Engineering New Risk Management Products Synthetic Options (II) Dr. J. D. Han King’s College, UWO

1. Straight Options: “Vanilla” We have already studied 4 Basic Options 2

TD Bank wants to be hedged against downward risk of FX rate to be applied to U.S. $ 1 million coming in a year. TD may (buy/sell) U.S. $ forward; * This is OTC. TD may (buy/sell) U.S. $ future; *what are advantages in moving from forwards to futures? TD may buy (call/put) option of U.S. $ *In which Exchanges do you buy U.S. $ with Cdn $? What are advantages in moving from futures to options? 3

What would be the benefits from One Vanilla Options to Combined/Synthetic Options? For hedging against FX risk, TD buys Put on US $. What if the TD bank wants to save on the premium on this Long Put US$ options? TD may take Short Put on US$ at a lower strike price. This will lead to Bear Spread 4

2. Creating New Products Combining existing instruments Restructuring existing instruments Applying existing instruments to new markets 5

Combining Options with Options: ‘Synthetic Options’- Mainly Tools for Speculators Straddle Strangle Butterfly Condor Collar Spread 6

1) Bear Spread You are betting on the falling of the asset price You may just Buy Put option of the asset, but the premium may be too much. You want to save the above premium by Selling Put option of the same asset at a lower strike price. 7

Profits/Loss, or (net) Payoff Diagram 8 Cdn$/US$ Typical Long Put Contract Rate

Now Sell Put option at a lower strike price (with the red dotted line of Pay Off) 9 Cdn$/US$ Typical Long Put Contract Rate

The net Pay Off curve of the Combined Options (with the Yello thick line of Pay Off) 10 Cdn$/US$ Typical Long Put Contract Rate This synthetic option is called ‘Bear Spread’ The basic idea is that when the price falls moderately you get all profits; when the price falls further to a quite low price, then you can share the profits with somebody by selling the Option, and you use the premium received from the sale to make up for the initial premium.

2) Bull Spread 11 S

3) Long “Straddle” 12 Use: Betting on an Increased Price Volatility Construction: Long Call and Long Put at the same Strike Price

Demonstration: How do you make Long Straddle, and when do you use it? Go to my Option Modeller again. 13

3) Short “Straddle” 14 Use: Betting on an Increased Price Stability Construction: Short Call and Short Put at the same Strike Price

Discovery/Comment By changing Long to Short of the Basic Options, or vice versa, while leaving the Call/Put options the same, you can flip from Long to Short of the Combined Options. 15

5) Long ‘Strangle’ 16 Use: the same as ‘Straddle’ but a lower premium Construction: long call and long put at different strike prices Lower costs than Straddle

6) Short Strangle 17

7) Long ‘Butterfly’ 18 You need 4 Options, or 2 Staddles. You are betting on (increased) Price Stabilities. Compared with Straddle, you are limiting/foregoing your upside potentials for the premiums received(so, lower costs)

8) Short ‘Butterfly’ 19 You need 4 Options, or 2 Staddles. You are betting on (increased) Price Instabilities.

Demonstration of How to Make a Butterfly Long. Go to The second part Example in my Instruction for Option Modeller.my Instruction for Option Mod 20

9) We can even make Long ‘Condor’ and further save the hedging costs. 21