.3-19Strangles•Buyinganout-of-the-mone