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Options: The Fundamentals

ISBN 0- 9701975-0-0

aUBS

Options: The Fundamentals

Contents
Preface A Simple Objective Arbitrage Forwards and Futures Options Options as Risk Management Tools: Break-Even Graphs Options as Risk Management Tools: Combining Options with Underlying Positions Option Valuation Put/Call Parity Option Trading Beyond Option Value Conclusion 1 2 9 24

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38 44 63 66 76 82

Copyright 1999 UBS AG, Basel, Switzerland ISBN 0-9701975-0-0

Preface
The study of options and other derivative instruments can be an intimidating experience for a newcomer. Our objective in this book is to help introduce options in a straightforward but rigorous way. Most of the material in this work originated from the education program at UBS and its predecessor institutions - Swiss Bank Corporation and OConnor and Associates. In our training of traders, salespeople and other investment banking professionals, we believe we have developed an intuitive, practical approach to derivatives. The language we use is occasionally different from textbook language for good reason. Some textbooks talk about an option's "time value", combining several value components in a way that leaves many people confused. When we talk about the same ideas, we distinguish between an option's basis value and its volatility value to eliminate confusion. We dissect and examine the term "at-the-money", while most introductory discussions gloss over its possible interpretations. We also debunk some option myths. One of the greatest of these myths is the misconception that option trading is a zero-sum market. We talk about the objectives and viewpoints of option traders relative to the objectives and viewpoints of investors and risk managers. The perspectives, examples, and even the language we use have been very successful in educating trading personnel. We hope the insights developed in our classrooms will make options more understandable, accessible, and useful to a wider audience. We wish to express our appreciation to the individuals who have contributed to producing this book, principal among these are Glenn Satty, who contributed heavily to the first edition of the book; Gary Gastineau, without whose persistent urging-on the book would never have been written, and Tim Weithers who read the manuscript and made many helpful suggestions. We are indebted to Springboard Design for their superlative work on the production of the book. Inevitably, the author is responsible for any remaining errors. Joe Troccolo, Managing Director UBS Financial Markets Education

Email: sh-fme@ubs.com

A Simple Objective
In this book, we hope to demystify options and prepare readers to use these essential tools to manage the market risks in portfolios of assets and liabilities. We want to help the reader achieve a conceptual understanding of options and other derivative instruments, backed up by enough quantitative support to make the reader comfortable with these markets. This publication is intended for anyone interested in the options markets: experienced corporate treasurers, fund managers, brokers, and traders, as well as new trainees. Even a complete understanding of the contents will not qualify you as a "rocket scientist" or a financial engineer, but you will be better equipped to discuss derivative products intelligently and to evaluate the claims made about many financial markets and instruments. We begin our introduction to options with the concepts of arbitrage and expected value. We introduce forwards and futures, define options, and show why options are useful in risk management. We illustrate option payoffs using break-even graphs, examine some option strategies, and discuss the valuation of options. Finally, we explore some popular option myths. We offer this introduction as a prerequisite to more sophisticated option studies, not as the answer to all questions you might have about options and other derivative instruments.

Arbitrage
Buy low sell high
$10 riskfree profit
Before we can discuss options properly, we must understand the concept of arbitrage. Arbitrage is a powerful market force that helps to establish the value of many financial instruments. When we talk about arbitrage, we distinguish between deterministic arbitrage and statistical arbitrage.

Deterministic Arbitrage
Deterministic arbitrage is the classic technique of simultaneously buying and selling the same or equivalent products at different prices to achieve a riskless profit. For example, what do we do if gold trades at $400 in New York and at $410 in London? The answer is quite simple: we buy low and we sell high. Specifically, we buy low for $400 in New York, and we sell high at $410 in London-and we make $10 risklessly. By "risklessly," we mean there is no risk of price movement. If we can execute these two trades simultaneously, there is no gold price risk, and we can be confident of a profit as long as other factors do not intervene. One of the best ways to illustrate arbitrage opportunities is to use examples based on simple raffles. Raffles define and clarify some of the ideas of profit and probability we want to discuss. Let's assume that a daily raffle sells exactly 100 tickets each morning. At the end of the day, 1 of these 100 tickets is chosen, and the holder of that ticket wins $1,000. What is the fair price or expected value of 1 ticket? To solve this problem, we divide the $1,000 prize by 100 tickets for a fair price of $10. If we pay $10 for the ticket and we do not win, we will not feel we were cheated because we paid too much. We will attribute it to, say, the luck of the draw. Similarly, if we win, we will be ecstatic, but we will not think we bought a cheap ticket because, by the accident of probability, we won the prize. When we divide the value of the prize by the number of tickets, we are able to derive the fair value or, in statistical terminology, the expected value or mean value of each ticket.

Buy gold for $400 in New York


2

Sell gold at $410 in London

What do we do if tickets sell for $9 instead of $10? At $9, the ticket is cheap - so cheap that we want to buy every ticket in the raffle. When the winning number is drawn at the end of the day we stand to make a riskless profit of $100. If we hold all the tickets, we win the $1,000 prize-having paid only $900. We can arbitrage a deterministic $100 profit - meaning we are certain to make that $100 - as long as the person who created the raffle does not leave town after collecting our money! It is important to understand that these cheap tickets will not be available at $9 very long. The raffle seller will lose money continuously at $9 a ticket and eventually will raise the price of the tickets. What do we do if tickets sell for $11? Because $11 is too much to pay for a ticket, we want to sell raffle tickets instead of buying them if we can. We might hold our own raffle selling tickets at $10.50. After selling 100 tickets, we will take in $1,050. The prize we have to pay the raffle winner is $1,000, so we have $50 left in our pockets. If any raffle ticket sells for less than fair value, we want to buy it. If it is overvalued, we want to sell it. In reality, since raffles usually are held to raise money for non-profit organizations, it would be difficult to start our own raffle for financial gain. In addition, raffles generally do not compete against each other. People buy raffle tickets to support a favourite charity and are unconcerned if the ticket is overpriced or underpriced. However, if raffles did compete against each other, sellers would force the price of overpriced raffles down, and buyers would force the price of underpriced raffles up until the price of raffle tickets stabilised at $10 and that price would be, in the statistical sense, fair to everyone. These raffle scenarios are similar to gold trading at $400 in New York and at $410 in London. When there are many buyers of gold in New York, their demand forces the price up. When there are many sellers of gold in London, their supply forces the price down. Nobody can say where the price will end up, but we presume it will fall between $400 and $410. Eventually, we know that the price will equilibrate to a fair value - the same price to buyers and sellers in all markets. The fair value of gold does not necessarily mean the price gold is "worth" - it means the efficient market value or the price that eliminates arbitrage. Expected Value Buying a Whole Raffle $9.00/ticket x100 tickets $900.00 cost $1,000.00 prize -$900.00 cost $100.00 profit

Selling a Raffle $10.50/ticket x100 tickets $1,050.00 proceeds $1,050.00 proceeds -$1,000.00 cost $50.00 profit

Statistical Arbitrage
Locking in a sure profit by taking advantage of mispricings is deterministic arbitrage. While taking advantage of ticket mispricings is not within the spirit of a charity raffle, let's assume for purposes of illustration that raffle tickets sell for less than their fair value. Let's look at a different, but related, kind of arbitrage: statistical arbitrage. What do we do if raffle tickets sell for $9 but we are permitted to buy only one ticket a day? Do we: (1) never buy a ticket, (2) buy a ticket once in a while, or (3) buy a ticket every day? In this case, the ticket should be selling for $10 but only costs $9, so we have a $1 "edge," or expected profit per ticket. If we buy only one ticket a day, we are engaged in statistical arbitrage. We do not have a certain profit if we cannot buy all the tickets in an underpriced raffle. We have to decide the best thing to do in an uncertain situation. In fact, the correct choice for someone who can accept the risk of a string of losses before he wins the prize is not 1, 2, or even 3. The full answer is: buy one ticket every day until the universe ends. What do we expect to happen after buying a ticket every day until the end of time? We expect our fortune to grow without limit! 100 winners 100 tickets per raffle 1 expected winning ticket value: $100 1,000 winners 100 tickets per raffle 10 expected winning tickets value: $1,000 1,000,000 winners 100 tickets per raffle 10,000 expected winning tickets value: $1,000,000 4 The key word in this scenario is expect. We are not certain to win this money, but we do expect to win this money. We expect to earn an average of $1 a day on this raffle, because our edge, the expected value of our position, is $1. We expect to make that edge on average after repeated trials. This is called a statistical arbitrage because it is not certain or determined that we will make this profit - but we expect to make this profit over time. What do we expect to happen after 100 days when we have spent $900 on raffle tickets? We expect to win 1 time. Are we assured of winning 1 time? Absolutely not - we could lose every time or we could win 2, 3, or even 99 times. What do we expect to happen after 1,000 days? There will be 1,000 winners after 1,000 days. With 1,000 winners and a 1 in 100 chance of winning each day, we expect to win 10 times. We may not win 10 times - we may win only 8 times, or we may win 12 times. In fact, there is about a 70% chance that we will win between 7 and 13 times. If we play 1,000 times, we will be very surprised if we do not win at all - because the probability of not winning at all in 1,000 tries is extremely small, if the raffle is fair.

The more times we play, the closer we should come to the number of times we expect to win and to the average of $1 a day we expect to make. If we play 1,000,000 times, we expect to make close to $1,000,000 - our profit might fall a few hundred dollars short of $1,000,000 or rise a few hundred dollars beyond $1,000,000, but that is a fairly small percentage variation compared to the percentage variation we might see after 100 days. After 1,000,000 raffles, we expect to win about 10,000 times (1/100 of 1,000,000). Statisticians tell us we have about a 70% chance of winning between 9,900 and 10,100 times. The larger number of raffles brings us closer to our expected average of 1 win for every 100 times. The longer the period, the closer we expect to come to the average payoff. A different probability example illustrates additional important features of expected value. The boards of two companies, A and B, are meeting to discuss a takeover. If the takeover occurs, stock A will be worth $60. If the takeover does not occur, the stock will be worth only $40. From our experience, we believe there is a 70% chance of a takeover. What is the fair value of stock A? If there is a 70% chance that stock A will be worth $60, that leaves a 30% chance that it will be worth $40. We multiply the probabilities by the values and add the result to get the expected value. 70% x $60 = $42 30% x $40 = $12 $54 expected value With these probabilities, the fair value of the stock is $54. With the stock trading at $52, what do we do? We buy the stock, since it should trade at $54, and we expect to make $2. Similarly, if the stock trades at $55, we sell it and expect to make $1. We determined the expected value of stock A - but did we determine our profit? Will we make $2 if we buy the stock for $52? No. In fact, it will be impossible for us to make $2. If we buy the stock for $52 and it trades at $60, we will make $8. If we buy
Price Cost Profit/Loss

Stock A
$60 $40 $54

70%

30%

Fair value

With the stock at $52, we buy and expect to make $2 But the stock must trade at $60 or at $40 once the decision on the takeover is made
Takeover $60 -$52 = $8 No Takeover $40 -$52 = -$12

If we do 1,000 trades $8 x 700 - 12 x 300 = $5,6000 - $3,6000 = $2,000 expected profit Average Profit = $2/trade

the stock at $52 and it trades at $40, we will lose $12. Expected value is not necessarily the value of any individual trade. If we buy stock like A in 1,000 takeovers at a price of $52, about 700 of those times we will make $8; and about 300 of those times, we will lose $12. After 1,000 times, we expect to net $2,000, an average or expected value of $2 a trade. We have learned some interesting things about statistical arbitrage. First, we found that we must trade often. We cannot talk meaningfully about what happens at the end of one trade. We can begin to think about what happens at the end of 100 trades. We are more comfortable thinking about what happens at the end of 1,000 trades, but we prefer thinking about what happens after 1,000,000 trades. In our stock example, we can talk about the expected return after 1,000 such trades very easily, but we cannot know what happens after 1 trade even though we have determined that the fair value of the position is $54. In addition to trading a large number of times, we must have correct probabilities to ensure an accurate expected value. If our chances were 50/50 instead of 70/30, our expected value would become 50% x $60 = $30 50% x $40 = $20 $50 making the stock we purchased at $52 expensive and causing us to lose money over time. Unlike the simple raffle examples, where it should be possible to know the probabilities, the statistical arbitrageur usually has to estimate probabilities. There is another characteristic of statistical arbitrage that we have to think about. To trade a number of times, we need to have "deep pockets." We need access to a large amount of capital. If we are undercapitalized, we may lose all our money on the first 10 trades and not be able to trade anymore. If we cannot trade anymore, we cannot possibly get our expected results. We do not want to run out of money before the probabilities take over. If there is a difference between market price and value, someone with deep pockets and the opportunity to make a large number of transactions should be able to arbitrage the difference, absent other restrictions. 6

Real World Applications


Insurance
One of the most important applications of statistical arbitrage is simple insurance. Insurance companies use statistical arbitrage to determine fair value by trying to predict how much they will pay out in claims. They divide the estimated amount they will pay out by the number of insurance buyers and add an edge (profit) to determine the premium they will charge each client. They expect to make the edge they added on. With enough occurrences (customers) and with accurate estimates of their probable aggregate losses, they will make that edge. Actually, managing the risk of an insurance operation is more complicated than this simple example suggests, but statistical arbitrage is one of the most important principles of insurance. Insurance companies employ a large number of analysts to ensure accurate estimates of what they will need to pay out in claims. Similarly, in the financial industry, analysts are employed to project earnings, evaluate takeovers, and study other significant events, as well as to determine the value of financial instruments, such as options.

Gambling
Another industry that bases its business on statistical arbitrage is casino gambling. The odds (or edge) in a casino always favour the house. Roulette is a good example of a casino's use of statistical arbitrage. In roulette, there are 36 numbered spaces plus 0 and double 0 for a total of 38 spaces. The fair odds are 37 to 1. If you win on a given number, you should get your own chip back and 37 more. The house, under United States rules, pays only 35 to 1, keeping two chips out of 38 for itself. Is it possible for the house to lose? Of course! Haven't you seen people sitting at roulette tables with piles and piles of money - at least in James Bond movies? When Bond won all that money, did the house lose at that table on that night? Absolutely. Do you think the house loses at that table every night? If it lost every night, the house would not operate that table. It is possible that the house loses at a particular table on a particular night, but it is highly unlikely that the house loses in general. The statistical argument for the house is very convincing.

An important difference between casinos on one hand and insurance companies and financial firms on the other is that casinos can calculate easily and accurately the probabilities for their losses and then add an edge that almost certainly will protect their profits. The expected claims for insurance companies and the true values of financial instruments are not as easily predicted or calculated. The fact that most gambling probabilities are easily calculable makes simple gambling examples useful in understanding the principles of probability.

Forwards and Futures


There are three keys to understanding options. The first you already know about arbitrage. The second is forwards or futures. Forwards and futures are financial instruments that relate present and future prices, and they are very important in understanding what options are and how options are valued.

Distributions
Suppose gold is trading at $400 an ounce today. What price will gold be in one year? If we ask many different people this question, we will probably get many different answers. Some people will be very pessimistic, predicting a dramatic drop in gold prices. Others will be very optimistic, predicting a large rise in gold prices. A number of people will fall in between the two extremes. After we accumulate all of the responses, we will get a picture of where people think gold is going to trade for in a year. The picture might look something like this:

Probability

25% 23% 20% 16% 12% 10% 7% 5% 3% 0% 350 375 400 425 450 475 500 525 13% 11% 8%

15%

Predictions of the Price of Gold in One Year

7%

550

Gold Price ($/ounce)

The numbers at the top of each bar represent the percentage of people who predict that the price of gold will fall in that price category in a year. Our first bar, centred at $350 an ounce, indicates that 3% of the people surveyed think gold will be around $350; about 7% of the people think it will be around $375; 12% predict a price near $400, and so forth. Many people are clustered in the middle--around $450. 9

Distribution Mean

This picture is called a distribution. A distribution is characterised by its mean or average - its expected value. The expected value is the centre of the distribution. When we add up and average the different responses from the people surveyed, we find that, for this particular example, the mean is centred around $450. (The mean calculated from the actual responses is $453.50.) On average, the people in this group feel that the forward price of gold, that is the price of gold a year from now, should be approximately $450. A distribution also is characterised by its width or dispersion, which is sometimes expressed as the standard deviation or the volatility. You can see in this distribution that, even though it is centred around $450, there is a great deal of variation in the responses. Some people estimate a price as low as $350, and some people estimate a price as high as $550. The standard deviation measures the dispersion in the distribution, and for our gold price survey distribution this measure of dispersion is around $50. The mean and the standard deviation are two important quantitative characteristics of the distribution. Many distributions we encounter in nature and in the financial markets have a particular shape called a normal or bell-shaped distribution. Returns for commodities, such as gold, or for Japanese yen or stocks or bonds have underlying distributions that often are approximately normal. A normal distribution is characterised in part by its symmetry about the mean and by the fact that it is high in the middle and low at the ends. We will assume for purposes of the illustration which follows that gold prices are approximately normally distributed. The normal distribution has some very useful characteristics. In a normal distribution of gold price forecasts, we have 68% confidence that the future price will be within one standard deviation of the mean. In our forecast distribution, the mean is about $450, and the standard deviation is about $50. Assuming this distribution is normal, we are 68% confident that the future price will fall somewhere between $400 and $500 - $450 minus $50 and $450 plus $50. Adding the percentage responses in the price range between $400 and $500 on our bar chart, we find that about 75% of our forecasters feel the future price will be within one standard deviation of the mean. We have 95% confidence the future price will be within two standard deviations of the mean in a normal distribution. Two standard deviations down from the mean is

Standard deviation Volatility

Normal Distribution

$450 + $50 = $500 68% confidence $450 - $50 = $400 68% confidence % Responses 12% 16% 23% 13% 11% 75% Forecast Price $400 $425 $450 $475 $500

10

about $350, and two standard deviations up from the mean is about $550; we have about 95% confidence that the forward price of gold will be somewhere between $350 and $550. In our forecast distribution, all the responses are within that interval. Finally, we are 99% confident that the future price will be within three standard deviations of the mean in a normal distribution. Three standard deviations from the mean is $150. We are 99% confident, or almost completely confident, that the future price of gold will be within a range of $300 to $600, that is, $150 down from the mean and $150 up from the mean. These are very important properties of the normal distribution. The figure below illustrates the general shape of a normal distribution if responses could be any price. It is almost identical to the shape of the bar graph distribution we examined earlier. We used bars and large price intervals, but if we took smaller price intervals, say from $350 to $355, $355 to $360, and so forth, the distribution would become more like a smooth curve. The high point in the middle of the normal distribution curve is the mean, and the distribution tails off on both sides. Many underlying distributions look approximately like this one, and the assumption of normality is used as an input for many financial models.
normal Probability 0.45

A Normal Distribution

0.30 normal 0.15

-4

-3

-2 z value

-1

Mean

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Market Participants
The expected future price of gold is important to anyone who uses the gold spot markets and the gold futures and forward markets: A. Investors B. Long speculators C. Short speculators D. Long hedgers E. Short hedgers F. Arbitrageurs It is useful to describe each of these market participants, discuss what they are doing in the market, and look at how their actions affect the spot and the future or forward price of an underlying commodity or security. Let's look first at A, our investor. A thinks that gold is a good investment. She wants to buy gold and hold it long term. When A buys gold, she tends to make the spot price of gold go up because she is buying gold in the spot market. When the spot price of gold rises, the future or forward price tends to rise as well. B, our long speculator, is not a long-term investor, like A, but she thinks gold is going up and would like to take a position that is going to be profitable if she is right. B can accomplish this in a couple of different ways. First, B can buy spot gold. If gold goes up in a short period of time, she can sell that gold at a higher price and make a profit. Alternatively, B can buy a future or forward contract on gold. B's purchase of forward gold tends to make the future or forward price go up; and, just as demand for spot gold tends to raise future or forward prices, demand for forward gold tends to raise spot prices. As we will see later, when B buys a future or a forward, she does not have to pay out much money. When A buys spot gold, say 100 ounces at $400, she has to pay $40,000, immediately. Our short speculator, C, thinks that the gold price is going down. He is very pessimistic about the outlook for gold. Like A and B, C has two choices. He can sell gold, or he can sell a future or forward contract on gold. If C happens to own gold, it will not be very difficult for him to sell it. Alternatively, if he is in a position to borrow gold relatively easily and sell it short, he might do that. 12

But if he does not have direct access to gold, he probably will find it easier to sell a future or forward contract on gold. Short speculators like C affect the price of spot gold. The effect on the spot price is clear if the short speculators own gold and want to shift their investment to something else. If they are not trading in the spot market, the direct effect of their sale will be on the forward or future price, making it trade at a lower price. D is someone who needs gold a year from now. D might be a dentist or a jeweller someone who has all the gold he needs right now but who wants to be assured of a price for gold a year from now. There is no advantage in buying the gold now and spending a large sum of money to store it. D probably will want to buy a future or forward contract on gold, which will tend to push up the future or forward price. E, our gold producer, is very busy digging gold out of the ground. He does not have much gold right now, but in a year he expects to have a large store of gold to sell. He wants to make sure his hard work pays off and that he sells his gold at a good price. He cannot sell spot gold because he does not have it. However, he can sell a future or forward contract on gold now. E is likely to affect the future or forward price, and since he is selling, his actions will tend to make the future or forward trade at a lower price. Our last market participant is the most important in some ways. F has no opinion about gold's value and no opinion on the likely direction of gold prices, but he is very aware of gold price relationships. Even if F did have a personal opinion about the value of gold or the direction of gold prices, his opinion would not affect his financial transactions. F is an arbitrageur, and his actions in the marketplace tie the actions of all other market participants together. F ensures the spot price of gold and the future or forward price of gold are in their proper relationship. If the prices are not appropriate relative to one another, he will try to profit by buying in the cheap market and selling in the expensive market. The actions of arbitrageurs are extremely important in seeing that prices are kept in line.

13

The Arbitrageurs Role


One of the reasons for emphasising the role of the arbitrageur in a discussion of options is that arbitrageurs are an important factor in determining the spot/forward price relationship, and the first step in finding the value of an option is finding the value of the future or forward price. If gold is trading at $400 today, at what price will someone agree today to buy or sell it one year in the future? We used a survey to forecast the price of gold in a year, but there is a rational, deterministic relationship between spot price and the forward price of gold that does not rely on an opinion survey or on anyones price forecast. Suppose that the carry cost, that is, the cost of money or the cost of buying something and financing it for a year, is 10%. We will have to pay $400 to buy gold today. Holding the gold position will cost us 10% for a year, because if we had not spent the $400 on gold we could have left it in the bank and it would have continued to draw interest at 10%. To own gold a year from now, it will cost us more than the $400 we pay now. In fact, it will cost us $440:

Spot price + Cost of carry = Future or Forward price

FUTURE OR FORWARD PRICE spot price of gold + cost of carry = future or forward price of gold $400 + (10% x $400) = $440 If the present price of gold is $400, the future value of gold in one year is $440. By future value, we do not necessarily mean the price gold will sell for in the future; it is the value that future gold has to trade for today because of the cost of carrying gold for a year.

Present (spot) value

Present value and spot value are the same thing. We have been talking about spot gold, but we can also talk about the spot value or current market value of a stock, a bond, a currency, or some other underlying commodity or financial instrument. Future value is the value of the future or the forward. There is a difference between futures and forwards, but the difference is in how they are traded, not in how they are valued. At this point we will treat futures and forwards as though they were interchangeable. Later, we will discuss the practical differences between futures and forwards.

Future value

14

Basis
Basis is the difference between the forward value and the spot value. For many products, the basis is defined as the cost minus the benefit of holding the underlying. BASIS basis = cost of underlying - benefits of underlying In our gold future value example, we have considered only the financial cost of carrying gold at 10%, because there are no economic or financial benefits from owning gold. (It might give you a feeling of comfort to own gold, but we are not counting that.) In some other products, there are benefits as well as costs. For an equity, we consider the cost of carry, that is, the cost of the money to buy the equity, and we consider the possible benefit of receiving a cash dividend. Not all stocks pay dividends, but if they do, the dividend is a benefit. In currency markets, the cost of carrying a foreign currency is the investor's domestic interest rate. If a U.S. dollar-based investor wants Swiss francs (CHF), she has to give up dollars to buy the CHF. When she gives up the dollars, she either takes them out of an interest-bearing account, which means she loses the interest income, or she borrows the dollars from a bank and pays domestic interest. Either way she has a carry cost in the domestic currency, and that is the dollar cost. On the other hand, when she gets the CHF, she can invest them in a CHF account and earn interest at Swiss rates. The interest on the CHF account is a benefit of owning the CHF. Examining costs and benefits illustrates an important feature of the bond market. Often, traders or portfolio managers have to borrow money to carry bonds, They borrow money in the repo (repurchase agreement) market, posting the bonds as collateral for the loan. The repo rate is the term used for the interest rate charged on such a loan. On the other hand, while they own the bond they are entitled to any coupon interest that accumulates. For a bond, the repo rate is the carry cost of the bond, and the coupon is the benefit.

Basis equals Costs minus Benefits


Stocks

Currencies

Bonds

15

Today Borrow $400 from the bank

Buy spot gold

Sell $450 forward gold

The basis in each of these examples consists of the cost minus the benefit of owning the underlying from the spot date to the forward date. For gold, the basis is simply the cost of carrying the gold; For a stock, the basis is the cost of carrying the stock minus the dividends; For a currency, the basis is the cost of the interest on the domestic currency minus the benefit of the interest earned on the foreign currency; For a bond, the basis is the cost of borrowing at the repo rate minus the benefit of the coupon payment.

A Year from Today Deliver forward gold take in $450

Spot Versus Forward Arbitrage


Applying the idea of basis to arbitrage examples will help clarify some spot and forward pricing relationships. Suppose that gold is trading for $400, and the forward, which we said before should be trading for $440, is trading for $450. It will cost us $400 plus 10% of $400 to buy gold and carry it for one year. That means we can buy gold today by borrowing money from the bank, and in one year we have to repay the bank $440. With the gold forward trading today for $450, we can sell it and make a profit. In one year, we do two more transactions: Deliver gold for $450 an ounce to complete the forward contract Repay bank - $440 an ounce Net difference $10 profit With a spot price of $400 and a forward price of $450, we can buy gold today and sell it forward, making a certain profit of $10 per ounce. This is a riskless profit - an arbitrage profit - which we make by simultaneously buying and selling equivalent instruments. What are the equivalent instruments? It may seem as though we bought gold, but because we bought the gold by borrowing money and carrying it for a year, we effectively bought the forward, paying $440 an ounce to own gold in one year. Simultaneously, we sold the actual forward, the one that is tradable, for $450. These are equivalent instruments, and they should be priced identically. When the equivalent instruments do not trade at the same price, we can make an arbitrage profit.

Repay bank $400 + ($400 x 10%) = $440

Make a sure $10 profit

16

Suppose that spot gold is trading at $400 and forward gold is trading at $420 - lower than the $440 forward price we calculated earlier. Forward gold at $420 sounds like a bargain - let's buy the forward and simultaneously sell the spot to make a certain profit of $20. If we do not own gold, we must borrow it and sell it for $400, that is, sell spot gold short. We can then invest the $400 from the sale of the gold. The bank will pay us 10% interest, and we will have $440 in the bank a year later. Then, we will do two more transactions to close out the arbitrage: Withdraw money from the bank $440 an ounce Accept delivery of forward gold at -$420 an ounce Net difference $20 profit We have to return the gold we borrowed, and our profit may be reduced if we have to pay a fee for borrowing the gold. In the first example, the gold forward was expensive compared to the $440 it would cost us to buy gold and carry it for a year. So we sold forward gold, bought spot gold, and carried it for a year. In the second example, the gold forward was cheap, so we bought forward gold, sold spot gold, and earned interest on a bank deposit. In both cases, we arbitraged a profit with no price risk. In fact, we exchanged price risk for basis risk. It is important to emphasise that, in both cases, forward transactions were agreed on at the beginning of the period, and the actual transactions were done at the end.

Index Arbitrage
Let's look at another example of arbitrage - one that many people have heard about, called index arbitrage. To understand how it works, we assume that a stock index is trading at $200 or 200 index points, and the carry rate is 10%. The stocks in this index have a dividend flow of $8 or 8 index points over the next year. We want to determine where the forward or future on the stock index should be trading. The carry cost on the index is 10%; 10% of $200 is $20, so it is going to cost $20 or 20 index points to carry the index for the next year. On the other hand, $200 x 10% = $20

Spot + Basis = Future 17

Carrying the stocks in an index Index arbitrage cash flows Buy Stock -$200 Cost of basis -$12 Sell future +$230 Arbitrage profit $18

we are entitled to an $8 or 8-index-point dividend flow over the next year, which partially offsets our carry cost. $20 (Cost) - $8 (Benefit) = $12 (Basis) $200 (Spot) + $12 (Basis) = $212 (Future) The index future or forward should be trading at $212. Suppose the one-year future is actually trading at $230. As in the first gold example, the future is priced too high. Let's sell the future and buy appropriate quantities of all the stocks in the index - that is how we get to own the index. To keep the numbers small, let's assume it will cost us $200 to buy the necessary shares of each of the index stocks. It will cost us $12 (net of dividends) over the next year to carry the index. At the end of one year, we will have $212 in net costs, but we receive $230 for selling the future. Consequently, we will make an arbitrage profit of $18 or 18 index points. Let's look at this example again with the forward or future price of the index too low at $210. Suppose we have two long-term investors, A and B, who view the market differently. A does not believe in futures. He is a long-term investor, and he cares only about stocks. With the future trading too low at $210, A does nothing - he simply continues to hold stocks. B, on the other hand, decides to sell all of his stocks and buy the future simultaneously. B invests the $200 from the sale of the stock at 10%. Does this mean that B is not a long-term investor anymore? No. B is still a long-term investor even though he sold his stock, because he immediately bought the equivalent of his stock back by buying the future. B's new position illustrates that owning the future is cheaper for B than owning the actual stock. Let's assume the index is still at $200 at the expiration of the future in one year. A never sold his stock. His stock was worth $200 at the beginning; it is still worth $200. On the other hand, he received $8 worth of dividends, so from his point of view, he made 4% over the year. How does B look at his position? B gave up the dividends but earned $20 in interest on the proceeds of the stock that he sold. B is going to buy back his stock

With index at $200 at expiration A A keeps his stock He makes $8 in dividends 18 B B sells his stock Invests $200 from the sale at 10% interest In a year, B withdraws $220 Pays out $210 for stock under the forward contract B makes $10

at the $210 forward price he agreed to at the beginning of the transaction. His portfolio will consist of $200 in stock plus $10 in cash. A has $200 in stock plus $8 in cash. By switching from stock to the underpriced future, B got a 5% return over the year, 1% higher than As return. What happens if the price of the index ends up at $210 at expiration? A is happy, because his stock is worth $210 and he got a 4% dividend flow, so he made 9% over the year. What about B? B's stock also is worth $210, but he still has that $10 in cash in his pocket, so B made10% - once again, 1% better than A. Suppose something unfortunate happens: the index falls to $190 at the end of the year. The stock positions of A and B are the same as before. A collects $8 in dividends; B collects $20 in interest less the $10 from the spot/futures arbitrage ($210 - $200), or a net of $10. A started with $200 of stock, but now only has $190 worth of stock plus $8 in dividends, for a loss of $2 over the year-that is a -1% return. B has $190 worth of stock, but he has $10 in his pocket. Therefore, his total portfolio is still worth $200, and his return is zero. He may not like a 0% return, but it is better than A's -1% return. In fact, no matter where the index ends up, B's return always will be 1% better than A's. Index arbitrage has gotten a bad name in the press - largely from people who do not understand the pricing relationships that lead to arbitrage. In our simplified example, we have tried to portray the reasons for this type of arbitrage realistically. We see in our gold and index arbitrage examples that there is a rational relationship between the price of the spot and the price of the forward. Regardless of what any investor thinks the price of gold will be in a year, the actions of arbitrageurs - the people who monitor the relationships between the spot and the forward - will ensure that the spot and the forward have the appropriate relationship to each other. That does not mean the arbitrageurs determine the value of the spot or the value of the forward. While hedgers, speculators, and investors affect the spot price or the forward price, arbitrageurs ensure that the rational relationship between the spot and forward is preserved. We have emphasised this relationship because knowing how to value futures and forwards relative to spot is the first step toward knowing how to value options. 19
5% 4% 3% 2% 1% 0%

B is better off no matter what happens to stock prices

The Difference Between Forwards and Futures


Although we have used the terms forwards and futures interchangeably, some of the differences between forwards and futures are significant.

Forwards
No exchange market Customised contract

Forward Contracts
A forward contract is an agreement between two parties made independently of any organised exchange market. The forward contract is a stand-alone, customised contract. It can be based on any amount of any good. It can be written for settlement at any time and at any price. It can be, as an extreme example, for delivery of 37,000 gallons of vodka in 52 days at $2 a gallon. The terms can be virtually anything so long as both parties agree to them. One party agrees to sell the vodka at the contract price, and the other party agrees to buy it at that price. Since the contract can be for any amount of any good, at any time, and at any price and since each party depends on the other party to meet contractual obligations, the forward contract cannot be traded freely with other counterparties. Forwards are not fungible; that is, one forward contract is not interchangeable with another contract that has similar terms, and the present value of the forward contract is not easily converted to cash. Each party has to be able to trust that the other party will uphold its side of the agreement, because the two counterparties are exposed to each other's ability and willingness to perform on the contract. There is credit risk associated with a forward contract, which must be controlled. Often, the credit risk is controlled by banks, which act as intermediaries, assuring the performance of their clients. That is, if a client fails to fulfil the agreement, the bank assumes the obligation. A very important point to remember about forwards is that no money is exchanged by the parties until the actual exchange of goods or financial instruments at settlement. There is no interim cash flow, unless there is a mark-to-market agreement between a party to the contract and its bank.

Nonfungible

Credit risk managed by banks

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Futures Contracts
A futures contract, in contrast to a forward, is an agreement between two parties made through their agents on an organised futures exchange. The parties who trade on the exchange can represent themselves or they can represent customers. There are specific rules and regulations that set the terms of the contract and the procedures for trading. The contract is for a specific amount of a specific good to be delivered at a specific time determined by the exchange, and the price discovery usually is determined by open outcry in a trading pit, that is, by people yelling and screaming at each other in a large room. If you have been to a futures exchange, you may have seen just that - people yelling and screaming and calling out numbers - yet the process is actually quite organised. This is the way prices are discovered and goods are exchanged in many efficient markets. Some markets now use computer systems which expose bids and offers to a large number of potential traders at many locations, but the principle of bringing bids and offers together is the same. Several features of futures markets are worth noting. First, a futures contract is always for a standardised amount of a specific good. We cannot set our own contract amount, say 37,000 bushels of soybeans. If the soybean futures contract set by the exchange is 5000 bushels, we can trade any number of contracts, but each contract will be for 5000 bushels. The exchange also specifies the quality of soybeans that can be delivered in fulfilment of the contract (Grade A?) and exactly where the soybeans are to be physically delivered. Although we may not be interested in the details of the soybean futures contract, every futures contract must be uniquely specified in order to be a tradable instrument. Since all terms are determined in the futures contract, the contracts can be traded freely with other counterparties. We can buy the contract from one person, sell the contract to another, and wash our hands of the commitment. We can eliminate our obligation, because, with futures, the exchange takes the other side of the contract. The exchange is the ultimate counterparty for all futures trades, so the only credit risk is the creditworthiness of the exchange. Once a trade is completed, the transaction is passed to the exchange clearing corporation. The futures contract

Futures
Organised futures exchange

Price discovery by open outcry

Standard contract specifies amount and type of underlying

Exchange is counterparty

Margin

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buyers and sellers have agreements with the clearing corporation. Ultimately, if we take delivery rather than offset our contract, the exchange will select someone who is short the contract to make delivery. The party making delivery does not have to be the party who sold us the contract originally. After the trade settles, the original parties to the trade lose any direct tie to each other based on the trade. No credit intermediary is necessary, but performance bonds, sometimes called margin, must be deposited to ensure each party meets its obligations. The exchange clearing corporation has to stand behind the creditworthiness of its members, so it asks everyone for a deposit. Customers make a deposit with their broker, and the broker passes the deposit to the clearing corporation. "Margin" is a misleading name for this deposit because people confuse this performance bond margin with stock margin. While both types of margin protect creditors, that is all they have in common. Stock margin is actually collateral for a loan. Futures margin is a good faith deposit, demonstrating ability and willingness to meet contractual obligations.

How creditworthy is a clearing corporation? The Options Clearing Corporation, which is responsible for all exchange-traded securities options in the United States, has a AAA credit rating. Other clearing corporations would probably get similar ratings if they sought them. There have been instances when futures investors have lost money due to credit problems after a trade has settled, but most of these problems have involved their brokers rather than the clearing corporation. Credit problems in the U.S. futures markets are not a common experience.

Forwards Versus Futures


Let's look at an example that illustrates some of the differences between forwards and futures. Hayashi agrees to buy 5,000 troy ounces of gold from Tanaka at $400 per ounce exactly 57 days from today. Hayashi buys the forward, Tanaka sells the forward - no money changes hands today. In 57 days, Hayashi pays Tanaka $2 million and Tanaka gives Hayashi 5,000 troy ounces of gold regardless of what the spot price of gold is on that date. In other words, in 57 days, there is an exchange of cash for gold.

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Now, let's look at a futures contract. On the floor of the New York COMEX, the commodity exchange where gold is traded, Franz sells Heidi 50 gold futures contracts. Each gold futures contract represents 100 troy ounces. So 50 futures contracts cover 5,000 troy ounces of gold for near-term settlement at $400 per troy ounce. The Hayashi/Tanaka forward agreement is basically the same as the Heidi/Franz futures agreement. No money changes hands today in either case, but Franz and Heidi must post margin (performance bonds) with the exchange. Every day Franz's and Heidi's accounts will be adjusted for daily gold market moves until they close out their futures positions. If the price of gold goes up, a cash variation margin payment is taken from Franz's (the seller's) account and an equal amount is deposited to Heidi's (the buyer's) account. If the price goes down the next day, the cash transfer goes from the buyer's account to the seller's account. These variation margin flows mark the position to the market each day. What happens at settlement in 57 days, assuming that neither Franz nor Heidi has offset (traded out of) his/her position before that time? Franz delivers 5,000 troy ounces of gold at the exchange's directions, and he is paid the spot rate. Note that Franz does not receive the rate agreed on when the trade was made. He gets the spot rate in effect at delivery. Heidi pays the spot rate and receives 5,000 troy ounces. The daily flow of funds between the margin accounts over the life of the contracts makes up any difference between current market conditions and the original contract terms. The net result of forward and futures transactions is identical, but the cash flows during the period from the original trade to expiration usually cause a difference in interest earnings or interest costs. Statistically, rates are not expected to change to the systematic advantage of the buyer or the seller.

A futures transaction 50 contracts x 100 oz. 5,000 oz. 5,000 oz. x $400 $2,000,000 On the trade date Franz sells Heidi 50 gold futures contracts @ 400/oz Franz and Heidi post margin; account p/l adjusted daily At contract settlement Franz delivers 5,000 oz. Gold at spot rate Heidi pays the spot rate for 5,000 oz.

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Options
Introduction
Now we are ready to define options and compare graphical representations of spot and forward values with option values. Lets start with a graph of the spot and forward values of an ounce of gold.
Position Value Basis

Spot and Forward

Forward Spot 400 Spot Price

The green line represents the price of spot gold. When we buy an ounce of spot gold at $400, what happens to the value of our position as the value of gold changes? If the spot gold price increases by $20, the value of the position increases by $20. Similarly, if the spot price of gold decreases, the value of the position decreases. $400 + ($400 x 10%) = $440 $500 + ($500 x 10%) = $550 $300 + ($300 x 10%) = $330 The blue line represents the one-year forward value for any given spot price of gold. If interest rates are 10%, the one-year forward value is $440 when gold is at $400. The vertical distance between the two lines is the basis. Notice that the basis increases as the price of gold increases and decreases as the price of gold decreases. If gold is at $500, it costs $50 to carry the gold for a year. If gold is at $300, it costs $30 to carry the gold for a year.
Forward Value Option

Forward

strike

Spot Price

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To the graphical representation of the forward price, we add the orange line. The orange line tracks the forward in part, but it never drops below zero; we are protected from any losses associated with the forward. This protection comes from holding a call option position. The orange line illustrates the forward value of the call. We know how to value a forward, and soon we will learn how to value the loss protection associated with a call. This protection feature is the third key to understanding options. We have examined arbitrage and futures or forwards. When we understand this protection feature, we will have a solid understanding of options.

Call Options
UBS defines a call option as a substitute for a long forward position with downside protection. The standard text book definition of a call, however, is the right but not the obligation to buy a spot instrument or a commodity at a specific price at or before a particular time in the future. While these two definitions are equivalent, the UBS definition emphasises the components of option value. The right but not the obligation is equivalent to the protection in our definition. To buy is a long position. A spot instrument or a commodity at a specific price at or before a particular time in the future is the specification of a transaction in the future, which corresponds to our term forward.

Call = right to buy

Options Versus Forwards


Lets look at an example that distinguishes options from forwards. Suppose we want to buy a new car. We go to our favourite ZoomMobile* dealer and say How much is this car? What is your best price? The dealer says, Ill give you my best price, but you have to buy the car today. The best price is $50,000. We do want to buy the car but we are not really sure that we couldnt get the car at a lower price from some other dealer. On the other hand, if we go away to look for a better price, we may lose out on the $50,000 price. That may be the best we could do after all. So we say to the dealer, "Heres $100. This is not a deposit on the car.
*Not a real brand!

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To keep the $100, just hold the price for one week. If I want to buy your car for $50,000, Ill come back within a week and do so. But whether I do or not, you keep the $100." If the car dealer agrees, we have bought a "one week $50,000 call" on the ZoomMobile. Whats the next step? We visit other car dealers to try to find a better price for the same car. If we can find a dealer who will sell us the car for less than $50,000, we will buy it from the dealer with the lowest such price. In this case the first dealer keeps our $100 and we do not exercise i.e. use, our option. If, however, we cannot find another dealer with a better price, we can return to the first dealer and buy the car. The car will cost us a total of $50,100 - $50,000 for the car and $100 for the option. Buying the car from the dealer for $50,000 is called exercising our option. Suppose in fact we go back to the original dealer because we were not able to find anyone who would sell the car for less than $50,000. When we get there the dealer says, "That car you wanted is now priced at $55,000." We reply "Perfect! Now I can buy the car from you for $50,000 and be very happy that I didnt have to pay the higher price. Furthermore I can either keep the car at the bargain price of $50,000, or I can sell it to someone else for more than $50,000 and make a profit!" We said we wanted to contrast the option with a forward. So suppose that we instead bought a one week forward on the ZoomMobile. This means that we agree today with the dealer that we will come back in one week and buy the car for $50,000. (We might want to do this so that we would have one week to arrange financing for the car.) A week later, we find that prices have risen to $55,000. This is no problem for us because we have "locked-in" the $50,000 price. Also we did not pay the $100 for the option so we are really ahead compared to buying the option.
ALL ZoomMobiles 10% OFF

$50,000 $45,000

But what if we come back a week later and there is a big sign in the dealers window saying "All ZoomMobiles 10% off!" The price of the car is now $45,000 ($50,000 minus the 10% discount of $5000). But we have agreed with the dealer that we will buy the car for $50,000! We are probably angry with ourselves, or at least full of regrets, that we did not spend the relatively small amount of $100 to buy the option instead of the forward. Why? Because we would now have the opportunity to participate in the lower price. We would not exercise our option. Instead we would let it expire (go unused). We would have paid just $45,000 plus the $100 for the option. Wouldnt we also regret having paid the $100 for the option? Maybe we

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should have not done anything, i.e. just come back after one week and buy the car at whatever price it is offered at that time? Thats fine if the price stays the same or goes down, but if it goes up (as in the first example) we could end up paying a lot more than we had planned. If we dont want to take the risk, we need the protection the option gives us. The difference between the option and the forward in this case is that the option lets us participate in an advantageous price move - we have the option to buy at a lower price. The option assures us that we will pay, at most, the agreed-upon price. With the forward, we will pay the original, lower, price if the price goes up. But if the price goes down, we will be obligated to pay the original, higher, price we agreed to when we bought the forward.

Option Terminology
Let's define some of the terminology that we will use throughout our discussion of options. The spot instrument or commodity that is the subject of a forward, future, or option is called the underlying. In the case of the car, the ZoomMobile is the underlying. The specific price at which we can buy the underlying, $50,000, is called the exercise or strike price. The date in the future that we agreed on for a possible transaction is called the option's expiration date. In our ZoomMobile example, the expiration date was one week from the day of our agreement. If we choose to buy the car, we exercise our option. There are two common styles of exercise - American and European. An American option allows you to exercise the option at any time prior to expiration. The European option allows you to exercise the option only on the expiration date. For example, if the car dealer says, "Come back anytime during the week," we hold an American option, giving us the opportunity to exercise at any time. If he says, "I only work on Saturdays," then we have a European option. Underlying ZoomMobile Strike $50,000 Expiration one week Exercise Style American/European

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Continental Etymology Many investors wonder about the origin of the names for "Europeanstyle" options, which can be exercised only at expiration, and "American-style" options, which can be exercised at anytime during their lives. The genesis of these terms can be traced to an early option article by Nobel laureate Paul Samuelson*. In this article, Samuelson calls a warrant that is exercisable only at the end of its life a European warrant because of its similarity to call options traded in Europe. He contrasts these European instruments with the pre-exchange-traded options market in the United States where put and call options could be exercised at the holders discretion. Samuelson has revealed that his choice of the names European and American for these exercise styles was not based solely on his observations of the exercise patterns in European and American markets. As an inside joke, he chose the name American for the more complex option because he had grown tired of Europeans telling him that options and warrants were too complex for unsophisticated Americans to understand. The importance of Samuelsons paper, which anticipates many features of the later Black-Scholes option formula, extends well beyond its contribution to options nomenclature. * Paul Samuelson, "Rational Theory of Warrant Pricing," Industrial Management Review 6 no. 2 (Spring 1965); also in P.H. Cootner, editor, The Random Character of Stock Market Prices, (Cambridge: M.I.T. Press, 1964), 506-532.

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Put Options
So far we have been discussing a call - a long forward with downside protection. But there is another type - a put option. UBS defines a put as a substitute for a short forward position with upside protection. If we are short a forward, and the price goes up, we will lose money. A put protects us against a loss on the way up. What is a short position? A short position is one that increases in value as the market price declines. There are two types of short positions. Agreeing today to sell gold one year from today means we have a short forward position. If we expect to have gold to sell one year from now, because we are gold producers, we have a covered short position. If we are selling in anticipation of a lower price without holding gold, our position is uncovered. It is possible to take a short position in the spot market, too. In order to short spot, we need to borrow the underlying to make delivery on our sale. We will have to buy the underlying back later and return it. We would like to cover our short position at a cheaper price. Remember, "buy low, sell high." In the case of a short position, first we sell high, then we buy back low, still measuring our profit by the price difference as we would in the more familiar long position. The danger in a short position is that we may sell high and have to buy back higher. If prices go up, we want to be protected against potential loss. Buying a put option is an alternative to taking an outright short forward position. The classic book definition of a put is the right but not the obligation to sell a spot instrument or a commodity at a specific price at or before a particular time in the future. "The right but not the obligation" represents the "protection" of our definition. "To sell" corresponds to "short;" "a spot instrument or a commodity at a specific price at or before a particular time in the future" means the specifics of a contract in the future, which corresponds to our use of the term "forward." A jeweller gives her customer a "money-back" guarantee on a diamond ring. The customer buys the ring for $10,000 and has the right, but not the obligation (does this sound familiar?) to return the ring to the jeweller and get the $10,000 purchase price back. The dealer has given the customer a put option. Perhaps the ring is a present and the person the customer wants to give it to doesnt want it (sad story). Well at least our, possibly heart-broken, customer wont have a monetary loss because he can return the ring for the full $10,000. If the price has fallen in the meantime to $9,000, he has avoided a $1,000 loss. 29

On the other hand, if the price has risen to $11,000, he could now sell the ring to someone else, possibly the jeweller, or maybe some other hopeful suitor, for a profit. Note once again the protection and the opportunity the option has given to the owner of the option. Put = right to sell Puts and insurance To contrast a put option with a forward lets consider a different example. Your employer has told you that you are going to be transferred in 3 months to another office and this will require you to move house. You find a buyer for your house and agree that you can live there for another three months but at the end of the 3 months, you will sell the house for $1,000,000 (you are an important executive!). Three months from now it turns out that house prices in your neighbourhood have increased dramatically and your house is now worth $1,100,000. Unfortunately you will not be able to participate in this higher price because you have agreed to sell it for less. Suppose instead that your employer wants to make you feel better about moving and says, " I know you are unhappy about moving so I will agree to buy your house from you for $1,000,000 3 months from now, if you havent already sold it." You can now advertise your house at a higher price. If someone offers you $1,100,000 you can sell the house to them rather than your employer you are allowing your option to expire and have a profit of $100,000 compared to the $1,000,000 price you were guaranteed. What if instead, after putting your house on the market, the best bid you received was $950,000? Then you can exercise i.e. use, your option and make your employer buy the house for $1,000,000, thereby avoiding a $50,000 loss. Your employer gave you a put option. In summary, a call is a substitute for a long forward with downside protection, which assures a maximum price and enables the holder to pay less if the price declines. A put is a substitute for a short forward with upside protection, which locks in a minimum price and enables the holder to sell for more if the price rises.

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Options as Risk Management Tools: Break-Even Graphs


When we buy properly-priced forwards, no money changes hands. However, it is different with options. When we buy options, we have to pay out money. Why do we pay out money? This is a fairly complicated question, so we are going to look at one simple aspect of it in this section - namely, what we can expect at expiration when we buy an option. We are going to look at options in terms of risk management, using break-even graphs for illustration.

Buying a Call
First, let's look at a call break-even graph where we have purchased a $100 strike call for $6 - meaning we have paid $6 for the right to buy the underlying at the strike price of $100. In the figure, we, as the call buyer, will break-even when the underlying reaches $106, because if we exercise our option and buy the underlying for $100 and then sell it for the current market price of $106, we make $6. However, we paid $6 for the call option, so we just break even on the whole transaction.
Profit/ Loss 10

We pay out $6 for a $100 strike call $100 strike +$6 premium $106 break-even

Break-even of a Long Call

-6 -10 80 100 106 120 Price of Underlying

Underlying at strike -$106 effective cost +$100 value -$6 loss Underlying at $107 -$106 effective cost +$107 value $1 profit 31

At the underlying price of $100, we lose all the money we paid for the call option. We paid $6, but the underlying ended up at $100, so we do not want to exercise the option. We can exercise, but, since the underlying is trading for $100 anyway, it does not matter whether we exercise the option to buy the underlying for $100 or simply buy it for $100 in the market. At any underlying price below $100, of course, we do

not exercise the option - we do not want to exercise the right to buy something for $100 that is worth less than $100. However, above the underlying price of $100, the option has value. Above the underlying price of $106, the option has a positive net pay off. In fact, the option position profits dollar for dollar above $106. For example, if the underlying is at $107 and we pay $106 total for something worth $107, we make a $1 profit. If, at expiration, the price of the underlying is at $101, we will exercise our option, even though we will show a net loss of $5. A $5 loss - while not desirable - is more tolerable than a $6 loss. Buy option Exercise option Sell spot Net profit (loss) ($6) ($100) $101 ($5)

At an underlying price of $110, we make a $4 profit overall: Buy option Exercise option Sell spot Net profit ($6) ($100) $110 $4

Leverage and Risk


Option Myth The myth that high leverage means high risk Options have been much maligned since their appearance in ancient times, and, as a result, option myths occasionally overshadow the helpful function options can serve in the market place. One option myth is that high leverage means the same thing as high risk. When we talk about leverage, we mean "an investment or operating position subject to a multiplied effect on profit or position value from a small change in sales quantity or price." Options traditionally have been associated with high leverage. When we buy the $6 call to get the right to buy stock at $100, we are highly leveraged because we are paying only $6 for the right to buy something selling for $100. Is it also true, however, that we have a high-risk position? 32

Suppose we want to buy a stock for $100, but we buy a call with a strike price of $100 for $6, instead - and buy a $100 T bill* priced at $98 today for a total outlay of 104. In a year, if the price of the stock is above $100, we can exercise our option and buy the stock with the proceeds from the T bill. The call provides leverage - one call is covering an entire $100 share of stock - but we do not have high risk. In fact, we have used the leverage of the call to lower our risk. We can understand the reduction in risk by comparing this strategy to simply buying the stock. What happens if we buy the stock outright? We could lose much more than the option premium. If we buy the stock at $100 and it ends up at $90, we will lose $10. By buying the call for $6, and the T bill for $98 we end up with enough money in our account to buy the stock at $90 and have some $10 cash left over. Why, then, do people say that buying options is risky? Because options can be used in risky ways. For instance, we could be greedy and use the $98 to buy junk bonds or to gamble at the black-jack tables - instead of buying the T bill - thereby increasing our risk. Or we could buy 16 calls with our $100 for a total of $96 invested in calls. If the price of the underlying stock does not exceed $100 at expiration, we will not want to exercise our options, they will expire worthless, and we will lose the entire $96 - even though the stock may be only a dollar or two below $100. By spending nearly all of our money on calls, we can use the leverage of the calls to increase our risk. It is possible to use calls to take on risk, but it is an investment choice, not an unavoidable outcome.

High Leverage and Low Risk $100 stock price (6) call price (98) T bill price pay 104 today Stock price at expiration: Above 100 - Exercise option Below 100 - Buy stock in market High Leverage and High Risk 16 number of calls x$6 price of calls $96 amount invested in calls

Selling a Call
We have been talking about buying a call option. Now, let's sell a call option, using a short call position break-even graph to illustrate the results. At expiration, with the price of the underlying stock above $100, the option buyer exercises the call option, and we have to sell her the stock for $100. For example, if the stock is trading at $103 at expiration, the call buyer will certainly exercise her right to buy the stock at $100 - and we will be obligated to sell her the stock for $100. If we do not already own the stock, we have to go to the market, buy the stock for $103, then turn around and sell it to the call buyer for $100 - for a $3 loss on the transaction. Of course, we are compensated for the loss by taking in a $6 premium for the option; so at $103, our net profit is $3.
* A T bill is sold at a discount to its face value. The differential 100-98 is interest earned on the bill.

We take in $6 for a $100 strike call +$6 sell call +$100 stock called -$103 buy stock $3

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Profit/ Loss

10 6

Break-even of a Short Call

-10 80 100 106 120 Price of Underlying

Underlying at break-even +$6 sell call +$100 stock called -$106 buy stock 0

We receive $6 for undertaking the potential obligation to sell the underlying at the strike price. We break even when the underlying reaches $106 and lose dollar for dollar as the stock rises above $106. If the underlying is above $106 at expiration, we have not received enough of a fee to cover the risk we took on in this instance. If the underlying is lower than $106 at expiration, we make a profit.

Buying and Selling a Put


Buying a put We pay out $6 for a $100 strike put Underlying at break-even -$6 buy put +$100 sell stock -$94 buy stock 0 Let's look at the break-even graph of a put option. Let's buy a $100 strike price put for $6. What have we bought? We have bought the right to sell the underlying for $100, and we have paid $6 for this right. We will break even when the underlying reaches $94. Why $94? We will exercise our option only if the underlying is below $100 at expiration, because we do not want to exercise our option to sell the underlying at $100 if we can sell it at a higher price in the market. As the underlying falls below the strike price of $100, we, as the owner of the long put, begin to benefit from the price decline. Since we have paid $6 for this option, the underlying will have to drop at least $6 below the exercise price or strike price of the option for us to break even. As the underlying continues to fall below $94, we continue to profit dollar for dollar as illustrated in the break-even graph of a long put.

34

Profit/ 10 Loss 6

Break-even of a Long Put

-10

80

94

100 strike

124 Price of Underlying

Again, if the underlying is at $100 or higher at expiration, we lose all the money we paid for the put. However, below $100, we start to recoup our option premium and, at even lower prices, we earn a profit. Even if the underlying is $98 at expiration, for example, we will exercise our $100 put, recapturing $2, and netting a loss of $4 on the transaction: Buy option Exercise option Buy spot Net profit (loss) ($6) $100 ($98) ($4) Selling a put We take in $6 for a $100 strike put Underlying at break-even +$6 sell put -$100 buy stock +$94 sell stock 0

Now, let's become a put seller. We may be obligated to buy the underlying at $100 if the put buyer chooses to exercise his option - but the put buyer will not exercise unless the stock price at expiration is below $100. Obviously, if the underlying is trading for less than $100 in the market, we do not want to buy it for $100; but if we sell a $100 put option, we have the obligation to do just that. However, we take in a $6 fee or premium for undertaking this potential obligation. Because we receive $6 for the potential obligation, we break even when the underlying hits $94, and we lose dollar for dollar below $94. The graph for the short put position, shown on the next page, is the mirror image of the long put position.

35

Profit/ 10 Loss 6

Break-even of a Short Put

-10

84

94

100 strike

124 Price of Underlying

Above $100, we get to keep the entire $6 premium, but below $100, we lose the premium dollar for dollar until the underlying reaches $94, the break-even point. Below $94, we lose, period. Option Myth The myth that selling naked puts is risky This position is the subject of another option myth - that selling puts uncovered or "naked" is risky. To sell puts naked means to sell a put on an underlying instrument without having a short position in the underlying. Presumably, naked put sellers believe the price of the stock is not going to fall. If the price goes down, the naked put seller can lose a great deal of money. If the naked put seller simply is "betting" that the underlying will not go down, then selling puts can be a very risky undertaking indeed. Selling naked puts received a great deal of negative publicity following the crash of many stock markets around the world in October 1987. Many investors lost a lot of money on this strategy. Some of these investors were unaware that they could lose more than they had "invested." Neither the investors nor, in many cases, their advisors understood options well enough to use them safely. Our hope is to improve understanding of options and option strategies. Limit order to buy As with many myths, reality is far more mundane than the popular fable. Suppose, for example, we want to buy a stock for $100. If the stock is trading at $100, we can buy it in the market. However, if the stock is trading a bit above $100, we might decide we do not want to buy it at that price. What can we do? One way we can try to implement a $100 stock purchase is to call up a broker and place a $100 limit

36

order, meaning an order to buy the stock at $100. The broker holds our order and, if the stock trades down to $100, he buys the stock for us. Alternatively, we can sell a $100 strike put for $6 and place $100 in the bank to earn interest. If the underlying is below $100 at expiration, the put buyer will exercise, and we will have to buy the stock for $100. But there are two advantages in taking this position: 1) if we deposit our money in the bank, we earn interest, which will help offset any loss on a stock purchase, and 2) we collect a $6 fee for giving someone else the right to sell us the stock for $100. Effectively, we buy the stock for $94 rather than $100. At expiration, the stock could be trading considerably below $100; it could be trading for $95 or even for $90. If owning the stock at $100 is our goal and we place a limit order instead of selling a put, we definitely will buy that stock for $100 if the price drops. We may be better off pursuing the naked put seller's strategy, because we may be able to buy the stock at a lower price. And if the stock does not trade below $100, we have $6 plus interest on the purchase price! Of course, there is a disadvantage to the short "naked" put position. Suppose the stock starts to trade down, and suddenly we decide we do not want to own the stock at $100 anymore. That is, the stock looks appealing at $102 - and even at $100; but as the stock begins to trade lower and lower, we decide to back out. If we place a limit order with our broker, we can call the broker and quickly cancel the order. If we are quick enough, we do not have to buy the stock. If we sell the put we have to go into the market and buy that put back in order to get out of our position. Buying the put back might be expensive. If the put is worth $6 when the stock is trading higher, it is likely to be worth more than $6 at a lower underlying price. Is it risky to sell naked puts? It can be risky if the investor simply takes a position on which way the stock is going to trade. But if the investor sells the put because he likes the stock at a certain strike price and invests the purchase price of the stock to earn interest, selling naked puts can be a low risk strategy. Again, it is very important to evaluate option characteristics with respect to one's objective. 37 Buy $100 stock or Sell $100 put for $6; deposit $100 in the bank

Options as Risk Management Tools:


Combining Options with Underlying Positions
Long Synthetic Call
We are long an underlying at $100 We pay out $3 for $95 strike put Suppose we own an underlying security that is trading at $100, and we buy a $95 strike put for $3. Since a long put gains dollar for dollar below the strike, it negates or offsets the potential loss from a long underlying position. As a put buyer, we are protected from a loss below $95 at a cost of $3. The combination of the long underlying position and the long put creates a new position which, as we can see in the figure below, looks like a call. We call this position a long synthetic call.
Profit/ 10 Loss 5 Long Put 0 -5 -10 Long Underlying

Break-even of a Long Synthetic Call

Long Synthetic Call 90 95 100 105 110 Price of Underlying

Let's examine the long synthetic call position more closely. We are long the underlying. What is our risk? Our risk is that the price of the underlying may decline. When we buy a stock, a bond, or a currency, we incur price risk (among other types of risk). We can hedge price risk by buying something that will protect us if the price of the underlying moves against us. Buying protection We own the underlying, and we are worried that its price will go down. We can protect ourselves by buying a put. Remember, buying a forward plus downside protection is like buying a call. When we buy the underlying, we are long the forward. If we then buy the protection provided by the put, we are effectively buying a call. This combination of a long forward position and a long put creates a long synthetic call. Let's look at the maximum loss and possible gain on the long synthetic call break-even graph.

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In the figure, we are long the underlying at $100 (represented by the blue line). If the underlying price subsequently goes up, we will gain dollar for dollar on that position. If the underlying price goes down, we will lose dollar for dollar. To protect ourselves against the price decline, we have bought a put (represented by the green line). Notice that the protection the put gives us does not begin until we have already suffered a $5 loss on the underlying position. We paid $3 for the long put, so if the underlying price ends up at $95, we have a $5 loss on our underlying plus the $3 cost of the put premium for a total loss of $8 on the position. This is the maximum amount we can lose on the position, however, since at any price below $95, we gain dollar for dollar on our long put. If the underlying price ends up at $100 at expiration, the $95 put is not worth anything, and we have neither gained nor lost on our underlying position - we are still out the $3 for the put premium, though. The underlying must rise to $103 in order for us to break even on the overall position. At $103, we have a gain on our underlying position that exactly offsets the loss of the premium we pay for the put. When we combine the underlying and the put positions, we create a long synthetic call - the orange line. This line is plotted by simply adding the gains and subtracting the losses of the long underlying and long put positions. Why is this combination position called a long synthetic call? Let's take it apart. First, the orange line in the graph looks like the graph of a long call position. We have limited loss on the downside and unlimited gain on the upside. Also, it looks like we are paying $8 for the protection because at $95 we have a maximum loss of $8. Then, as the price goes up from $95, we gain dollar for dollar, until we get to $103, where we break even. The position is called synthetic because we are not actually buying a call - not directly. We do not go into the market and buy a call; we construct it ourselves with instruments that have the same risk profile but different cash flows. We buy the underlying, and we buy protection. Remember, a put is like a short forward plus upside protection; a call is like a long forward plus downside protection. In our figure, it looks as though we have a Protective put Worst case -$100 buy at spot +$95 sell at strike -$5 underlying loss -$3 put premium -$8 net loss Underlying unchanged -$100 original cost +$100 sell at spot 0 underlying profit/loss -$3 put premium -$3 net loss

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protected long forward. Since we constructed the strategy from a long underlying position and a long put, we call it a synthetic call instead of a real call. The put option in this case is called a protective put because it protects the underlying position from a price decline.

Covered Write - Short Synthetic Put


Covered write We are long underlying at $100 We take in $3 for a $105 strike call Let's look at another strategy, a position called a buy-write or a covered write because we sell or write a call, which is collateralised by a long underlying position. Let's assume we are long the underlying at $100 (represented by the blue line). Again, as the underlying goes down, we lose, and as the underlying goes up, we gain. We sell a $105 strike call for $3 (represented by the green line). Below $105 at expiration, we keep the premium from the call, but at any underlying price above $105, we lose dollar for dollar on the call as the underlying moves up, offsetting the gain in our spot position. When we put these two positions together, we create a synthetic position that looks like the graph of a short put (the orange line). The return pattern is the same pattern we saw when we examined the short put position. We have a maximum gain of $8 (a $5 gain on the price of the underlying and a $3 gain from selling the option) at an underlying price of $105. Below $105, we lose dollar for dollar, breaking even on the position at $97. Below $97, we lose outright. If we buy the underlying only, we will have a rate of return of zero with the underlying at $100. By selling the call, we make a 3% return at an underlying price of $100 over the period of the call. Selling the call "enhances the yield" of the long underlying position. This yield enhancement continues up to an underlying gain of $5. If the underlying rises from $100 to $105, we keep the $5 profit on the underlying in addition to the $3 premium from the call. Instead of making a 5% return, we will make an 8% return with the underlying at $105. Above $108, the call limits our return to 8% no matter how high the underlying price goes. On the downside, at $95 we incur a 2% loss (a 5% loss on the underlying minus a 3% gain from the call premium). The 2% loss is not as dramatic, however, as the 5% loss we incur if we own the underlying and do not sell the call. 40

This yield enhancement in some circumstances is the rationale behind the covered write position. The combination of a long underlying and short call creates a new position, a short synthetic put, with a maximum gain of $8, the potential for a large loss on the downside, and a break-even of $97.
Profit/ 10 Loss 5 0 Long Underlying -5 -10 Short Call Short Synthetic Put

Yield enhancement -$100 +$105 $5 +$3 $8 -$100 +$95 -$5 +$3 -$2 buy at spot sell at strike underlying profit call premium net profit buy sell underlying loss call premium net loss sell call buy stock at strike sell stock in market break-even on position

Covered Write or Short Synthetic Put

90

95

100

105

110 Price of Underlying

From the figure, it looks as though we are long the forward, but we lack the protection. Actually, we have sold protection to our counterparty, and we have the equivalent of a short put position. Earlier, we talked about naked put selling and the risks associated with it. Here, in effect, we sell a put. However, we do not leverage our position. That is, we actually have a net investment of $97. The position is unleveraged relative to a straight put sale because the potential profit or loss per point of movement in the underlying is relatively small. We have taken on an option strategy that has a payoff we want without increasing our leverage or our risk. We sell off the possibility of some of our upside gain on the stock in return for additional "yield" at lower price levels. This strategy can be implemented in many ways by using calls at different strikes and with different times to expiration. Each choice of strike and expiration reflects the investor's view of the future stock price and the trade-off of possible gain for reduction in risk.

+$3 -$100 +$97 0

Containing risk

41

Range Forward
We are long underlying at $100 We pay out $3 for a $95 strike put We take in $3 for a $105 strike call Let's look at another combination strategy, a zero-premium strategy called a range forward or a collar or a risk reversal - it goes by a number of other names as well. We hold a long underlying position at $100 and buy a $95 strike put for $3 - the protective put again. In addition, we sell a $105 strike call for $3. When we buy a put for $3 and sell a call for $3, we do not pay or receive any net option premium. We have protection below $95, because we are long the $95 put. At an underlying price below $95, we do not suffer any further losses. On the other hand, we eliminate our upside gain above $105 by selling the $105 call. We do not participate in any price increase above $105 because we have sold the opportunity for further gains. In between $95 and $105, we participate dollar for dollar in the movement of the underlying. (To participate dollar for dollar means to participate in both the gains and the losses.) If we own the underlying at $100 and it falls to $95 at expiration, we incur a $5 loss. If the underlying ends up at $97, we incur a $3 loss (again, we participate dollar for dollar). On the upside, if the underlying rises to $102, we have a $2 gain; at $104, a $4 gain; and at $105 or above, a $5 gain.
Profit/ 10 Loss 5 0 -5 -10 Long Put Short Call Long Underlying Range Forward

Breakeven of a Range Forward

90

95

100

105

110

115 Price of Underlying

A zero-premium option position

Let's look at the range forward break-even graph. We are long the underlying position at $100 (indicated by the blue line), long the $95 put (the green line), which is going to protect us below $95, and short the $105 call (the orange line), which limits our upside gain. Instead of paying for the put with cash, we pay for it by selling another option. In this example, the strategy has no net upfront premium.

42

We buy protection below $95 by selling the appreciation above $105. The combination of these positions is called a range forward (represented by the yellow line) because the return on the position is limited to a range of underlying prices. As indicated in the figure, we participate dollar for dollar in the underlying between $95 and $105. So, if we buy the underlying at $100 and the price of the underlying falls, we lose money until it hits $95. Below $95, we have no further losses on the downside. If the underlying price goes up, we gain until the underlying hits $105. Beyond $105, we have no further gains on the upside. The graph actually looks like we took the graph of the long forward position, broke it at the top and bottom, and made the broken pieces parallel to the horizontal axis. This range forward position is the kind of investment strategy you can create only with options.

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Option Valuation
Introduction
500 380

440

Now that we understand how options change return patterns and how we can create some combination strategies with options, we are ready to begin to value options. We will look at specific examples of valuation, using a one-year $380 strike American call on gold, a one-year $500 strike American call on gold, and a one-year $440 strike European put on gold. We also will look more closely at the protection and opportunity values associated with options.

More Terminology
Parity Basis Protection First, we need to define some additional terminology. There are three components that we must consider when valuing options: parity, basis, and protection. Parity is the difference between the strike and the spot. Basis, as we already know, is the difference between the spot and the forward. Protection is the difference between the forward and the option value. We will spend more time with each of these components. Many option books use only two concepts to discuss option value: intrinsic value, which is generally the same as parity, and time value, which is generally the sum of basis and protection value. Combining basis and protection value and calling the result time value is confusing because time affects basis and protection in very different ways. We want to eliminate any confusion, so we use three terms instead of two. We will describe these concepts in more detail as we go through some examples.

Intrinsic value Time value

$380 call on gold $40 basis 10% x $400 +$400 spot $440 forward $400 spot -$380 strike $20 parity

An Arbitrage Transaction with Options


Let's buy a one-year American $380 strike call on gold. The call gives us the right to buy gold for $380 any time during the year. The spot price of gold is $400. Assuming interest rates are 10%, the basis is $40, and the forward value of gold is $440. We need to value the $380 call as a substitute for the long forward position since an option is always a forward-valued product, even if it settles into a spot instrument. At expiration, if we exercise our option, we will hold the underlying,

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gold, which we expect to have a value of $440. So how much are we willing to pay for the option to buy gold for $380? We know the option has $40 worth of basis value. Are we willing to pay $40 for the call? If we pay $40 for the call, our effective cost to buy gold is $40 plus $380 or $420. In a year, we can sell gold for $440, netting a risk-free $20 profit. We definitely are willing to pay $40 for the option, but the market would never sell us the call that cheaply. We must add another value to basis: parity. The valuation component that measures the difference between the spot price and the strike price is parity. Parity for this option is $400 minus $380 or $20. In addition to the $40 of basis value, we have to pay $20 in parity value to buy the option. Parity increases dollar for dollar as the price of the underlying rises above the strike. Adding the $40 basis value to the $20 parity value, we find that the call option must be worth at least $60. When we subtract the strike ($380) from the forward ($440), we are determining value relative to the forward. There are two components in that value: parity to spot ($20) and basis value ($40). If we pay less than $60 for this call, we have a clear opportunity for an arbitrage. For example, if the call is available for only $55, we want to buy low and sell high. We buy the call, effectively allowing us to buy gold at $380 plus the $55 value of the premium, or $435. We can then sell forward gold at $440, netting a certain profit of $5.
Position Value Basis Parity Forward Spot
345.45 350 380 400
Forward/ 380 Strike Spot 345.45 Basis No value as forward

Basis and Parity of a $380 Call

Forward 385 Strike 380 Spot 350

Strike 380

Forward 418

Full basis value

Strike/ Spot

380

Spot Price

Forward 440 Spot Strike 400 380

Basis Parity

Now, let's assume the spot price of gold is $345.45 instead of $400. The corresponding forward price is $380. As a substitute for the forward, the $380 call

45

has no value - even though the basis between spot and forward is nearly $35-because we could buy a $380 forward without paying an option premium. The basis below the strike does not contribute to the value of the option. What if the spot is $350? Now the forward is $385, and the $380 call is worth at least $5. That $5 comes from the basis. There is $35 worth of basis between the spot and the forward, but the $30 between the spot and the strike does not contribute to the value of the option. Only the last $5 of basis above the strike counts toward the option's value. In the figure, the effective basis value of an option is represented by the green shaded area between the forward line and the horizontal line drawn at the level of the option's strike. Let's continue to examine cross sections of the option value components as we move to the right in the basis and parity figure. Call strike Call price Forward cost of underlying Forward price of underlying Forward cost from call Minimum profit from buying call and selling forward $380 +$50 $430 When the spot price reaches $380, the option has the full basis value, which is now $38. Above $380, a new value component begins to add to the value of the call: parity. Remember, even with spot gold as low as $350, the $380 call has $5 of basis value, but it has no "parity" value relative to the spot price. As we saw earlier, at a spot price of $400, the option has basis value of $40 plus parity value of $20. Thus, the call must be worth at least $60. Let's examine an arbitrage opportunity based on these relationships. With spot gold at $400, the $380 call trading at $50 (which is $10 less than parity plus basis), and the gold forward trading at $440, we can make a profit of at least $10. If we buy the call for $50, we effectively buy the forward for $430. We then sell the actual forward at $440. We can make a profit of at least $10 by buying the call, selling the forward, and holding the position to expiration. Under some circumstances, we can make more than $10. We are doing something a little different here than we did in our earlier arbitrage examples. We are not buying the call and exercising it immediately. We are buying the call and selling the forward - we are actually creating a new arbitrage strategy. Let's see what happens as we work through this position. As planned, we hold our position to expiration. Let's examine our two positions (long call and short forward) relative to the closing spot price of gold. 46

+$440 -$430 $10

First, suppose the closing price of gold at expiration is $440. As indicated in the table in the margin, it looks as though we make $10 on the transaction. We sell the forward at $440--then we have to buy it back. The parity value of the call is $60; we paid $50 for it; so we have a $10 profit on the option. The forward settles at $440, the same price we sold it at, so we have no profit or loss on the forward. We gain $10, as we expected. Suppose we sell the forward at $440 then buy it back for $500, incurring a loss of $60 on the forward part of the transaction. The net gain for the entire transaction, including the option portion, is still $10, which is the minimum we expect to make. If gold = $500 at expiration, Initial transaction Opening price Buy $380 call ($50) Sell $440 forward $440

Closing price $120 ($500) Net gain

Gain (Loss) =$70 =($60) $10

An Extra Profit
Now, let's suppose gold is selling for $300 a year from now. We look like a loser on the option because our $380 call, which we paid $50 for, is worth nothing, netting a loss of $50 for the option part of the transaction. We cannot lose more than $50 on this part of our position. While the option has lost value, something very important has happened to the forward part of our strategy. We sold the forward at $440. We now have the opportunity to buy it back at $300 for a profit of $140. Although we lose $50 on the long call, we net $90 for the entire transaction. Not only do we make the $10 minimum gain, but we make an extra $80! If gold = $300 at expiration Initial transaction Opening price Buy $380 call ($50) Sell $440 forward $440

Closing price 0 ($300) Net gain

Gain (Loss) = ($50) = $140 $90 47

Where does the extra $80 come from? If we had been long the underlying at $380 instead of being long the $380 call, with spot gold at $300, we would have lost $80. With the call, however, we are protected from losing that much - we can only lose $50. Lets look at a graph for this combination.
Profit/ 100 Loss Short Underlying Long Synthetic Put 0 Long Call

A Long Synthetic Put Arbitrage

-100 300 340 380 420 460 500 Price of Underlying

As the price of the underlying increases, the value of the call increases, but the call's increase is offset by the decrease in the value of the short forward. In fact, these gains and losses offset dollar for dollar at any price above $380. However, as the price of the underlying falls below $380, the value of the overall position gains dollar for dollar. The call position is flat below $380, i.e., we cannot lose more than $50 on the call below $380, and the short forward position gains dollar for dollar. By buying a call and selling a forward, we create a long synthetic put. One problem with this position is that it looks as though someone gave us $10 to accept the long synthetic put. We have a sure $10 profit, and we have the opportunity to profit further as the underlying price drops below the $380 strike. Taking in $10 so we can participate in further profits sounds too good to be true-and, in fact, it is. This example did not take into account all of the factors necessary to evaluate an option. This option would not sell for $50 in the marketplace. Its value would be higher due to its basis and parity value components and to another option valuation component - the option's volatility value.

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An Option Valuation Formula


The volatility value of an option depends on the underlying's price distribution, which depends mostly on volatility and time. Let's look at an in-the-money option. An in-the-money option has intrinsic value, or parity value, and sometimes it has basis value. UBS defines an in-the-money option as any option that has parity or basis value*. An in-the-money option has value standing alone. Let's assume our in-the-money $380 strike gold option has a parity value of $20 and a basis value of $40, so that the option must be worth at least $60. Let's assume, also, the option's volatility value is $10, bringing the total future value of the option to $70. Will the option sell for $70 today? If interest rates are 10%, the value of $70 a year from now is $63 today. The fair value of the option today is not $70 but $63. Our general option pricing formula for a call looks like this: CALL VALUE call value = parity + basis + volatility value - carry cost of option price c = parity + b + vv ort where c = call value parity = spot minus strike (for a call) basis = forward minus spot vv = volatility value = protection value or opportunity value ort = carry cost of call premium, or option price x rate x time In-the-money

$70 - ($70 x 10%) = $63

The value of a call is the present value (or the discounted value) of the parity plus the basis plus the opportunity or protection value. For simplicity, we will not spend much time on the carry cost of the option premium or on applying the premium discounting factor. Discounting the future value of an option does have some significance, however. We have shown the relationship of the forward and the spot prices as two lines separated by the basis--the net cost of carry of the underlying to the future date. Interest costs dominate the value of the basis, so the basis increases as the spot price goes up. This future/spot relationship suggests that the value of a call might increase more than
* Many users of options define an in-the-money option as an option that has parity value. We include basis value because option pricing looks to the forward price, not the spot price.

49

proportionally to the increase in the spot as the option moves into the money. Actually, as the underlying moves into the money, the discount factor in the cost of carry of the option premium reduces the value of the option by roughly the same amount that the basis increases. A figure which adjusts for this cost of carry of the option looks like this:
Value of Call Forward Discounted for Option Cost of Carry Forward Spot Spot Underlying Price

Strike 0

Spot, Forward and Forward Discounted for Call Carry Values

A Closer Look at Volatility Value


Let's set parity and basis aside for a moment and look at the contribution volatility makes to option value. Specifically, let's look at what happens when we buy a oneyear American $500 call on gold, giving us the right to buy gold for $500 anytime during the year. The spot price of gold is at $400. With interest rates at 10%, we expect gold to be at $440 in a year, so why would we want to buy a $500 strike call on gold now? Because there is a chance that gold can go up to $500, $600, or possibly even $800. If we pay $0.25 for the $500 call and gold rises to $800, we can buy gold at $500 and sell it at $800, for a $300 profit (before deducting the $0.25 cost of our call). That is an excellent return on our money - a great opportunity. In fact, this option does have value, and we call this value opportunity value. This option has no parity or basis, because the option is out of the money, but it still has value. As another example, let's buy a one-year European $440 put on gold, giving us the right to sell gold for $440 in one year. Since $440 is the future value of gold in a year, the option is at-the-money forward. Although it has parity to the spot price of gold, 50

the $40 basis gives it a net value, or parity - basis, of 0. (See the section on the put for more details.) However, it does have an additional value. The $440 put has pure opportunity value or pure protection value. The $440 put has opportunity value: if gold does not rise above $440 we can profit by exercising our put. We would have the same profit by selling the forward at $440. The $440 put has protection value: if gold rises above $440, the put protects us against the potential for unlimited loss, compared to selling the forward. If gold goes to $600, the seller of the forward at $440 would lose $160, while the holder of the $440 put would lose no more than the premium paid for the option. Before moving on to a discussion of how we calculate volatility value, the broader concept that includes both protection value and opportunity value, let's pause to consider the total value of an option. The figure below shows the components of value of a call option. In this figure, the underlying is assumed, like gold, to have a positive basis. Depending on the spot price of the underlying, the option value is either purely opportunity value or some combination of parity, basis, and protection value (less the carry cost of the option premium which we are leaving out for simplicity).
Value of Call

Value Cross Sections


A. Call has only opportunity value Opportunity Value

Call at 1 Year to Maturity Call at Expiration

} Volatility value } Basis } Parity

The Components of the Value of a Call

Strike Forward Spot

Strike 0 Forward Spot A B Strike C Present value of Strike

B. Call has basis and protection value Forward Strike Spot Protection value Basis value

Underlying Spot Price

C. Call has parity, basis and protection value Forward Spot Strike Protection value Basis value Parity value

In this figure, we look again at vertical cross sections of option value components, moving to the right across the figure - from lower to higher spot prices for the underlying and from out-of-the-money to in-the-money call values. At spot price A, which is below the present value of the strike, the option is out of the money and has

51

only opportunity value. At spot price B, which is above the present value of the strike, the option is in the money by our definition. The option has some basis value and some protection value. At spot price C, the option has some parity value, full basis value, and some protection value.

Put Option Valuation


The analogous valuation relationship for puts is developed in this section. We are leaving much of the detailed analysis of puts for a more advanced discussion, but the differences between calls and puts should be made explicit. The formula for put valuation (comparable to the call pricing formula) can be written: PUT VALUE Put value = parity - basis + volatility value - carry cost of option price p = parity - b + vv ort where p = put value parity = strike minus spot (for a put) basis = forward minus spot vv = volatility value = protection value or opportunity value ort = carry cost of put premium, or option price x rate x time

The value of the put is the present value (or the discounted value) of the parity minus the basis plus the opportunity or protection value. If there were no volatility and no discounting for the carry cost of the option premium, a put would be worth only parity minus basis. For example, consider a European-style put with a strike price of $500. With spot equal to $400 and the forward at $440, we recognise that the parity in this put is $100. However, the value of the European put may be less than $100 because we cannot exercise this option today. The basis, the expected appreciation of the spot due to the carry on the underlying, causes the forward to be greater than the spot; this, in turn, lowers the future value of the $500 strike put. With spot at $440 in one year, the $500 European put will have a minimum value of $60 (parity minus basis, or 100 - 40). 52

With the spot at $400 and the forward at $440, let's look at the $430 strike European put. Basis is $40 and parity to spot is $30, so that parity minus basis is -$10. Does the $430 strike put have any value when "parity-minus-basis" is -$10? Because the put option is a right, not an obligation, there is no deduction from the put value when the basis exceeds the parity. Although the "parity-net-of-basis" portion of our put value contributes nothing to the total put value, the $430 put still has value - and that value is pure volatility value. We can illustrate the value of the $400 strike European put graphically. In the figure below, the straight line is the net value of parity minus basis. If there were no volatility value (insurance or opportunity) to the put, its value would follow this line. Notice that above a spot price of $360 absent volatility value the $400 put would be worthless even though it has 40 points of parity to the spot; since the put cannot be exercised prior to expiration, there is no way to cash in this value. Looking instead at a price of $325, we see that the put is worth about $65. Of this total, $35 is the net of parity minus basis ($75 - $40). The rest, $30, is volatility value, which in this case is protection value. As the spot price decreases, the parity-minusbasis value of the put increases while the protection value decreases. At a spot price of $250, the $400 European put is worth about $115 of which $110 ($150 - $40) is parity minus basis. With the spot price so low, the protection value of the option is only $5.
Value 150 of put

100

The Components of the Value of a European Put

50 Parity - Basis 0 250 300 350 400

Option Value

450

500 Underlying Price

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In-the-money-spot European puts are frequently worth less than parity - especially if volatility is low, interest rates are high (making basis large), or the option is deeply in the money. Buy put Buy stock Effective cost Exercise put/sell stock at strike Effective cost Risk-free profit -$80 -$400 -$480 $500 -$480 $20 However, the value of American options can never be less than parity; otherwise, an instantaneous arbitrage opportunity would exist. Let's suppose the $500 strike American put is trading today for $80 when spot is $400. We buy the put for $80, buy the underlying for $400 (for an effective cost of $480), and exercise the put. Exercising the put allows us to sell the underlying at $500, so we make a risk-free $20 profit. The value of American options can also never be smaller than the value of an otherwise identical option that is European. The next figure shows the value of the $400 strike American put. American puts cannot trade for less than parity to the spot price since the value could be realised immediately by exercising the option and simultaneously buying the spot, as we did in the example above. Thus the straight line in the figure is parity rather than parity minus basis. However, any value the put has above parity minus basis is due either to volatility or to the ability to exercise. For example, at a spot price of $375, the $400 strike American put is worth about $45 while the European put at the same spot price is worth only about $40.
Value 150 of put 100 Volatility and Exercise Value Option Value Parity 350 400 450 500 Underlying Price

The Components of the Value of an American Put

50 Parity - Basis 0 250 300

Since parity minus basis is negative ($25 - $40), the only value the European option has is volatility value or exercise value. The European option cannot be exercised 54

now, so $40 is its volatility value. The American option can be exercised immediately, so there is no need to wait until expiration and incur the basis; its immediate exercise value (parity) is $25. Its total value, $45, reflects the possibility of being able to exercise at any future date. This exercise flexibility accounts for the additional $5 of value for the American option. As a last note for the American put, consider a spot price of $320. At that price, the American put is worth exactly parity. If spot gold were actually at $320, the holder of the $400 American put would consider exercising it. Note that at a spot price of $320, the European put is worth only $70. The American put has an exercise value of $80. The additional value ($10) now is early exercise value rather than volatility value. The holder gains this value through exercise. Early exercise of American-style puts and calls is an important topic, but it is more appropriate for an advanced study of options. The key things to remember are that exercise style can affect the value of some options and often there are important differences between the pricing and behaviour of puts and the pricing and behaviour of calls.

early exercise

Time and Volatility


The calculation of opportunity value or protection value is based on statistical expectation (which we will examine later), but this value component is determined largely by time and volatility. The importance of time and volatility accounts for the fact that value in excess of parity is often called time value or volatility value.

Time. The greater the time to expiration, the greater the volatility value of an option. If we buy car insurance, we will have to pay more for one-year car insurance than for six-month car insurance. However, double the time does not mean double the insurance cost. We can determine statistically that the protection value of an option does not double as time doubles. Actually, other things equal, as time increases, the value of the protection in an option increases by the square root of time. That is, the protection value of a four-month option is worth only about twice the protection value of a one-month option.

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Volatility. The greater the price volatility, the greater the volatility value of an option. Since greater volatility increases the protection value of an in-the-money option and increases the opportunity value of an out-of-the-money option, greater volatility means we will pay more for the option. Paying more for the option when volatility is high seems reasonable. We would pay more for fire insurance on a cardboard house in the Southwest during the summer than on an asbestos house on top of a mountain in the Alps during the winter. The cardboard box is more volatile - it is more likely to burn. (We might have to pay more for health insurance if we lived in the asbestos house, but that is a different problem.) These comments should give you some preliminary insights into how options are priced, but we need to describe how volatility value is determined in more detail.

Components of Volatility Value


To add to our understanding of volatility value, we need to look at the essence of the option. We need to take away the forward piece and concentrate on the protection piece - the option's volatility value.
Profit/ Loss

Comparison between $440 Forward and $440 Call

400

420

440 460 strike

480 Price of Underlying

First, if we look at a comparison between the $440 forward and the $440 call, we find that they differ only in that the call prevents us from some losses. How much does the call prevent us from losing? In the diagram, the call keeps us from losing $20 if the forward drops to $420, and it keeps us from losing $40 if the forward drops to $400 when the option and forward contracts mature. 56

There are other questions that are harder to answer, however. What is the expected loss on the forward relative to the option? How much should we be willing to pay for the protection the call provides? We can answer those questions only if we have a forward price distribution for the underlying. In the discrete distribution we are going to examine in detail, we assume for simplicity that gold can finish only at $400, $420, $440, $460, or $480 over the next year - it cannot finish anywhere else. There is a 10% probability of gold finishing at $400, a 20% chance of $420, a 40% chance of $440, a 20% chance of $460, and a 10% chance of $480. If we were to use a continuous gaussian, or normal distribution, like the distribution on page 11, very few people would continue to read this book, because the solution would be very complicated. To make the mathematics approachable, we simplify the calculation and assume gold can finish only at certain prices. This simplification does not change the essence of the valuation approach. Our purpose in using options, rather than holding spot or buying forward contracts, is that we want to protect ourselves from loss. From the next figure, we can see that with forward gold at $440, there is a 20% chance that gold will end up at $420 a year from now - causing us to lose $20 on our position.
Profit/ Loss 20% 10% 0 $20 $40

40% 20% 10%

Calculating the Protection Value of $440 Call

400

420

440 Strike

460

480 Price of Underlying

10% x $40 + 20% x $20 $4 + $4 =$8

Calculating expected loss Segments of volatility value Total volatility value 57

What would be the expected value of that loss? Quite simply, the expected value of the loss is 20% of $20, or $4. If gold finishes at $400, there is a 10% chance of a $40 loss or an additional $4. Therefore, the volatility value of this call is $4 + $4 = $8.

Protection Value
We are willing to pay $8 for the protection this call provides because we want to protect ourselves from the possibility of loss. If the forward price is at $440, the call is at-the-money, and the total value of the call (ignoring option carry costs) consists of this $8 protection value. We said that call option value consists of parity plus basis plus volatility value. This position has no parity value and no basis value - it has only protection value. (We will talk about the opportunity side of volatility value later.) In the next figure, the probabilities are the same as in the previous chart, but the distribution has widened. By widening the distribution, we have increased the volatility (or dispersion of returns). Volatility increases Option value increases

Profit/ Loss 20% 10% 0 $30 $60

40% 20% 10%

Calculating the Protection Value of $440 Call: Volatility Increases

380

410

440 Strike

470

500 Price of Underlying

10% x $60 + 20% x $30 $6 + $6 =$12

Calculating expected loss Segments of volatility value Total volatility value

Now we have a 20% chance of losing $30, worth $6, and a 10% chance of losing $60, worth an additional $6, for a total expected loss of $12. When volatility increases, the value of the option's protection component increases. 58

At this point, let's go back to the earlier distribution and talk about an option with a different strike. The distribution is the same one we looked at on page 49, and the forward is the same, but the call strike is $430 instead of $440. With the forward at $440, the $430 strike option is in the money, because it immediately has $10 worth of value - $10 in basis value. Again, there is a 20% chance that gold will finish at $420 making us lose $10 without the protection component of our $430 call; 20% of $10 is $2. There is also a 10% chance of losing $30, 10% of $30 is $3, for a total value of $5 for the protection. Therefore, the total value of the option, or the price that you would have to pay, is $15: $10 of basis value and $5 of protection*.
Profit/ Loss 20% 10% 0 $30 $10 40% 20% 10%

Calculating the Protection Value of $430 Call

400

420 430 440 Strike

460

480 Price of Underlying

10% x $30 + 20% x $10 $3 + $2 =$5

Calculating expected loss Segments of volatility value Total volatility value

$10-deductible protection

The volatility value of this option is only $5 - cheaper than the $8 volatility value of the first example when we used this distribution to evaluate a $440 strike call. The remaining $10 of the option premium makes up the difference between the strike and the forward value-it does not represent protection. Remember, an option is a forward plus protection. In the original example based on this distribution, the $8 option was made up of pure volatility value because it was struck at the forward price.

* We are not discounting the option value, as we discussed earlier, to simplify the calculations.

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We can interpret the protection component of the $430 strike option as protection with a $10 deductible. The protection does not begin until we lose $10. When we have a deductible insurance policy, we pay a smaller insurance premium. In this case, we pay a $5 premium for protection with a $10-deductible rather than an $8 premium for zero-deductible protection.

Opportunity Value
Expected future value of parity We can look at option value in different ways. Another useful approach is that the value of an option is the present value of the expected future value of parity at expiration. Again, we are not going to talk very much about present value calculations or the option premium discount factor. It is enough to know that they are part of the package. But let's look at the other piece, the expected future value of parity at expiration. When we talk about expected future value of parity at expiration, we look at the opportunity side rather than the protection side of the option contract. We are talking about how much we expect the option to be worth in the future rather than the losses it protects us from. Let's look again at our example of a $430 call on gold with the forward at $440, this time evaluating the expected future value of the option. There is a 10% chance gold will end up at $400. We would not want to exercise our option to buy at $430 what we could buy at $400 in the market - so there is a 10% chance that the option will be worth nothing. There is a 20% chance gold will finish at $420, and again the option will be worth nothing. There is a 40% chance that the option will be worth $10, or a weighted value of (.40 x $10) = $4, a 20% chance that the option will be worth $30, or a weighted value of (.20 x $30) = $6, and a 10% chance that the option will be worth $50, or a weighted value of (.10 x $50) = $5. Adding these numbers, we get a total value of $15. That is the same total option value we arrived at by adding parity plus basis ($10) plus protection ($5).

Parity + basis + volatility Expected future value of parity

60

Profit/ Loss 20% 10% 0

40%

20% 10%

Calculating the Total Value of $430 Call

$10

$30

$50

400

420 430 440 Strike

460

480 Price of Underlying

40% x $10 + 20% x $30 + 10% x $50 Calculating expected gain Segments of option value $4 + $6 + 5 Total option value =$15 Now let's evaluate a $450-strike call - still using our simplified distribution with the forward value of gold at $440. The $450-strike call is out-of-the-money - it has no parity, no basis, and no protection value. However, the option does have opportunity value, and we can evaluate the option using the expected future value method. There is a 20% chance that the option will be worth $10, or a weighted value of (.20 x $10) = $2, and a 10% chance that the option will be worth $30, or a weighted value of (.10 x $30) = $3, for a total option value of $5. This out-of-the-money call has an expected future value of $5.
Profit/ Loss 20% 10% 0 $10 40% 20% 10% $30

Calculating the Opportunity Value of a $450 Call

400

420

440 450 460 Strike

480 Price of Underlying

20% x $10 + 10% x $30 $2 + $3 =$5

Calculating expected gain Segments of volatility value Total volatility value 61

We are close to putting it all together now; so let's look at the $430 put. We have graphed the $440 forward and the $430 call, which we have determined is worth $10 in parity plus $5 in protection, or, alternatively, an expected future value of $15. To that graph, we add the $430 put. The $430 put is out-of-the-money: it has no parity, and it has no basis. However, the $430 put does have opportunity value. If gold were to drop below $430, we would have the opportunity to sell it at $430. Let's look at that opportunity value more closely. Opportunity value of put equals protection value of call There is a 20% chance the $430 put option will be worth $10, or a weighted value of (.20 x $10) = $2, a 10% chance that the option will be worth $30, or a weighted value of (.10 x $30) = $3, for a total of $5. You may have noticed that calculating the opportunity value of the $430 put is exactly the same as calculating the protection value of the $430 call.
Profit/ Loss 10% 40%

{
$30 400

20%

20%

{
$10

10%

Calculating the Protection Value of $430 Call

420 430 440 Strike

460

480 Price of Underlying

10% x $30 + 20% x $10 $3 + $2 =$5

Calculating expected gain Segments of volatility value Total volatility value

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Put/Call Parity
Put/call parity describes the relationship between the protection and opportunity values of puts and calls. We will look at an example of what happens when put/call parity is violated, creating an arbitrage opportunity. Before we talk about an arbitrage, though, let's look more closely at put/call parity. If the opportunity value of a put is exactly the same as the protection value of a call at the same strike, what would happen if we bought the call and sold the put? When we sell the put, it looks like we flipped the graph of the long call, as illustrated in the figure, so that we are actually selling the protection value of the call. Remember, the call is a long forward plus protection. When we sell the protection, we are left with a long forward position.
Profit/ Loss Long Call 20% 10% 0 Short Put 40% Synthetic Forward 20%

Forward 10%

Long Synthetic Forward

430 440

Price of Underlying

So, when we buy a call and sell a put, we create a long synthetic forward position. The protection simply cancels out. Let's evaluate our synthetic forward position. We bought the $430 call for $15 and sold the $430 put for $5, for a net expenditure of $10. To get from the $430 spot to the $440 forward, we must add $10 of basis. We paid a $10 net premium to buy the $430 underlying which is now equivalent to the $440 forward, so we do not have an arbitrage profit. In fact, the positions are equal*. The synthetic position must be equivalent to the actual position. What if it isn't? What if people suddenly cry, "The sky is falling, buy puts, gold is going to drop drastically; buy puts, buy puts, buy puts!" and the put price rises to $7? Let's see how we can make an arbitrage profit if the puts trade at $7 with other prices unchanged.
* Remember, this is not perfectly accurate because we have not discounted the values; but that is more detail than is necessary for our discussion.

Buy $430 call -$15 Sell $430 put +$5 Buy synthetic forward-$430 Sell actual forward +$440 0 Sell put Buy call Net cost of option position + strike Effective cost of synthetic forward +$7 -$15 -$8 -$430 -$438

Sell actual forward +$440 Buy synthetic forward-$438 Riskless profit $2 63

If the put gets bid up to $7 when it should be $5, we buy the call for $15 and sell the put for $7. Now we have paid out a total of $8 to be synthetically long at $430 - and we will be long at $430 no matter where the underlying price actually ends up. For example, let's assume the price of the underlying ends up above $430 at expiration. What will we do? Obviously, we will exercise the call option to buy the underlying for $430, and we will be long at $430. What if the price ends up below $430? Since we sold the put, the put buyer will exercise and we will be assigned on that put, forcing us to buy gold at $430. Once again, we will be long at $430. The $430 synthetic instrument is equivalent to the one-year $440 forward position. We paid out $8 for the options. At expiration, we will pay out an additional $430 to buy the underlying for a total expenditure of $438. We bought something for $438 that is worth $440. So if we can sell the actual forward today at $440, we will make a riskless $2 profit at expiration. What is going to happen in this process? As we sell the put, we may not push the price down because there are still plenty of buyers demanding it. However, when we buy the call, we will probably push the call price up, and when we sell the actual forward, we will push the forward price down. Eventually, arbitrage will cause these prices to come into line with each other, and the price adjustment will eliminate further opportunities for arbitrage profit. Arbitrage will make the protection value of one option equal to the opportunity value of the other option. Then the volatility values of the two options will be identical. Reversal Conversion This arbitrage where we are synthetically long the spot at $430 and actually short the forward at $440 is called a reversal. If puts were cheap relative to calls, we would do exactly the opposite - buy $430 puts, sell $430 calls, and buy the forward at $440 and we would have a conversion. These are the names of techniques that take advantage of small violations of put/call parity. At this point, we have a basic understanding of volatility value and its components, opportunity value and protection value. Furthermore, given a distribution, we can price any option. We know that call option value is parity plus basis plus volatility value. When we take the present value of that combination, we have the secret of the option evaluator's black box. There is no more mystery to the pricing of options. 64

Now that we understand option valuation, we need to take a look at another option myth. Many investors think it is better to receive an option premium than to pay one. Some investors even refuse to pay an option premium because they see it as a cost of using options. As our analysis of option value has shown us, the components of option value, parity, basis, and volatility value, all represent cash flows that the option buyer expects to get back, on average, by the time the option expires. Similarly, the option seller expects to pay out the future value of these components by the time the option expires. The protection or opportunity features of the option payout pattern are important, but the expected cash flows will net out if the option is appropriately valued. Option buyers and sellers need to think about valuation and return patterns, but once they are satisfied on these points, the appropriate way to evaluate the cost of using an option is the same way traders would evaluate any financial instrument: estimate the option's trading cost - the spread between the cost to buy the option and the cost to sell it. This bid-ask spread, plus a commission in some markets, is the average or expected cost of using an option. Keeping this principle in mind will dispel the effects of the myth that the option premium measures the cost of using an option. Having examined one more option myth, all that remains to complete our introductory discussion of options is a commentary on risk, risk measurement, and risk control.

Option Myth The myth that the option premium is the cost of using an option

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Option Trading
How do we make money trading options? Like trading anything else, we make money by buying low and selling high. Since we know how to value options, we know when they are underpriced, and we know when they are overpriced. Consequently, our general plan is to buy options when they are undervalued in the market and to sell them when they are overvalued. We expect to make money by doing that. When we trade anything, we are exposed to risk, and that is what we are going to discuss in this section. We are going to look at what risk is, how we measure our exposure to various risks, and how we control these risks. Let's start by asking ourselves, what is risk? The professional trader's answer is that risk is exposure to change. When we trade options, what kinds of things change? The spot price can move, volatility can change, time certainly will pass, and interest rates can change. We want to monitor and control our exposure to some or all of these changes.

Risk = Exposure to Change

Hedging
We can control our risk by hedging. Hedging is an action that reduces risk, usually at the expense of potential reward. How do we hedge? Let's look at our earlier example where the gold forward is trading at $440 an ounce, making the $440 call worth $8. Remember, with the forward at $440, there is a 20% chance that the price will end up at $460. If the price ends up at $460, the call is going to be worth $20; 20% of $20 is $4. There is also a 10% chance that the price will end up at $480. If the price ends up at $480, the call is going to be worth $40; 10% of $40 is $4.

66

Profit/ Loss 10% 0 20%

40% 20% $20 $40 10%

Value of a $440 Call

400

420

440 Strike

460

480 Price of Underlying

10% x $40 + 20% x $20 $4 + $4 =$8

Calculating expected value Segments of value Total value Call value =$8 With forward at Our value Market value Expected profit $440 $8.00 -$6.50 $1.50

The value of the call, then, is $4 + $4 or $8. That is our theoretical value based on the probability distribution of price. Suppose that the call is trading for $6.50 in the market, not the $8.00 we calculate. This looks like a great opportunity. We think the option is worth $8; the market thinks it is only worth $6.50, what are we going to do? Obviously, we want to buy the option. If we buy the option for $6.50 when it is really worth $8.00, we expect to make a profit of $1.50. When are we going to make that $1.50? We are not going to make that profit right now, because the market thinks that option is worth only $6.50. If we buy the call for $6.50, and we say to the other traders, "That option you sold us for $6.50 was really worth $8.00," they're not going to turn around and say, "Oh, yes, you're right. Let me buy it back from you for $8.00." That is just not going to happen. We need a plan to extract the theoretical profit from the option position. Our overall plan is to take a position in the underpriced option and hold the position until one of two things happens: 1) we reach expiration or 2) the market changes its collective mind and agrees with our option valuation. Obviously, our valuation is a moving target because the option value will change as the underlying price changes, as time passes, and so forth, but we are willing to wait until the market price agrees with our value. Between the time when we put the trade on and when we take the trade off either at expiration or when we sell out the position before expiration - we are exposed to risk. Let's examine that risk.

Strategy to profit from option misvaluation: HOLD POSITION UNTIL A. Options expire B. Market agrees with our Theoretical Option Value

67

Suppose that sometime before expiration, the forward falls to $420. Why did the forward fall? Maybe people in the market simply decided that $420 was the right price for the gold forward a year from now, maybe the spot fell from $400, or maybe interest rates changed. For some reason, the forward is at $420 now.
Profit/ Loss 20% 10% 0 40% 20% 10% $20

Value of a $440 Call; Forward at $420

380

400

420

440 Strike

460 Price of Underlying

10% x $20 $2 =$2

Calculating expected gain Segment of value Total volatility value

What has happened to our long $440 call option? How much is the call worth with the forward at $420? The call is not going to be worth anything unless the forward ends up above $440. Notice that the shape of the distribution does not change; the probabilities do not change. The only change is where the distribution is centred. The distribution is always centred at the current forward price. With the distribution centred at $420, there is only a very small probability that the option will be worth anything. Even at $440, the $440 strike call option is going to be worth nothing. The option will have value at expiration only if the forward rises above $440. At $460, the option is going to be worth $20, but we are not going to pay $20 today, because the probability of the price reaching that level is only 10%. How much is the option worth? It is worth 10% of $20 or $2. The call, which was worth $8 when the forward was at $440, now is worth $2 with the forward at $420. Remember, that is our theoretical value - it is worth $2 according to us.

68

Now, let's assume the market agrees that the option is worth $2.00, too. If that is the case, it is time to take our profit. Our plan was to hold onto the position until expiration or until the market agrees with us. How do we take our profit? We are long the option, so we will sell it back to the market for $2.00. We paid $6.50 for the option, and we sell it for $2.00, so what happened? We lost $4.50. There must be something wrong! It did not have to happen that way. It is possible the forward could have moved to $460 instead of $420. What would be the value of the $440 call with the forward price at $460?
Profit/ Loss 40% 20% 10% 0 $20 $40 20% 10% $60

We buy at We sell at Loss

-$6.50 +$2.00 -$4.50

Value of a $440 Call; Forward at $460

420

440 Strike

460

480

500 Price of Underlying

40% x $20 + 20% x $40 + 10% x $60 $8 + $8 + $6 =$22

Calculating expected gain Segment of value Total value We buy at We sell at Profit -$6.50 +$22.00 +$15.50

The forward distribution is centred at $460, because that is the forward price now. At $440, the option is not worth anything, but it is worth 40% of $20 or $8 at $460; plus 20% of $40 or $8 at $480; plus 10% of $60 or $6 at $500. So we have weighted values of $8.00, $8.00, and $6.00, together worth $22. We bought the call for $6.50, and now it is worth $22.00. Let's assume again that the market agrees with our valuation of the option - the market now is willing to buy the option for $22.00. Remember, when the market agrees with us, we take the position off. Now, we sell the option back to the market for a profit of $15.50.

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Forward moves up $20 Forward moves down $20 Long call position gains $15.50 Long call position loses 4.50

To review, at $440.00 we believe our call is worth $8.00 even though it is trading at $6.50 in the market. When the forward is at $420.00, we agree with the market that our call is worth only $2.00. We lose $4.50 because we bought the call for $6.50 and had to sell it for $2.00. But if the forward moves up to $460.00, our call is worth $22.00. We only paid $6.50 for the call, so we made $15.50. Forward at $420 $2.00 ($6.50) ($4.50) Forward at $460 $22.00 ($6.50) +$15.50

Our theoretical value Our cost Gain (Loss)

When the forward goes down, we lose money, and when the forward goes up, we make money. We are not hedged against price movement! $8.00 -$6.50 +$1.50 Price movement is a risk we take on when we trade options. We would like to hedge ourselves against this risk; that is, we would like to preserve the value of our position when the underlying moves. What is the real value of our position? We bought an option for $6.50 that we thought was worth $8.00 - that $1.50 is what we are trying to capture. How do we capture that statistical valuation edge - that difference between the market price and the theoretical value - without taking the risk of price movement in the underlying? Perhaps we can do something in the forward market. Suppose we can make $10.00 when the forward goes down $20.00, and suppose we can lose $10.00 when the forward goes up $20.00. If we want to make money when the forward goes down, we have to be willing to lose money when the forward goes up. If we can combine this forward position with our option position, we will end up making exactly $5.50, regardless of price direction, as detailed in the table on the next page. We want our hedging position to make $10 when the forward moves down from $440 to $420 and lose $10 when the forward moves up from $440 to $460. When we add this hedging position to our option position, we will make exactly the same amount whether the forward moves down or moves up.

Theoretical value Market value Edge

70

If the forward moves down from $440.00 to $420.00, we will sell the option for $2.00, having paid $6.50 for it, netting us a loss of $4.50. But we gain $10.00 on our hedging position when the forward price moves down, so we make $5.50 after subtracting the loss on the option. If the forward moves up from $440 to $460, we sell the option for $22.00, having paid $6.50, netting us $15.50. But we lose $10 on the hedging position when the price moves up, so we make $5.50. Forward at $420 $2.00 ($6.50) 10.00 +5.50 Forward at $460 $22.00 ($6.50) (10.00) +5.50

Hedging position loses $10.00

Hedging position gains $10.00

Forward moves up $20 Forward moves down $20 Long call position gains $15.50 Long call position loses 4.50

Our theoretical value Our cost Hedge Profit/loss

Does this mathematical calculation work in the market? Not necessarily. We have to think of some way that we can do a trade that is going to simulate this net effect and create the hedging position we need. How are we going to do that? We want to make money when the forward goes down, and we are willing to lose money when the forward goes up. It sounds like we want to be short the forward. We do not want to be short the entire forward, however. If we were short the entire forward, we would lose $20 when the forward moved up $20 and we would make $20 when the forward moved down $20. How do we make $10 as the underlying falls and lose $10 as the underlying rises?

Delta

Delta
We establish our hedging position by selling half the forward amount. By buying the $440 call and simultaneously selling forward half the gold covered by the option, we are going to hedge ourselves against price movement. Essentially, for every dollar move in the forward, the call is going to move about $.50. This call is said to have a 0.50 or 50 delta. Delta refers to the change in the value of the call when the underlying price changes. When the delta is 50 and the underlying price changes by $1.00, our call position will change in value by $.50. When the forward moves up, our call becomes more valuable. When the forward moves down, our call becomes less valuable. Our
.5

Spot Value

Hedge Ratio 71

Call Value

forward hedging position offsets much of the risk of our long call position. As we gain value on the call when the forward goes up, we lose value on our short forward position. As we lose value on our call when the forward moves down, we gain value on our short forward position. Delta is a measure of price risk. It is our first option risk parameter. Delta tells us how the option price moves when the underlying price moves. Another way to look at delta is as the option's hedge ratio. It tells us how to hedge our position when we buy or sell an option. In this case, we bought a call. When we buy a call, the value of our position increases when the forward goes up. A delta of 50 tells us to sell half the forward amount to hedge the option's price risk because the short forward position moves in the opposite direction of our call. Delta also tells us how the option price changes with a one-point price move in the underlying. The option has a 50 delta, so we expect it to gain $.50 as the forward moves up $1.00 and to lose $.50 as the forward moves down $1.00. 8 -2 6 Stock value 440 -420 20 6/20 = 0.30 Upside Delta Call value Downside Delta Call value What did we expect to make out of this position? We bought the option at a $1.50 edge. We thought the option was worth $8.00, and the market valued it at only $6.50. We said we were going to hold onto the position until the option expired or the market agreed with us on valuation. When the market finally agreed with us, we took that position off, and we made our profit. But, because we hedged ourselves, we made $5.50 instead of $1.50. Actually, we made too much money. It is a little embarrassing for an option trader to admit she has made too much money; but, it is obviously better to make too much money than to lose too much money. On the other hand, if the trader does not know why she made it, the next time she could just as easily lose it. We expected to make $1.50, but we actually made $5.50. The question we must answer is - why? As the forward goes down $20 from $440 to $420, the call value decreases to $2. We calculate the option value as $8 when the forward is at $440 and as $2 when the forward is at $420. So the call value goes down $6 when the forward goes down $20. The hedge ratio, the change in the call relative to the change in the forward, is $6 $20, which is .30 or a 30 delta.

8 -22 -14 Stock value 440 -460 -20 -14/-20 = 0.70 Changes 72

Delta on the way down is really 30 - not the 50 we assumed. On the other hand, when the future goes up $20 from $440 to $460, the call value increases from $8 to $22 or $14. The call value rises $14 when the forward rises $20. That hedge ratio is $14 $20 or .70, which is a 70 delta. Delta on the way up is 70 rather than 50. The option is a 30 delta on the way down and a 70 delta on the way up. On the way down, we were over hedged because we were hedged at a 50 delta rather than a 30. On the way up, we were under hedged because we were hedged at a 50 delta instead of a 70. We took an average delta of 50 because we did not know if the price move was going to be up or down. We bought the option and sold the forward at a 50 delta because on average it was the right thing to do. Clearly, however, delta is not constant. Delta changes when the price changes. We started off appropriately hedged at $440, but when the forward moved to $420 or $460, we became partly unhedged. In this case, we were unhedged the right way and ended up making extra money. The changing ratio of our hedge is what made us that extra money. That was good because we did not lose enough on the short forward on the way up to offset the increase in the value of our option. We gained more than we should have on the short forward on the way down to more than make up for the loss in the value of our option. So, the 20 extra delta points multiplied by a 20-point price move caused us to make $4 more than we initially expected in each case. Now we should feel better for two reasons: 1. We made more money than we expected, and 2. We know why we made it. What if we had been short the call position and long the forward position? As the forward price increased, we would have gained money on our forward position, but we would have lost on our call position. Because call delta increases as the forward price increases, we would have lost extra money instead of gaining extra money. Our short call position gains and our long forward position loses as the forward price decreases. If we are fully hedged, meaning the weight of our positions are exactly equal, our positions cancel each other. But since our forward position weighs more heavily than our call position (50 delta for the forward versus 30 delta for the call), 73
Short call position loses $15.50 Short call position gains $4.50

Forward moves up $20 Forward moves down $20 Long 1/2 forward gains $10.00 Long 1/2 forward loses $10.00

Gamma

we lose more than we gain: in fact, we lose $5.50, exactly the amount we made before. Position Short call Long forward Net gain (loss) Forward at $420 +$4.50 ($10.00) ($5.50) Forward at $460 ($15.50) +$10.00 ($5.50)

We know we made that extra money because our delta changed. The change in delta in response to the underlying price change leads us to our second risk measure: gamma.

Other Option Risk Measures


Gamma indicates how quickly we become unhedged when the underlying price changes. Gamma is the measurement of the change in delta in response to a one-point change in the underlying price. We started with an option that was 50 delta; it moved down to a 30 delta when the forward decreased $20 and moved up to a 70 delta when the forward increased $20. That change in delta when the underlying moves is called gamma. Tau, Vega or Kappa There are risks in trading options that go beyond the risk of changes in underlying price. For example, volatility can change. The measurement of exposure to changes in volatility is called tau, vega, or kappa. We know that an increase in volatility tends to make options worth more. Increased volatility increases the value of both calls and puts. Interest rates can change. The measurement of the effect of a change in interest rates is called rho. Remember that an option is a substitute for a forward position plus protection. Think about what the interest rate does to the forward part of the option. An increase in interest rates tends to increase the forward value. Therefore, an increase in interest rates and corresponding carrying costs tends to increase the basis, thus increasing the value of calls and decreasing the value of puts. Time passes, and the remaining life of an option declines. The relationship of option value to time change is called theta, or time decay. We buy or sell an at-the-money (forward) option today and hold that position for some time. What happens over

Rho

Theta

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time? Remember, an option is a wasting asset. As time goes by, if nothing else happens - if volatility does not change, if interest rates do not change, if the forward price does not move - both the call and the put will be worth less. Correspondingly, short option positions become more profitable with the passage of time if everything else is constant. Let's summarise the risks that we are exposed to when we trade options. Our first risk is price movement. When the underlying price changes, the value of our option position changes. The measure of that price movement risk is called delta, and this exposure to price change is the first risk we try to hedge when we trade an option. However, we know that the appropriate hedge is not going to stay constant. Over time, we are going to have to change it. The measurement of the movement in the delta or hedge ratio in response to price changes is called gamma. Gamma tells us how quickly we are becoming unhedged as prices move. Tau or vega or kappa measures the change in the value of the option as volatility changes. Time can change the value of our position, too. Options become worth less as we get closer to expiration. The measure of time change, theta, measures decay in the option value over time. Lastly, we have the possibility of changes in interest rates. This is particularly important if the option has a long time to expiration. The measure of the effect of the change in interest rates is called rho. Options traders are appropriately concerned about these option risks. When we trade options, we have to be concerned with all of the risks that we face. Otherwise, any gains that we make by conscientiously buying low and selling high could easily become losses through failure to manage risk effectively.

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Beyond Option Value


Option Myth The myth that options are a zero-sum market Although the valuation of options and other financial instruments plays a significant role in risk management, it is not always possible to buy an undervalued financial instrument or to sell an overvalued instrument. Even if an investor must buy a slightly overpriced product - in a valuation sense - or if an issuer must sell a slightly underpriced instrument, there is still ample scope for both parties to the transaction to be better off than before the transaction occurred if they have different market forecasts or different perspectives on risk. Critics of options argue that option trading adds nothing of real value to the economy or even to financial markets. Option buyers are paying premiums to option sellers, and the net cash flow is zero - even negative after the costs of maintaining the market. This narrow cash-flow analysis misses the point of having an option market. Options exist to help participants in financial markets implement price or rate forecasts and protect positions from unacceptable risks. We have learned that the option trader's job is to sell options that her analysis indicates are overvalued and buy options that are undervalued in the marketplace. Options, unlike stocks, will have a day on which theoretical value and price come into line; that day is expiration day. If an option trader sells an overvalued option and properly hedges her position until expiration, she hopes to capture exactly the difference between the price and the theoretical value. If she buys an undervalued option and hedges effectively, she hopes to capture the undervaluation. If an investor who is trading in the market believes the distribution of the future spot price for the underlying will not be centred at its forward value at expiration, that option may look very cheap to the investor, even if the option trader believes it is very expensive. An investor with conviction in a market forecast may choose to buy this option to implement his forecast because options are highly leveraged financial instruments with limited downside risk. Let's return to our gold example to illustrate how a forecast can change the attractiveness of an option. We assume the spot price of gold is $400. Interest rates are 10%, so the forward is $440. Option traders, therefore, expect the forward price distribution to be centred at $440. Given the distribution we used earlier, we arrived at a value for the $430 call of $15.

76

If this call were trading for $15.50, an option trader would gladly sell it, hedge her position, and expect to make $.50. Why would anyone be willing to pay $15.50 for this call? Obviously, there has to be a difference of opinion or a difference in perspective. An investor might believe the future price is likely to be $460. If this is his expected value for the future spot (i.e., the centre of his distribution), with exactly the same dispersion or forecast of volatility as the option trader, then his valuation of the call will be based on an entirely different distribution. To this investor, it appears that the $430 call has an expected value of $31; a price of $15.50 seems like an incredible bargain to him since he expects to double his money in a year. Regardless of the fact that the trader will sell only overvalued options, the investor can obtain
Profit/ Loss 20% 10% 0 10% 40% 20%

}
$10 $30 $50

Calculating the Total Value of $430 Call

400

420 430 440 Strike

460

480 Price of Underlying

40% x $10 + 20% x $30 + 10% x $50 Calculating expected gain $4 + $6 + $5 Segments of expected value =$15 Total option value a very high rate of return if his forecast is correct. The trader, by hedging, will still capture the $.50 edge in her trade if her volatility expectation is correct.

77

Profit/ Loss 40% 20% 10% 0 20% 10% $30 $50 $70

}
$10

Calculating the Total Value of $430 Call; Forward at $460

420 430 440 Strike

460

480

500 Price of Underlying

20% x $10 + 40% x $30 + 20% x $50 + 10% x $70 Calculating expected gain Segments of option value $2 + $12 + 10 + 7 Total option value =$31

Both parties to this transaction can be better off. The investor wishes to use the highly leveraged character of options and their protection feature to express his directional view with limited risk. The option trader does not care about the directional movement in the underlying because she hedges that risk away. Differences in forecasts are one reason the view of options as a zero-sum market is misleading. Differences in attitudes towards risk also point to another important function of option markets - risk transfer. One person's risk is usually someone else's potential reward. By exchanging packages of risks and rewards, both parties to an option transaction can be better off. This is often true even if everyone in the market uses the same forecast. To draw an illustration from a typical price risk environment, let's consider a new issue of common stock from the viewpoints of three key market participants:

78

The corporate issuer who sells the new stock into the marketplace, The asset manager or investor who buys the stock on the initial offering or in the secondary market, The market maker who trades the stock in the secondary market as the needs of asset managers and investors change over time.

The figure on the next page illustrates each market participant's notion of risk. The common feature of their respective notions of risk is exposure to financial loss accounting loss or opportunity loss - but each views the possibility of loss from a different perspective. Starting our examination of risk with the market maker, we find a classic risk position. His risk is exposure to any large price change. Nothing could make him happier than a regular alternation of buyers who take his offer and sellers who hit his bid. However, by posting a continuous bid and offer, the market maker exposes himself to potential loss if the stock price moves very far in either direction. If the market falls, the market maker will be called upon to buy more stock, and his inventory will decline in value. If the price of the stock rises, the market maker will be called upon to deplete his inventory of stock. With a reduced inventory, the market maker's participation in the rally will be limited. He might even sell stock short to meet market demand. As a short seller, the market maker will face out-of-pocket losses in a market advance. The market makers position is unacceptably risky if prices fall or rise sharply. The stock's issuer and the investors who hold the stock in portfolios view risk from very different perspectives. Each views risk from one side of the market. The issuing corporation views risk as exposure to a rising market. If the corporation had waited to issue the stock until after the market rise, it could have obtained the same amount of cash for fewer shares. For the issuer, risk is a stock price that rises after he sells stock. If the stock price falls tomorrow, the issuer's sale of the stock today will appear fortuitous.

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Less

Issuer

Market Marker

Investor

Risk

Unacceptable Risk More Down Stock Price Up

The asset manager or investor who buys stock as a portfolio investment sees risk as the possibility of a stock price decline. If prices drop tomorrow, the investor will wish she had waited to buy. Of course, a stock price that rises after purchase is a favorable development for the investor. In this simplified picture of the stock market, participants have no obvious way to trade some of their profit potential for a reduction in risk. In the real world, risk management products and services provided by options and futures exchanges and by financial intermediaries are a response to demands for help in reducing risks. Convertible bonds, capped return equity issues, range forwards (see page 36), and traditional puts and calls can modify the risk-reward patterns of any of these market participants to keep them out of positions with unacceptable risk. Many market participants are willing to trade some of their opportunity to profit from favorable price behaviour for protection against an adverse price move. The essential role of options and futures markets and financial intermediaries is to help asset and liability managers - investors and issuers - modify risks and rewards so that some or all of the effects of price movements are transferred to other market participants. Actual or opportunity losses often cause more pain than an equivalent profit causes pleasure. Consequently, many market participants are willing to give up 80

sizable profit opportunities in exchange for protection from loss. This normal, human risk aversion creates the market for financial risk management products and illustrates how options add value. In virtually any price or rate risk situation, financial instruments can reallocate participation in price or rate movements in a variety of ways. When a single market is integrated with financial markets around the world, the opportunities for risk and return reallocation become extremely complex. However, the basic principle behind all financial risk management is the exchange of one set of risks and rewards for another set that fits a market participant's preferences more closely. While options are not suitable for every investor, they may be useful in facilitating this kind of risk exchange.

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Conclusion
This introduction has attempted to take the mystery out of options, to relate them to basic financial concepts like arbitrage, expected value, forward pricing, and price volatility. We have simplified some of the mathematics, but essentially we have presented the same tools and ideas that professional traders use to evaluate options, to enhance returns, and to manage risk. UBS publishes additional material which readers of this book may find useful in the management of financial assets and liabilities. UBS representatives or representatives of its affiliated broker/dealer can provide additional information upon request.

82

Global Disclaimer
This material has been prepared by UBS AG, or an affiliate thereof ("UBS"). In certain countries UBS AG is referred to as UBS SA. This material is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the materials. It should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this material are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of UBS as a result of using different assumptions and criteria. UBS is under no obligation to update or keep current the information contained herein. UBS, its directors, officers and employees' or clients may have or have had interests or long or short positions in the securities or other financial instruments referred to herein and may at any time make purchases and/or sales in them as principal or agent. UBS may act or have acted as market-maker in the securities or other financial instruments discussed in this material. Furthermore, UBS may have or have had a relationship with or may provide or has provided investment banking, capital markets and/or other financial services to the relevant companies. Neither UBS nor any of its affiliates, nor any of UBS' or any of its affiliates, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or any part of this material. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this presentation. Prior to entering into a transaction you should consult with your own legal, regulatory, tax, financial and accounting advisers to the extent you deem necessary to make your own investment, hedging and trading decisions. Any transaction between you and UBS will be subject to the detailed provisions of the term sheet, confirmation or electronic matching systems relating to that transaction. Clients wishing to effect transactions should contact their local sales representative. Additional information will be made available upon request. 2005. All rights reserved. No part of this material may be reproduced or distributed in any manner without the written permission of UBS AG. UBS AG specifically prohibits the re-distribution of this material, via the Internet or otherwise, and accepts no liability whatsoever for the actions of third parties in this respect.

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