5/24/2022

Financial Engineering
• Financial engineering involves the design, the development, and the
implementation of innovative financial instruments and process, and the
formulation of creative solutions to the problems of risk management
• Option strategies involve different investment strategies in options and
the combination of options with stock or another option. By combining
options with stocks or another option, investors can modify the risk and
return characteristics of their investments.
• These combinations are also used to create different types of
instruments which is part of financial engineering.

1
 5/24/2022

Profit equations
Recall from chapter 2
• The profit for a stock buyer,  = ST – S0
• The profit for a short sold stock,  = S0 –ST
• Long call profit = Max [(ST – E), 0] – C
• Short call profit = – Max [(ST – E), 0] + C
• Long put profit = Max [(E – ST), 0] – P
• Short put profit = – Max [(E – ST), 0] + P

Stock and call: The covered call

• If an investor writes one call for each share of stock owned, it is said to be
writing a covered call
• Writing call without having underlying stock is known as writing naked
or uncovered call
• Covered call is less risky than uncovered call because covered call is
backed by underlying asset
The profit for covered call
 = ST – S0 – Max [(ST – E), 0] + C
Profit,  = ST – S0 + C If ST  E
 = ST – S0 – ST + E + C If ST  E
= E – S0 + C
The breakeven price S*T = S0 – C 4

2
 5/24/2022

Stock and call: The covered call

BEP
Profit/ loss

E
Stock price at expiration

• Investment = S0 – C
• Breakeven stock price at expiration (𝑆𝑇∗ ) = 𝑆0 − 𝐶
• Maximum profit is limited to E – S0 + C
• Maximum loss is limited to S0 – C when ST = 0
5

Example
An investor purchased a stock of BOK Company at current market price of Rs 1,200 per
share. At the same time, she also wrote a call on BOK stock with exercise price of
Rs 1,200 per share by receiving a premium of Rs 100. What is the investor’s position
called? What is the amount of investment required? Calculate the gain/loss to the
investor from covered call strategy at expiration BOK prices of Rs 800, Rs 900, Rs 1,000,
Rs 1,100, Rs 1,200, Rs 1,300, Rs 1,400, and Rs 1,500. Find the maximum possible gain
and loss for this strategy. Also calculate the breakeven price.
• Since investor has bought stock and written call on same stock, the name of his/her
position is covered call.
• Investment = S0 – C = Rs 1200 - Rs 100 = Rs 1100
• Breakeven price = S0 – C = Rs 1200 - Rs 100 = Rs 1100
• Maximum loss = S0 – C = Rs 1200 - Rs 100 = Rs 1100
• Maximum gain = E – S0 + C = 1200 – 1200 + 100 =Rs 100

3
 5/24/2022

Calculation of gain/loss from covered call

Stock price at Gain/loss from stock Gain/loss from short call Gain/loss for covered
expiration (ST) (ST-S0) – Max [(ST – E), 0] + C call (combined)
0 – 1200 100 –1100
800 – 400 100 – 300
900 – 300 100 – 200
1000 – 200 100 – 100
1100 – 100 100 0
1200 0 100 100
1300 100 0 100
1400 200 –100 100
1500 300 –200 100
1600 400 –300 100
1700 500 – 400 100
1800 600 – 500 100

Covered call
150

100

50

0
800 900 1000 1100 1200 1300 1400 1500 1600 1700 1800
-50

-100

-150

-200

-250

-300

-350

4
 5/24/2022

Stock and put: the protective put

• Buying a put option for each stock owned.
• Loss on stock is protected by gain on put in bear market.
• Put does not disturb stock to gain in bull market
• Protective put works like an insurance policy.
The profit from a protective put is
 = ST – S0 + Max [(E – ST), 0] – P
if ST  E, Profit () = ST – S0 + E – ST - P
= E – S0 – P
if ST  E, Profit () = ST – S0 - P
The breakeven price, 𝑺𝑻∗ = S0 + P
9

Protective put continued … …

Maximum profit
= unlimited
Breakeven •Maximum loss is
limited to S0 – E + P
Profit

•Maximum gain is
0 Maximum loss unlimited

Stock price at Expiration

10

5
 5/24/2022

Protective put: example

An investor buys 100 shares of NB Bank for Rs 300 each. At the
same time she buys one put contract on NB stock with Rs 310
strike price. The option matures in 3 months. The put premium is
Rs 30 per option.
Calculate and graph the gain/loss on this protective put for end of
period NB stock prices of Rs 230 Rs 250, Rs 270, Rs 290, Rs 310, Rs
330, Rs 350, Rs 370 and Rs 390.
Find the breakeven stock price.
What is the maximum possible gain and loss on this strategy?
11

Calculation of gain/loss from protective put

ST Gain/loss on stock Gain/loss on put Gain/loss on protective
= (ST – S0)100 = [Max{(E – ST),0 –P}]100 put
230 – 7000 5000 – 2000
250 – 5000 3000 – 2000
270 – 3000 1000 – 2000
290 – 1000 – 1000 – 2000
310 1000 – 3000 – 2000
330 3000 – 3000 0
350 5000 – 3000 2000
370 7000 – 3000 4000
390 9000 – 3000 6000
Maximum loss is limited to Rs 2000
12

6
 5/24/2022

Protective put
7000
6000
5000
4000
3000
2000
1000
0
-1000 230 250 270 290 310 330 350 370 390
-2000
-3000

Option combinations
• Combination strategy involves taking positions in both calls and
puts options. Combination strategies include:
➢Straddle
➢Strangle
➢Strip
➢Strap

7
 5/24/2022

Straddle
Combination of calls and puts in same number on same underlying assets with
same time to expiration and same exercise price is called straddle.
Long straddle: purchase of calls and puts in same number on same underlying
assets with same time to expiration and same exercise price
Profit equation and breakeven prices
 = Max (0, ST – E) – C + Max (0, E - ST) – P
 = ST – E – C – P If ST > E
 = E – ST – C – P If ST < E
=–C–P If ST = E
Breakeven Price, S *T = E + C + P
and ST = E – C – P
Or Breakeven Price S*T = E ± combined premium

Contd …
Gain/loss on long straddle

Maximum profit
Breakeven = unlimited ❖ Maximum loss is
limited to C + P and
occurs when ST = E
0 ❖ Maximum gain on
E downside is limited to
Maximum loss E – C – P when ST = 0
❖ Maximum gain on
upside is unlimited
Stock price at Expiration

8
 5/24/2022

Example
Supposes the current price of the stock is Rs 30. A 3-month call on this stock is selling
for Rs 7 and a 3-month put on same stock is selling for Rs 3. The exercise price of both
call and put is Rs 35. An investor bought a put option and a call option. (i) Why do
investor buy call and put options simultaneously on same underlying with same
exercise price and same time to expiration? (ii) What is the net cost of the position?
(iii) For the stock prices of Rs 15, Rs 20… and Rs 55 at expiration, construct a table and
a position graph showing gain/loss on position. (iv) Indicate the stock price at which
the position holder breaks-even. (v) Find out the maximum gain and maximum loss
of the position.
SOLUTION
i. Investors buy equal number of call and put options on same underlying asset with
same time to expiration and same exercise price to create a long straddle. If investor
is certain about the significant change in the price of stock and is uncertain about the
direction of change in price, s/he create straddle to get benefit from either side
change in stock price.
ii. Cost of the position is the premium paid for call and put options.
= C + P = Rs 7 + Rs 3 = Rs 10.
Since one option contract involves 100 individual options,
Total cost = Rs 10 × 100 = Rs 1000.

Calculation of gain/loss on long straddle

Gain/ loss on long Gain/ loss on long Gain/ loss on long
Price of
call put straddle
stock
Max (ST – 35, 0) – 7 Max (35 – ST, 0) – 3 (combined)
15 -7 17 10
20 -7 12 5
25 -7 7 0
30 -7 2 -5
35 -7 -3 -10
40 -2 -3 -5
45 3 -3 0
50 8 -3 5
55 13 -3 10

BEP = E – C – P = 35 – 7 – 3 = Rs 25 Max loss = C + P = 7 + 3 = Rs 10 or Rs 1000 in total

BEP = E + C + P = 35 + 7 + 3 = Rs 45 Maximum gain on upside = unlimited
Maximum gain on down side = E – C – P = 35 – 7 – 3 =
Rs 25 or Rs 2500 in total.

9
 5/24/2022

Long straddle
15

10

0
15 20 25 30 35 40 45 50 55
-5

-10

-15

Contd …
Short straddle: write or sell of calls and puts in same number on same the
underlying assets with same time to expiration and same exercise price

Profit equation and breakeven prices

 = - Max [0, (ST – E)] + C - Max [0, (E - ST)] + P

 = - ST + E + C + P If ST ≥ E
 = - E + ST + P +C If ST < E

Breakeven Price ST*= E + C + P

and ST* = E – C – P
Or Breakeven Price ST*= E ± combined premium
20

10
 5/24/2022

Contd …
Gain/loss on short straddle

E
0

Stock Price at Expiration

❖ Maximum gain is limited to C + P and occurs when ST = E

❖ Maximum loss on downside is limited to E – C – P when ST = 0
❖ Maximum loss on upside is unlimited
21

Strangle
Combination of calls and puts in equal number on same underlying asset with
same time to expiation and call having higher exercise price than put
Long strangle: purchase of calls and puts in equal number on same underlying
asset with same time to expiation and call having higher exercise price than
put
The profit equations are:
π = Max (0, ST – E2) – C + Max (0, E1 - ST) – P
where E2 > E1
If ST ≤ E1 < E2 π = E1 – ST – C – P
If E1< ST ≤ E2 π=-C–P
If E1 < E2 ≤ ST π = ST – E2 – C – P
Breakeven price = E2 + C + P and E1 – C – P
22

11
 5/24/2022

Contd …
Gain / Loss on long strangle

0
E1 E2

Stock Price at
Expiration

❖ Maximum loss is limited to C + P and occurs when E1< ST ≤ E2

❖ Maximum gain on downside is limited to E1 – C – P when ST = 0
❖ Maximum gain on upside is unlimited
23

Contd …
Short strangle: An option strategy that involves selling a call and a put option
on the same underlying asset with the same time to expiration, with the call
having higher exercise price than the put.
The profit equations are:
π = - Max (0, ST – E2) + C - Max (0, E1 - ST) + P
where E2 > E1
If ST ≤ E1 < E2 π = C - E1 + ST + P
If E1< ST ≤ E2 π=C+P
If E1 < E2 ≤ ST π = - ST + E2 + C + P
Breakeven prices, ST * = E2 + C + P and E1 – C – P
Or BEP = E1 – combined premium and E2 + combined premium

24

12
 5/24/2022

Contd …
Gain / Loss on short strangle

E1 E2
0

Stock Price at Expiration

❖ Maximum gain is limited to C + P and occurs when E1< ST ≤ E2

❖ Maximum loss on downside is limited to E1 – C – P when ST = 0
❖ Maximum loss on upside is unlimited

25

Short strangle: Example

An investor sells a call and a put on the stock of ABC Company. Both put and
call mature 3 months hence. The exercise price of call is Rs 45 and selling at Rs
5. The exercise price of put is Rs 35 and selling at Rs 4. What is the name of the
position created by investor? Find out the initial total cash flow of position.
Make a position graph for end of period prices of Rs 15, 20…Rs 65. Also indicate
the maximum gain and loss for the position. What are the breakeven prices?
Solution: Since the position holder has sold one call and a put on same
underlying stock, ABC stock, with same time to expiration and call with higher
exercise price, Rs 45, than the put’s exercise price, Rs 35, the position is short
strangle.
There is initial cash inflow because both options have been sold. The initial cash
inflow = (Rs 5+ Rs 4) × 100 = Rs 900.

26

13
 5/24/2022

Contd …
Calculation of gain/loss from short strangle
Stock Gain/loss on call Gain/ loss on put Gain/ loss on short
Price -Max(ST - 45, 0) + 5 -Max[35-ST), 0]+4 strangle [combined]
15 5 -16 -11
20 5 -11 -6
25 5 -6 -1
30 5 -1 4
35 5 4 9
40 5 4 9
45 5 4 9
50 0 4 4
55 -5 4 -1
60 -10 4 -6
65 -15 4 -11
27

• Maximum gain = (C+ P)×100 = (5 + 4)×100 = Rs 900

• Maximum loss on downside = (E1 – C – P)×100 = (35 – 5 – 4)×100
= Rs 2600
• Maximum loss on upside = unlimited because it increases with
increase in stock price.
• Breakeven stock price:
ST* = E1 – C – P = 35 – 5 – 4 = Rs 26
ST* = E2 + C + P = 45 + 5 + 4 = Rs 54

14
 5/24/2022

Strip
A long strip consists of a long position in one call and two puts with the same
strike price and expiration date on same underlying asset.
Profit for Long Strip
 = Max [(ST – E), 0] – C + 2 [Max.{(E – ST), 0}] - 2P
Breakeven prices
S*T = E – P – C/2
S*T= E + C + 2P

29

Contd …
Gain / Loss on long strip

Long strip

0
E

Stock Price at Expiration

❖ Maximum loss is limited to C + 2P and occurs when ST = E

❖ Maximum gain on downside is limited to E – P – C/2 when ST = 0
❖ Maximum gain on upside is unlimited
30

15
 5/24/2022

Contd …
Short strip: A short position in one call and two puts with the same strike price
and expiration date on same underling asset.

Profit for Short Strip

 = – Max (ST – E, 0) + C – 2 [Max {(E – ST), 0}] + 2P
Breakeven prices:
S*T = E – P – C/2
S*T = E + C + 2P

31

Contd …

Short strip

E
Gain / Loss

Stock Price at Expiration

❖ Maximum gain is limited to C + 2P and occurs when ST = E

❖ Maximum loss on downside is limited to E – P – C/2 when ST = 0
❖ Maximum loss on upside is unlimited
32

16
 5/24/2022

Strap
A long strap consists of a long position in two calls and one put with the
same strike price and expiration date on same underlying asset.
= 2[Max{(ST – E), 0}] – 2C + Max[(E – ST), 0] - P
Breakeven prices
S*T = E – 2C – P
S*T = E + C + P/2

33

Contd …
Gain / Loss on long strap

Long strap

0
E

Stock Price at Expiration

❖ Maximum loss is limited to 2C + P and occurs when ST = E

❖ Maximum gain on downside is limited to E – 2C – P when ST = 0
❖ Maximum gain on upside is unlimited
34

17
 5/24/2022

Contd …
Short strap: A short strap consists of a short position in two calls and one put
with the same strike price and expiration date on same underlying asset.

Profit for Short Strap

 = – 2 [Max {(ST – E, 0}] + 2C – Max (E – ST, 0)} + P

Breakeven prices:
S*T = E – 2C – P
S*T = E + C + P/2

35

Contd …
Short strap
Gain / Loss on short strap

Stock Price at Expiration

❖ Maximum gain is limited to 2C + P and occurs when ST = E

❖ Maximum loss on downside is limited to E – 2C – P when ST = 0
❖ Maximum loss on upside is unlimited
36

18
 5/24/2022

Option spread
Spread strategy involves taking long and short positions in calls or puts
with some different characteristics. Spread include following:
• Money spread
➢Bull spread
➢Bear spread
➢Butterfly spread
➢Collar
➢Condor
• Calendar spread
• Ratio spread
• Box spread
37

Bull spread
Buying an option with certain exercise price and selling an option on same
underlying asset with same time to expiration and higher exercise price
Bull spread from call
Buy call with E1 exercise price at C1 call premium
Sell call with E2 exercise price at C2 call premium Where E2 > E1
Since call premium and exercise price are inversely related C1>C2 and there is
initial net cash outflow.
Profit from Call Bull Spread
 = [Max (ST –E1), 0]-C1 - [Max (ST - E2), 0] + C2 where E2>E1
Breakeven price = E1 + C1- C2
Maximum gain is limited to E2 – E1 – C1+ C2
Maximum loss is limited to ST – E1 – C1+ C2 38

19
 5/24/2022

Call bull spread Possible

gain is
4 greater
3
than
possible
2 loss
1

0
15 20 25 30 35 40 45 55
Gain / Loss

-1

-2

Stock Price at Expiration

39

Bull spread from put

Buy put with E1 exercise price at P1 put premium
Sell put with E2 exercise price at P2 put premium
Where E2 > E1
Since put premium and exercise price are directly related P1< P2 and there is initial
net cash inflow.

Profit for put bull spread:

 = Max [(E1 – ST), 0] – P1 – Max [(E2 – ST), 0] + P2
where E2>E1
Breakeven price = E2 + P1 − P2
Maximum gain is limited to ST – E2 – P1 + P2
Maximum loss is limited to E1 – E2 – P1 + P2
40

20
 5/24/2022

Put bull spread Possible

gain is less
4 than
3
possible
loss
2

0
15 20 25 30 35 40 45 55
Gain / Loss

-1

-2

Stock Price at Expiration

41

Bear spread

Selling an option with certain exercise price and buying an option with
higher exercise price with same other characteristics.
Bear spread from call
Buy call with E2 exercise price at C2 premium
Sell call with E1 exercise price at C1 premium
Profit from call bear spread
π = [Max (ST –E2), 0] – C2 − [Max (ST - E1), 0] +C1
where E2>E1
Breakeven price = E1 + C1 - C2
Maximum gain is limited to E1 − ST + C1 - C2
Maximum loss is limited to E1 −E2 + C1 - C2
42

21
 5/24/2022

Call bear spread

2
Gain / Loss

0
15 20 25 30 35 40 45 55
-1

-2

Stock Price at Expiration

43

Bear spread from put

Buy put with E2 exercise price at P2 premium
Sell put with E1 exercise price at P1 premium
Profit from put bear spread
π = [Max (E2 – ST), 0] - P2 - [Max (E1 – ST), 0] + P1
where E2>E1
Breakeven price = E2 + P1- P2
Maximum gain is limited to E2 – E1 + P1 - P2
Maximum loss is limited to P1 + E2 - ST - P2

44

22
 5/24/2022

Put bear spread

2
Gain / Loss

0
15 20 25 30 35 40 45 55
-1

-2

Stock Price at Expiration

45

Butterfly spread
Butterfly Spread from Call

LONG CALL BUTTERFLY

➢an option trading strategy that involves long position in one call with E1
exercise price, short position in two calls with E2 exercise price and long
position in one call with E3 exercise price
E3>E2>E1
➢E2 halfway between E1 and E3
➢Generally, E2 is close to the current market price of underlying stock.
➢ A butterfly spread leads to a profit if the stock price stays close to E2, but
gives rise to a small loss if there is a significant stock price move in either
direction
➢The strategy requires a small investment initially.
46

23
 5/24/2022

Profit from long butterfly from call

π = Max [(ST –E1), 0] – C1 – 2 Max [(ST – E2), 0] + 2C2
+ Max [(ST – E3), 0] – C3

Breakeven price, S*T = E1+ C1 – 2C2 + C3

and S*T = 2E2 – E1 – C1 + 2C2 – C3
4
3
2
1
Profit/loss

0
-1 85 90 95 100 105 110 115 120
-2
-3
Stock price at expiration

47

Short butterfly from call

A short butterfly spread from call can be created by selling a call option with lower
exercise price E1, buying two call options with middle exercise price, E2, and
selling one call option with higher exercise price E3.
profit for short butterfly spread from call
π= – Max [(ST – E1), 0] + C1 + 2 Max [(ST – E2), 0] – 2C2 – Max [(ST – E3), 0] + C3

Breakeven price, S*T = E1+ C1 – 2C2 + C3

and S*T = 2E2 – E1 – C1 + 2C2 – C3

48

24
 5/24/2022

Short butterfly

3
2
1
0
Profit/loss

-1 85 90 95 100 105 110 115 120

-2
-3
-4

Stock price at expiration

49

Butterfly Spread from put

LONG PUT BUTTERFLY

➢an option trading strategy that involves long position in one put with E1
exercise price, short position in two puts with E2 exercise price and long
position in one put with E3 exercise price
E3>E2>E1
➢E2 halfway between E1 and E3
➢A butterfly spread leads to a profit if the stock price stays close to E2, but
gives rise to a small loss if there is a significant stock price move in either
direction
➢The strategy requires a small investment initially.
50

25
 5/24/2022

Profit from long butterfly from put

 = Max [(E1 – ST),0] – P1 – 2Max [(E2 – ST),0] + 2P2 + Max [(E3 – ST),0] – P3

Breakeven price, S*T = 2E2 – E3 + P1 – 2P2 + P3

and S*T = E3 – P1 + 2P2 – P3

4
3
2
Profit/loss

1
0
-1 85 90 95 100 105 110 115 120
-2
-3
Stock price at expiration

51

Short butterfly from put

A short butterfly spread from put can be created by selling a put

option with lower exercise price E1, buying two put options with
middle exercise price, E2, and selling one put option with higher
exercise price E3.
profit for short butterfly spread from call
 = – Max [(E1 – ST),0] + P1 + 2Max [(E2 – ST),0] – 2P2
– Max [(E3 – ST),0] + P3
Breakeven price, S*T = 2E2 – E3 + P1 – 2P2 + P3
and S*T = E3 – P1 + 2P2 – P3

52

26
 5/24/2022

Short butterfly

3
2
1
0
Profit/loss

-1 85 90 95 100 105 110 115 120

-2
-3
-4

Stock price at expiration

53

Butterfly spread: example

Consider the following given strike prices and option premiums. Time to
expiration for all calls is same. Assume possible stock price at expiration of
Rs 85, Rs 90…Rs 120.
Exercise prices Call premiums Put premiums
Rs 105 Rs 3 Rs 6
Rs 100 Rs 4 Rs 3
Rs 95 Rs 7 Rs 1
a. How can you construct a long butterfly spread from call.?
b. Find the cost of long butterfly spread?
c. What are the breakeven stock prices at expiration?
d. Construct a table showing gain/loss at expiration for given stock prices.
e. Find the maximum gain and maximum loss.
f. At what range of stock prices would long butterfly lead to a loss?
54

27
 5/24/2022

Solution
a. Long butterfly spread can be created by buying a call with exercise
price of Rs 95 at Rs 7, writing two call options with exercise price of
Rs 100 at Rs 4 each and buying a call with Rs 105 exercise price at Rs
3.

b. cost = 7-2×4+3 = Rs 2 or Rs 200 in total.

c. breakeven stock price,

S*T = E1+ C1 – 2C2 + C3
= 95 + 7 – 2 × 4 + 3 = Rs 97

and S*T = 2E2 – E1 – C1 + 2C2 – C3

= 2 ×100 – 95 – 7 + 2 × 4 – 3 = Rs 103
55

d. Calculation of gain/loss for long butterfly from call

Expiration Long call 2 short call Long call Butterfly
Stock profit, profit, profit spread
prices E=105, C=3 E=100, C=4 E=95, C=7 (combined)
85 -3 8 -7 -2
90 -3 8 -7 -2
95 -3 8 -7 -2
100 -3 8 -2 3
105 -3 -2 3 -2
110 2 -12 8 -2
115 7 -22 13 -2
120 12 -32 18 -2
e. Maximum gain = Rs 300
Maximum loss = Rs 200
f. Any stock price below Rs 97 and above Rs 103, long butterfly would lead to
loss to the investor. Between stock price of Rs 97 and Rs 103, there will be a
profit. Maximum profit can be attained at stock price of Rs 100 i.e. equal56to
exercise price.

28
 5/24/2022

Synthetic instruments

• If combined cash flow from security ‘i’ and ‘j’ is exactly the
same with the cash flow from security ‘k’, the combination
of security ‘i’ and security ‘j’ is known as synthetic ‘k’.
• Using put-call parity, we can create synthetic instruments

Synthetic put
• Using put-call parity, put can be expressed as

• Synthetic long put can be created by buying a call option, buying a risk-
free zero coupon bond with face value equal to exercise price (or lend
amount equal to PV of E) and selling short a stock.

• Synthetic short put can be created by writing a call option, selling short
a risk-free zero coupon bond with face value equal to exercise price (or
borrow amount equal to PV of E) and buying a stock.

29
 5/24/2022

Synthetic call
• Using put-call parity, call can be expressed as

• Synthetic long call can be created by buying a put option, buying a stock
and selling short a risk-free zero coupon bond with face value equal to
exercise price (or borrowing amount equal to PV of E).
• Synthetic short call can be created by selling a put option, selling a stock
and buying a risk-free zero coupon bond with face value equal to
exercise price (or lending amount equal to PV of E).

Synthetic stock or equity

• Using put-call parity, stock can be expressed as

• Synthetic long position in stock can be created by buying a call option,

buying a zero coupon bond with face value equal to exercise price and
writing a put option.
• Synthetic short position in stock can be created by selling a call option,
selling short a zero coupon bond with face value equal to exercise price
and buying a put option.

30
 5/24/2022

Synthetic zero coupon bond

• Using put-call parity, bond can be expressed as

• Synthetic long position in bond can be created by buying a stock,

buying a put and selling or writing a call.
• Synthetic short position in bond can be created by selling a stock,
writing a put and buying a call.

Example
ABC stock is currently selling at Rs 100. Call and put options on ABC with
Rs 100 strike price and 6 months to expiration are currently selling at Rs
16 and Rs 5 respectively. The risk-free rate is currently 10% per annum.
a) Explain how you can create synthetic long position in put option with
available instruments.
b) Find the cost of synthetic long put.
c) Is synthetic long put worthwhile?
d) Show the cash flow from synthetic long put and actual long put as a
function of stock price at expiration are the same.

31
 5/24/2022

Solution
Solution
Current price of stock (S0) = Rs 100
Strike price (E) = Rs 100
Time to expiration (t) = 6 months
Price of call (c) = Rs 16
Price of Put (P) = Rs 5
Risk-free interest rate (r) = 10% p.a.

a) Synthetic long position in put can be created by buying a call option

at Rs 16, buying a zero coupon bond with face value of Rs 100 at
100
(1+0.1)6/12 = Rs 95.35 and selling short a stock for Rs 100.

𝐸
b) Cost of synthetic long put, P = C + - S0
(1+𝑟)𝑡

P = 16 + 95.35 – 100 = Rs 11.35

c) Since cost of synthetic long put is greater than the cost of

actual put (11.35>5), synthetic long put is not worthwhile.
Synthetic short put is worthwhile in this case.

32
 5/24/2022

d) Calculation of cash flow at expiration form synthetic and actual put

Portfolio Insurance
• It is an investment strategy that involves the combination of
investment in securities in such a way that establishes a minimum
value or floor value of the portfolio. The value of insured portfolio
does not go below a certain level but it can earn profit in bull
market.
• Portfolio can be insured in two ways
• Stock and put combination
• Call and risk-free security (Fiduciary call)

33
 5/24/2022

Portfolio insurance: Stock and put combination

• Portfolio can be insured by investing in equal number of stock and puts.
When stock price decreases, put covers the loss on stock. When stock
price increases, portfolio earns profit.
• Initial value of insured portfolio (V) = Ns × S0 + Np × P
where Ns = number of stocks, Np = number of puts, P = put price and S0 =
stock price
• Since we need equal number of puts and stocks, Ns = Np = N, then
V = N × S0 + N × P
Or V = (S0 + P) × N
𝑉
Or N =
𝑆0+𝑃
where V = available fund or value of portfolio to be insured

• Value of portfolio at expiration of insurance period (i.e., expiration of

put option) (VT)
• If stock price at expiration is greater than or equal to exercise price (E)
If ST ≥ E, VT= N × ST + Max [(E – ST),0]×N
Since put becomes out of the money, VT= N × ST
• The value of portfolio increases as stock price increases and vice versa.
• If stock price at expiration is less than exercise price (E)
If ST < E, VT= N × ST + Max [(E – ST),0]×N
VT= N × ST + (E – ST)×N
VT= NST + NE – NST
VT= NE
• This value is fixed and does not change with change in stock price.

34
 5/24/2022

• The worst possible case occurs when stock price decreases to zero. In
this case also, the value of portfolio remains at NE.
• Therefore, the minimum value or floor value or insured value of
portfolio is NE.
• That is, Vmin= NE
𝑉𝐸 𝑉
Or Vmin = because N =
𝑆0+𝑃 𝑆0+𝑃
• Upside capture: It is the percentage of value of uninsured portfolio
captured by insured portfolio.
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑠𝑢𝑟𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
Upside capture = × 100
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑖𝑛𝑠𝑢𝑟𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
• Cost of insurance = It is the return forgone by insured portfolio in bull
market.
Cost of insurance = 100% - upside capture

Example

24. PORTFOLIO INSURANCE. On July 5, a market index is at 550. You hold a portfolio
that duplicate the index and is worth 2000 times the index. You wish to insure the
portfolio at a particular value over the period until October 20. You can buy T-bills
maturing on October 20 with a face value of Rs 100 for Rs 97.
a. You plan to use put options, which are selling for Rs 20 and have an exercise
price of 560. Determine the appropriate number of puts and shares to hold. What
is the insured value of the portfolio?
b. Determine the value of the portfolio if the index on October 20 is at 530.
c. Determine the value of portfolio if index on October 20 is at 600. Compute the
upside capture and cost of insurance.
Given: Today’s value of index or current price of stock (S0) = 550
Number of shares = 2000 shares
Value of portfolio to be insured (V) = 550 × 2000 = Rs 1100000

35
 5/24/2022

Solution
a. Price of put (P) = Rs 20, Exercise price (E) = 560
Number of puts and number of stocks required to insure the portfolio
𝑉 1100000
N= = = 1929.82
𝑆0+𝑃 550 +20
We need to hold 1929.82 stocks and same number of puts to insure the
portfolio at particular value.
𝑉𝐸 1100000×560
Minimum value, Vmin = = = Rs 1080701.75
𝑆0+𝑃 550 +20
The value of portfolio remains at Rs 1080701.75 even if stock price
decreased to zero.
b. Index value at expiration, (ST) = 530
VT= N × ST + Max [(E – ST),0]×N
= 1929.82 × 530 + Max[(560-530),0]×1929.82
= Rs 1080699.20 which is equal to minimum value.

C. Index value at expiration, (ST) = 600

VT= N × ST + Max [(E – ST),0]×N
= 1929.82 × 600 + Max[(560-600),0]×1929.82
= Rs 1157892.0 which is greater than minimum value.

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑠𝑢𝑟𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

Upside capture =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑖𝑛𝑠𝑢𝑟𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝑉𝑇 1157892
= 𝑉 = 1100000 = 0.9649 or 96.49%
×𝑆𝑇 ×600
𝑆0 550

Cost of insurance = 100% - upside capture = 100% - 96.49% = 3.51%

36
 5/24/2022

Portfolio insurance: Call and T-bill

(Fiduciary call)
• Portfolio can also be insured by investing in Treasury bill (risk-free
security) and call options, which is known as fiduciary call.
• Investor can define minimum value of portfolio or insured value.
• To insure the portfolio, investor should buy T-bills with face value equal
to the minimum value of portfolio.
• Remaining amount should be invested in call options.
• Value of portfolio initially (V) = NB × B + NC × C
Where NB = number of T-bills, NC = number of calls, B = price of T-bill and
C = price of call

• Value of portfolio at expiration

(VT) = NB × BT + Max[(ST – E),0] NC
Where BT = Face value of T-bill, ST = Stock price at expiration and E
= Exercise price of call
• Cost of insurance and upside capture can be calculated by using
the same procedure as in stock-put combination of portfolio
insurance.

37
 5/24/2022

Problem 25
Today’s value of index or current price of stock (S0) = 550
Number of shares = 2000 shares
Value of portfolio to be insured (V) = 550 × 200 = Rs 1100000
Insurance period = July 5 – October 20
Price of put (P) = Rs 20, Exercise price (E) = 560
Price of Treasury bill (B) = Rs 97
Face value of T-bill (BT) = Rs 100
Minimum value = Rs 1081701.75

• Number of T-bills to hold (NB) = Vmin / BT

= 1080701.75 / 100 = 10807.02 bills should be purchased to insure portfolio
at the value insured by stock put combination.
• Investment in T-bills = NB × B = 10807.02 × 97 = Rs 1048280.94
• Investment in call = V - NB × B = 1100000 - 1048280.94 = Rs 51719.06
• Number of call to hold (NC) = [V - NB × B]/C
To calculate the price of call, use put-call parity
C = S0 + P – E/(1+r)t
= 550 + 20 – 560/(1+0.1095)107/365 t= July 5 – October 20 =107 days
C = Rs 26.80 𝐵 /
r = ( 𝑇)365 𝑡 - 1
𝐵
NC = [V - NB × B]/C
= investment in call / C r = (100/97)365/107 – 1
= 51719.06/26.80 = 1929.82 r = 10.95%

38
 5/24/2022

• Value of portfolio at expiration if ST = 600

VT = NB × BT + Max[(ST – E),0] NC
= 10807.02 × 100 + Max[(600 – 560),0] 1929.82
= Rs 1157894.8, which is equal to the value of portfolio in stock-put
combination at ST = 600.

Thank You

39