Engineering New Risk Management Products Option-Related Derivatives (II) Dr. J. D. Han King’s College, UWO

1. Straight Options: “Vanilla” USD call/JP Yen put “Face values in dollars = $10,000,000 Option call/put = USD call or JPY put Option Expiry = 90 days Strike = Exercise = European” The buyer of this option has a right to buy USD $10 million by delivering JP Y 1,200 millions (USD call); He has a right to sell his JP Y 1,200 million for USD $1 (JPY put). This option will be exercise only when the actual price of a US dollar in terms of Yen goes above

2. Creating New Products Combining existing instruments Restructuring existing instruments Applying existing instruments to new markets 3

3. Combining Options with Forwards Allows hedge against unfavorable outcome Allows retention of possible benefits Three types of forward options are common – Break forwards – Range forwards – Participating forwards 4 Most common in Foreign Exchange Markets

1) Break Forwards Modifies forward to have features of a call Premium is paid “implicitly” Owner can “break” or unwind the forward position at a price below the contract price 5

Break Forward Payoff Diagram 6 $/£ Standard Forward Break Forward Contract Rate Price where owner may break (unwind) Typical Forward Contract Rate

2) Range Forward A forward contract with limited gain & loss Major merit: Low Cost Also known as – A flexible forward – Forward band a long position in a currency put plus a short position in a currency call 7

3) Participating Forward Way to eliminate the “up-front” premium Combine short forward position with Long out-of-money call Short fraction of in-money put 8

Participating Forward Diagram 9 PP VV Sell 1/2 Put Buy 1 Call Combined Option Payoff Inherent Risk Resulting Exposure

3. Combining Options with Options: ‘Synthetic Options’- Mainly Tools for Speculators Straddle Strangle Butterfly Condor Spread Cylinder = Collar 10

1) Long “Straddle” 11 Use: Betting on an Increased Price Volatility Construction: Long Call and Long Put at the same Strike Price

2) Long ‘Strangle’ 12 Use: the same as ‘Straddle’ but a lower premium Construction: long call and long put at different strike prices

3) Long ‘Butterfly’ 13

4) Long ‘Condor’ 14

5) Spread: ‘Low or Zero Cost Options’ 15 (1)Bull Spread Buy Call at X1 and Sell Call at X2 X2X2 X1X1 Sell call option and use the premium to buy another call option at a lower strike price: X1 > X2

(2) Bear Spread: Buy Put at X1 and sell Put at X2 16 Short put Long put Use the premium from short Put in order to buy another Put at a higher strike price X2>X1 X1 X2

6) Collar = Cylinder =Range Forward 17 Short Call Long Put S1 A kind

Another kind of Collar 18 Which one to choose depends on the Initial FX risk of the hedger.

A collar is an interesting strategy that is often employed by major investment banks and corporate executives. This position is made by selling a call option at one strike price and using the proceeds to purchase a put option at a lower price. The cost to the investor to make this trade, therefore, is low or close to zero. It is called Cylinder = Option fence = collar = range forward. 19

When this collar or cylinder is used for a long position of any asset(FX), then the net wealth position of the combination of initial FX risks and hedging looks like a ‘Spread’. That is the upside potential modified because of the cost saving actions.actions 20