Final - Role of Options Strategies in Hedging and Risk Management-1

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A PROJECT REPORT
ON
ROLE OF OPTIONS IN HEDGING AND RISK MANAGEMENT

Project Submitted in the fulfillment of (Post Graduate Diploma in
Management/MMS)

Submitted by:
MISS NEHA VILAS MORE
Roll No. P1209
Batch 2012-2014

Under the guidance of
Professor SRINJAY SENGUPTA

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Declaration

I, MISS NEHA VILAS MORE solemnly declare that the project work entitled ROLE
OF OPTIONS IN HEDGING AND RISK MANAGEMENT, is my original work, it is
neither copied from any earlier submitted work elsewhere or not merely copied,
this is specifically prepared as a part of MMS/PGDM curriculum, to be conducted
in Year 2014.

Signature of the student: ________________________
Name of the Student: MISS NEHA VILAS MORE

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ACKNOWLEDGMENT
It gives me immense pleasure to express my deep sense of Gratitude to Prof. Srinjay
Sengupta, Faculty Guide Chanakya Institute of Management Studies and Research for
his valuable guidance and consistent supervision throughout the project His
constructive comments and contributions had been of immense help for giving a
tangible shape to this project.

I am also extremely thankful to Prof. Mahesh Narvekar and Prof. Sameer Kulkarni,
for their timely guidance and support for the project. Finally I am indebted to our other
faculty members, my friends who gave their full-fledged co-operation for successful
completion of my project. It was an indeed a learning experience for me.

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CERTIFICATE

This is to certify that the project titled ROLE OF OPTIONS IN HEDGING
AND RISK MANAGEMENT has been successfully and satisfactorily
completed and submitted by M Mr r. ./ / M Mi is ss s: :
N NE EH HA A V VI IL LA AS S M MO OR RE E bearing a roll number, P1209 as a student of Chanakya
Institute of Management Studies & Research as Prescribed by AICTE in fulfillment
of the requirement for Post Graduate Diploma in Management (PGDM) /MMS
during the year 2012 14.

Internal Guide Director

Prof. SRINJAY SENGUPTA Mr. Biswas B. Das

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Index

SR NO Topic Page
No.
1 EXECUTIVE SUMMARY 7
2 OBJECTIVE 8
3 LIMITATIONS 8
4 RESEARCH METHODOLOGY 9
5 INTRODUCTION OF OPTIONS 10
5.1 BASIC TERMS AND DESCRIPTIONS ABOUT EQUITY
OPTIONS
12
5.2 WHAT ARE THE BENEFITS & RISKS? 21
5.3 OPTIONS PRICING 23
5.4 MAJOR FACTORS INFLUENCING OPTIONS PREMIUM 24
6 INDEX OPTIONS 26
6.1 BENEFITS OF LISTED INDEX OPTIONS 26
6.2 DIFFERENT METHODS TO CALCULATE OR MEASURE THE
RELEVANT MARKET
28
6.3 ADJUSTMENTS & ACCURACY 29
6.4 EQUITY VS. INDEX OPTIONS 30
7 VOLATILITY & THE GREEKS 35
8 PUT/CALL PARITY 38
9 BLACK-SCHOLES FORMULA 45
10 RISK MANAGEMENT 46
11 WHY USE OPTIONS? 53
12 HOW YOU CAN USE OPTIONS 54
13 EXITING AN OPTIONS POSITION 56
14 HEDGING A DETAIL STUDY 57
14.1 WHAT IS HEDGING? 57
14.2 HOW DO INVESTORS HEDGE? 58
14.3 TO HEDGE OR NOT TO HEDGE? 59
14.4 THE COSTS OF HEDGING 59
14.5 THE BENEFITS OF HEDGING 60
15 THE PREVALENCE OF HEDGING 65
15.1 WHO HEDGES? 65
15.2 WHAT RISKS ARE MOST COMMONLY HEDGED? 67
15.3 DOES HEDGING INCREASE VALUE? 68
16 ALTERNATIVE TECHNIQUES FOR HEDGING RISK 71
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17 PICKING THE RIGHT HEDGING TOOL 78
18 OPTION STRATEGIES
79
18.1 BUY CALL 76
18.2 BUYING PUTS 84
18.3 BUYING INDEX STRADDELES 90
18.4 PROTECTIVE INDEX COLLARS 97
18.5 BUYING INDEX PUTS TO HEDGE THE VALUE OF A
PORTFOLIO
103
19 CURRENCY HEDGING SCENARIO'S 110
19.1 HEDGING AGAINST INDIAN RUPEE APPRECIATION 110
19.2 HEDGING AGAINST INDIAN RUPEE DEPRECIATION 111
20 OPTIONS STRATEGY FOR IMPORTERS 112
21 OPTIONS STRATEGY FOR EXPORTERS 113
22 CONCLUSION 114
23 BIBLIOGRAPHY 115

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1. EXECUTIVE SUMMARY

By viewing the current market scenario its been noticed that markets are falling and are
in very bad state. The top notches can survive to an extent but for small companies it
becomes a do or die situation wherein most do get even bankrupt. Basically situation
becomes worse for both large and medium firms. So first and foremost is there any
solution or a way for such firms? If yes, then what is the solution to such companies?
How can such firms help themselves so that their shops dont get closed or at least
minimize the risk faced?
Yes, there is a solution for such companies and that is OPTIONS TRADING. To start
up with options everybody needs to understand that everything in life has a risk so as
options. But the best part is that it is a tool which allows assessing the risk and
mitigating it at the right time and in a proper way. This of course needs an analysis to be
done on a regular basis to make things work out the way the business needs. As there
are two sides for everything, we have a set of investors who has genuine concerns for
their business and other set of investors which rides on market sentiment. Thus it can
be used for speculations as well as for hedging. Here we focus only on hedging which is
a tool used maximally to mitigate the risk and to gain a profit to some extent.
Before hedging its essential to understand what is the risk that options can have? And
what are the factors that lead to this risk? And then how it can it can hedge? A detail
study of the risk management of the factors that lead to this risk is been done through
the use of various options strategies. Also a view is been provided for the Indian
entrepreneurs as to how to behave when there is an rupee appreciation or
depreciation? And what the importers or exporters should do when such a case arises
in front of them.
Hoping that the Indian entrepreneurs can take the maximum advantage of the options
and enter into the exchange trading to boost their business with optimum advantage
provided by the government and attain new heights

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2. OBJECTIVE
To have a brief understanding about options, its terms, its working.
What is risk management for options
How this risk can be managed through hedging
How entrepreneurs who are connected globally can hedge the currency risk
What are the necessary steps to be taken when a rupee appreciates or
depreciates

3. LIMITATIONS

Speculation are not focused
All strategies are not considered

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4. Research Methodology
The project is on role of options in hedging and risk management. Hence study has to
be done on the basis of information and news available about the topic through
secondary data by various modes. Secondary data was collected from the internet,
company websites and.
Approach of Research: this research work is designed for deductive inferences based
on the empirical data available at various sites. This may not be necessarily declared for
the objective described in the beginning of this research work.
Sample Frame: The sample frame for this research work is strictly those firms which
have any kind of risk exposure either because of import or export. The frame used for
sampling is EXIM data bank
Sample Size: Selective convinence random sample method is adopted for sampling.
The sample size is fixed to make the inferences for 90% confidence level specifically
sample size is (no. of companies include).

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5. INTRODUCTION OF OPTIONS
An option is a contract to buy or sell a specific financial product known as the option's
underlying instrument or underlying interest. For equity options, the underlying
instrument is a stock, exchange traded fund (ETF) or similar product. The contract itself
is very precise. It establishes a specific price, called the strike price, at which the
contract may be exercised, or acted upon.
Contracts also have an expiration date. When an option expires, it no longer has value
and no longer exists.
Options come in two varieties, calls and puts. You can buy or sell either type. You
decide whether to buy or sell and choose a call or a put based on objectives as an
options investor.
http://www.optionseducation.org/content/oic/en/getting_started/options_overview/what_is_an_option.html
Options are financial instruments that provide flexibility in almost any investment
situation. Options give you options by providing the ability to tailor your position to your
situation.
You can protect stock holdings from a decline in market price.
You can increase income against current stock holdings.
You can prepare to buy stock at a lower price.
You can position yourself for a big market move, even when you don't know
which way prices will move.
You can benefit from a stock price's rise or fall without incurring the cost of
buying the stock outright.
Describing Equity Options
An equity option is a contract that conveys to its holder the right, but not the
obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the
underlying security at a specified price (the strike price) on or before a given date
(expiration day). After this given date, the option ceases to exist. The seller of an
option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a
put) the shares to (or from) the buyer of the option at the specified price upon the
buyer's request.

http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_1.html

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Equity option contracts usually represent 100 shares of the underlying stock.
Strike prices (or exercise prices) are the stated price per share for which the
underlying security may be purchased (in the case of a call) or sold (in the case
of a put) by the option holder upon exercise of the option contract. Do not
confuse the strike price, a fixed specification of an option contract, with the
premium. Premium is the price at which the contract trades. This price fluctuates
daily.
Equity option strike prices are listed in increments of 5, 1, 2.5, 5 or 10 points,
depending on their price level.
Adjustments to an equity option contract's size, deliverable and/or strike price
may be made to account for stock splits or mergers.
Generally, at any given time, you can purchase a particular equity option with
one of at least four expiration dates.
Equity option holders do not enjoy the rights due stockholders (e.g., voting rights,
regular cash or special dividends). A call holder must exercise the option and
take ownership of underlying shares to be eligible for these rights.
Buyers and sellers set option prices in the exchange markets. All trading is
conducted in the competitive manner of an auction market.


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5.1. BASIC TERMS AND DESCRIPTIONS
ABOUT EQUITY OPTIONS
Calls and Puts
The two types of equity options are calls and puts.
A call option gives its holder the right to buy 100 shares of the underlying security at the
strike price, anytime before the option's expiration date. The writer (or seller) of the
option has the obligation to sell the shares.
The opposite of a call option is a put option, which gives its holder the right to sell 100
shares of the underlying security at the strike price, anytime before the option's
expiration date. The writer (or seller) of the option has the obligation to buy the shares.

Holder (Buyer)
Writer (Seller)
Call Option Right to buy Obligation to sell
Put Option Right to sell Obligation to buy

The Options Premium
An option's price is called the premium. The option holders potential loss is limited to
the initial premium paid for the contract. Alternately, the writer has unlimited potential
loss. This loss is somewhat offset by the initial premium received for the contract.
Investors can use put and call option contracts to take a position in a market using
limited capital. The initial investment is limited to the price of the premium.
Investors can also use put and call option contracts to actively hedge against market
risk. Investors can purchase a put as insurance to protect a stock holding against an
unfavorable market move while maintaining stock ownership.
A call option on an individual stock issue may be sold to provide a limited degree of
downside protection in exchange for limited upside potential.

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Underlying Security
The underlying security (such as XYZ Corporation) is the instrument that an option
writer must deliver (in the case of call) or purchase (in the case of a put) upon
assignment of an exercise notice by an option contract holder.

Expiration Thursday
The last Thursday of the expiry month or the previous trading day if the last Thursday is
a trading holiday is the options expiration day. After the option's expiration date, the
contract ceases to exist. At that point, the owner of the option who does not exercise the
contract has no right and the seller has no obligations as previously conveyed by the
contract.
SOURCE: NCFM book
Leverage & Risk
Options can provide leverage. This means an option buyer can pay a relatively small
premium for market exposure in relation to the contract value (usually 100 shares of the
underlying stock). An investor can see large percentage gains from comparatively small,
favorable percentage moves in the underlying product.
Leverage also has downside implications. If the underlying stock price does not rise or
fall as anticipated during the lifetime of the option, leverage could magnify the
investment's percentage loss. Options offer their owners a predetermined, set risk.
However, if the owner's options expire with no value, this loss can be the entire amount
of the premium paid for the option. An uncovered option writer may face unlimited risk.
In-the-money, At-the-money, Out-of-the-money
An options strike price, or exercise price, determines whether a contract is in-the-
money, at-the-money, or out-of-the-money.
If the strike price of a call option is less than the current market price of the underlying
security, the call is said to be in-the-money. This is because the holder of this call has
the right to buy the stock at a price less than the price he would pay to buy the stock in
the stock market. Likewise, if a put option has a strike price that is greater than the
current market price of the underlying security, it is said to be in-the-money because the
holder of this put has the right to sell the stock at a price greater than the price he would
receive selling the stock in the stock market.
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The inverse of in-the-money is out-of-the-money. If the strike price equals the current
market price, the option is said to be at-the-money.
The amount that an option, call or put is in-the-money at any time is called intrinsic
value. By definition, an at-the-money or out-of-the-money option has no intrinsic value.
This does not mean investors can obtain these options at no cost.
The amount that an option's total premium exceeds intrinsic value is known as the time
value. Fluctuations in volatility, interest rates, dividend amounts and the passage of time
all affect the time value portion of an options premium. These factors give options value
and therefore affect the premium at which they are traded.
Equity Call Option
In-the-money = strike price less than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price greater than stock price
Equity Put Option
In-the-money = strike price greater than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price less than stock price

Option Premium
Intrinsic Value + Time Value
Time Decay
The longer the time remaining until an option's expiration, the higher its premium will be.
This is because the longer an option's lifetime, the greater the possibility that the
underlying share price might move the option in-the-money. Even if all other factors
affecting an option's price remain the same, the time value portion of an option's
premium will decrease (or decay) with the passage of time.
NOTE: Time decay is a term used to describe how the theoretical value of an option
reduces with the passage of time. Time decay increases rapidly in the last several
weeks of an option's life. When an option expires in-the-money, it is generally worth only
its intrinsic value.

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Long
With respect to this section's usage of the word, long describes a position (in stock
and/or options) in which you have purchased and own that security in your brokerage
account.
For example, if you have purchased the right to buy 100 shares of a stock and are
holding that right in your account, you are long a call contract. If you have purchased
the right to sell 100 shares of a stock and are holding that right in your brokerage
account, you are long a put contract. If you have purchased 1,000 shares of stock and
are holding that stock in your brokerage account or elsewhere, you are long 1,000
shares of stock.
When you are long an equity option contract:
You have the right to exercise that option at any time prior to expiration.
Your potential loss is limited to the amount you paid for the option contract.
Short
With respect to this section's usage of the word, short describes a position in options in
which you have written a contract (sold a contract that you did not own). As a
result, you now have obligations from terms of that option contract. If the owner
exercises the option, you must meet those obligations.
If you have sold the right to buy 100 shares of a stock, you are short a call contract. If
you have sold the right to sell 100 shares of a stock, you are short a put contract.
When you write an option contract, you are creating it. The writer of an option collects
and keeps the premium received from its initial sale. When you are short (write) an
equity option contract
You can be assigned an exercise notice at any time during the life of the option
contract. You should be aware that assignment prior to expiration is a distinct
possibility.
Your potential loss on a short call is theoretically unlimited. For a put, the fact that
the stock cannot fall below $0 in price limits the risk of loss. This potential loss
could still be quite large if the underlying stock declines significantly in price.


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Open
An opening transaction is one that adds to or creates a new trading position.
It can be either a purchase or a sale. With respect to an option transaction,
consider both
An opening purchase is a transaction in which the purchaser's intention is to
create or increase a long position in a given series of options.
An opening sale is a transaction in which the seller's intention is to create or
increase a short position in a given series of options.
Close
A closing purchase is a transaction in which the purchaser's intent is to reduce or
eliminate a short position in a given series of options. This transaction is
frequently referred to as covering a short position.
A closing sale is a transaction in which the seller's intent is to reduce or eliminate
a long position in a given series of options.
NOTE: An investor does not close out a long call position by purchasing a put or vice
versa. A closing transaction for an option involves the purchase or sale of an option
contract with the same terms on any exchange where the option may be traded. An
investor intending to close out an option position must do so by the end of trading hours
on the option's last trading day.
Exercise
The holder of an American-style option can exercise his right to buy (in the case of a
call) or to sell (in the case of a put) the underlying shares of stock. They first must direct
their brokerage firm to submit an exercise notice to OCC. For an option holder to ensure
that they exercise the option on that particular day, the holder must notify his brokerage
firm before that days cut-off time for accepting exercise instructions.
The brokerage firm notifies OCC that an option holder wishes to exercise an option.
OCC then randomly assigns the exercise notice to a clearing member. For an investor,
this is generally his brokerage firm chosen at random from a total pool of such firms.
The firm must then assign one of its customers who has written (and not covered) that
particular option.
Assignment to a customer is either random or on a first-in-first-out basis. This depends
on the firms method. Ask your brokerage firm which method it uses for assignments.

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Assignment
The holder of an American-style option contract can exercise the option at any time
before expiration. Therefore, an option writer may be assigned an exercise notice on a
short option position at any time before expiration. If an option writer is short an option
that expires in-the-money, they should expect assignment on that contract, though
assignment is not guaranteed as some long in-the-money option holders may elect not
to exercise in-the-money options. In fact, some option writers are assigned on short
contracts when they expire exactly at-the-money or even out-of-the money. This
occurrence is usually not predictable.
To avoid assignment on a written option contract on a given day, the position must be
closed out before that day's market close. Once assignment is received, an investor has
no alternative but to fulfill assignment obligations per the terms of the contract.
There is generally no exercise or assignment activity on options that expire out-of-the-
money. Owners usually let them expire with no value. Although this is not always the
case as post-market underlying moves may lead to out-of-the-money options being
exercised and in-the-money options not being exercised.
What's the Net?
When an investor exercises a call option, the net price paid for the underlying stock on a
per share basis is the sum of the call's strike price plus the premium paid for the call.
Likewise, when an investor who has written a call contract is assigned an exercise
notice on that call, the net price received on per share basis is the sum of the call's
strike price plus the premium received from the call's initial sale.
When an investor exercises a put option, the net price received for the underlying stock
on per share basis is the sum of the put's strike price less the premium paid for the put.
Likewise, when an investor who has written a put contract is assigned an exercise
notice on that put, the net price paid for the underlying stock on per share basis is the
sum of the put's strike price less the premium received from the put's initial sale.
Early Exercise/Assignment
For call contracts, owners might exercise early to own the underlying stock to receive a
dividend. It is extremely important to realize that assignment of exercise notices can
occur early, days or weeks in advance of expiration day. Investors should expect this as
expiration
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nears with a call considerably in-the-money and a sizeable dividend payment
approaching. Call writers should be aware of dividend dates and the possibility of early
assignment.
When puts become deep in-the-money, most professional option traders exercise
before expiration. Therefore, investors with short positions in deep in-the-money puts
should be prepared for the possibility of early assignment on these contracts.
Volatility
Volatility is the tendency of the underlying security's market price to fluctuate up or
down. It reflects a price change's magnitude. It does not imply a bias toward price
movement in one direction or the other. It is a major factor in determining an option's
premium.
The higher the volatility of the underlying stock, the higher the premium. This is because
there is a greater possibility that the option will move in-the-money. Generally, as the
volatility of an underlying stock increases, the premiums of both calls and puts overlying
that stock increase and vice versa.

Buying and Selling
If you buy a call, you have the right to buy the underlying instrument at the strike price
on or before expiration. If you buy a put, you have the right to sell the underlying
instrument on or before expiration. In either case, the option holder has the right to sell
the option to another buyer during its term or to let it expire worthless.
The situation is different if you write or sell to open an option. Selling to open a short
option position obligates the writer to fulfill their side of the contract if the option holder
wishes to exercise.
When you sell a call as an opening transaction, you're obligated to sell the underlying
interest at the strike price, if assigned. When you sell a put as an opening transaction,
you're obligated to buy the underlying interest, if assigned.
As a writer, you have no control over whether or not a contract is exercised, and you
must recognize that exercise is possible at any time before expiration. However, just as
the buyer can sell an option back into the market rather than exercising it, a writer can
purchase an offsetting contract to end their obligation to meet the terms of a contract
provided they have not been assigned. To offset a short option position, you would
enter a buy to close transaction.
http://www.optionseducation.org/getting_started/options_overview/what_is_an_option.html
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At a Premium
When you buy an option, the purchase price is called the premium. If you sell, the
premium is the amount you receive. The premium isn't fixed and changes constantly.
The premium is likely to be higher or lower today than yesterday or tomorrow. Changing
prices reflect the give and take between what buyers are willing to pay and what sellers
are willing to accept for the option. The point of agreement becomes the price for that
transaction. The process then begins again.
If you buy options, you begin with a net debit. That means you've spent money you
might never recover if you don't sell your option at a profit or exercise it. If you do make
money on a transaction, you must subtract the cost of the premium from any income to
find net profit.
As a seller, you begin with a net credit because you collect the premium. If the option is
never exercised, you keep the money. If the option is exercised, you still keep the
premium but are obligated to buy or sell the underlying stock if assigned.

The Value of Options
The worth of a particular options contract to a buyer or seller is measured by its
likelihood to meet their expectations. In the language of options, that's determined by
whether or not the option is, or is likely to be, in-the-money or out-of-the-money at
expiration.
A call option is in-the-money if the current market value of the underlying stock is above
the exercise price of the option. The call option is out-of-the-money if the stock is below
the exercise price. A put option is in-the-money if the current market value of the
underlying stock is below the exercise price. A put option is out-of-the-money if its
underlying price is above the exercise price. If an option is not in-the-money at
expiration, the option is assumed worthless.
An option's premium can have two parts: an intrinsic value and a time value. Intrinsic
value is the amount that the option is in-the-money. Time value is the difference
between the intrinsic value and the premium. In general, the longer time that market
conditions work to your benefit, the greater the time value.

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Options Prices
Several factors affect the price of an option. Supply and demand in the market where
the option is traded is a large factor. This is also the case with an individual stock.
The status of overall markets and the economy at large are broad influences. Specific
influences include the identity of the underlying instrument, the instruments traditional
behavior and current behavior. The instruments volatility is also an important factor
used to gauge the likelihood that an option will move in-the-money.

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5.2. What are the Benefits & Risks?
Most strategies used by options investors have limited risk but also limited profit
potential. Options strategies are not get-rich-quick schemes. Transactions generally
require less capital than equivalent stock transactions. They may return smaller figures
but a potentially greater percentage of the investment than equivalent stock
transactions.
Even investors who use options in speculative strategies such as writing uncovered
calls don't usually realize dramatic returns. The potential profit is limited to the premium
received for the contract. The potential loss is often unlimited. While leverage means
the percentage returns can be significant, the amount of cash required is smaller than
equivalent stock transactions.
Although options may not be appropriate for all investors, they're among the most
flexible of investment choices. Depending on the contract, options can protect or
enhance the portfolios of many different kinds of investors in rising, falling and neutral
markets.
Reducing Your Risk
For many investors, options are useful tools of risk management. They act as insurance
policies against a drop in stock prices. For example, if an investor is concerned that the
price of their shares in LMN Corporation is about to drop, they can purchase puts that
give the right to sell the stock at the strike price, no matter how low the market price
drops before expiration. At the cost of the option's premium, the investor has insured
themselves against losses below the strike price. This type of option practice is also
known as hedging.
While hedging with options may help manage risk, it's important to remember that all
investments carry some risk. Returns are never guaranteed. Investors who use options
to manage risk look for ways to limit potential loss. They may choose to purchase
options, since loss is limited to the price paid for the premium. In return, they gain the
right to buy or sell the underlying security at an acceptable price. They can also profit
from a rise in the value of the option's premium, if they choose to sell it back to the
market rather than exercise it. Since writers of options are sometimes forced into buying
or selling stock at an unfavorable price, the risk associated with certain short positions
may be higher.
Many options strategies are designed to minimize risk by hedging existing portfolios.
While options act as safety nets, they're not risk free. Since transactions usually open
http://www.optionseducation.org/getting_started/options_overview/what_benefits_risks.html
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and close in the short term, gains can be realized quickly. Losses can mount as quickly
as gains. It's important to understand risks associated with holding, writing, and trading
options before you include them in your investment portfolio.
Risking Your Principal
Like other securities including stocks, bonds and mutual funds, options carry no
guarantees. Be aware that it's possible to lose the entire principal invested, and
sometimes more. As an options holder, you risk the entire amount of the premium you
pay.
But as an options writer, you take on a much higher level of risk. For example, if you
write an uncovered call, you face unlimited potential loss, since there is no cap on how
high a stock price can rise.
Since initial options investments usually require less capital than equivalent stock
positions, your potential cash losses as an options investor are usually smaller than if
you'd bought the underlying stock or sold the stock short. The exception to this general
rule occurs when you use options to provide leverage. Percentage returns are often
high, but percentage losses can be high as well.
http://www.optionseducation.org/getting_started/options_overview/what_benefits_risks.html

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5.3. OPTIONS PRICING
Main Components of an Option's Premium
An options premium has two main components: intrinsic value and time value.

Intrinsic Value (Calls)
A call option is in-the-money when the underlying security's price is higher than the
strike price.
Intrinsic Value (Puts)
A put option is in-the-money if the underlying security's price is less than the strike price.
Only in-the-money options have intrinsic value. It represents the difference between the
current price of the underlying security and the option's exercise price, or strike price.
Time Value
Time value is any premium in excess of intrinsic value before expiration. Time value is
often explained as the amount an investor is willing to pay for an option above its
intrinsic value. This amount reflects hope that the options value increases before
expiration due to a favorable change in the underlying securitys price. The longer the
amount of time available for market conditions to work to an investor's benefit, the
greater the time value.
http://www.optionseducation.org/content/oic/en/getting_started/options_overview/options_pricing.html

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5.4. MAJOR FACTORS INFLUENCING
OPTIONS PREMIUM
Factors having a significant effect on options premium include:
1. Underlying price
2. Strike
3. Time until expiration
4. Implied volatility
5. Dividends
6. Interest rate
Dividends and risk-free interest rate have a lesser effect.
Changes in the underlying security price can increase or decrease the value of an
option. These price changes have opposite effects on calls and puts. For instance, as
the value of the underlying security rises, a call will generally increase. However, the
value of a put will generally decrease in price. A decrease in the underlying security's
value generally has the opposite effect.
The strike price determines whether an option has intrinsic value. An option's premium
(intrinsic value plus time value) generally increases as the option becomes further in-
the-money. It decreases as the option becomes more deeply out-of-the-money.
Time until expiration, as discussed above, affects the time value component of an
option's premium. Generally, as expiration approaches, the levels of an option's time
value decrease or erode for both puts and calls. This effect is most noticeable with at-
the-money options.
The effect of implied volatility is subjective and difficult to quantify. It can significantly
affect the time value portion of an option's premium. Volatility is a measure of risk
(uncertainty), or variability of price of an option's underlying security. Higher volatility
estimates indicate greater expected fluctuations (in either direction) in underlying price
levels. This expectation generally results in higher option premiums for puts and calls
alike. It is most noticeable with at-the-money options.
The effect of an underlying security's dividends and the current risk-free interest rate
has a small but measurable effect on option premiums. This effect reflects the cost to
carry shares in an underlying security. Cost of carry is the potential interest paid for

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margin or received from alternative investments (such as a Treasury bill) and the
dividends from owning shares outright. Pricing takes into account an options hedged
value so dividends from stock and interest paid or received for stock positions used to
hedge options are a factor.

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6. INDEX OPTIONS
What is an Index?
A stock index is a compilation of several stock prices into a single number. Indexes
come in various shapes and sizes. Some are broad-based and measure moves in
diverse markets. Others are narrow-based and measure more specific industry
sectors of the marketplace.

It is not the average number of stocks that determines if an index is broad-based or
narrow-based. Rather, it is the diversity of the underlying securities and their market
coverage. Different stock indexes are calculated in different ways. Even where
indexes are based on identical securities, they may measure the relevant market
differently because of differences in methods of calculation.
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6.1. BENEFITS OF LISTED INDEX OPTIONS
Like equity options, index options offer investors an opportunity either to capitalize
on an expected market move or to protect holdings in the underlying instruments.
The difference is that the underlying instruments of index options are indexes. These
indexes can reflect the characteristics of either the broad equity market as a whole
or specific industry sectors within the marketplace.
1. Diversification
Index options enable investors to gain exposure to the market as a whole or to
specific segments with one trading decision and often one transaction. An investor
must make numerous decisions and transactions to obtain the same level of
diversification using individual stock issues or individual equity option classes. Using
index options defrays both the costs and complexities.
2. Predetermined Risk for Buyer
Unlike other investments with unlimited risk, index options offer a known risk to
buyers. An index option buyer absolutely cannot lose more than the price of the
option (the premium).
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3. Leverage
Index options can provide leverage. This means an index option buyer pays a
relatively small premium for market exposure in relation to the contract value. An
investor can see large percentage gains from relatively small, favorable percentage
moves in the underlying index. If the index does not move as anticipated, the buyer's
risk is limited to the premium paid. However, because of leverage, a small adverse
move in the market can result in a substantial or complete loss of the buyer's
premium. Writers of index options bear substantially greater risk, if not unlimited.
4. Guaranteed Contract Performance
Prior to the existence of option exchanges and OCC, an option holder who wanted
to exercise an option depended on the ethical and financial integrity of the writer or
his brokerage firm for performance. Furthermore, there was no convenient way to
close out a position prior to the expiration of the contract. As the common clearing
entity for all U.S. exchange-traded securities option transactions, OCC resolves
these difficulties.
As a result, rather than relying on a particular option writer, an option holder can rely
on the system created by OCC's Rules and By-Laws (which includes the brokers
and clearing members involved in a particular option transaction) and to certain
funds held by OCC.
Once OCC ensures matching orders from a buyer and a seller, it severs the link
between the parties. In effect, OCC becomes the buyer to the seller and the seller to
the buyer. As a result, the seller can buy back the same option they have written.
This closes out the initial transaction and terminates the sellers obligation to deliver
cash equal to the exercise amount of the option to OCC. This does not affect the
right of the original buyer to sell, hold or exercise his option. All premium and
settlement payments are made to and paid by OCC.
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6.2. DIFFERENT METHODS TO CALCULATE
OR MEASURE THE RELEVANT MARKET
1. Capitalization-Weighted
An index can be constructed so that weightings are biased toward the securities of
larger companies. This method of calculation is known as capitalization-weighted. To
calculate index value, the market price of each component security is multiplied by
the number of shares outstanding. This allows a security's size and capitalization to
have a greater impact on the value of the index.
2. Equal Dollar-Weighted
Another type of index is known as equal dollar-weighted. This index assumes an
equal number of shares of each component stock. It is calculated by first
establishing an aggregate market value for every component security of the index.
Then, by dividing the aggregate market value by the current market price of the
security. This determines the number of shares of each security. This method of
calculation does not give more weight to price changes of the more highly
capitalized component securities.
3. Other Types
An index can also be a simple average. It can be calculated by adding up the prices
of the indexs securities and dividing by the number of securities, disregarding
numbers of shares outstanding. Another type measures daily percentage
movements of prices by averaging the percentage price changes of all securities
included in the index.

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6.3. ADJUSTMENTS & ACCURACY
Securities may be dropped from an index because of events such as mergers and
liquidations or because a particular security is no longer considered representative
of the types of stocks in the index. Securities may also be added to an index
occasionally.
Adjustments to indexes might be made because of substitutions or following the
issuance of new stock by a component security. Such adjustments and other similar
changes are within the discretion of the indexs publisher. They will not usually
cause any adjustment in the terms of outstanding index options. However, an
adjustment panel has authority to make adjustments if the publisher of the
underlying index makes a change in the index's composition or method of calculation
that, in the panel's determination, may cause significant discontinuity in the index
level.
Finally, an equity index is accurate only to the extent that:
The component securities in the index are being traded.
The prices of these securities are being promptly reported.
The market prices of these securities, as measured by the index, reflect price
movements in the relevant markets.
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6.4. EQUITY V/S. INDEX OPTIONS
An equity index option is a security which is intangible and whose underlying instrument
is composed of equities: an equity index. The market value of an index put and call
tends to rise and fall in relation to the underlying index.
The price of an index call generally increases as the level of its underlying index
increases. Its purchaser has unlimited profit potential tied to the strength of these
increases.
The price of an index put generally increases as the level of its underlying index
decreases. Its purchaser has substantial profit potential tied to the strength of these
decreases.
Risk
As with an equity option, an index option buyer's risk is limited to the amount of the
premium paid for the option. The premium received and kept by the index option writer
is the maximum profit a writer can realize from the sale of the option. However, the loss
potential from writing an uncovered index option is generally unlimited. Any investor
considering writing index options should recognize that there are significant risks
involved.
Cash Settlement
The differences between equity and index options occur primarily in the underlying
instrument and the method of settlement. Generally, cash changes hands when an
option holder exercises an index option and when an index option writer is assigned.
Only a representative amount of cash changes hands from the investor who is assigned
on a written contract to the investor who exercises his purchased contract. This is
known as cash settlement.
Purchasing Rights
Purchasing an index option does not give the investor the right to purchase or sell all of
the stocks contained in the underlying index. Because an index is simply an intangible,
representative number, you might view the purchase of an index option as buying a
value that changes over time as market sentiment and prices fluctuate.
An investor purchasing an index option obtains certain rights per the terms of the
contract. In general, this includes the right to demand and receive a specified amount of
cash from the writer of a contract with the same terms.
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Option Classes
An option class is a term used for option contracts of the same type (call or put) and
style (American or European) that cover the same underlying index. Available strike
prices, expiration months and the last trading day can vary with each index option class.
Strike Price
The strike price, or exercise price, of a cash-settled option is the basis for determining
the amount of cash, if any, that the option holder is entitled to receive upon exercise.
In-the-money, At-the-money, Out-of-the-money
An index call option is:
In-the-money when its strike price is less than the reported level of the underlying
index.
At-the-money when its strike price is the same as the level of that index.
Out-of-the-money when its strike price is greater than the level of that index
An index put option is:
In-the-money when its strike price is greater than the reported level of the
underlying index.
At-the-money when its strike price is the same as the level of that index.
Out-of-the-money when its strike price is less than the level of that index
Premium
Premiums for index options are quoted like those for equity options, in dollars and
decimal amounts. An index option buyer generally pays a total of the quoted premium
amount multiplied by $100 per contract. The writer, on the other hand, receives and
keeps this amount.
The amount by which an index option is in-the-money is called its intrinsic value. Any
amount of premium in excess of intrinsic value is called an option's time value. As with
equity options, changes in volatility, time until expiration, interest rates and dividend
amounts paid by the component securities of the underlying index affect time value.
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Exercise & Assignment
The exercise settlement value is an index value used to calculate how much money will
change hands (the exercise settlement amount) when a given index option is exercised,
either before or at expiration. The reporting authority designated by the market where
the option is traded determines the value of every index underlying an option, including
the exercise settlement value. Unless OCC directs otherwise, this value is presumed
accurate and deemed final for calculating the exercise settlement amount.
In order to ensure that an index option is exercised on a particular day before expiration,
the holder must notify his brokerage firm before the firm's exercise cut-off time for
accepting exercise instructions on that day. On expiration days, the cut-off time for
exercise may be different from that for an early exercise (before expiration).
Note: Different firms may have different cut-off times for accepting exercise instructions
from customers. Those cut-off times may be different for different classes of options. In
addition, the cut-off times for index options may be different from those for equity
options.
Upon receipt of an exercise notice, OCC assigns it to one or more clearing members
with short positions in the same series in accordance with its established procedures.
The clearing member then assigns one or more of its customers who hold short
positions in that series, either randomly or on a first-in first-out basis. Upon assignment
of the exercise notice, the writer of the index option has the obligation to pay a cash
amount. Settlement and the resulting transfer of cash generally occur on the next
business day after exercise.
Note: Many firms require their customers to notify the firm of the customer's intention to
exercise at expiration, even if an option is in-the-money. Every firm should be asked to
explain its exercise procedures thoroughly, including any deadline for exercise
instructions on the last trading day before expiration.
AM & PM Settlement
Reporting authorities determine the exercise settlement values of equity index options in
a variety of ways. The two most common are:
PM settlement - Exercise settlement values based on the reported level of the
index calculated with the last reported prices of the index's component stocks at
the close of market hours on the day of exercise.
AM settlement - Exercise settlement values based on the reported level of the
index calculated with the opening prices of the index's component stocks on the
day of exercise.
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If a particular component security does not open for trading on the day the exercise
settlement value is determined, the last reported price of that security is used.
When the exercise settlement value of an index option is derived from the opening
prices of the component securities, investors should be aware that value might not be
reported for several hours following the opening of trading in those securities. A number
of updated index levels may be reported at and after the opening before the exercise
settlement value is reported. There could be a substantial divergence between those
reported index levels and the reported exercise settlement value.

American vs. European Exercise
Although equity option contracts generally have only American-style exercise, index
options can have either American- or European-style.
In the case of an American-style option, the holder of the option has the right to exercise
it on or any business day before its expiration date. The writer of an American-style
option can be assigned at any time, either when or before the option expires. Early
assignment is not always predictable.
An investor can only exercise a European-style option during a specified period prior to
expiration. This period varies with different classes of index options. Likewise, the writer
of a European-style option can be assigned only during this exercise period.

Exercise Settlement
The amount of cash received upon exercise of an index option or at expiration depends
on the closing value of the underlying index in comparison to the strike price of the
index option. The amount of cash changing hands is called the exercise settlement
amount. This amount is calculated as the difference between the strike price of the
option and the level of the underlying index reported as its exercise settlement value (in
other words, the option's intrinsic value and is generally multiplied by $100. This
calculation applies whether the option is exercised before or at its expiration.
In the case of a call, if the underlying index value is above the strike price, the holder
may exercise the option and receive the exercise settlement amount. For example, with
the settlement value of the index reported as 79.55, the holder of a long call contract
with a 78 strike price would exercise and receive $155 [(79.55 - 78) x $100 = $155]. The
writer of the option pays the holder this cash amount.
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In the case of a put, if the underlying index value is below the strike price, the holder
may exercise the option and receive the exercise settlement amount. For example, with
the settlement value of the index reported as 74.88, the holder of a long put contract
with a 78 strike price would exercise and receive $312 [(78 - 74.88) x $100 = $312]. The
writer of the option pays the holder this cash amount.

Closing Transactions
As with equity options, an index option writer wishing to close out his position buys a
contract with the same terms in the marketplace. In order to avoid assignment and its
inherent obligations, the option writer must buy this contract before the close of the
market on any given day to avoid potential notification of assignment on the next
business day. To close out a long position, the purchaser of an index option can either
sell the contract in the marketplace or exercise it if profitable to do so.
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7. VOLATILITY & THE GREEKS
Volatility
Volatility can be a very important factor in deciding what kind of options to buy or sell.
Historical volatility reflects the range that a stocks price has fluctuated during a certain
period. We denote the official mathematical value of volatility as "the annualized
standard deviation of a stocks daily price changes."
There are two types of volatility: statistical volatility and implied volatility.
Statistical (Historical) Volatility is a measure of actual asset price changes over a
specific period.
Implied Volatility is a measure of how much the marketplace expects asset price to
move for an option price. That is, the volatility that the market implies.
Volatility is difficult to compute mathematically. A strategist can let the market compute
the volatility using implied volatility. This is similar to an efficient market hypothesis
which states that if there is enough trading interest in an option that is close to at-the-
money, that option is priced fairly.
The Black-Scholes Formula
The Black-Scholes formula was the first widely used model for option pricing. A
strategist can use this formula to calculate theoretical value for an option using current
stock prices, expected dividends, the option's strike price, expected interest rates, time
to expiration and expected stock volatility. While the Black-Scholes model does not
perfectly describe real-world options markets, it is still often used in the valuation and
trading of options.
Variables of the Black-Scholes formula are:
Stock Price
Strike Price
Time remaining until expiration expressed as a percent of a year
Current risk-free interest rate
Volatility measured by annual standard deviation
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The Greeks

The Greeks are a collection of statistical values that give the investor a better overall
view of option premiums change given changes in pricing model inputs. These values
can help decide what options strategies to use. The investor should remember that
statistics show trends based on past performance. It is not guaranteed that the future
performance of the stock will behave according to the historical numbers. These trends
can change drastically based on new stock performance.

1. Beta
Beta is a measure of how closely the movement of an individual stock tracks the
movement of the entire stock market.

2. Delta
Delta is a measure of the relationship between an option premium and the
underlying stock price. For a call option, a Delta of .50 means a half-point rise in
premium for every dollar that the stock goes up. For a put option contract, the
premium rises as stock prices fall. As options near expiration, in-the-money
contracts approach a Delta of 1.00.
In this example, the Delta for stock XYZ is 0.50. As the price of the stock
changes by $2.00, the price of the options changes by $.50 for every $1.00.
Therefore the price of the options changes by (.50 x 2) = $1.00. The call options
increase by $1.00 and the put options decrease by $1.00. The Delta is not a fixed
percentage. Changes in price of stock and time to expiration affect the Delta
value.
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3. Gamma
Gamma is the sensitivity of Delta to a one-unit change in the underlying. Gamma
indicates an absolute change in Delta. For example, a Gamma of 0.150 indicates
the Delta increases or decreases by 0.150 if the underlying price increases or
decreases by $1.00. Results will usually not be exact.

4. Lambda
Lambda is a measure of leverage, the expected percent change in an option
premium for a 1% change in the value of the underlying product.

5. Rho
Rho is the sensitivity of option value to change in interest rate. Rho indicates the
absolute change in option value for a 1% change in the interest rate. For
example, a Rho of .060 indicates the option's theoretical value increases by .060
if the interest rate decreases by 1.0. Results may not be exact due to rounding.

6. Theta
Theta is the sensitivity of an options premium to change in time. Theta indicates
an absolute change in the option value for a one-unit reduction in time until
expiration. Theta may be displayed as a 1-day or 7-day measure. For example, a
Theta of -.250 indicates the option's theoretical value changes by -.250 if the
days to expiration reduce by seven. Results may not be exact due to rounding.

NOTE: seven day Theta will change to one day Theta if days to expiration are
seven or less (see Time decay).

7. Vega
Vega is the sensitivity of option value to changes in implied volatility. Vega
indicates an absolute change in option value for a 1% change in volatility. For
example, a Vega of .090 indicates the options theoretical value increases by .090
if the implied volatility increases by 1.0%. Alternately, the options theoretical
value decreases by .090 if the implied volatility decreases by 1.0%. Results may
not be exact due to rounding.
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8. PUT/CALL PARITY
Put/call parity is a captivating, noticeable reality arising from the options markets. By
gaining an understanding of put/call parity, one can begin to better understand some
mechanics that professional traders may use to value options, how supply and demand
impacts option prices and how all option values (at all the available strikes and
expirations) on the same underlying security are related. Prior to learning the
relationships between call and put values, well review a couple of items.
1. Arbitrage
Let us begin by defining arbitrage and how arbitrage opportunities serve the markets.
Arbitrage is, generally speaking, the opportunity to profit arising from price variances on
one security in different markets. For example, if an investor can buy XYZ in one market
and simultaneously sell XYZ on another market for a higher price, the trade would result
in a profit with little risk.
The selling pressure in the higher priced market will drive XYZs price down.
Conversely, the buying of XYZ in the lower price market will drive XYZs price higher.
The buying and selling pressure in the two markets will move the price difference
between the markets towards equilibrium, quickly eliminating any opportunity for
arbitrage. The no-arbitrage principle indicates that any rational price for a financial
instrument must exclude arbitrage opportunities. That is, we can determine the value of
a financial instrument if we assume arbitrage to be unavailable. Using this principle, we
can value options under the assumption that no arbitrage opportunities exist.
When trying to understand arbitrage as it relates to stock and options markets, we often
assume no restrictions on borrowing money, no restrictions on borrowing shares of
stock, and no transactions costs. In the real world, such restrictions do exist and, of
course, transaction costs are present which may reduce or eliminate any perceived
arbitrage opportunity for most individual investors. For investors with access to large
amounts of capital, low fee structures and few restrictions on borrowing, arbitrage may
be possible at times, although these opportunities are fairly rare.
2. Defining Derivatives
Options are derivatives; they derive their value from other factors. In the case of stock
options, the value is derived from the underlying stock, interest rates, dividends,
anticipated volatility and time to expiration. There are certain factors that must hold true
for options under the no arbitrage principle.
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For example, a $50 call option on XYZ expiring June of the current year must be priced
at the same or lower price than the September XYZ $50 call option for the current year.
If the September call is less expensive, investors would buy the September call, sell the
June call and guarantee a profit. Note that XYZ is a non-dividend paying stock, the
options are American exercise style and interest rates are expected to be constant over
the life of both options.
Here is an example of why a longer term option premium must be equal to or greater
than the premium of the short term option.
Transaction 1: Buy September call for $3.00
Transaction 2: Sell June call for $3.50
Transaction 3: Assigned on June call, receive $50/share, short 100 XYZ
Transaction 4: Exercise September call, pay $50/share, flatten existing short position
Result: $0.50 per share profit
*note XYZ is a non-dividend paying stock*
In our interest free, commission free, hypothetical world, the timing of the assignment
does not matter, however the exercise would only occur after an assignment. Note too
that if XYZ falls below the $50 strike price, it does not impact the trade as a result of the
$0.50 credit received when the positions were opened. If both options expire worthless,
the net result is still a profit of $0.50.
This example shows why a $50 XYZ call option expiring this June, must trade at the
same or lower premium than a $50 call option expiring the following September. If the
June premium was higher (like in the example), investors would sell the June call,
causing the price to decline and buy the September, causing the price of that option to
rise. These trades would continue until the price of the June option was equal to or
below the price of the September option.
A similar relationship can be seen between two different strike prices but the same
expiration. For example, if an XYZ June $50 call was trading at $4.00 and the June $45
call was trading at $3.00, a rational investor would sell the $50 call, buy the $45 call,
generating a $1 per share credit and pocket a profit.

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3. Synthetic Relationships
With stock and options, there are six possible positions from three securities when
dividends and interest rates are equal to zero stock, calls and puts:
1. Long Stock
2. Short Stock
3. Long Call
4. Short Call
5. Long Put
6. Short Put

Original Position = Synthetic Equivalent
Long Stock = Long Call + Short Put
Short Stock = Short Call + Long Put
Long Call = Long Stock + Long Put
Short Call = Short Stock + Short Put
Long Put = Short Stock + Long Call
Short Put = Long Stock + Short Call

Synthetic relationships with options occur by replicating a one part position, for example
long stock, by taking a two part position in two other instruments. Similar to how
synthetic oil is not extracted from the fossil fuels beneath the ground. Rather synthetic
oil is manufactured with chemicals and is man-made. Similarly, synthetic positions in
stocks and options are generated from positions in other instruments.
To replicate the gain/loss characteristics of a long stock position, one would purchase a
call and write a put simultaneously. The call and put would have the same strike price
and the same expiration. By taking these two combined positions (long call and short
put), we can replicate a third one (long stock). If we were to look at the gain/loss
characteristics of a long stock position, the gain/loss characteristics of a combined short
put/long call position would be identical. Remember the put premiums typically increase
when the stock prices decline which negatively impacts the put writer; and of course the
call premiums typically increase as the stock price increases, positively impacting the
call holder. Therefore, as the stock rises, the synthetic position also increases in value;
as the stock price falls, the synthetic position also falls.

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Lets take a closer look at a synthetic long stock position. ABC is trading at $49 per
share. The $50 put is trading at $2.00 and the $50 call is trading at $1.00 the call and
the put have the same expiration - for purposes of this example the actual expiration
does not matter. An investor can purchase the call and write the put. In doing so, the
investor generated a $1.00 credit per share.
If assigned on the short put, the put writer pays the strike price of $50 (a total of $5,000
for one put) and receives 100 shares of ABC. If the investor elects to exercise the call,
they would pay $50 per share and (similar to the assigned put) receives 100 shares. But
remember the investor took in a credit of $1 when they entered the synthetic position,
thus the effective purchase price of the stock is $50 (paid when assignment or
exercise occurs) less $1 credit from initial trade equals $49/share the price of ABC in
the market.
Example:
ABC = $49/share
ABC $50 put = $2.00
ABC $50 call = $1.00
The relationship of put/call parity can now be seen. In the previous example, if the
relationship did not hold, rational investors would buy and sell the stock, calls and puts,
driving the prices of the calls, puts and stock up or down until the relationship came
back in line.
Change the ABC price to $49.50 and leave the call and put premiums the same. The
synthetic long stock position can be established for $49/share - $0.50 less than the
market price of ABC. Rational investors would buy calls and sell puts instead of
purchasing stock (and maybe even short the stock to offset the position completely and
lock in a $.50 profit technically called a reversal). Eventually the buying of the calls
would drive the price up and the selling of the puts would cause the put premiums to
decline (and any selling of the stock would cause the stock price to decline also). This
would occur until the put/call parity relationship falls back in line, thus diminishing the
opportunity for arbitrage.
Bid/ask spreads and other transaction costs impact the ability of investors to implement
the above trades. Other factors too will change the relationship notably dividends and
interest rates. Options are priced using the no arbitrage principle. The previous
examples show how the markets participants would react to a potential arbitrage
opportunity and what the impact may be on prices.
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All this leads us to the final put/call parity equation-assuming interest rates and
dividends equal zero: +stock = +call put where + is long and - is short; or stated as
written: stock price equals long call premium less the put premium; any credit received
or debit paid is added to or subtracted from the strike price of the options. The strike
price of the call and put are the same. This assumes the strike prices and the
expirations are the same on the call and put with interest rates and dividends equal to
zero.

4. Impact of Dividends & Interest Rates
The next logical question is how ordinary dividends and interest rates impact the put call
relationship and option prices. Interest is a cost to an investor who borrows funds to
purchase stock and a benefit to investors who receive and invests funds from shorting
stock (typically only large institutions receive interest on short credit balances). Higher
interest rates thus tend to increase call option premiums and decrease put option
premiums.
For a professional trader looking to remain delta neutral and not be impacted by
market movements the offset to a short call is long stock. Long stock requires capital.
The cost of these funds suggests the call seller must ask for higher premiums when
selling calls to offset the cost of interest on money borrowed to purchase the stock.
Conversely, the offset to a short put is short stock. As a short stock position earns
interest (for some large investors at least), the put seller can ask for a lower premium as
the interest earned decreases the cost of funds.
For example, an investor is looking to sell a one-year call option on a $75 stock at the
$75 strike price. If the one-year interest rate is 5%, the cost of borrowing $7,500 for one
year is: $7,500 x 5% = $375. Therefore, the call option on this non-dividend paying
stock would have to be sold (at a minimum) for $3.75 just to cover the cost of carrying
the position for one year.
Dividends reduce the cost of borrowing if an investor borrows $7,500 (or some
percentage thereof) to purchase 100 shares of a $75 stock and receives a $1/share
dividend, he pays less interest on the money borrowed (assuming the $100 from the
dividend is applied to the loan). This reduces the cost of carry as the cost of carrying
the stock position into the future is reduced from the dividend received by holding the
stock. Opposite of interest rates, higher dividends tend to reduce call option prices and
increase put option prices.

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Professional traders understand the relationships among calls, puts, interest rates and
dividends, among other factors. For individual investors, understanding the early
exercise feature of American style options is essential. When writing options, intuition as
to when assignment may occur and when holding options understanding when to
exercise at an opportunistic time is very important. For dividend paying stocks, exercise
and assignment activity occurs more frequently just before (call exercises) and after (put
exercises) an ex-dividend date.

Put/Call Parity Formula - Non-Dividend Paying Security
c = S + p Xer(T t)
p = c - S + Xer(T t)
c = call value
S = current stock price
p = put price
X = exercise price of option
e = Eulers constant approximately 2.71828 (exponential function on a financial
calculator)
r = continuously compounded risk free interest rate
T-t = term to expiration measured in years
T = Expiration date
t = Current value date
Put-call parity: The relationship that exists between call and put prices of the same
underlying, strike price and expiration month.
Conversion: An investment strategy in which a long put and short call with the same
strike and expiration is combined with a long stock position. This is also referred to as
conversion arbitrage.
Reverse Conversion: An investment strategy in which a long call and short put with the
same strike and expiration is combined with a short stock position. This is also referred
to as reversal arbitrage.
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Arbitrage: Purchase or sale of instruments in one market versus the purchase or sale
of similar instruments in another market in an effort to profit from price differences.
Options arbitrage uses stock, cash and options to replicate other options. Synthetic
options imitate the risk reward profile of "real" options using a combination of call and
put options and the underlying stock.
http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/put_call_parity.html

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9. BLACK-SCHOLES FORMULA
In 1973, mathematicians Fischer Black, Myron Scholes, and Robert Merton published
their formula for calculating the premium of an option. Known as the Black-Scholes
model, this formula accounted for a variety of factors that affect premium:
Underlying stock price
Options strike price
Time until expiration
Implied volatility
Dividend status
Interest rates
Although the Black-Scholes formula is well known, it isnt the only method for computing
an options theoretical value. American-style equity options are typically priced using a
bi-nomial model due to the early exercise feature.
Investors can tweak or manually adjust inputs to any pricing model to illustrate the
impact of stock movement, volatility changes or other factors that influence an options
actual value. For example, you could adjust the days until expirations or underlying
price to see the effect on the Delta, Gamma and other Greeks.
The limitation of all pricing models is that market forces determine actual premiums, not
formulas, no matter how sophisticated a formula might be. Market influences can result
in highly unexpected price behavior during the life of a given options contract.
While no model can reliably predict what options premiums will be available in the
future, some investors use pricing models to anticipate an options premium under
certain future circumstances. For instance, you can calculate how an option might react
to an interest rate increase or a dividend distribution to help better predict the outcomes
of your options strategies
http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/black_scholes.html

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10. RISK MANAGEMENT
To manage risk, you first have to understand the risks that you are exposed to. This
process of developing a risk profile thus requires an examination of both the immediate
risks from competition and product market changes as well as the more indirect effects
of macroeconomic forces. Lets, begin by looking at ways in which we can develop a
complete risk profile for a firm, where we outline all of the risks that a firm is exposed to
and estimate the magnitude of the exposure. Later, we turn to a key question of what
we should do about these risks. We can try to protect ourselves against the risk using a
variety of approaches using options and futures to hedge against specific risks,
modifying the way we fund assets to reduce risk exposure or buying insurance
Risk Profile
Every business faces risks and the first step in managing risk is making an inventory of
the risks that the business/organization face and getting a measure of the exposure to
each risk. In this, we examine the process of developing a risk profile for a business and
consider some of the potential pitfalls. There are four steps involved in this process.

http://people.stern.nyu.edu/adamodar/pdfiles/papers/hedging.pdf

List all risks that a firm is exposed to, from all
sources and without consideration to the type of
risk
Categorize these risks into broad groups
Analyze the exposure to each risk
Examine the alternatives available to manage each
type of risk and the expertise that the firm brings
to deal with the risk
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Step 1: A listing of risks
Assume that you run a small company in the United States, packaging and selling
premium coffee beans for sale to customers. You may buy your coffee beans in
Columbia, sort and package them in the California and ship them to your customers all
over the world. In the process, you are approached to a multitude of risks. There is the
risk of political turmoil in Columbia, compounded by the volatility in the dollar-peso
exchange rates. Your packaging plant in California may sit on top of an earthquake fault
line and be staffed with unionized employees, exposing you to the potential for both
natural disasters and labor troubles. Your competition comes from other small
businesses offering their own gourmet coffee beans and from larger companies like
Starbucks that may be able to get better deals because of higher volume. On top of all
of this, you have to worry about the overall demand for coffee ebbing and flowing, as
customers choose between a wider array of drinks and worry about the health concerns
of too much caffeine consumption.

Not surprisingly, the risks you face become more numerous and complicated as you
expand your business to include new products and markets, and listing them all can be
exhausting. At the same time, though, you have to be aware of the risks you face before
you can begin analyzing them and deciding what to do about them.

Step 2: Categorize the risks

A listing of all risks that a firm faces can be overwhelming. One step towards making
them manageable is to sort risk into broad categories. In addition to organizing risks into
groups, it is a key step towards determining what to do about these risks. In general,
risk can be categorized based on the following criteria:

a. Market versus Firm-specific risk:

We can categorize risk into risk that affects one or a few companies (firm-specific risk)
and risk that affects many or all companies (market risk). The former can be diversified
away in a portfolio but the latter will persist even in diversified portfolios; in conventional
risk and return models, the former have no effect on expected returns (and discount
rates) whereas the latter do.

b. Operating versus Financial Risk:

Risk can also be categorized as coming from a firms financial choices (its mix of debt
and equity and the types of financing that it uses) or from its operations. An increase in
interest rates or risk premiums would be an example of the former whereas an increase
in the price of raw materials used in production would be an example of the latter.

c. Continuous Risks versus Event Risk:
Some risks are dormant for long periods and manifest themselves as unpleasant events

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that have economic consequences whereas other risks create continuous exposure.
Consider again the coffee bean companys risk exposure in Columbia. A political
revolution or nationalization of coffee estates in Columbia would be an example of event
risk whereas the changes in exchange rates would be an illustration of continuous risk.

d. Catastrophic risk versus smaller risks:

Some risks are small and have a relatively small effect on a firms earnings and value,
whereas others have a much larger impact, with the definition of small and large varying
from firm to firm. Political turmoil in its Indian software operations will have a small
impact on Microsoft, with is large market cap and cash reserves allowing it to find
alternative sites, but will have a large impact on a small software company with the
same exposure.

Some risks may not be easily categorized and the same risk can switch categories
overtime, but it still pays to do the categorization.

Step 3: Measure exposure to each risk
A logical follow up to categorizing risk is to measure exposure to risk. To make this
measurement, though, we have to first decide what it is that risk affects. At its simplest
level, we could measure the effect of risk on the earnings of a company. At its broadest
level, we can capture the risk exposure by examining how the value of a firm changes
as a consequence.

a. Earnings versus Value Risk Exposure

It is easier to measure earnings risk exposure than value risk exposure. There are
numerous accounting rules governing how companies should record and report
exchange rate and interest rate movements. Consider, for instance, how we deal with
exchange rate movements. From an accounting standpoint, the risk of changing
exchange rates is captured in what is called translation exposure, which is the effect of
these changes on the current income statement and the balance sheet. In making
translations of foreign operations from the foreign to the domestic currency, there are
two issues we need to address.

The first is whether financial statement items in a foreign currency should be translated
at the current exchange rate or at the rate that prevailed at the time of the transaction.

The second is whether the profit or loss created when the exchange rate adjustment is
made should be treated as a profit or loss in the current period or deferred until a future
period.

Accounting standards in the United States apply different rules for translation depending
upon whether the foreign entity is a self-contained unit or a direct extension of the
parent company. For the first group, FASB 52 requires that an entitys assets and

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liabilities be converted into the parents currency at the prevailing exchange rate. The
increase or decrease in equity that occurs as a consequence of this translation is
captured as an unrealized foreign exchange gain or loss and will not affect the income
statement until the underlying assets and liabilities are sold or liquidated. (shld v delete
this)

For the second group, only the monetary assets and liabilities have to be converted,
based upon the prevailing exchange rate, and the net income is adjusted for unrealized
translations gains or losses.

Translation exposure matters from the narrow standpoint of reported earnings and
balance sheet values. The more important question, however, is whether investors view
these translation changes as important in determining firm value, or whether they view
them as risk that will average out across companies and across time, and the answers
to this question are mixed. In fact, several studies suggest that earnings changes
caused by exchange rate changes do not affect the stock prices of firms.

While translation exposure is focused on the effects of exchange rate changes on
financial statements, economic exposure attempts to look more deeply at the effects of
such changes on firm value. These changes, in turn, can be broken down into two
types.

Transactions exposure looks at the effects of exchange rate changes on transactions
and projects that have already been entered into and denominated in a foreign
currency.

Operating exposure measures the effects of exchange rate changes on expected
future cash flows and discount rates, and, thus, on total value.

In his book on international finance, Shapiro presents a time pattern for economic
exposure, in which he notes that firms are exposed to exchange rate changes at every
stage in the process from developing new products for sale abroad, to entering into
contracts to sell these products to waiting for payment on these products. To illustrate, a
weakening of the U.S. dollar will increase the competition among firms that depend
upon export markets, such as Boeing, and increase their expected growth rates and
value, while hurting those firms that need imports as inputs to their production process.

Measuring Risk Exposure

We can measure risk exposure in subjective terms by assessing whether the impact of
a given risk will be large or small (but not specifying how large or small) or in
quantitative terms where we attempt to provide a numerical measure of the possible
effect. In this, two approaches are considered


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Qualitative approaches

When risk assessment is done for strategic analysis, the impact is usually measured in
qualitative terms. Thus, a firm will be found to be vulnerable to country risk or exchange
rate movements, but the potential impact will be categorized on a subjective scale.
Some of these scales are simple and have only two or three levels (high, average and
low impact) whereas others allow for more gradations (risk can be scaled on a 1-10
scale).
No matter how these scales are structured, we will be called upon to make judgments
about where individual risks fall on this scale. If the risk being assessed is one that the
firm is exposed to on a regular basis, say currency movements, we can look at its
impact on earnings or market value on a historical basis. If the risk being assessed is a
low-probability event on which there is little history as is the case for an airline exposed
to the risk of terrorism, the assessment has to be based upon the potential impact of
such an incident.

While qualitative scales are useful, the subjective judgments that go into them can
create problems since two analysts looking at the same risk can make very different
assessments of their potential impact. In addition, the fact that the risk assessment is
made by individuals, based upon their judgments, exposes it to all of the quirks
(trait/habit) in risk assessment. For instance, individuals tend to weight recent history
too much in making assessments, leading to an over estimation of exposure from
recently manifested risks. Thus, companies over estimate the likelihood and impact of
terrorist attacks, right after well publicized attacks elsewhere.

Quantitative approaches
If risk manifest itself over time as changes in earnings and value, you can assess a
firms exposure to risk by looking at its past history. In particular, changes in a firms
earnings and value can be correlated with potential risk sources to see both whether
they are affected by the risks and by how much. Alternatively, you can arrive at
estimates of risk exposure by looking at firms in the sector in which you operate and
their sensitivity to changes in risk measures.

1. Firm specific risk measures

Risk matters to firms because it affects their profitability and consequently their value.
Thus, the simplest way of measuring risk exposure is to look at the past and examine
how earnings and firm value have moved over time as a function of pre-specified risk. If
we contend, for instance, that a firm is cyclical and is exposed to the risk of economic
downturns, we should be able to back this contention up with evidence that it has been
adversely impacted by past recessions.

Consider a simple example where we estimate how much risk Walt Disney Inc. is
exposed to, from, to changes in a number of macro-economic variables, using two
measures: Disneys firm value (the market value of debt and equity) and its operating

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income. We begin by collecting past data on firm value, operating income and the
macroeconomic variables against which we want to measure its sensitivity. In the case
of the Disney, we look at four macro-economic variables the level of long term rates
measured by the 10 year treasury bond rate, the growth in the economy measured by
changes in real GDP, the inflation rate captured by the consumer price index and the
strength of the dollar against other currencies (estimated using the trade-weighted dollar
value).

The question of what to do when operating income and firm value have different results
can be resolved fairly simply. The former provides a measure of earnings risk exposure
and is thus narrow, whereas the latter captures the effect not only on current earnings
but also on future earnings. It is possible, therefore, that a firm is exposed to earnings
risk from a source but that the value risk is muted, as is the alternative where the risk to
current earnings is low but the value risk is high.

2. Sector-wide or Bottom up Risk Measures
There are two key limitations associated with the firm-specific risk measures. First, they
make sense only if the firm has been in its current business for a long time and expect
to remain in it for the foreseeable future. In todays environment, in which firms find their
business mixes changing from period to period as they divest some businesses and
acquire new ones, it is unwise to base too many conclusions on a historical analysis.
Second, the small sample sizes used tend to yield regression estimates that are not
statistically significant. In such cases, we might want to look at the characteristics of the
industry in which a firm plans to expand, rather than using past earnings or firm value as
a basis for the analysis. To illustrate, we looked at the sector estimates for each of the
sensitivity measures for the four businesses that Disney is in: movies, entertainment,
theme park and consumer product businesses. Table summarizes the findings:

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These bottom-up estimates suggest that firms in the business are negatively affected by
higher interest rates (losing 4.71% in value for every 1% change in interest rates), and
that firms in this sector are relatively unaffected by both the overall economy. Like
Disney, firms in these businesses tend to be hurt by a stronger dollar, but,, unlike
Disney, they do not seem have much pricing power (note the negative coefficient on
inflation. The sector averages also have the advantage of more precision than the firm-
specific estimates and can be relied on more.
Step 4: Risk analysis

Once you have categorized and measured risk exposure, the last step in the process
requires us to consider the choices we can make in dealing with each type of risk.
While we will defer the full discussion of which risks should be hedged and which should
not to the later section, we will prepare for that discussion by first outlining what our
alternatives are when it comes to dealing with each type of risk and follow up be
evaluating our expertise in dealing with that risk.

There are a whole range of choices when it comes to hedging risk. You can try to
reduce or eliminate risk through your investment and financing choices, through
insurance or by using derivatives. Not all choices are feasible or economical with all
risks and it is worthwhile making an inventory of the available choices with each one.
The risk associated with nationalization cannot be managed using derivatives and can
be only partially insured against; the insurance may cover the cost of the fixed assets
appropriated but not against the lost earnings from these assets. In contrast, exchange
rate risk can be hedged in most markets with relative ease using market-traded
derivatives contracts.

A tougher call involves making an assessment of how well you deal with different risk
exposures. A hotel company may very well decide that its expertise is not in making real
estate judgments but in running hotels efficiently. Consequently, it may decide to hedge
against the former while being exposed to the latter


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11. WHY USE OPTIONS?
There are two main reasons why an investor would use options: to speculate and to
hedge.
Speculation
You can think of speculation as betting on the movement of a security. The advantage
of options is that you aren't limited to making a profit only when the market goes up.
Because of the versatility of options, you can also make money when the market goes
down or even sideways.
Speculation is the territory in which the big money is made - and lost. The use of options
in this manner is the reason options have the reputation of being risky. This is because
when you buy an option, you have to be correct in determining not only the direction of
the stock's movement, but also the magnitude and the timing of this movement. To
succeed, you must correctly predict whether a stock will go up or down, and you have to
be right about how much the price will change as well as the time frame it will take for all
this to happen. And don't forget commissions! The combinations of these factors means
the odds are stacked against you.
Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as
you insure your house or car, options can be used to insure your investments against a
downturn. Critics of options say that if you are so unsure of your stock pick that you
need a hedge, you shouldn't make the investment. On the other hand, there is no doubt
that hedging strategies can be useful, especially for large institutions. Even the
individual investor can benefit. Imagine that you wanted to take advantage of
technology stocks and their upside, but say you also wanted to limit any losses. By
using options, you would be able to restrict your downside while enjoying the full upside
in a cost-effective way
http://www.investopedia.com/walkthrough/corporate-finance/5/risk-management/hedging-options.aspx

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12. HOW YOU CAN USE OPTIONS
Options can be used in a variety of ways to profit from a rise or fall in the underlying
market. The most basic strategies employ put and call options as a low capital means of
garnering a profit on market movement. Options can also be used as insurance policies
in a wide variety of trading scenarios. You probably have insurance on your car or
house because it is the responsible and safe thing to do. Options provide the same kind
of safety net for trades and investments. They also increase your leverage by enabling
you to control the shares of a specific stock without tying up a large amount of capital in
your trading account.
The amazing versatility that an option offers in today's highly volatile markets is
welcome relief from the uncertainties of traditional investing practices. Options can be
used to offer protection from a decline in the market price of a long underlying stock or
an increase in the market price of a short underlying stock. They can enable you to buy
a stock at a lower price, sell a stock at a higher price, or create additional income
against a long or short stock position. You can also use option strategies to profit from a
move in the price of the underlying asset regardless of market direction.
There are three general market directions: up, down, and sideways. It is important to
assess potential market movement when you are placing a trade. If the market is going
up, you can buy calls, sell puts or buy stocks. Do you have any other available choices?
Yes, you can combine long and short options and underlying assets in a wide variety of
strategies. These strategies limit your risk while taking advantage of market movement.
The following tables show the variety of options strategies that can be applied to profit
on market movement:

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Bullish Limited Risk
Strategies
Bullish High to
Unlimited Risk
Strategies
Bearish Limited Risk
Strategies
Buy Call
Bull Call Spread
Bull Put Spread
Call Ratio Backspread
Buy Stock
Sell Put
Covered Call
Call Ratio Spread
Buy Put
Bear Put Spread
Bear Call Spread
Put Ratio Backspread

Bearish High to
Unlimited Risk
Strategies
Neutral Limited Risk
Strategies
Neutral High Unlimited
Risk Strategies
Sell Stock
Sell Call
Covered Put
Put Ratio Spread
Long Straddle
Long Strangle
Long Synthetic Straddle
Put Ratio Spread
Long Butterfly
Long Condor
Long Iron Butterfly
Short Straddle
Short Strangle
Call Ratio Spread
Put Ratio Spread

http://www.optionetics.com/education/detail.aspx?id=1

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13. EXITING AN OPTIONS POSITION
Once you own an option, there are three methods that can be used to make a profit or
avoid loss: exercise it, offset it with another option, or let it expire worthless. By
exercising an option you have purchased, you are choosing to take delivery of (call) or
to sell (put) the underlying asset at the option's strike price. Only option buyers have the
choice to exercise an option. Option sellers, may experience the other side of that
exercisebeing assigned on the short contract and having to fulfill the obligation.
Offsetting is a method of reversing the original transaction to exit the trade. If you
bought a call, you have to sell the call with the same strike price and expiration. If you
sold a call, you have to buy a call with the same strike price and expiration. If you
bought a put, you have to sell a put with the same strike price and expiration. If you sold
a put you have to buy a put with the same strike price and expiration. If you do not offset
your position, then you have not officially exited the trade.
If an option has no value at expiration, and it has not been offset or exercised, the
option expires worthless and no further action is required. If you originally sold an
option, then you want it to expire worthless because then you get to keep the credit you
received from the option premium. Since an option seller wants an option to expire
worthless, the passage of time is an option seller's friend and an option buyer's enemy.
As an option gets closer to expiration, it decreases in value.
In certain instances, an option may be auto-exercised by the Options Clearing
Corporation. Stock and ETF options with intrinsic value > 0.25 at expiration are subject
to auto-exercise. It is always best to actively manage an option position rather than
allowing auto-exercise to occur.
It is important to note that most options traded on U.S. exchanges are American style
options.(X) In essence, they differ from European options in one main way. American
style options can be exercised at any time up until expiration. In contrast, European
style options can be exercised only on the day they expire, however they can be traded
any time prior.
All the options of one type (put or call) which have the same underlying security are
called a class of options. For example, all the calls on IBM constitute an option class. All
the options that are in one class and have the same strike price are called an option
series. For example, all IBM calls with a strike price of 80 (and various expiration dates)
constitute an option series.
http://www.optionetics.com/education/detail.aspx?id=2
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14. HEDGING A DETAIL STUDY

14.1. What is hedging?
The best way to understand hedging is to think of it as insurance. When people decide
to hedge, they are insuring themselves against a negative event. This doesn't prevent a
negative event from happening, but if it does happen and you're properly hedged, the
impact of the event is reduced. So, hedging occurs almost everywhere, and we see it
everyday. For example, if you buy house insurance, you are hedging yourself against
fires, break-ins or other unforeseen disasters.
Portfolio managers, individual investors and corporations use hedging techniques to
reduce their exposure to various risks. In financial markets, however, hedging becomes
more complicated than simply paying an insurance company a fee every year. Hedging
against investment risk means strategically using instruments in the market to offset the
risk of any adverse price movements. In other words, investors hedge one investment
by making another.
Technically, to hedge you would invest in two securities with negative correlations. Of
course, nothing in this world is free, so you still have to pay for this type of insurance in
one form or another.
Although some of us may fantasize about a world where profit potentials are limitless
but also risk free, hedging can't help us escape the hard reality of the risk-return
tradeoff. A reduction in risk will always mean a reduction in potential profits. So,
hedging, for the most part, is a technique not by which you will make money but by
which you can reduce potential loss. If the investment you are hedging against makes
money, you will have typically reduced the profit that you could have made, and if the
investment loses money, your hedge, if successful, will reduce that loss.

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14.2. HOW DO INVESTORS HEDGE?
Hedging techniques generally involve the use of complicated financial instruments
known as derivatives, the two most common of which are options and futures.
Let's see how this works with an example. Say you own shares of Cory's Tequila
Corporation (Ticker: CTC). Although you believe in this company for the long run, you
are a little worried about some short-term losses in the tequila industry. To protect
yourself from a fall in CTC you can buy a put option (a derivative) on the company,
which gives you the right to sell CTC at a specific price (strike price). This strategy is
known as a married put. If your stock price tumbles below the strike price, these losses
will be offset by gains in the put option
The other classic hedging example involves a company that depends on a certain
commodity. Let's say Cory's Tequila Corporation is worried about the volatility in the
price of agave, the plant used to make tequila. The company would be in deep trouble if
the price of agave were to skyrocket, which would severely eat into profit margins. To
protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures
contract (or its less regulated cousin, the forward contract), which allows the company
to buy the agave at a specific price at a set date in the future. Now CTC can budget
without worrying about the fluctuating commodity.
If the agave skyrockets above that price specified by the futures contract, the hedge will
have paid off because CTC will save money by paying the lower price. However, if the
price goes down, CTC is still obligated to pay the price in the contract and actually
would have been better off not hedging.
Keep in mind that because there are so many different types of options and futures
contracts an investor can hedge against nearly anything, whether a stock, commodity
price, interest rate and currency - investors can even hedge against the weather.
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if
the benefits received from it justify the expense. Remember, the goal of hedging isn't to
make money but to protect from losses. The cost of the hedge - whether it is the cost of
an option or lost profits from being on the wrong side of a futures contract - cannot be
avoided. This is the price you have to pay to avoid uncertainty.

http://www.investopedia.com/articles/basics/03/080103.asp

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14.3. TO HEDGE OR NOT TO HEDGE?
Assume now that you have a list of all of the risks that you are exposed to, categorizes
these risks and measured your exposure to each one. A fundamental and key question
that you have to answer is which of these risks you want to hedge against and which
you want to either pass through to your investors or exploit. To make this judgment, you
have to consider the potential costs and benefits of hedging; in effect, you hedge those
risks where the benefits of hedging exceed the costs.
14.4. THE COSTS OF HEDGING
Protecting yourself against risk is not costless. Sometimes, as is the case of buying
insurance, the costs are explicit. At other times, as with forwards and futures contracts,
the costs are implicit. In this section, we consider the magnitude of explicit and implicit
costs of hedging against risk and how these costs may weigh on the final question of
whether to hedge in the first place.
1. Explicit Costs
Most businesses insure against at least some risk and the costs of risk protection are
easy to compute. They take the form of the insurance premiums that you have to pay to
get the protection. In general, the trade-off is simple. The more complete the protection
against risk, the greater the cost of the insurance. In addition, the cost of insurance will
increase with the likelihood and the expected impact of a specified risk. A business
located in coastal Florida will have to pay more to insure against floods and hurricanes
than one in the mid-west.
Businesses that hedge against risks using options can also measure their hedging costs
explicitly. A farmer who buys put options to put a lower bound on the price that he will
sell his produce at has to pay for the options. Similarly, an airline that buys call options
on fuel to make sure that the price paid does not exceed the strike price will know the
cost of buying this protection.
2. Implicit Costs
The hedging costs become less explicit as we look at other ways of hedging against
risk. Firms that try to hedge against risk through their financing choices using peso
debt to fund peso assets, for instance may be able to reduce their default risk (and
consequently their cost of borrowing) but the savings are implicit. Firms that use futures
and forward contracts also face implicit costs. A farmer that buys futures contracts to
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lock in a price for his produce may face no immediate costs (in contrast with the costs of
buying put options) but will have to give up potential profits if prices move upwards.
The way in which accountants deal with explicit as opposed to implicit costs can make a
difference in which hedging tool gets chosen. Explicit costs reduce the earnings in the
period in which the protection is acquired, whereas the implicit costs manifest
themselves only indirectly in future earnings. Thus, a firm that buys insurance against
risk will report lower earnings in the period that the insurance is bought whereas a firm
that uses futures and forward contracts to hedge will not take an earnings hit in that
period. The effects of the hedging tool used will manifest itself in subsequent periods
with the latter reducing profitability in the event of upside risk.
14.5. THE BENEFITS OF HEDGING
There are several reasons why firms may choose to hedge risks, and they can be
broadly categorized into five groups.
First, the tax laws may benefit those who hedge risk.
Second, hedging against catastrophic or extreme risk may reduce the likelihood and the
costs of distress, especially for smaller businesses.
Third, hedging against risks may reduce the under investment problem prevalent in
many firms as a result of risk averse managers and restricted capital markets.
Fourth, minimizing the exposure to some types of risk may provide firms with more
freedom to fine tune their capital structure.
Finally, investors may find the financial statements of firms that do hedge against
extraneous or unrelated risks to be more informative than firms that do not.
a. Tax Benefits
A firm that hedges against risk may receive tax benefits for doing so, relative to an
otherwise similar firm that does not hedge against risk. There are two sources for these
tax benefits. One flows from the smoothing of earnings that is a consequence of
effective risk hedging; with risk hedging, earnings will be lower than they would have
been without hedging, during periods where the risk does not manifest itself and higher
in periods where there is risk exposure. To the extent that the income at higher levels
gets taxed at higher rates, there will be tax savings over time to a firm with more level
earnings. To see why, consider a tax schedule, where income beyond a particular level
(say $ 1 billion) is taxed at a higher rate i.e., a windfall profit tax. Since risk
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management can be used to smooth out income over time, it is possible for a firm with
volatile income to pay less in taxes over time as a result of risk hedging. Table below
illustrates the tax paid by the firm, assuming at tax rate of 30% for income below $ 1
billion and 50% above $ 1 billion:

Risk hedging has reduced the taxes paid over 4 years by $140 million. While it is true
that we have not reflected the cost of risk hedging in the taxable income, the firm can
afford to spend up to $ 140 million and still come out with a value increase. The tax
benefits in the example above were predicated on the existence of a tax rate that rises
with income (convex tax rates). Even in its absence, though, firms that go from making
big losses in some years to big profits in other years can benefit from risk hedging to the
extent that they get their tax benefits earlier. In a 1999 study, Graham and Smith
provide some empirical evidence on the potential tax benefits to companies from
hedging by looking at the tax structures of U.S. firms. They estimate that about half of
all U.S. firms face convex effective tax functions (where tax rates risk with income),
about a quarter have linear tax functions (where tax rates do not change with income)
and a quarter actually have concave tax functions (where tax rates decrease with
income). They also note that firms with volatile income near a kink in the statutory tax
schedule, and firms that shift from profits in one period to losses in another, are most
likely to have convex tax functions. Using simulations of earnings, they estimate the
potential tax savings to firms and conclude that while they are fairly small for most firms,
they can generate tax savings that are substantial for a quarter of the firms with convex
tax rates. In some cases, the savings amounted to more than 40% of the overall tax
liability. The other potential tax benefit arises from the tax treatment of hedging
expenses and benefits. At the risk of over simplification, there will be a tax benefit to
hedging if the cost of hedging is fully tax deductible but the benefits from insurance are
not fully taxed. As a simple example, consider a firm that pays $2.5 million in insurance
premiums each year for three years and receives an expected benefit of $7.5 million at
the third year. Assume that the insurance premiums are tax deductible but that the
insurance payout is not taxed. In such a scenario, the firm will clearly gain from hedging.
Mains (1983) use a variation of this argument to justify the purchase of insurance by
companies. He cites an Oil Insurance Association brochure entitled To Insure or Not to
Insure that argues that self-insure property damages are deductible only to the extent
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of the book value but that income from insurance claims is tax free as long as it is used
to repair or replace the destroyed assets. Even if used elsewhere, firms only have to
pay the capital gains tax (which is lower than the income tax) on the difference between
the book value of the asset and the insurance settlement. Since the capital gains tax
rate is generally lower than the income tax rate, firms can reduce their tax payments by
buying even fairly-priced insurance.(X)

b. Better investment decisions
In a perfect world, the managers of a firm would consider each investment opportunity
based upon its expected cash flows and the risk that the investment adds to the
investors in the firm. They will not be swayed by risks that can be diversified away by
these investors, substantial though these risks may be, and capital markets will stand
ready to supply the funds needed to make these investments.
But, there are frictions that can cause this process to break down. In particular, there
are two problems that affect investment decisions that can be traced to the difference
between managerial and stockholder interests

c. Managerial risk aversion
Managers may find it difficult to ignore risks that are diversifiable, partly because their
compensation and performance measures are still affected by these risks and partly
because so much of their human capital is tied up in these firms. As a consequence,
they may reject investments that add value to the firm because the firm-specific risk
exposure is substantial.

d. Capital market frictions:
A firm that has a good investment that it does not have cash on hand to invest in will
have to raise capital by either issuing new equity or by borrowing money. In a well cited
paper, Jensen and Meckling note that firms that are dependent upon new stock issues
to fund investments will tend to under invest because they have to issue the new shares
at a discount; the discount can be attributed to the fact that markets cannot distinguish
between firms raising funds for good investments and those raising funds for poor
investments easily and the problem is worse for risky companies. If firms are dependent
upon bank debt for funding investments, it is also possible that these investments
cannot be funded because access to loans is affected by firm-specific risks. Froot,
Scharfstein and Stein generalize this argument by noting that the firms that hedge
against risk are more likely to have stable operating cash flows and are thus less likely
to face unexpected cash shortfalls. As a consequence, they are less dependent upon
external financing and can stick with long-term capital investment plans and increase
value. By allowing managers to hedge firm-specific risks, risk hedging may reduce the
number of good investments that get rejected either because of managerial risk
aversion or lack of access to capital.

e. Distress Costs
Every business, no matter how large and healthy, faces the possibility of distress under
sufficiently adverse circumstances. While bankruptcy can be the final cost of distress,
the intermediate costs of being perceived to be in trouble are substantial as well.
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Customers may be reluctant to buy your products, suppliers will impose stricter terms
and employees are likely to look for alternative employment, creating a death spiral from
which it is difficult to recover. These indirect costs of distress can be very large, and
studies that try to measure it estimate they range from 20% to 40% of firm value.
Given the large costs of bankruptcy, it is prudent for firms to protect themselves against
risks that may cause distress by hedging against them. In general, these will be risks
that are large relative to the size of the firm and its fixed commitments (such as interest
expenses). As an example, while large firms with little debt like Coca Cola can easily
absorb the costs of exchange rate movements, smaller firms and firms with larger debt
obligations may very well be pushed to their financial limits by the same risk.
Consequently, it makes sense for the latter to hedge against risk. The payoff from lower
distress costs show up in value in one of two ways. In a conventional discounted cash
flow valuation, the effect is likely to manifest itself as a lower cost of capital (through a
lower cost of debt) and a higher value. In the adjusted present value approach, the
expected bankruptcy costs will be reduced as a consequence of the hedging. To the
extent that the increase in value from reducing distress costs exceeds the cost of
hedging, the value of the firm will increase. Note that the savings in distress costs from
hedging are likely to manifest themselves in substantial ways only when distress costs
are large. Consequently, we would expect firms that have borrowed money and are
exposed to significant operating risk to be better candidates for risk hedging.

f. Capital Structure
Closely related to the reduced distress cost benefit is the tax advantage that accrues
from additional debt capacity. Firms that perceive themselves as facing less distress
costs are more likely to borrow more. As long as borrowing creates a tax benefit, this
implies that a firm that hedges away large risks will borrow more money and have a
lower cost of capital. The payoff will be a higher value for the business. The evidence on
whether hedging does increase debt capacity is mixed. In supporting evidence, one
study documents a link between risk hedging and debt capacity by examining 698
publicly traded firms between 1998 and 2003. This study notes that firms that buy
property insurance (and thus hedge against real estate risk) borrow more money
and have lower costs of debt than firms that do not. Another study provides evidence
on why firms hedge by looking at firms that use derivatives. The researchers conclude
that these firms do so not in response to convex tax functions but primarily to increase
debt capacity and that these tax benefits add approximately 1.1% in value to these
firms. They also find that firms with more debt are more likely to hedge and that hedging
leads to higher leverage. However, there is other research that contests these findings.
To provide one instance, Gercy, Minton and Schraud examine firms that use currency
derivatives and find no link between their usage and higher debt ratios.

g. Informational Benefits

Hedging away risks that are unrelated to the core business of a firm can also make
financial statements more informative and investors may reward the firm with a higher
value. Thus, the changes in earnings for a multinational that hedges exchange rate risk
will reflect the operating performance of the firm rather than the luck of the draw when it
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comes to exchange rates. Similarly, a hotel management company that has hedged
away or removed its real estate risk exposure can be judged on the quality of the hotel
management services that it provides and the revenues generated, rather than the
profits or losses created by movements in real estate prices over time.

In a 1995 paper, DeMarzo and Duffie explore this issue in more detail by looking at both
the informational advantages for investors when companies hedge risk and the effect on
hedging behavior of how much the hedging behavior is disclosed to investors.

They note that the benefit of hedging is that it allows investors to gauge management
quality more easily by stripping extraneous noise from the process. They also note a
possible cost when investors use the observed variability in earnings as a measure of
management quality; in other words, investors assume that firms with more stable
earnings have superior managers. If managers are not required to disclose hedging
actions to investors, they may have the incentive to hedge too much risk; after all,
hedging reduces earnings variability and improves managerial reputation.

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15. THE PREVALENCE OF HEDGING
A significant number of firms hedge their risk exposures, with wide variations in which
risks get hedged and the tools used for hedging. In this section, we will look at some of
the empirical and survey evidence of hedging among firms.

15.1. Who hedges?

In 1999, Mian studied the annual reports of 3,022 companies in 1992 and found that
771 of these firms did some risk hedging during the course of the year. Of these firms,
543 disclosed their hedging activities in the financial statements and 228 mentioned
using derivatives to hedge risk but provided no disclosure about the extent of the
hedging. Looking across companies, he concluded that larger firms were more likely to
hedge than smaller firms, indicating that economies of scale allow larger firms to hedge
at lower costs. As supportive evidence of the large fixed costs of hedging, note the
results of a survey that found that 45% of Fortune 500 companies used at least one full-
time professional for risk management and that almost 15% used three or more fulltime
equivalents.

In an examination in 1996 of risk management practices in the gold mining industry,
Tufano makes several interesting observations.

First, almost 85% of the firms in this industry hedged some or a significant portion of
gold price risk between 1990 and 1993. Figure below summarizes the distribution of the
proportion of gold price risk hedged by the firms in the sample.


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Second, firms where managers hold equity options are less likely to hedge gold price
risk than firms where managers own stock in the firm. Finally, the extent of risk
management is negatively related to the tenure of a companys CFO; firms with long-
serving CFOs manage less risk than firms with newly hired CFOs.

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15.2. WHAT RISKS ARE MOST COMMONLY
HEDGED?

While a significant proportion of firms, hedge against risk, some risks seem to be
hedged more often than others. In this section, we will look at the two most widely
hedged risks at U.S. companies (X) exchange rate risk and commodity price risk and
consider how and why firms hedge these risks.

1. Exchange Rate Risk

Surveys consistently indicate that the most widely hedged risk at U.S. firms remains
currency risk. There are three simple reasons for this phenomenon.

a. It is ubiquitous: It is not just large multi-national firms that are exposed to
exchange rate risk. Even small firms that derive almost all of their revenues
domestically are often dependent upon inputs that come from foreign markets
and are thus exposed to exchange rate risk. An entertainment software firm that
gets its software written in India for sale in the United States is exposed to
variations in the U.S. dollar/ Indian Rupee exchange rate.
b. It affects earnings: Accounting conventions also force firms to reflect the effects
of exchange rate movements on earnings in the periods in which they occur.
Thus, the earnings per share of firms that do not hedge exchange rate risk will be
more volatile than firms that do. As a consequence, firms are much more aware
of the effects of the exchange rate risk, which may provide a motivation for
managing it.
c. It is easy to hedge: Exchange rate risk can be managed both easily and
cheaply. Firms can use an array of market-traded instruments including options
and futures contracts to reduce or even eliminate the effects of exchange rate
risk. Mercks CFO in 1990, Judy Lewent, and John Kearny described the
companys policy on identifying and hedging currency risk. They rationalized the
hedging of currency risk by noting that the earnings variability induced by
exchange rate movements could affect Mercks capacity to pay dividends and
continue to invest in R&D, because markets would not be able to differentiate
between earnings drops that could be attributed to the managers of the firm and
those that were the result of currency risk. A drop in earnings caused entirely by
an adverse exchange rate movement, they noted, could cause the stock price to
drop, making it difficult to raise fresh capital to cover needs.(y dis happens)

2. Commodity Price Risk

While most firms hedge against exchange rate risk than commodity risk, a greater
percentage of firms that are exposed to commodity price risk hedge that risk. Tufanos
study of gold mining companies, cited earlier in this section, notes that most of these
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firms hedge against gold price risk. While gold mining and other commodity companies
use hedging as a way of smoothing out the revenues that they will receive on the
output, there are companies on the other side of the table that use hedging to protect
themselves against commodity price risk in their inputs. For instance, Hersheys can
use futures contracts on cocoa to reduce uncertainty about its costs in the future.

Southwest Airlines use of derivatives to manage its exposure to fuel price risk provides
a simple example of input price hedging and why firms do it. While some airlines try to
pass through increases in fuel prices through to their customers (often unsuccessfully)
and others avoid hedging because they feel they can forecast future oil prices,
Southwest has viewed it as part of its fiduciary responsibility to its stockholders to hedge
fuel price risk. They use a combination of options, swaps and futures to hedge oil price
movements and report on their hedging activities in their financial statements.

The motivations for hedging commodity price risk may vary across companies and are
usually different for companies that hedge against output price risk (like gold
companies) as opposed to companies that hedge against input price risk (such as
airlines) but the end result is the same. The former are trying to reduce the volatility in
their revenues and the latter are trying to do the same with cost, but the net effect for
both groups is more stable and predictable operating income, which presumably allows
these firms to have lower distress costs and borrow more. With both groups, there is
another factor at play. By removing commodity price risk from the mix, firms are letting
investors know that their strength lies not in forecasting future commodity prices but in
their operational expertise. A gold mining company is then asking to be judged on its
exploration and production expertise, whereas a fuel hedging airlines operating
performance will reflect its choice of operating routes and marketing skills.

15.3. DOES HEDGING INCREASE VALUE?

Hedging risks has both implicit and explicit costs that can vary depending upon the risk
being hedged and the hedging tool used, and the benefits include better investment
decisions, lower distress costs, tax savings and more informative financial statements.
The trade-off seems simple; if the benefits exceed the costs, you should hedge and if
the costs exceed the benefits, you should not.

This simple set-up is made more complicated when we consider the investors of the
firm and the costs they face in hedging the same risks. If hedging a given risk creates
benefits to the firm, and the hedging can be done either by the firm or by investors in the
firm, the hedging will add value only if the cost of hedging is lower to the firm than it is to
investors. Thus, a firm may be able to hedge its exposure to sector risk by acquiring
firms in other businesses, but investors can hedge the same risk by holding diversified
portfolios. The premiums paid in acquisitions will dwarf the transactions costs faced by
the latter; this is clearly a case where the risk hedging strategy will be value destroying.

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In contrast, consider an airline that is planning on hedging its exposure to oil price risk
because it reduces distress costs. Since it is relatively inexpensive to buy oil options
and futures and the firm is in a much better position to know its oil needs than its
investors, this is a case where risk hedging by the firm will increase value. Figure below
provides a flowchart for determining whether firms should hedge or not hedge the risks
that they are faced with.

The evidence on whether risk hedging increases value is mixed. In a book on risk
management, Smithson presents evidence that he argues is consistent with the notion
that risk management increases value, but the increase in value at firms that hedge is
small and not statistically significant. The study by Mian, referenced in the last section,
finds only weak or mixed evidence of the potential hedging benefits lower taxes and
distress costs or better investment decisions. In fact, the evidence is inconsistent with a
distress cost model, since the companies with the greatest distress costs hedge the
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least. Tufanos study of gold mining companies, also referenced in the last section, also
finds little support for the proposition that hedging is driven by the value enhancement
concerns; rather, he concludes that managerial compensation mechanisms and risk
aversion explain the differences in risk management practices across these companies.

In summary, the benefits of hedging are hazy at best and non-existent at worst, when
we look at publicly traded firms. While we have listed many potential benefits of hedging
including tax savings, lower distress costs and higher debt ratios, there is little evidence
that they are primary motivators for hedging at most companies. In fact, a reasonable
case can be made that most hedging can be attributed to managerial interests being
served rather than increasing stockholder value.


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16. ALTERNATIVE TECHNIQUES FOR
HEDGING RISK

If you decide to reduce your exposure to a risk or risks, there are several approaches
that you can use. Some of these are integrated into the standard investment and
financing decisions that every business has to make; your risk exposure is determined
by the assets that you invest in and by the financing that you use to fund these assets.

Some have been made available by large and growing derivatives markets where
options, futures and swaps can be used to manage risk exposure.

1. Investment Choices

Some of the risk that a firm is exposed to is mitigated by the investment decisions that it
makes. Consider retail firms like the Gap and Ann Taylor. One of the risks that they face
is related to store location, with revenues and operating income being affected by foot
traffic at the mall or street that a store is placed on. This risk is lowered by the fact that
these firms also have dozens of store locations in different parts of the country; a less-
than-expected foot traffic at one store can be made up for with more-then-expected foot
traffic at another store.

It is not just the firm-specific risks (like location) that can be affected by investment
decisions. Companies like Citicorp and Coca Cola have argued that their exposure to
country risk, created by investing in emerging markets with substantial risk, is mitigated
(though not eliminated) by the fact that they operate in dozens of countries.

A sub-standard performance in one country (say Brazil) can be offset by superior
performance in another (say India). Strategists and top managers of firms that diversify
into multiple businesses have often justified this push towards becoming conglomerates
by noting that diversification reduces earnings variability and makes firms more stable.
While they have a point, a distinction has to be drawn between this risk reduction and
the examples cited in the previous two paragraphs. Ann Taylor, The Gap, Citicorp and
Coca Cola can all reduce risk through their investment choices without giving up on the
base principle of picking good investments. Thus, the Gap can open only good stores
and still end up with dozens of stores in different locations. In contrast, a firm that
decides to become a conglomerate by acquiring firms in other businesses has to pay
significant acquisition premiums. There are usually more cost-effective ways of
accomplishing the same objective.

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2. Financing Choices

Firms can affect their overall risk exposure through their financing choices. A firm that
expects to have significant cash inflows in yen on a Japanese investment can mitigate
some of that risk by borrowing in yen to fund the investment. A drop in the value of the
yen will reduce the expected cash inflows (in dollar terms) but there will be at least a
partially offsetting impact that will reduce the expected cash outflows in dollar terms.

The conventional advice to companies seeking to optimize their financing choices has
therefore been to match the characteristics of debt to more of the project funded with
the debt. The failure to do so increases default risk and the cost of debt, thus,
increasing the cost of capital and lowering firm value. Conversely, matching debt to
assets in terms of maturity and currency can reduce default risk and the costs of debt
and capital, leading to higher firm value.

What are the practical impediments to this debt matching strategy?

First, firms that are restricted in their access to bond markets may be unable to borrow
in their preferred mode. Most firms outside and even many firms in the United States
have access only to bank borrowing and are thus constrained by what banks offer. If, as
is true in many emerging markets, banks are unwilling to lend long term in the local
currency, firms with long-term investments will have to borrow short term or in a
different currency to fund their needs.

Second, there can be market frictions that make it cheaper for a firm to borrow in one
market than another; a firm that has a low profile internationally but a strong reputation
in its local market may be able to borrow at a much lower rate in the local currency
(even after adjusting for inflation differences across currencies). Consequently, it may
make sense to raise debt in the local currency to fund investments in other markets,
even though this leads to a mismatching of debt and assets.

Third, the debt used to fund investments can be affected by views about the overall
market; a firm that feels that short term rates are low, relative to long term rates, may
borrow short term to fund long term investments with the objective of shifting to long
term debt later.

3. Insurance

One of the oldest and most established ways of protecting against risk is to buy
insurance to cover specific event risk. Just as a home owner buys insurance on his or
her house to protect against the eventuality of fire or storm damage, companies can buy
insurance to protect their assets against possible loss. In fact, it can be argued that, in
spite of the attention given to the use of derivatives in risk management, traditional
insurance remains the primary vehicle for managing risk.

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Insurance does not eliminate risk. Rather, it shifts the risk from the firm buying the
insurance to the insurance firm selling it. Smith and Mayers argued that this risk shifting
may provide a benefit to both sides, for a number of reasons.

First, the insurance company may be able to create a portfolio of risks, thereby gaining
diversification benefits that the self-insured firm itself cannot obtain.

Second, the insurance company might acquire the expertise to evaluate risk and
process claims more efficiently as a consequence of its repeated exposure to that risk.

Third, insurance companies might provide other services, such as inspection and safety
services that benefit both sides. While a third party could arguably provide the same
service, the insurance company has an incentive to ensure the quality of the service.

From ancient ship owners who purchased insurance against losses created by storms
and pirates to modern businesses that buy insurance against terrorist acts, the
insurance principle has remained unchanged. From the standpoint of the insured, the
rationale for insurance is simple. In return for paying a premium, they are protected
against risks that have a low probability of occurrence but have a large impact if they
do.

The cost of buying insurance becomes part of the operating expenses of the business,
reducing the earnings of the company. The benefit is implicit and shows up as more
stable earnings over time.

The insurer offers to protect multiple risk takers against specific risks in return for
premiums and hopes to use the collective income from these premiums to cover the
losses incurred by a few. As long as the risk being insured against affects only a few of
the insured at any point in time, the laws of averaging work is in the insurers favor. The
expected payments to those damaged by the risk will be lower than the expected
premiums from the population.

Consequently, we can draw the following conclusions about the effectiveness of
insurance:

a. It is more effective against individual or firm-specific risks that affect a few and leave
the majority untouched and less effective against market-wide or systematic risks.

b. It is more effective against large risks than against small risks. After all, an entity can
self-insure against small risks and hope that the averaging process works over time. In
contrast, it is more difficult and dangerous to self-insure against large or catastrophic
risks, since one occurrence can put you out of business.

c. It is more effective against event risks, where the probabilities of occurrence and
expected losses can be estimated from past history, than against continuous risk.
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An earthquake, hurricane or terrorist event would be an example of the former whereas
exchange rate risk would be an example of the latter.

Reviewing the conditions, it is easy to see why insurance is most often used to hedge
against acts of god events that often have catastrophic effects on specific localities
but leave the rest of the population relatively untouched.

4. Derivatives

Derivatives have been used to manage risk for a very long time, but they were available
only to a few firms and at high cost, since they had to be customized for each user. The
development of options and futures markets in the 1970s and 1980s allowed for the
standardization of derivative products, thus allowing access to even individuals who
wanted to hedge against specific risk. The range of risks that are covered by derivatives
grows each year, and there are very few market-wide risks that you cannot hedge today
using options or futures.

5. Futures and Forwards

The most widely used products in risk management are futures, forwards, options and
swaps. These are generally categorized as derivative products, since they derive their
value from an underlying asset that is traded. While there are fundamental differences
among these products, the basic building blocks for all of them are similar. To examine
the common building blocks for each of these products, let us begin with the simplest
the forward contract. In a forward contract, the buyer of the contract agrees to buy a
product (which can be a commodity or a currency) at a fixed price at a specified period
in the future; the seller of the contract agrees to deliver the product in return for the fixed
price. Since the forward price is fixed while the spot price of the underlying asset
changes, we can measure the cash payoff from the forward contract to both the buyer
and the seller of the forward contract at the expiration of the contract as a function of the
spot price and present it in Figure

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If the actual price at the time of the expiration of the forward contract is greater than the
forward price, the buyer of the contract makes a gain equal to the difference and the
seller loses an equivalent amount. If the actual price is lower than the forward price, the
buyer makes a loss and the seller gains. Since forward contracts are between private
parties, however, there is always the possibility that the losing party may default on the
agreement.

A futures contract, like a forward contract, is an agreement to buy or sell an underlying
asset at a specified time in the future. Therefore, the payoff diagram on a futures
contract is similar to that of a forward contract. There are, however, three major
differences between futures and forward contract. First, futures contracts are traded on
exchanges whereas forward contracts are not. Consequently, futures contracts are
much more liquid and there is no default or credit risk; this advantage has to be offset
against the fact that futures contracts are standardized and cannot be adapted to meet
the firms precise needs. Second, futures contracts require both parties (buyer and
seller) to settle differences on a daily basis rather than waiting for expiration. Thus, if a
firm buys a futures contract on oil, and oil prices go down, the firm is obligated to pay
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the seller of the contract the difference. Because futures contracts are settled at the end
of every day, they are converted into a sequence of one-day forward contracts. This can
have an effect on their pricing. Third, when a futures contract is bought or sold, the
parties are required to put up a percentage of the price of the contract as a margin.
This operates as a performance bond, ensuring there is no default risk.

6. Options

Options differ from futures and forward contracts in their payoff profiles, which limit
losses to the buyers to the prices paid for the option i.e. call options give buyers the
rights to buy a specified asset at a fixed price any time before expiration, whereas put
options gives buyers the right to sell a specified asset at a fixed price. Figure illustrates
the payoffs to the buyers of call and put options when the options expire.

The buyer of a call option makes as a gross profit the difference between the value of
the asset and the strike price, if the value exceeds the strike price; the net payoff is the
difference between this and the price paid for the call option. If the value is less than the
strike price, the buyer loses what he or she paid for the call option. The process is
reversed for a put option. The buyer profits if the value of the asset is less than the
strike price and loses the price paid for the put if it is greater.


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There are two key differences between options and futures.

The first is that options provide protection against downside risk, while allowing you to
partake in upside potential.

Futures and forwards, on the other hand, protect you against downside risk while
eliminating upside potential. A gold mining company that sells gold futures contracts to
hedge against movements in gold prices will find itself protected if gold prices go down
but will also have to forego profits if gold prices go up. The same company will get
protection against lower gold prices by buying put options on gold but will still be able to
gain if gold prices increase.
The second is that options contracts have explicit costs, whereas the cost with futures
contracts is implicit; other than transactions and settlement costs associated with day-
to-day gold price movements, the gold mining company will face little in costs from
selling gold futures but it will have to pay to buy put options on gold.

7. Swaps
In its simplest form, titled a plain vanilla swap, you offer to swap a set of cash flows for
another set of cash flows of equivalent market value at the time of the swap.
Thus, a U.S, company that expects cash inflows in Euros from a European contract can
swaps thee for cash flows in dollars, thus mitigating currency risk. To provide a more
concrete illustration of the use of swaps to manage exchange rate risk, consider an
airline that wants to hedge against fuel price risk. The airline can enter into a swap to
pay a fixed price for oil and receive a floating price, with both indexed to fuel usage
during a period.

During the period, the airline will continue to buy oil in the cash market, but the swap
market makes up the difference when prices rise. Thus, if the floating price is $1.00 per
gallon and the fixed price is $0.85 per gallon, the floating rate payer makes a $0.15 per
gallon payment to the fixed rate payer.

Broken down to basics, a plain vanilla swap is a portfolio of forward contracts and can
therefore be analyzed as such. In recent years, swaps have become increasingly more
complex and many of these more complicated swaps can be written as combinations of
options and forward contracts.

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17. PICKING THE RIGHT HEDGING
TOOL

Once firms have decided to hedge or manage a specific risk, they have to pick among
competing products to achieve this objective. To make this choice, let us review their
costs and benefits:

1. Forward contracts provide the most complete risk hedging because they can be
designed to a firms specific needs, but only if the firm knows its future cash flow
needs. The customized design may result in a higher transaction cost for the
firm, however, especially if the cash flows are small, and forward contracts may
expose both parties to credit risk.

2. Futures contracts provide a cheaper alternative to forward contracts, insofar as
they are traded on the exchanges and do not have be customized. They also
eliminate credit risk, but they require margins and cash flows on a daily basis.
Finally, they may not provide complete protection against risk because they are
standardized.

3. Unlike futures and forward contracts, which hedge both downside and upside
risk, option contracts provide protection against only downside risk while
preserving upside potential. This benefit has to be weighed against the cost of
buying the options, however, which will vary with the amount of protection
desired. Giddy suggests a simple rule that can be used to determine whether
companies should use options or forward contracts to hedge risk. If the currency
flow is known, Giddy argues, forward contracts provide much more complete
protection and should therefore be used. If the currency flow is unknown, options
should be used, since a matching forward contract cannot be created.

4. In combating event risk, a firm can either self-insure or use a third party
insurance product. Self-insurance makes sense if the firm can achieve the
benefits of risk pooling on its own, does not need the services or support offered
by insurance companies and can provide the insurance more economically than
the third party.

As with everything else in corporate finance, firms have to make the trade-off. The
objective, after all, is not complete protection against risk, but as much protection as
makes sense, given the marginal benefits and costs of acquiring it.


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18. OPTION STRATEGIES
Hedge fund strategies are the backbone of return generation for the hedge fund
community. One of the most profitable are options strategies which can generate
healthy and stable returns. Options strategies range from complex volatility strategies to
a simple covered call approach.
18.1. Buy Call

Definition
Buying an index call gives the owner the right, but not the obligation, to buy upon
exercise the value of the underlying index at the stated exercise (strike) price
before the option expires. American-style index options may be exercised at any
time before the contracts expire. European-style index options may be exercised
only within a specific period of time, generally on the last business day before
expiration. However, any long index option may be sold in the marketplace on or
before its last trading day if it has market value. All index options are cash-
settled.

This is a bullish strategy because the value of the call tends to increase as the
level of the underlying index rises, and this gain will increasingly reflect a rise in
the value of the underlying index when its level moves above the options strike
price.

The profit potential for the long call is unlimited as the underlying index continues
to rise. The financial risk is limited to the total premium paid for the option, no
matter how low the underlying index declines. The break-even point is an
underlying index level equal to the calls strike price plus the premium paid for the
contract. As with any long option, an increase in volatility has a positive financial
effect on the long call strategy while decreasing volatility has a negative effect.
Time decay has a negative effect.

https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCalls/Part1.aspx

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Who Should Consider Buying Index Calls?

An investor who is very bullish on a particular broad market or industry
sector index, and wants to profit from a rise in its level.
An investor who wants to diversify a portfolio, but may not be willing to
commit the cash to an investment in a portfolio of multiple stocks.
An investor who would like to take advantage of the leverage that options
can provide, and with a limited dollar risk.

Buying an index call is one of the simplest and most popular strategies used by
option investors employing index options. It allows an investor the opportunity to
profit from an upward move in the price of the underlying index, while having
much less capital at risk than with the outright purchase of possibly scores of
component issues.

Example
Index XYZ is currently at 500. An investor could purchase one three-month XYZ
505 call, which represents the right to purchase the underlying index at a level of
505, for a quoted price of $11. The total cost for the call would be: $11 x 100
contract multiplier = $1,100. The underlying asset value for this option is not
shares of stock, but rather the current index level x 100 multiplier = $50,000.
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCalls/part2.aspx
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Instead of committing $50,000 to a bullish, speculative outlook, spending only
$1,100 for the purchase of one call would leave a balance of $48,900 that could
then be invested elsewhere.

By purchasing the call the investor is saying that by expiration he anticipates
index XYZ to have risen above the break-even point: $505 strike price + $11 (the
option premium paid), or an XYZ level of 516. The investors profit potential is
unlimited as XYZs level continues to rise above 516. The risk for the call
purchase is limited entirely to the total $1,100 premium paid for the contract no
matter how low XYZ declines.

Before expiration, if the call purchase becomes profitable the investor is free to
sell the option in the marketplace to realize this gain. On the other hand, if the
investors bullish outlook proves incorrect and XYZ declines in price, the call
might be sold to realize a loss less than the maximum.

Consider three possible scenarios at expiration:

XYZ closes above the break-even point
XYZ closes between the strike price and the break-even point
XYZ closes below the strike price

(Source: https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCalls/part2.aspx )

Close Above Breakeven point

Index XYZ is above break-even point of 516 at expiration
Buy 1 XYZ 505 Call at $11
If index XYZ closes above the break-even point of 516 at expiration, at 520 for instance,
the option will be in-the-money and worth its intrinsic value, or its cash settlement
amount (difference between the strike price and index level):

520 XYZ index level
-$505 call strike price
$15 intrinsic value (cash settlement amount)

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If you sell the XYZ 505 call for its intrinsic value of $15 then you would see a profit:

$15.00 intrinsic value received at calls sale
-$11.00 premium initially paid for call
$4.00 profit

This profit of $4.00 ($400 total) represents a return on an initial investment of $11
premium paid for the call ($1,100 total) of approximately 36.4% over the 3-month life of
the call contract.

With XYZ at 520 at expiration, the in-the-money XYZ 505 call could also be exercised.
The exercise settlement value would be the closing index level of 520. The cash
settlement amount would be: 520 (settlement value) $505 (call strike price) = $15. The
profit would be the same as if the call were sold for intrinsic value at expiration:

$15.00 settlement amount received at calls exercise
-$11.00 premium initially paid for call
$4.00 profit


Close Between Strike and Break-Even

Index XYZ is between 505 and 516 at expiration
With index XYZ exactly at the strike price of $505 at expiration, the 505 call would be
exactly at-the-money and have no value. With XYZ at the break-even point of 516 at
expiration the calls intrinsic value would be $11, or its initial cost. With XYZ closing
between 505 and 516 at expiration, the 505 call will be in-the-money and have an
intrinsic value of less than its initial cost. In this case the option could be sold to recoup
some of its original purchase price resulting in a partial loss for the position.

For example, index XYZ closes at 510 at expiration. The calls intrinsic value at this point
would be:

510 XYZ index level
$5 intrinsic value

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XYZ did rise in value, but not as much as anticipated. The option that cost $11 is now
worth $5, so the investor can sell the call and recoup some of its initial purchase price. If
the XYZ 505 call is sold for its intrinsic value of $5 then the loss for the position would be:

$11.00 premium initially paid for call
-$5.00 premium received at calls sale
$6.00 partial loss

partial loss would be the same as if the call were sold for intrinsic value at expiration:

$11.00 premium initially paid for call
-$5.00 settlement received at calls exercise
$6.00 partial loss

However, the call buyer could have earned interest on the $48,900 not originally
committed to this bullish position, which could offset some of the option loss.


Close Below Strike

Index XYZ is at or below 505 at expiration
Say index XYZ did not move as anticipated, but instead declined and closed at 500 at
expiration. The XYZ 505 call would expire out-of-the-money and with no value, so the
investor would lose the total premium of $1,100 initially paid for the option. This would
be the limited, maximum loss no matter how far XYZ had declined, and would also be
realized if at expiration XYZ closed at any point at or below the $505 strike price and the
call expired with no value.
By purchasing the call for $1,100, significantly less cash than the $50,000 underlying
asset value when the position was established, the investor limited the investment capital
at risk if index XYZ did not increase as anticipated. Now he still has the $48,900 cash
balance of his original investment capital, plus interest if it had been invested in short-
term interest bearing instruments, with which to make another investment decision.


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Learnings
For those who are very bullish on a particular index over the near- or long-term, and
who require a known, limited downside risk, buying an index call might be an appropriate
strategy to use. Purchasing an index call option usually requires a smaller initial cash
investment than an investment equal to the current underlying asset value (current index
level x 100 multiplier). In addition to reducing the capital at risk, the smaller call purchase
amount offers the potential of leveraged profits if a bullish outlook proves correct. As the
underlying index continues to increase, the long calls profit potential is theoretically
unlimited. On the downside, the call buyers maximum loss is known in advance and is
limited entirely to the options purchase price.

Today's investor has a choice of shorter-term expiration months afforded by regular
index option contracts, longer-term expirations available with LEAPS, as well as
multiple strike prices. So no matter an investors anticipated target price for an underlying
index after a bullish move, or the time frame over which this move might occur, there is
most likely a call contract that fits both his outlook and tolerance for risk.


18.2. Buying Puts
Definition
Buying an index put gives the owner the right, but not the obligation, to sell upon
exercise the value of the underlying index at the stated exercise (strike) price before the
option expires. American-style index options may be exercised at any time before the
contracts expire. European-style index options may be exercised only within a specific
period of time, generally on the last business day before expiration. However, any long
index option may be sold in the marketplace on or before its last trading day if it has
market value. All index options are cash-settled. For contract specifications for various
index option classes, please visit the Index Options Product Specification area here.

This is a bearish strategy because the value of the put tends to increase as the level of
the underlying index declines, and this gain in option value will increasingly reflect a
decline in the level of the underlying index when its level moves below the options
strike price.

The profit potential is significant as the level of the underlying index continues to
decline, and is limited only by a potential decrease in that level to no less than zero. The
financial risk is limited to the total premium paid for the option, no matter how high the
underlying index increases. Many investors find this limited risk more attractive than the
unlimited upside risk incurred from a short sale of component stocks. In addition, a short
seller of shares must pay any dividends distributed to shareholders while the short
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https://www.cboe.com/Strategies/IndexOptions/BuyingIndexPuts/Part1.aspx
position is held; a put holder does not. The break-even point is an underlying index level
equal to the puts strike price minus the premium paid for the contract. As with any long
option, an increase in volatility has a positive financial effect on the long put strategy
while decreasing volatility has a negative effect. Time decay has a negative effect.

Who Should Consider Buying Index Puts?

An investor who is very bearish on a particular broad market or industry sector
index and wants to profit from a decline in its level.
An investor who would like to take advantage of the leverage that options can
provide, and with a limited dollar risk.
An investor who anticipates a decline in the value of a particular index but does
not want the unlimited upside risk or the commitment of capital needed for a
short sale of underlying shares.

Buying an index put is one of the simplest and most popular bearish strategies used by
investors employing index options. It allows an investor the opportunity to profit from a
downward move in the price of the underlying index, while committing less capital
compared to the potentially significant margin requirements needed for a short sale of
numerous component issues. In addition, a long put holder is not subject to margin calls
with increasing underlying index prices as is an investor with short stock positions.
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexPuts/Part1.aspx

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Example
Index XYZ is currently at 500. An investor could purchase one three-month XYZ 495
put, which represents the right to sell the underlying index level at a level of 495, for a
quoted price of $9. The total cost for the put would be: $9 x 100 contract multiplier =
$900. By purchasing the put the investor is saying that by expiration he anticipates
index XYZ to have declined below the break-even point: $495 strike price $9 (the
option premium paid), or an XYZ level of 486.
The investors profit potential can be significant as the level of index XYZ continues to
decline below 486, and is theoretically limited only because an index can decline to no
less than zero. The risk for the put purchase is limited entirely to the total premium paid
for the contract, or $900, no matter how high the level of index XYZ might increase.
Before expiration, if the put purchase becomes profitable the investor is free to sell the
option in the marketplace to realize this gain. On the other hand, if the investors bearish
outlook proves incorrect and XYZ increases, the put might be sold to realize a loss less
than the maximum.


XYZ closes below the break-even point
XYZ closes between the strike price and the break-even point
XYZ closes above the strike price
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexPuts/part2.aspx

Close Below Break-Even Point
Index XYZ is below break-even point of 486 at expiration
Buy 1 XYZ 495 Put at $9
If index XYZ closes above the break-even point of 486 at expiration, at 480 for instance,
the option will be in-the-money and worth its intrinsic value, (difference between the
strike price and index level):
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$495 put strike price
-480 XYZ index level

If you sell the XYZ 495 put for its intrinsic value of $15 then you would see a profit:

$15.00 intrinsic value received at puts sale
-$9.00 premium initially paid for put
$6.00 profit

This profit of $6.00 ($600 total) represents a return on an initial investment of $9
premium paid for the put ($900 total) of approximately 66.7% over the 3-month life of
the put contract.

With XYZ at 480 at expiration, the in-the-money put could also be exercised. The
exercise settlement value would be the closing index level of 480. The cash settlement
amount would be: 495 (put strike price) $480 (settlement value) = $15. The profit
would be the same as if the put were sold for intrinsic value at expiration:

$15.00 settlement amount received at puts exercise
-$9.00 premium initially paid for put
$6.00 profit

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Close Between Strike and Break-Even Point
Index XYZ is between 495 and 486 at expiration
With index XYZ exactly at the strike price of $495 at expiration, the 495 put would be
exactly at-the-money and have no value. With XYZ at the break-even point of 486 at
expiration the puts intrinsic value would be $9, or its initial cost. With XYZ closing
between 495 and 486 at expiration, the 495 put will be in-the-money and have an
intrinsic value of less than its initial cost. In this case the option could be sold to recoup
some of its original purchase price resulting in a partial loss for the position.
For example, index XYZ closes at 490 at expiration. The puts intrinsic value at this
point would be:
-490 XYZ index level
$5 intrinsic value
XYZ did decline in value, but not as much as anticipated. The option that cost $9 is now
worth $5, so the investor can sell the put and recoup some of its initial purchase price. If
the XYZ 495 put is sold for its intrinsic value of $5 then the loss for the position would
be:
$9.00 premium initially paid for put
-$5.00 premium received at puts sale
$4.00 loss
With XYZ at 490 at expiration, the in-the-money XYZ 495 put could also be exercised.
settlement amount would be: 495 (put strike price) $505 (settlement value) = $5. The
loss would be the same as if the put were sold for intrinsic value at expiration:

$9.00 premium initially paid for put
-$5.00 settlement received at puts exercise
$4.00 loss
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Close Above Strike
Index XYZ is at or above 495 at expiration

Say index XYZ did not move as anticipated, but instead increased and closed at 505 at
expiration. The XYZ 495 put would expire out-of-the-money and with no value, so the
investor would lose the total premium of $900 initially paid for the option. This would be
the limited, maximum loss no matter how far XYZ had risen, and would also be realized
if at expiration XYZ closed at any point at or above the $495 strike price and the put
expired with no value.

Learnings
For those who are very bearish on a particular index over the near- or long-term, and
who require a known, limited upside risk, buying a put might be an appropriate strategy
to use. Purchasing an index put option requires a smaller initial cash investment than
the margin requirement for a short sale of multiple shares of component stocks. In
addition, there are no margin calls, nor does a put holder pay any dividends. This
reduces the capital at risk and offers the potential of leveraged profits if a bearish
outlook proves correct. As the underlying index level continues to decrease, the long
puts profit potential is limited only by the index declining to no less than zero, and large
returns on investment can be seen. On the upside, the investor with short stock
positions is exposed to a potentially unlimited dollar loss from an increase in share
value, while the put buyers maximum loss is known in advance and is limited entirely to
the options purchase price.

multiple strike prices. So no matter an investors anticipated target price for an
underlying index after a bearish move, or the time frame over which this move might
occur, there is most likely a call contract that fits both his outlook and tolerance for risk.

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18.3. Buying Index Straddles
Definition
Buying an index straddle involves the purchase of both an index call and an index put
on the same underlying index, with both options having the same strike price and
expiration month. A long straddle position is commonly purchased and sold as a
package, i.e., both options bought at the same time to establish the position as well as
sold at the same time to either realize a profit or cut a loss. In a sense, as long as both
call and put are held an investor is hedged, with the bullish call potentially increasing in
value with a rise in the underlying index, and the bearish put increasing with a decrease
in the index level.
But as with any long index call or put, the holder of these options can always exercise
them before the contracts expire. American-style index options may be exercised at any
time before expiration, while European-style index options may be exercised only within
a specific period of time, generally on the last business day before expiration. However,
any long index option may be sold in the marketplace on or before its last trading day if
it has market value. All index options are cash-settled. For contract specifications for
various index option classes, please visit the Index Options Product Specification area
here.
This is neither a bullish nor a bearish strategy, but instead a combination of the two. On
the upside, the profit potential of the long call at expiration is theoretically unlimited as
the level of the underlying index increases above the positions upside break-even point.
On the downside, the profit potential of the long put at expiration is substantial, limited
only by the underlying index decreasing to no less than zero. Again, profit potential for
the long straddle depends on the magnitude of change in the index, not the direction in
which it might move.
The maximum loss for the long straddle is limited to the total call and put premium paid.
This will occur at expiration if the index closes exactly at the strike price, and both the
call and the put expire exactly at-the-money and with no value.
There are two break-even points at expiration for this strategy. The upside break-even
is an underlying index level equal to the contracts strike price plus the total premium
paid for both the call and the put. The downside break-even is an index level equal to
the strike price less the call and put premium paid.
An increase in volatility has a positive financial effect on the long straddle strategy while
decreasing volatility has a negative effect - more so than with either a simple long call or
91

put because two long options are owned. Time decay has a negative effect on both long
options as well.

Who Should Consider Buying Index Straddles?

An investor who is convinced a particular index will make a major directional
move, but not sure whether up or down.
An investor who anticipates increased volatility in an index, up and/or down
around its current level, and a concurrent increase in overlying options implied
volatility.
An investor who would like to take advantage of the leverage that options can
provide, and with a limited dollar risk.
Buying an index straddle combines the benefits of both an index call and an index put
purchase. Leveraged potential profits can be substantial with a large move in the
underlying index either up or down from a certain level. On the other hand, straddle
buyers might instead be focused on short-term increases in call and put implied volatility
levels without a significant move in the underlying index, and taking smaller profits when
this might occur. With either motivation, the amount of capital at risk can be
predetermined, and is entirely limited
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexStraddles/Part1.aspx

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Example
Say the Federal Reserve has indicated that it is strongly considering raising the Fed
Funds rate to control inflation. Its decision, due in three weeks, will be influenced mainly
by the consumer and producer price data due out in the interim. A jump in interest rates
may send stocks sharply lower, while an announcement of steady inflation and interest
rates may boost XYZ to an all-time high. An investor expects that either of these
outcomes could move the market up or down by 5% or more over a timeframe of
approximately one month.
Index XYZ is currently at 100. The investor purchases a one-month XYZ 100 call for
$1.70, and a one-month XYZ 100 put for $1.50. The cost for the straddle is: $1.70 (call)
+ $1.50 (put) = $3.20. The total premium paid is therefore: $3.20 x 100 multiplier =
$320.
By purchasing the straddle the investor is saying that by expiration he anticipates index
XYZ to have either risen above the upside break-even point or below the downside
break-even point:
Upside Break-Even Point: 100 strike price + $3.20 straddle cost = 103.20
Downside Break-Even Point: 100 strike price - $3.20 straddle cost = 96.80

The investors profit potential is unlimited as XYZs level continues to rise above 103.20,
or substantial as XYZ declines below 96.80 by expiration one month away. The risk for
the straddle purchase is limited entirely to the total $320 premium paid for the position,
and would be seen if XYZ closes unchanged at expiration at a level of 100.
Before expiration, however, if the straddle purchase becomes profitable because of
either a move in index XYZ, and/or an increase in option implied volatility, the investor is
free to sell the position (the call and the put) in the marketplace to realize this gain. On
the other hand, if the investors outlook proves incorrect and the level of index XYZ
either does not change much over the next month, and/or the implied volatility does not
increase, the straddle might be sold to realize a loss (due to time decay) less than the
maximum.
XYZ closes above or below either break-even point at expiration
XYZ closes between the break-even points at expiration
Implied volatility changes and straddle sold prior to expiration
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexStraddles/part2.aspx
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Close Above/below Break-Even Point
Index XYZ is above 103.20 or below 96.80 at expiration
Buy 1 XYZ 100 Call at $1.70
Buy 1 XYZ 100 Put at $1.50

If index XYZ closes above the upside break-even point of 103.20 at expiration, at 105
for instance, the put will expire out-of-the-money and worthless. The call will be in-the-
money and worth its intrinsic value, or its cash settlement amount (difference between
the strike price and index level):
105 XYZ index level
On the other hand, if index XYZ closes below the downside break-even point of 96.80 at
expiration, at 95 for instance, the call will expire out-of-the-money and worthless. The
put will be in-the-money and worth its intrinsic value, or its cash settlement amount
(difference between the strike price and index level):
-95 XYZ index level
In either instance, if you sell the XYZ 100 call or put for its intrinsic value of $5, or
exercise either in-the-money option and receive its cash settlement amount, then you
would see a profit:
$5.00 intrinsic value or cash settlement amount for call or put
-$3.20 total premium initially paid for straddle
$1.80 profit
The investors prediction of at least a 5% move in XYZ index up or down (from 100 to
either 105 or 95) has proven true. The upside or downside profit of $1.80 ($180 total)
represents a return on an initial investment of $3.20 premium paid for the call ($320
total) of approximately 56.3% over the 1-month life of the straddle.
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Close Between Break-Even Points
Index XYZ is between 103.20 or below 96.80 at expiration

With index XYZ exactly at the strike price of 100 at expiration, both the 100 call and the
100 put would expire exactly at-the-money and with no value. The maximum,
predetermined loss of $3.20 (or $320 total) would be realized.
At expiration, with XYZ at either the upside break-even point of 103.20, or the downside
break-even point of 96.80, the call or puts intrinsic value would be $3.20, the initial cost
of the whole straddle.
With XYZ closing at expiration between 103.20 and 96.80, but not at the 100 strike
price, one of the options would expire in-the-money and have intrinsic value, with the
other expiring worthless. In this case the in-the-money option could be either sold or
exercised to recoup some of the original straddle purchase price resulting in a partial
loss for the position.
For example, index XYZ closes at 102 at expiration. The put would expire out-of-the-
money and with no value, and the call would have an intrinsic value (or cash settlement
amount) of:
102 XYZ index level
The level of index XYZ did change over one month, but not as much as anticipated. The
straddle that cost $3.20 is now worth only the intrinsic value of its in-the-money call, or
$2. The investor could sell the call and recoup some of the straddles initial purchase
price. If the XYZ 100 call is sold for its intrinsic value of $2 then the loss for the position
would be:
$3.20 premium initially paid for straddle
-$2.00 premium received at calls sale
$1.20 partial loss
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partial loss would be the same as if the call were sold for intrinsic value at expiration:

$3.20 premium initially paid for straddle
-$2.00 premium received at calls exercise
$1.20 partial loss

Volatility Change Before Expiration
Volatility Change Before Expiration


Say index XYZ fluctuated up and down around the level of 100, its level when the
straddle was purchased, and 10 days after purchase (20 days before expiration) it was
again at the level of 100. Time decay would have its natural, negative effect on the
value of both options. But assume the investor initially bought the straddle motivated
more by a predicted increase in option implied volatility than an expected change in the
level of XYZ, and that this prediction proved true.

The straddle was originally purchased at an implied volatility level of approximately
14%, but say the volatility level is now approximately 19%. What prices might the
investor expect to see in the marketplace for both the long at-the-money call and put,
given no change in interest rates or dividend yield of the underlying index?
XYZ 100 call = $1.85 expected value
XYZ 100 put = $1.70 expected value
XYZ 100 straddle = $3.50 expected value
96

If the investor could sell the straddle at these expected values for both the call and put,
the total received would be $3.50, or $350 total. The investor would make a profit:

$3.50 straddle sale price
-$3.20 straddle cost
$0.30 profit
The investors $0.30 profit ($30 total) after owning the XYZ 100 straddle for 10 days,
with the underlying index level unchanged, would come from the expected increase in
option implied volatility. This $30 represents a return on the initial $320 investment of
9.4% over 10 days. If during this 10-day period the option implied volatility actually
decreased, which was not expected by the investor, the straddle would most likely show
a loss due to time decay with XYZ unchanged at a level of 100.
While holding the straddle in anticipation of an implied volatility increase, the investor
was in a sense protected from a significant move in XYZ, up or down, which was not
part of his prediction. In fact, if the level of index XYZ had increased (or decreased)
dramatically while owning the straddle, a profit might have been made from a
concurrent increase in value of the call (or the put) instead, without an implied volatility
increase.

Learnings
For those who expect a move up or down in an underlying index over a given
timeframe, buying an index straddle might be an appropriate strategy to consider. If
expectations of an index move come true, an investor is positioned to profit on either the
upside by owning a call or the downside by owning a put at the same time.
At expiration, the profit potential on the upside from the long call is theoretically
unlimited. On the downside the profit potential from the long put is substantial, limited
only by the underlying index declining to no less than zero. The maximum loss for the
long straddle is limited to the total premium paid for the call and put, and will generally
occur at expiration with the underlying index closing at the straddles strike price and
both at-the-money options expiring with no value.

97

Time decay has an especially negative effect on a long straddle because this decay is
simultaneously working against the straddle owner on two long options, a call and a put.
The straddle owner is also especially vulnerable to changing volatility while holding the
straddle. A decrease in volatility has a simultaneous negative effect on both the long call
and long put. On the other hand, an increase in volatility will have a positive effect on
the market prices of both the call and the put, which can possibly overcome the natural
time decay in their values and result in a profit without a move in the underlying index.
This might be another motivation for purchasing the straddle in the first place.

18.4. PROTECTIVE INDEX COLLARS
Definition
Establishing an index collar to protect a portfolio involves purchasing puts for downside
insurance, while at the same time selling calls, with the premium taken in at least in part
financing the cost of the puts. The purchased puts will have a strike price less than that
of the calls sold, and very commonly both options are out-of-the-money when the
position is established. The short calls will limit upside profit potential of the portfolio, the
degree to which depending on the strike price chosen, because they expose the
investor to potential assignment on in-the-money contracts. Assignment may be
received on American-style index options at any time before the contracts expire. For
European-style index options, assignment is possible only within a specific period of
time, generally on the last business day before expiration. All index options are cash-
settled. For contract specifications for various index option classes, please visit the
Index Options Product Specification area here.
The degree to which the collars protective puts are paid for by the premium received
from the written calls depends entirely on the current level of the underlying index, and
the strike prices and premium amounts of the contracts chosen. It is possible to
construct a collar so that not only are the puts fully paid for by the call premium, but that
the call premium actually exceeds the puts cost. In other words the whole position may
established at a net credit, which the collar investor keeps whether the level of the
underlying index increases, decreases or remains unchanged.
Index collars are generally employed to protect unrealized profits from the portfolio
being protected, and the index option class chosen will generally have an underlying
index that most closely tracks the performance of the portfolio, or at least at a consistent
correlation, or beta. There are many option classes available from which a collar might
be constructed to provide the downside protection a portfolio might need. Again, losses
98

https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCollars/Part1.aspx
on the downside are limited by the protective index puts, as well profits on the upside
capped by the written index calls.

Who Should Consider Using an Index Collar?

An investor who owns a portfolio of mixed stocks, wants to protect its value with
puts on the downside, and in return is willing to cap its upside profit potential by
simultaneously selling calls to pay for the puts.
An investor whose portfolio tracks exactly, or at a consistent ratio or beta, the
performance of an index that underlies a class of index options.

Collars are often used by equity option investors for downside price protection of
underlying shares they own. Collars using index options may also be established to
protect the values of portfolios on the downside, and are commonly employed by
portfolio managers and investors with large portfolios of mixed stocks. In return for
downside protection, investors who turn to collars are also willing to make the trade-off
of limited profit potential of their protected assets on the upside by writing calls to at
least in part finance the cost of the puts.
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCollars/Part1.aspx

99

Example
An investor has a portfolio of mixed stocks worth $1 million that roughly matches the
composition of index XYZ. With the current level of index XYZ at 100, this investor
wants to establish a collar to protect the portfolio from a market decline of 5% over the
next 60 days. The investor might determine the number of collars to effect by dividing
the amount to be hedged (the $1,000,000 portfolio) by the current aggregate value of
index XYZ (100 x 100 multiplier = 10,000). $1,000,000 10,000 = 100 collars, so the
investor would purchase 100 puts and simultaneously sell 100 calls. This number of
contracts should be adjusted according to the beta of the portfolios performance
against XYZ if it does not track the underlying index exactly.
To establish the collar position with the downside protection needed the investor
chooses an XYZ put strike price 5% below the current XYZ level of 100, or the 60-day
XYZ 95 put. To pay for these puts the investor is willing to forego profit potential above
5% on the upside so the 60-day XYZ 105 call is also selected. The XYZ 95 puts are
purchased for a quoted price of $0.60, or $60 per option. 100 puts are therefore bought
for a total of $60 x 100 contracts = $6000. The XYZ 105 calls are sold for a quoted price
of $0.80, or $80 per call. 100 of these are sold, therefore, for a total of $80 x 100
contracts = $8000.
In this case, the investor has not only covered the cost of the puts with the call premium
received, but has actually taken in a net credit of $2000 ($8000 call premium received ?
$6000 put premium paid) for establishing this 60-day XYZ index collar. This $2000
credit is the investors to keep no matter the outcome of this position after 60 days.
XYZ Index at 100
Buy 100 XYZ 95 Puts at $0.60
Sell 100 XYZ 105 Calls at $0.80

XYZ closes below 95 put strike price
XYZ closes between the strike prices of 95 and 105
XYZ closes above 105 call strike price
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCollars/part2.aspx

100

Close Below Put Strike
Index XYZ is below 95 put strike price at expiration
XYZ Index at 100

Say index XYZ drops 8% and closes below the put strike put strike price of $95 at
expiration, at a level of 92. The puts will be in-the-money, and if sold for their total
intrinsic value of $300, or exercised for their cash settlement amount of $300 ($95 strike
price 92 index level x 100 multiplier), the investor will receive for the 100 puts a total
of: $300 put value x 100 contracts = $30,000. The out-of-the-money calls would expire
with no value.
The expected drop in value of the portfolio, if it in fact tracks the performance of index
XYZ, would be the 8% decline seen in index XYZ, or $80,000. However, the investor
was originally willing to tolerate a decline of 5%, or $50,000, and to insure the portfolio
only below that level. With an expected $80,000 loss in portfolio value after this market
drop, less the $30,000 received from either selling the puts at expiration or exercising
them, the investor has limited the downside loss to 5%, or $50,000, the original goal.
This loss could be expected if index XYZ closed at any point below the 95 put strike
price at expiration.
But remember, this investor received a net credit of $2000 when establishing the collar
position. This credit is kept, and to a limited extent offsets the loss on the portfolio to:
$50,000 $2000 = $48,000 total. If the collar had been originally established at a net
debit, this would instead add to the limited downside loss of $50,000 by the total debit
amount.

Close Between Strikes
Index XYZ is between strike prices of 95 and 105 at expiration

XYZ Index at 100
101

If index XYZ either declines or increases less than 5%, and therefore closes at
expiration between the put strike price of $95 and the call strike price of $105, both the
calls and the puts would expire out-of-the-money and with no value. The investor could
expect a drop in portfolio value of less than the tolerable 5% with a decline in XYZ, or an
increase in value of less than 5% if XYZ had gone up. In either case, the $2,000 credit
received form establishing the collar is the investors to keep. This credit would either
partially offset a loss in portfolio value by $2,000, or add $2,000 to any increase in
portfolio value on the upside. If the collar had been originally established at a net debit,
this would instead add to any loss or reduce any profit by the total debit amount.

Close Above Call Strike
Index XYZ is above 105 call strike price at expiration
XYZ Index at 100
If XYZ closes up 5% at a level of 105, the calls would expire at-the-money, with no
value, and with no assignment expected. The investors portfolio could be expected to
see an increase in value of this 5%, but the potential upside profit on the portfolio is
capped at this level.
Say index XYZ increases instead by 8% and closes above the call strike put strike price
of $105 at expiration, at a level of 108. The short calls will be in-the-money and
assignment can be expected. Upon assignment, the investor would be obligated to pay
the cash settlement amount to one or more persons exercising XYZ 105 calls. This
amount would be:
(108 index level $105 strike price strike price) x 100 multiplier = $300 for one contract.
Assignment on all 100 XYZ calls would therefore be:
$300 settlement amount x 100 contracts = $30,000. The out-of-the-money puts would
expire with no value.
The expected increase in value of the portfolio, if it in fact tracks the performance of
index XYZ, would be the 8% increase seen in index XYZ, or $80,000. However, the
investor was originally willing to cap the portfolios upside profit potential at 5%, or
$50,000, by writing the 100 XYZ 105 calls to finance the put purchase. With an
expected $80,000 increase in portfolio value after this market rise, less the $30,000
102

settlement amount paid upon assignment, the investor has limited the upside gain to
5%, or $50,000. This capped portfolio profit amount could be expected if index XYZ
closed at any point above the $105 call strike price at expiration.
But remember, this investor received a net credit of $2,000 when establishing the collar
position. This credit is kept, and to a limited extent increases the capped profit on the
portfolio to: $50,000 + $2,000 = $52,000 total. If the collar had been originally
established at a net debit, this would instead reduce the capped profit potential of
$50,000 by the total debit amount.
Learnings
For those investors holding a portfolio of mixed stocks who have unrealized profits to
protect, an index collar might be an appropriate strategy to consider. Purchasing index
put options with a given strike price for downside protection can, at least in part, be
financed by the simultaneous sale of the same number of calls with a higher strike price.
The written calls will, however, cap potential upside profits on the portfolio if the investor
is assigned on these short contracts.
When the decision is made to use a collar, the investor should at first select an index
that best tracks the performance of that portfolio and establish the collar position with its
overlying options. Then the investor considers the value of the portfolio and the current
level of the index chosen to determine the number of options to buy and sell. A put
strike price is chosen that provides the degree of downside protection wanted, and a
call strike price is selected that caps upside profit at an amount that is tolerable as a
trade-off for the downside portfolio insurance provided by the puts.
multiple strike prices. So no matter an investors anticipated target for downside
protection in return for capped upside profits, there are most likely put and call contracts
that fit both of these parameters.

103

18.5. BUYING INDEX PUTS TO HEDGE THE
VALUE OF A PORTFOLIO
Definition
Index puts can be a very useful hedge to protect the value of a portfolio of mixed stocks
in case of a market decline. Just as the way protective equity puts work, long index puts
can increase in value with a declining underlying index, the degree to which depending
on the put strike price chosen. Potential profits on the puts can be realized by either
selling the contracts or exercising them if in-the-money, with these gains at least
partially offsetting any decline in portfolio value. The puts limit the portfolio loss to a
specific level depending on their strike price in relation to the underlying index level
when the protective option position is established. On the upside the portfolios profit
potential is unlimited, but any profits are at least partially reduced by the initial cost of
the puts. The break-even point on the upside will be the current portfolio value when it is
insured plus the cost of the puts.
Index puts are generally employed to protect unrealized profits from an investors
portfolio. The index option class chosen should have an underlying index that very
closely tracks the performance of the portfolio itself, or at least at a consistent
correlation, or beta. There are many option classes available from which puts might be
chosen to provide the downside protection a portfolio might need.
American-style index options may be exercised at any time before the contracts expire.
European-style index options may be exercised only within a specific period of time,
generally on the last business day before expiration. All index options are cash-settled.
For contract specifications for various index option classes, please visit the Index
Options Product Specification area here.
104

https://www.cboe.com/Strategies/IndexOptions/BuyIndexPutstoHedge/Part1.aspx
Who Should Consider Using Index Puts to Protect a Portfolio?
An investor who owns a portfolio of mixed stocks and wants to protect its value
on the downside.
An investor whose portfolio tracks exactly, or at a consistent ratio or beta, the
performance of an index that underlies a class of index options.
Protective puts are commonly used by equity investors for protection on the downside of
the value of underlying shares they own. Index puts may used for the same type of
insurance on portfolios of mixed stocks, providing limited loss in case of a market
decline. The degree of protection depends on the put strike price selected. As the index
goes down, the value of the protective puts can increase, with profits on the options at
least partially offsetting any losses seen in the value of the portfolio.
https://www.cboe.com/Strategies/IndexOptions/BuyIndexPutstoHedge/Part1.aspx
Example
An investor has a portfolio of mixed stocks worth $2 million that closely matches the
composition of index XYZ. With the current level of index XYZ at 100, this investor
wants to buy XYZ puts to protect the portfolio from a market decline of 4% over the next
60 days. The investor might determine the number of puts to purchase by dividing the
amount to be hedged (the $2,000,000 portfolio) by the current aggregate value of index
XYZ (100 x 100 multiplier = 10,000). $2,000,000 10,000 = 200, so the investor
purchases 200 XYZ puts. This number of contracts should be adjusted according to the
beta of the portfolios performance against XYZ if it does not track the underlying index
exactly.
105

To establish the protective put position with the downside protection needed the
investor chooses an XYZ put strike price 4% below the current XYZ level of 100, or the
60-day XYZ 96 put. The XYZ 96 puts are purchased for a quoted price of $0.75, or $75
per option. 200 puts are therefore bought for a total of $75 x 200 contracts = $15,000.

https://www.cboe.com/Strategies/IndexOptions/BuyIndexPutstoHedge/part2.aspx

XYZ closes below 96 put strike price
XYZ closes between the strike price of 96 and the break-even point
XYZ closes above the break-even point

Close Below Strike Price
XYZ Index at 100
Buy 200 XYZ 96 Puts at
$0.75

intrinsic value of $400, or exercised for their cash settlement amount of $400 (96 strike
of: $400 put value x 200 contracts = $80,000.
The expected drop in value of the $2 million portfolio, if it in fact closely tracks the
performance of index XYZ, would be the 8% decline seen in index XYZ, or $160,000.
XYZ Index at 100
$0.75
106

However, the investor was originally willing to tolerate a decline of 4%, or $80,000, and
to insure the portfolio only below that level. With an expected $160,000 loss in portfolio
value after this market drop, less the $80,000 received from either selling the puts at
expiration or exercising them, the investor has limited the downside loss to 5%, or
$80,000, the original goal. This loss could be expected if index XYZ closed at any point
below the 96 put strike price at expiration.
But remember, this investor paid $15,000 total premium for the puts in the first place,
the cost of insuring the portfolio beyond a 4% decline in value. This cost would be
added to a loss in portfolio value, as would any insurance premium paid to protect any
asset.
Close Between Strike and Break-Even
XYZ Index at 100
$0.75
intrinsic value of $400, or exercised for their cash settlement amount of $400 (96 strike
of: $400 put value x 200 contracts = $80,000.
The expected drop in value of the $2 million portfolio, if it in fact closely tracks the
performance of index XYZ, would be the 8% decline seen in index XYZ, or $160,000.
However, the investor was originally willing to tolerate a decline of 4%, or $80,000, and
to insure the portfolio only below that level. With an expected $160,000 loss in portfolio
value after this market drop, less the $80,000 received from either selling the puts at
expiration or exercising them, the investor has limited the downside loss to 5%, or
$80,000, the original goal. This loss could be expected if index XYZ closed at any point
below the 96 put strike price at expiration.
But remember, this investor paid $15,000 total premium for the puts in the first place,
the cost of insuring the portfolio beyond a 4% decline in value. This cost would be
added to a loss in portfolio value, as would any insurance premium paid to protect any
asset.

107

Close Above Break-Even
Index XYZ is above the break-even point at expiration
XYZ Index at 100
$0.75

If at expiration index XYZ closes at a level of 100.75, and with the portfolio value at
$2,015,000, the $15,000 total cost of the puts has been covered. Above this level the
investor is positioned for potential profits which are theoretically unlimited as long as
index XYZ continues to increase.

Calculate Contracts to Hedge
Calculating Index Contracts to Hedge a Portfolio
Stock prices tend to move in tandem in response to the overall stock market as
measured by the S&P 500 Index (SPX). The 500 stocks that comprise the S&P 500
Index represent almost 85% of the stock market value in the United States. Therefore,
the index is an excellent reflection of the overall stock market. If an investor owns a
portfolio of stocks and is concerned about a near-term downward move in the overall
market, purchasing the appropriate SPX put options could be a desirable alternative to
hedging each stock individually.
Determining the number of contracts to use to hedge a portfolio is a fairly simple
process using the following formula:

Each SPX option represents $100 times the strike price. For instance, if an SPX put
with a strike price of 1250 is utilized, it would represent $125,000 of market value (1250
x $100). So, an investor with a stock portfolio valued at $500,000 would purchase 4
SPX 1250 puts ($500,000 / $125,000) to hedge the portfolio.
For example, consider an investor who has a diversified stock portfolio valued at
$500,000 and is concerned about a market correction of 10% over the next 30 days.
108

With the S&P 500 Index quoted at 1250, a correction of 10% would result in the S&P
500 trading at 1125.00. The investor could choose to purchase four 30-day SPX 1250
puts quoted at 25.00 ($2500 per contract) that would have a total cost of $10,000 or 2%
of the value of the portfolio.
PX % Gain
Portfolio $
Hedging Cost
1250 SPX
Total
Portfolio %
Gain / Loss Put Value Gain / Loss
1375 10% $50,000 $10,000 $0 $40,000 8%
1312.5 5% $25,000 $10,000 $0 $15,000 3%
1250 0% $0 $10,000 $0 $10,000 -2%
1187.5 -5% $25,000 $10,000 $25,000 $10,000 -2%
1125 -10% $50,000 $10,000 $50,000 $10,000 -2%
The previous table shows the dollar and percent results of this strategy based on the
S&P 500 index at a few levels upon option expiration. Because at-the-money SPX
option contracts are used for hedging, the maximum potential loss is equal to the 2%
cost of hedging. 2% of performance is sacrificed on the upside if an unanticipated
market rally occurs. A payout comparison between a hedged and un-hedged portfolio
appears in the payout diagram below.


109

Learnings
For those investors holding a portfolio of mixed stocks who have unrealized profits to
protect, protective index puts might be an appropriate strategy to consider. Purchasing
index put options with a given strike price for downside protection can, at least in part,
limit any losses on the downside.
When the decision is made to buy index puts, the investor should at first select an index
that best tracks the performance of that portfolio and establish a put position with its
overlying options. Then the investor considers the value of the portfolio and the current
level of the index chosen to determine the number of options to buy, and a put strike
price is chosen that provides the degree of downside protection wanted.
Todays investor has a choice of shorter-term expiration months afforded by regular
multiple strike prices. So no matter an investors anticipated target for downside
protection, there is most likely a put contract that fits this need.

110

19. CURRENCY HEDGING SCENARIO'S
Exchange Traded Currency Futures are used to hedge against the risk of rate volatilities in the
Forex markets.
Below we give two illustrations to explain the concept and mechanism of hedging.

19.1. HEDGING AGAINST INDIAN RUPEE
APPRECIATION
Lets assume an Indian IT exporter receives an export order worth EUR100, 000 from a
European telecom major with the delivery date being in three months. At the time of
placing the contract, the Euro is worth 64.05 Indian Rupees in the Spot market, while a
Futures contract for an expiry date that matches the order payment date is trading at
INR64. This puts the value of the order, when placed, at INR 6,405,000. However, if the
domestic exchange rate appreciates significantly (to INR63.20) by the time the order is
paid for (which is one month after the delivery date), the firm will receive only INR
6,320,000 rather than INR 6,405,000.
To insure against such losses, the firm can, at the time it receives the order, enter into
100 Euro Futures contracts of EUR 1,000 each to sell at INR 64 per Euro, which
involves contracting to sell a foreign Currency on expiry date at the agreed exchange
rate. If on the payment date the exchange rate is INR63.20, the exporter will receive
only INR 6,320,000 on selling the Euro in the Spot market, but gains INR80,000 (ie 64 -
63.20 * 100 * 1,000) in the Futures market. Overall, the firm receives INR 6,400,000 and
protects itself against the sharp appreciation of the domestic Currency against the Euro.
In the short term, firms can make gains or losses from hedging. The basic purpose of
hedging is to protect against excessive losses. Firms also tend to benefit from knowing
exactly how much they will receive from the export deals and can avoid the uncertainty
associated with future exchange rate movements.

111

19.2. HEDGING AGAINST INDIAN RUPEE
DEPRECIATION
An organic chemicals dealer in India places an import order worth EUR 100,000 with a
German manufacturer. Lets assume the current Spot rate of the Euro is INR64.05 and
at this rate the value of the order is INR 6,405,000. The importer is worried about the
sharp depreciation of the Indian Rupee against the Euro during the months until the
payment is due. So, the importer buys 100 Euro Futures contracts (EUR1, 000 each) at
INR64 per Euro. At expiry, the Rupee has depreciated to INR65 and the importer has to
pay INR 6,500,000, gaining INR100,000 (ie INR65-64 * 100 * 1,000) from the Futures
market and the resulting outflow would be only INR6,400,000.
In the short term, firms can make gains or losses from hedging. The basic purpose of
hedging is to protect against excessive losses. Firms also tend to benefit from knowing
exactly how much they will pay for the import order and avoid the uncertainty associated
with future exchange rate movements.
http://www.alpari.co.in/en/sme-corporate-services/currency-hedging-scenarios.html

112

20. OPTIONS STRATEGY FOR
IMPORTERS
Illustration

An Importer, importing raw materials from a foreign country is supposed to make
payments in dollar. In this situation the importers is exposed to appreciation in
USD/INR. The importer can thus buy USD CALL option to cover his transactions 1st
October 2010 at a strike rate of 45.50. The expiry is 2 months, i.e. 30th of December
2010. The premium for the above mentioned Call Option is 0.30 paise, so at the time of
making actual payment if the spot price has moved below the Strike Price, Dollar
becomes cheaper and the loss on Call Option is maximum up to 0.30 paise. If at the
time of making actual payment the spot price has moved above strike price, the Dollar
becomes costlier but the loss is compensated by an appreciation in the premium price.
Following is the Pay Off Table depicting gain and loss at various levels of exchange
rate:
SPOT RATE EXERCISE RATE PREMIUM PAID GAIN/LOSS
CALL@45.50
44.00 0.30 -0.30
44.50 0.30 -0.30
45.00 0.30 -0.30
45.50 0.30 -0.30
46.00 0.50 0.30 0.20
46.50 1.00 0.30 0.70
47.00 1.50 0.30 1.20

http://www.alpari.co.in/en/sme-corporate-services/options-strategy-importers.html

113

21. OPTIONS STRATEGY FOR
EXPORTERS
Illustration :

An exporter, exporting garments to USA is supposed to receive his payments in USD
(US Dollar) for the goods exported and thus is affected by depreciation or weakness in
Rupee. Thus the exporter buys Put Option to cover his transaction on 1st October 2010
at a Strike Rate or 45.50. The expiry is 2 months hence, i.e. 30th December 2010. The
premium for the call option is 0.30 paise. So at the time of making the actual payment if
the spot price has moved above the Strike Price, the dollar becomes costlier and the
loss on Call Option is maximum upto 0.30 paise. If at the time of making the actual
payment, the spot price has moved below Strike Price, the Dollar becomes cheaper but
the loss is compensated by an appreciation in the Premium Price.

Payoff Table depicting gains and losses at various levels of exchange rate
SPOT RATE EXERCISE RATE PREMIUM PAID GAIN/LOSS
CALL@45.50
44.00 1.50 0.30 1.20
44.50 1.00 0.30 0.70
45.00 0.50 0.30 0.20
45.50 0.30 -0.30
46.00 0.30 -0.30
46.50 0.30 -0.30
47.00 0.30 -0.30

http://www.alpari.co.in/en/sme-corporate-services/options-strategy-exporters.html

114

22. CONCLUSION

We looked at the process of risk profiling, where we outline the risks faced by a
business, categorize that risk, consider the tools available to manage that risk and the
capabilities of the firm in dealing with that risk.
We then move on to look at the costs and benefits of hedging. The costs of hedging can
be explicit when we use insurance or put options that protect against downside risk
while still providing upside potential and implicit when using futures and forwards, where
we give up profit potential if prices move favorably in return for savings when there are
adverse price movements. There are five possible benefits from hedging: tax savings
either from smoother earnings or favorable tax treatment of hedging costs and payoffs,
a reduced likelihood of distress and the resulting costs, higher debt capacity and the
resulting tax benefits, better investment decisions and more informational financial
statements.

While there are potential benefits to hedging and plenty of evidence that firms hedge,
there is surprisingly little empirical support for the proposition that hedging adds value.
The firms that hedge do not seem to be motivated by tax savings or reduce distress
costs, but more by managerial interests compensation systems and job protection are
often tied to maintaining more stable earnings. As the tools to hedge risk options,
futures, swaps and insurance all multiple, the purveyors of these tools also have
become more skilled at selling them to firms that often do not need them or should not
be using

115

23. BIBLIOGRAPHY
https://www.cboe.com/Strategies/IndexOptions/BuyingIndexCalls/Part1.aspx
http://www.optionseducation.org/getting_started/options_overview.html
http://www.alpari.co.in/en/sme-corporate-services/options-strategy-importers.html
http://www.alpari.co.in/en/sme-corporate-services/options-strategy-exporters.html
http://www.alpari.co.in/en/sme-corporate-services/currency-hedging-scenarios.html

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