1. © K. Cuthbertson and D. Nitzsche Figures for Chapter 1 DERIVATIVES : AN OVERVIEW (Financial Engineering : Derivatives and Risk Management)

2. © K. Cuthbertson and D. Nitzsche Figure 1.1 : Buy one European call option STST Profit Strike price K = $80 $5 -$3 Call premium $88$83 K = $80 0

3. © K. Cuthbertson and D. Nitzsche Figure 1.2 : Sell (write) a European call option STST Profit Strike price K = $80 -$5 $3 Call premium $88 $83 K = $80 0

4. © K. Cuthbertson and D. Nitzsche Figure 1.3 : Buy (long) a European put option Strike price K = $70 STST Profit $3 -$2 Put premium $68 $65K = $70 0

5. © K. Cuthbertson and D. Nitzsche Figure 1.4 : Sell (write) a European put option Strike price K = $70 STST Profit $2 -$3 Put premium $68 $65 K = $70 0

6. © K. Cuthbertson and D. Nitzsche Figure 1.5 : Liabilities : using swaps Floating to Fixed: Liability Fixed to Floating :Liability Issue Floating Rate Bond Firm’s Swap LIBOR LIBOR + 0.5% 6% fixed Net Payment = 0.5% + 6% = 6.5% (fixed) Issue Fixed Rate Bond Firm’s Swap 6% fixed 6.2% fixed LIBOR Net Payment = 0.2% + LIBOR (floating)

7. © K. Cuthbertson and D. Nitzsche Figure 1.6 : Assets : using swaps Floating to Fixed: Asset Fixed to Floating: Asset Hold Floating Rate Bond Firm’s Swap LIBOR LIBOR - 0.5% 6% fixed Net Receipts = 6% - 0.5% = 5.5% (fixed) Hold Fixed Rate Bond Firm’s Swap 6% fixed 5.7% fixed LIBOR Net Receipts = LIBOR - 0.3% (floating)

8. © K. Cuthbertson and D. Nitzsche Figure 1.7 : Swap : financial intermediary Hold Floating Rate Bond Firm’s Swap 11% fixed 12% fixed LIBOR After swap : Net Receipts = (12% - 11%) + LIBOR - (LIBOR - 1%) = 2% (fixed) LIBOR - 1% Without swap if LIBOR > 13% firm’s swap makes a loss.

9. © K. Cuthbertson and D. Nitzsche Figure 1.8 : Leverage from option (Purchase 100 shares) OPTIONS MARKET (JULY) Call premium, C = $3 Premium paid = $300 Strike price, K = $80 CASH MARKET (JULY) Spot price, S = $78 Cash paid = $7800 OPTIONS MARKET (OCT.) Profit = $8 = ($88 - $80) Net profit = $800 - $300 Return = $500/$300 = 167% CASH MARKET (OCT.) Profit = $10 = ($88 - $78) Total profit = $1000 Return = $1000/$7800 = 12.8%