PowerPoint Presentation

DERIVATIVES

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TOPICSSTRADDLEBUTTERFLYHAIRCUTCDSIRSFUTURESOPTIONS

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STRADDLE STRATEGYMEANING:A straddle is an options strategy in which the investor holds a position in both a call and put with the samestrike priceandexpiration date, paying bothpremiums. This strategy allows the investor to make a profit regardless of whether the price of the security goes up or down, assuming the stock price changes somewhat significantly.

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EXAMPLE

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $200 and a JUL 40 call for $200. The net debit taken to enter the trade is $400, which is also his maximum possible loss.If XYZ stock is trading at $50 on expiration in July, the JUL 40 put will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of $1000. Subtracting the initial debit of $400, the long straddle trader's profit comes to $600.On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put and the JUL 40 call expire worthless and the long straddle trader suffers a maximum loss which is equal to the initial debit of $400 taken to enter the trade.

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BUTTERFLY STRATEGYA long call (put) butterfly spread is a three-leg strategy with three different strike prices:Buy one call (put) with a lower strike price,Sell two calls (puts) with a middle strike price.Buy one call (put) with a higher strike price.Butterflyspreadsuse four option contracts with the same expiration but threedifferent strike pricesto create a range of prices the strategy can profit from. Thetradersells two option contracts at the middlestrike priceand buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread.

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EXAMPLESuppose XYZ stock is trading at $40 in June. An options trader executes a long call butterfly by purchasing a JUL 30 call for $1100, writing two JUL 40 calls for $400 each and purchasing another JUL 50 call for $100. The net debit taken to enter the position is $400, which is also his maximum possible loss.On expiration in July, XYZ stock is still trading at $40. The JUL 40 calls and the JUL 50 call expire worthless while the JUL 30 call still has an intrinsic value of $1000. Subtracting the initial debit of $400, the resulting profit is $600, which is also the maximum profit attainable.Maximum loss results when the stock is trading below $30 or above $50. At $30, all the options expires worthless. Above $50, any "profit" from the two long calls will be neutralised by the "loss" from the two short calls. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade.

HAIRCUTA haircut is the difference between prices at which amarket makercan buy and sell a security. The term comes from the fact that market makers can trade at such a thin spread.A haircut can also refer to the percentage by which an asset'smarket valueis reduced for the purpose of calculatingcapital requirement,marginandcollaterallevels.

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EXAMPLElet's say the Greek government borrowed about $483 billion from banks,investment fundsand other groups. Now it can't pay it back. So if an investor owns a Greekbondwith aface valueof, say, $1,000, the Greek government is now agreeing to pay back only $300. This means the investorwilltake a $700 haircut.

CREDIT DEFAULT SWAPA "credit default swap" (CDS) is acreditderivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrumentdefaultsor experiences a similarcreditevent.Acreditdefaultswapprotectsbondholdersandlendersagainst the risk that the borrowerwilldefault

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EXAMPLEsuppose Bob holds a 10-year bond issued by company XYZ with a par value of $1,000 and acouponinterest amount of $100 eachyear. Fearful that XYZ will default on its bond obligations, Bob enters into a CDS with Steve and agrees to pay him income payments of $20 (similar to an insurance premium) each year commensurate with the annual interest payments on the bond. In return, Steve agrees to pay Bob the $1,000 par value of the bond in addition to any remaining interest on the bond ($100 multiplied by the number of years remaining). If XYZ fulfills itsobligationon the bond throughmaturityafter 10 years, Steve will make a profit on the annual $20 payments.

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INTEREST RATE SWAPSAninterest rateswap(IRS) is aliquidfinancial derivativeinstrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. [1]Interest rate swaps can be used for bothhedgingandspeculating.

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EXAMPLEassume that Charlie owns a $1000 investmentthat pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes.Now assume that Sandy owns a $1000 investment that pays her 1.5% every month. The payment she receives never changes.Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rateswapcontract.Under thetermsof their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000principalamount (called the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.

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OPTIONSAnoptions contractis an agreement between a buyer and seller that gives the purchaser of theoptionthe right to buy or sell a particularassetat a later date at an agreed upon price. Options contracts are often used in securities, commodities, andreal estatetransactions.TYPES: Call Options Put Options

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EXAMPLEFor example, in a simple call options contract, a trader may expect Company XYZ's stock price to go up to $90 in the next month. The trader sees that he can buy an options contract of Company XYZ at $4.50 with a strike price of $75 per share. The trader must pay the cost of the option ($4.50 X 100 shares = $450). The stock price begins to rise as expected and stabilizes at $100. Prior to the expiry date on the options contract, the trader executes thecall optionand buys the 100 shares of Company XYZ at $75, the strike price on his options contract. He pays $7,500 for the stock. The trader can then sell his new stock on themarketfor $10,000, making a $2,050profit($2,500 minus $450 for the options contract).

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FUTURESAfutures contractis a legal agreement, generally made on the trading floor of afuturesexchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time inthefuture.Futures are contracts traded in exchange.

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EXAMPLEThat you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.WHEAT

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