CH 14: OPTIONS, SWAPS AND CREDIT DERIVATIVES

MUHAMMAD NASIRUDDIN
 specified price
Options
 With options, one pays money to have a choice in the
future

 Essence of options is not that I buy the ability to

vacillate, or to exercise free will. The choice one makes
actually depends only on the underlying asset price

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Option types
 Call Option : The Right to buy an asset (the
underlying asset) for a given price (exercise price)
on or before a given date (expiration date)
 Put Option: The right to sell an asset for a given

price on or before the expiration date

 Example: It is April 1st, 2018 and Apple is trading

$166 and June $180 call is trading for $3.60 and

June $180 put is trading for $17

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 Option types…continued
4

 When buying stock options, a “contract” is based on 100 shares of the

underlying stock. Therefore, if we buy one of the June $180 contracts,
It will cost $360 (plus commissions). This will give us the right, but not
the obligation, to buy 100 shares of Apple for $180 per share anytime
between now and 3rd Friday of June (Option expires on 3rd Friday of the
expiring month)

 Now assume that the Apple’s stock rises to $185 when the option’s
expiration arrives. Our options will now be worth $5 per share (or $500
per contract) Since we paid only $360 per contact, we have a profit of
39% [($500-$360)/$360] over few weeks!

 If the apple stock rises to $180, we have the right to buy a $180 stock
for $180. As you can see there is no value to this, so the option will
expire worthless and we will loose $360! 4
 Exercise styles, Key elements and Notation
 European Option: Gives owner the right to exercise the option only on the
5 expiration date.
 American Option: Gives owner the right to exercise the option on or before

the expiration date.

Key elements in defining an option
 Underlying asset and its price

 Exercise price (strike price)

 Expiration date (maturity date) T (today is 0)

 European or American.

Notation
S0 : Price of stock now
ST : Price of stock at T
K : Strike Price or Exercise Price
C : Price of a European call with strike price K and maturity T
P : Price of a European put with strike price K and maturity T
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 Option Payoff
6

The payoff of an option on the expiration date is determined by the price of the
underlying asset.
 Example. Consider a European call option on IBM with exercise price $100.

This gives the owner (buyer) of the option the right (not the obligation) to buy
one share of IBM at $100 on the expiration date. Depending on the share
price of IBM on the expiration date, the option owner’s payoff looks as
follows:

 The payoff of an option is never negative.

 Sometimes, it is positive.
 Actual payoff depends on the price of the underlying asset. The net payoff
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 Option Payoff
7

 Actual payoff depends on the price of the underlying asset. The net
payoff from an option must includes its cost.
Example. A call option on IBM shares with an exercise price of $100 and
maturity of three months is trading at $5. What is the price of IBM that
makes the call break-even? At maturity, the call’s net payoff is as follows:

The break even point is given by:

Net payoff = ST − 100 − 5 = 0 7
 Option Payoff
The break even point is given by:
Net payoff = ST − 100 − 5 = 0
8

Or ST = $105
The pay off diagram:
30 Profit ($)

20

10
70 80 90 100 stock price ($)
0
-5 110 120 130

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 Options Buyers and Sellers (Writers)
9

 For every option there is both a buyer and a seller

(writer)
 The buyer pays the writer for the ability to choose

when to exercise, the writer must abide by buyer’s

choice
 Buyer puts up no margin, naked writer must post

margin

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 In-the-money and Out-of-the-Money and at-the-money
Option
10

 In-the-money options would be worth something if exercised

now. For calls, in-the-money refers to options where the strike
price is less than the current price of the underlying asset. A
put option is in-the-money if its strike price is greater than the
current price of the underlying asset
 Out-of-the-money options would be worthless if exercised

now. For calls, out-of-the-money refers to options where the

strike price is more than the current price of the underlying
asset. A put option is out-of-the-money if its strike price is less
than the current price of the underlying asset
 At the money option refers to the option where the strike

price is equal to the current price of the underlying asset

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 Option Positions
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 Long call: Buyer of a call

 Short call: Seller of a call

 Long put: Buyer of a put

 Short put: Seller of a put

Muhammad Nasiruddin
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 Long Call
12

Profit from buying one call option: option price = $5, strike price =
$100, option life = 2 months; Break-Even stock Price=100+5 = 105

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
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 Short Call
13

Profit from writing one European call option: option price = $5,
strike price = $100; Break-Even stock Price=100+5 = 105

Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30

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 Long Put
14

Profit from buying a European put option: option price = $7,

strike price = $70; Break-Even stock Price=70-7 = 63

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7

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 Short Put
15

Profit from writing a European put option: option price = $7, strike
price = $70; Break-Even stock Price=70-7 = 63

Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30
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Factors Affecting Option Price

 Higher strike price, lower premium on call options

and higher premium on put options.
 Greater term to expiration, higher premiums for
both call and put options.
 Greater price volatility (riskiness) of underlying
instrument, higher premiums for both call and put
options.

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 Hedging with Options : Protective Put (owning stock
and buying a put)
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 A protective put is a risk-management strategy that

investors can use to guard against the loss of
unrealized gains. The put option acts like an
insurance policy — it costs money, which reduces
the investor's potential gains from owning the
security but also reduces his risk of losing money if
the security declines in value.
 Protective put = Long (Own) Asset + Long (Own) a

put

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Protective Put Profit Diagram

Profit
Stock
Protective
Put Portfolio

-P ST
Hedging with Options (Protective Put)

Example: Rock Solid has a stock portfolio worth $100

million, which tracks closely with the S&P 500. The
portfolio manager fears that a decline is coming and
want to completely hedge the value of the portfolio
against any downside risk. If the S&P is currently at
1,000, how is this accomplished?

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Hedging with Options
 Value of the S&P 500 Option Contract = 100  index
 Currently 100 x 1,000 = $100,000
 To hedge $100 million of stocks that move 1 for 1
(perfect correlation) with S&P currently selling at 1000,
you would:
 buy $100 million of S&P put options =
1,000 contracts

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Hedging with Options

 The premium would depend on the strike price. For

example, a strike price of 950 might have a premium
of $200 / contract, while a strike price of 900 might
have a strike price of only $100.
 Let’s assume Rock Solid chooses a strike price of
950. Then Rock Solid must pay $200,000 for the
position. This is non-refundable and comes out of
the portfolio value (now only $99.8 million).

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Hedging with Options

 Suppose after the year, the S&P 500 is at 900 and the
portfolio is worth $89.8 million.
 options position is up $5 million (since 950 strike
price)
 in net, portfolio is worth $94.8 million
 If instead, the S&P 500 is at 1100 and the portfolio is
worth $109.8 million.
 options position expires worthless, and portfolio is
worth $109.8 million
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Hedging with Options

 Note that the portfolio is protected from any

downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million. However,
to accomplish this, the manager has to pay a
premium upfront of $200,000.

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 Income Strategy: Covered Call (owning stock and
writing a call)
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 A covered call is an options strategy whereby an

investor holds a long position in an asset and writes
(sells) call options on that same asset in an attempt
to generate increased income from the asset. This is
often employed when an investor has a short-term
neutral view on the asset and for this reason holds
the asset long and simultaneously has a short
position via the option to generate income from the
option premium

Muhammad Nasiruddin
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Covered Call Profit Diagram

Profit
Stock

Covered
Call
Portfolio
-P ST
 SWAPS: Interest-Rate Swaps
 Interest-rate swaps involve the exchange of one set
of interest payments for another set of interest
payments, all denominated in the same currency.
 Simplest type, called a plain vanilla swap, specifies
(1) the rates being exchanged,
(2) type of payments, and
(3) notional amount.

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Mismatch in durations of Mutual savings bank and
Finance company

 A mutual bank usually has long-term assets such as 30-

year mortgage and short-term liabilities such as 1-year
time-deposits
 A finance company usually has short-term assets such

as 3-year automobile loan and long-term liability such

as issue of 30-year bond
 Both mutual savings bank and finance company have

interest rate risk

 If the market short-term interest rate increases

(decreases), the saving bank (finance company) will

suffer
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Interest-Rate Swap Contract Example

 Midwest Savings Bank wishes to hedge rate changes

by entering into variable-rate contracts.
 Friendly Finance Company wishes to hedge some of

its variable-rate debt with some fixed-rate debt.

 Notional principle of $1 million

 Term of 10 years

 Midwest SB swaps 7% payment for T-bill + 1%

from Friendly Finance Company.

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Interest-Rate Swap Contract Example
Hedging with Interest-Rate Swaps

 Reduce interest-rate risk for both parties

1. Midwest converts $1m of fixed rate assets to
rate-sensitive assets, RSA, lowers GAP
2. Friendly Finance $1 m of rate sensitive assets,
RSA, to fixed rate assets, lowers GAP

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Hedging with Interest-Rate Swaps

 Advantages of swaps
1. Reduce risk, no change in balance-sheet
2. Longer term than futures or options

 Disadvantages of swaps
1. Lack of liquidity
2. Subject to default risk
 Financial intermediaries help reduce disadvantages
of swaps (but at a cost!)

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Credit Derivatives

 Credit derivatives are a relatively new derivative

offering payoffs based on changes in credit
conditions along a variety of dimensions. Almost
nonexistent twenty years ago, the notional amount
of credit derivatives today is in the trillions.
 Credit derivatives can be generally categorized as

credit options, credit swaps, and credit-linked notes.

We will look at each of these in turn

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Credit Derivatives

 Credit options are like other options, but payoffs are

tied to changes in credit conditions.
 Credit options on debt are tied to changes in credit
ratings.
 Credit options can also be tied to credit spreads.
For example, the strike price can be a
predetermined spread between AAA-rated and
BBB-rated corporate debt.

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Credit Derivatives

 Credit options are like other options, but payoffs are

tied to changes in credit conditions.
 Credit options on debt are tied to changes in credit
ratings.
 Credit options can also be tied to credit spreads.
For example, the strike price can be a
predetermined spread between BBB-rated
corporate debt and T-bonds.

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Credit Derivatives

 For example, suppose you wanted to issue $100

million in debt in six months, and your debt is
expected to be rated single-A. Currently, A-rated
debt is trading at 100 basis points above the
Treasury. You could enter into a credit option on the
spread, with a strike price of 100 basis points.

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Credit Derivatives

 If the spread widens, you will, of course, have to

issue the debt at a higher-than-expected interest
rate. But the additional cost will be offset by the
payoff from the option. Like any option, you will
have to pay a premium upfront for this
protection.

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Credit Derivatives

 Credit swaps involve, for example, swapping actual

payments on similar-sized loan portfolios. This
allows financial institutions to diversify portfolios
while still allowing the lenders to specialize in local
markets or particular industries.

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Credit Derivatives

 One form of a credit swap, called a credit default

swap, involves option-like payoffs when a basket of
loans defaults. For example, the swap may payoff
only after the 5th bond in a bond portfolio defaults
(or has some other bad credit event).

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Are derivatives a time bomb?

 In the 2002 annual report for Berkshire Hathaway,

Warren Buffett referred to derivatives (bought for
speculation) as “…weapons of mass destruction.”
(although also noting that Berkshire uses
derivatives). Is he right?

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Are derivatives a time bomb?

 There are three major concerns with the use of

financial derivatives:
 Derivatives allow financial institutions to increase
their leverage (effectively changing their capital),
possibly to take on more risk
 Derivatives are too complicated
 The derivative positions of some banks exceed
their capital – the probability of failure has greatly
increased

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Are derivatives a time bomb?

 As usual, the blanket comments are usually not

accurate. For example, although the notional
amount of derivatives exceeds capital, often these
are offsetting positions on behalf of clients – the
bank has less exposure. In other words, you have to
look at each situation individually.
 However, the experience of 2009-09 suggests that

derivatives markets without proper regulation could

lead to crisis

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Are derivatives a time bomb?

 In the end, derivatives do have their dangers. But so

does hiring crooks to run a bank (Bernard Madoff
rings a bell!). But derivatives have changed the
sophistication needed by both managers and
regulators to understand the whole picture.

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