Risk Management Cheatsheet

Call Option Put Option

• Buy assets at given price • Sell assets at given price

Long Position Payoff: Long Position Payoff

Short Position Payoff: Short Position Payoff:

Price of a European call option for non-dividend-paying Price of a European call option for dividend-paying
stock stock
Straddle

• Long call and put option on same stock for same strike price at same exercise date

• If stock volatile -> Makes money when stock and strike prices far apart

Strangle

• Long call and put options on same stock for different strike prices (call>put) at same exercise
date

• The strike of the put imbedded in the strangle is necessarily lower than the one imbedded in
the straddle (as the call strikes are the same). As puts are the cheaper the lower their strikes, a
strangle will be cheaper than a straddle.

Protective Put
• Long put on a stock I already own

Portfolio Insurance
• Protective put written on a portfolio rather than a single stock
• Can also be achieved by purchasing a bond and a call option
Butterfly Spread

• Long 2 call options to different strike prices and short 2 call options to average strike price of
long calls

• Makes money when stock and strike prices close

Put-Call Parity
Constructing a portfolio:

• Purchase stock + put

• Purchase zero-coupon bond (face value K) + call
• Same payoffs and same price

Factors affecting option prices

Effect of increase in Call Put
Stock price positive negative
Strike price negative positive
Risk-free rate positive negative
Volatility positive positive
Time to expiration positive positive
Dividend negative positive

• American option cannot be worth more than European

• Put option cannot be worth more than strike price
• Call option cannot be worth more than stock price
• American option with a later exercise date cannot be worth less than an otherwise identical
American option with an earlier exercise date, but European can be (OPTION VALUE)
Non-Dividend-Paying Stock
Intrinsic Value Time Value
Amount in-the-money or zero Option price – intrinsic value

• American option cannot be worth less • American option never negative

than intrinsic value
• European call always positive

• The price of any call option on a non-dividend-paying stock always exceeds its intrinsic value
prior to expiration, thus never optimal to exercise early

• However, it may be optimal to exercise a put option on a non-dividend paying stock early
o Put option is sufficiently deep in-the-money, dis(K) will be large relative to the value of
the call, and the time value of a European put option will be negative

Dividend-Paying Stock
➔ Stock price drops by the amount of dividend -> value of call option decreases, value of put
option increases
Intrinsic Value Time Value

• Price of American option can exceed • European call can be negative

European’s

• It may be optimal to exercise the American call option early

o When a company pays a dividend, investors expect the price of the stock to drop. When
the stock price falls, the owner of a call option loses. Unlike the owner of the stock, the
option holder does not get the dividend as compensation.
o By exercising early and holding the stock, the owner of the call option can capture the
dividend
Equity (share of a stock) Debt
• Call option on the assets of • Debt holders - owners of the firm having sold a
the firm with a strike price equal to the value of debt call option with a strike price equal to the
outstanding required debt payment
• If the value exceeds the value of debt • Debt can also be viewed as a portfolio of riskless
outstanding, the equity holders get whatever debt and a short position in a put option on the
is left once the debt has been repaid firm’s assets with a strike price equal to the
• required debt payment

Replicating Portfolio
• A portfolio consisting of a stock and a risk-free bond that has the same value and payoffs in one
period as an option written on the same stock
• Absence of arbitrage opportunities -> current value of call option and replicating portfolio is
equal
• E.g.
Binomial Option Pricing Model
Call Option (S-K,0)

Option Price:

Put Option (K-S,0)

• No assumption needed for the risk preferences of investors

Multiperiod Model
Current price (S)= 40, strike price (K)= 50, 2 period, r_f=6% (when it expires value=intrinsic value)

C=6,13

C=0

➔ By American option comparing all the payoffs at all periods, and exercising at the best time
Risk-Neutral Two State Model – finding the risk-neutral probability
E.g. K=50, S_u=60 S_d=40 r_f=0,06 p=probability of stock price going up

p=0,65

• Risk premium: if true probabilities are given, then

• To ensure that all assets in the risk-neutral world have an expected return equal to the risk-
free rate, relative to the true probabilities, the risk-neutral probabilities overweight the bad
states and underweight the good states

E.g.

The Black-Scholes Option Pricing Model

Assumptions
- It is possible to borrow and lend cash at a
constant risk-free rate.
- No transactions costs or taxes occur.
- Short selling is allowed.
- Fractions of stocks can be traded.
- The return volatility is constant.
- Security trading is continuous.
- The stock does not pay dividends.
- No arbitrage possibilities.
- The option is European.
- Returns are normally distributed.
Reality
- In reality the volatility and interest rates are
not constant.
- No dividends: possible to adjust for
dividends.
- There are restrictions on lending and
borrowing.
- We have taxes and transactions costs.
- Continuous trading is not possible.
- We cannot trade fractions of a stock.
- Returns are not normally distributed

➔ Historic volatility we need real volatility expectations of the market

• Pricing European-style options when the stock can be traded continuously
• Call Option on a Non-Dividend-Paying Stock

N(d) is the cumulative normal distribution. (The probability that an outcome from a
standard normal distribution will be below a certain value)

sigma is the annual volatility, and T is the number of years left to expiration

OPTION EXPIRATION DATE: THE SATURDAY FOLLOWING THE 3RD FRIDAY OF THE MONTH

today

Red line:

• Put Option on a European Non-Dividend-Paying Stock

• For Dividend-Paying Stocks

Price of the stock excluding dividends

Stock will pay a dividend that is proportional to its stock price at the time
the dividend is paid. q is the stock’s (compounded) dividend yield until the
expiration date.

• Sigma (volatility) is not observable directly -> must be estimated through

o Historical data
 o Implied volatility: The volatility of an asset’s returns that is consistent with the quoted
price of an option on the asset
• Use average bid and ask price for call/put price to calculate implied volatility
Replicating Portfolio of a Call
ALWAYS LONG POSITION IN STOCK AND SHORT IN BOND!

The change in the price of an option given a $1 change in the price of the stock. The number of
shares in the replicating portfolio for the option.

Replicating Portfolio of a Put

ALWAYS SHORT POSITION IN STOCK AND LONG POSITION IN BOND!

 Insurance Pricing
Actuarially fair

• r_L (risk adjusted rate) is equal to risk-free interest rate, if risk is company-specific
(diversifiable)
• otherwise risk-free interest rate plus risk premium
• E.g.
Damage= $2 million, likelihood= 0,05%, risk-free interest rate= 3%, expected return of market= 8%

Exchange Rate Risk

• 1€=1$ - a year later 1,22€=1$

• Currency forward contract to lock in exchange rates

o It allows to price forward currency contracts using arbitrage arguments.

o The difference between the forward and spot price is related to the interest rate
differential between the two currencies.

o Incentive to borrow in the low interest rate country and invest in the high interest rate
country. Forward will offset any possible arbitrage opportunity. Therefore, it will not
matter whether you borrow in the low or high interest rate country and invest in the
high or low interest rate country, respectively.
 No-arbitrage forward rate in T years:

• Currency options to put a cap on its potential cost, but benefit if the euro depreciates in value
o Allows to walk away if it’s not beneficial

Interest Rate Risk

• Risk measurement in duration
C_t is the cashflow
on date t
 • Interest rate sensitivity: If 𝑟 increases to 𝑟 + 𝜖, where 𝜖 is a small change, then the present
value of the cash flows changes by approximately:

k: number of compounding periods per year

• Duration of a Portfolio:

• Duration of a firm’s equity

If interest rates rise by 1%, the value of a firm’s equity will fall by about D_E %.
➔ D_E= 0 duration-neutral portfolio is to be achieved -> immunizing portfolio
➔ In order to be immunized from changes in interest rates the duration of the asset side has to
equal the duration of the liabilities.

e.g. selling mortgages for cash

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