Engineering New Risk Management Products

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Engineering New Risk Management Products

• Option-Related Derivatives (II)
• Dr. J. D. Han
• Kings College, UWO

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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 120.00
• 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
  120.00.

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2. Creating New Products

• Combining existing instruments
• Restructuring existing instruments
• Applying existing instruments to new markets

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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

Most common in Foreign Exchange Markets
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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

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Break Forward Payoff Diagram
Standard Forward
Break Forward
Typical Forward Contract Rate
/
1.40 1.45 1.50 1.55 1.60
Contract Rate
Price where owner may break (unwind)
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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

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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

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Participating Forward Diagram
?V
Buy 1 Call
Resulting Exposure
?P
Combined Option Payoff
Sell 1/2 Put
Inherent Risk
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3. Combining Options with Options Synthetic
Options- Mainly Tools for Speculators

• Straddle
• Strangle
• Butterfly
• Condor
• Spread
• Cylinder Collar

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1) Long Straddle
Use Betting on an Increased Price
Volatility Construction Long Call and Long Put
at the same Strike Price
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2) Long Strangle
Use the same as Straddle but a lower
premium Construction long call and long put at
different strike prices
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3) Long Butterfly
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4) Long Condor
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5) Spread Low or Zero Cost Options

• Bull Spread
• Buy Call at X1 and Sell Call at X2

X1
X2
Sell call option and use the premium to buy
another call option at a lower strike price X1 gt
X2
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(2) Bear Spread Buy Put at X1 and sell Put at X2
Short put
X1
Long put
X2
Use the premium from short Put in order to buy
another Put at a higher strike price X2gtX1
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6) Collar Cylinder Range Forward
A kind
Long Put
S1
Short Call
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Another kind of Collar
Which one to choose depends on the Initial FX
risk of the hedger.
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• 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.

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• 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.