ST K Payoff

Long Position in Future (ST - K)

90 95 -5
91 95 -4 6

92 95 -3 4
93 95 -2
94 95 -1 2

95 95 0 0
96 95 1 90 91 92 93 94 95 96 97 98

97 95 2 -2

98 95 3 -4
99 95 4
100 95 5 -6

ST K Payoff
90 95 5 Short Position in Future (K - ST)
91 95 4 6
92 95 3
4
93 95 2
94 95 1 2
95 95 0
0
96 95 -1 90 91 92 93 94 95 96 97 98
97 95 -2 -2
98 95 -3
-4
99 95 -4
100 95 -5 -6

K d1 d2 d3
95 94.5 94 93.5
0.5 0.5 0.5
100
 K Strike Price
n Future (ST - K)
St Price at Maturity

95 96 97 98 99 100

in Future (K - ST)

95 96 97 98 99 100
ST K Payoff
Long Position in Forward (ST - K)
90 95 -5
91 95 -4 6

92 95 -3 4
93 95 -2
94 95 -1 2

95 95 0 0
96 95 1 90 92 94 96 98 10

97 95 2 -2

98 95 3 -4
99 95 4
100 95 5 -6

ST K Payoff
90 95 5 Short Position in Forward (K - ST)
91 95 4 6
92 95 3
4
93 95 2
94 95 1 2
95 95 0
0
96 95 -1 90 92 94 96 98 10
97 95 -2 -2
98 95 -3
-4
99 95 -4
100 95 -5 -6
Forward (ST - K)

96 98 100 102

n Forward (K - ST)

96 98 100 102
Today 3-May-16
Company Name (Based in USA) ImportCo
Company has to pay £10 million on August 3, 2016
USD–GBP exchange rate in in the 3-month forward market 1.4551
GBP British pounds
USD US Dollars

Today 3-May-16
Company Name ExportCo
Company has to receive £30 million on August 3, 2016
USD–GBP exchange rate in in the 3-month forward market 1.4547
GBP British pounds
USD US Dollars

Learning
Sometimes A company might do better if it chooses not to
hedge than if it chooses to hedge
t=0

t=3

ImportCo Rate Unit Pay (USD-GBP) Amount (in Dollar)

Contract Pay 1 1.4551 £ 10,000,000 $ 14,551,000
Market Rate Case 1 2 1.4 £ 10,000,000 $ 14,000,000
Market Rate Case 2 3 1.5 £ 10,000,000 $ 15,000,000

ExportCo Rate Unit Pay (USD-GBP) Amount (in Dollar)

Contract Receive 1 1.4547 £ 30,000,000 $ 43,641,000
Market Rate Case 1 2 1.4 £ 30,000,000 $ 42,000,000
Market Rate Case 2 3 1.5 £ 30,000,000 $ 45,000,000
As per Contract Obligated to pay this much
Hedging is not effective
Hedging is effective in this case

As per Contract Obligated to receive this much

Hedging is effective since they are obligated to receive at 1.4547
Hedging is not effective
Consider a U.S. speculator who in February thinks that the British pound will strengthen relative to the U.S. dollar over the nex
Speculation Amount of £250,000
One thing the speculator can do is purchase £250,000 in the spot market in the hope that the sterling can be sold later at a hig
Another possibility is to take a long position in four CME April futures contracts on sterling.
Each futures contract is for the purchase of £62,500 in April.
Initial margin on four futures contracts = $20,000

Possible Trades
Buy £250,000
Spot Price Purchase Spot price = 1.4540
1.454 250,000 363,500
-13500 -0.054 1.4 250,000 (13,500)
11500 0.046 1.5 250,000 11,500

Learning
What then is the difference between the two alternatives?
The first alternative of buying sterling requires an up-front investment of 250,000 *1.4540 = $363,500
In contrast, the second alternative requires only a small amount of cash to be deposited by the speculator in what is termed a

Long ST-K
Short K-ST
engthen relative to the U.S. dollar over the next 2 months

hope that the sterling can be sold later at a higher price.

Speculatio betting

250,000
1.454

Possible Trades
Buy 4 futures contracts
Futures price = 1.4543 Buy 250K @ 1.4543
20,000 Investment
(13,575)
11,425

0 *1.4540 = $363,500
posited by the speculator in what is termed a ‘‘margin account’’.
ST K Premium Payoff
90 95 1 -1 Long Position in Call Option: m
91 95 1 -1 5
92 95 1 -1 4
93 95 1 -1
3
94 95 1 -1
95 95 1 -1 2
96 95 1 0 1
97 95 1 1
0
98 95 1 2 90 92 94 96
-1
99 95 1 3
100 95 1 4 -2

ST K Premium Payoff
90 95 1 1 Short Position in Call Option: Pr
91 95 1 1 2
92 95 1 1 1
93 95 1 1
0
94 95 1 1 90 92 94 96
95 95 1 1 -1

96 95 1 0 -2
97 95 1 -1 -3
98 95 1 -2
-4
99 95 1 -3
100 95 1 -4 -5
tion in Call Option: max(ST - K, 0) - Premium

94 96 98 100 102

ition in Call Option: Premium - max(ST - K, 0)

94 96 98 100 102
ST K Premium Payoff
90 95 1 4 Long Position in Put Option: ma
91 95 1 3 5
92 95 1 2 4
93 95 1 1
3
94 95 1 0
95 95 1 -1 2
96 95 1 -1 1
97 95 1 -1
0
98 95 1 -1 90 92 94 96
-1
99 95 1 -1
100 95 1 -1 -2

ST K Premium Payoff
90 95 1 -4 Short Position in Put Option: Pr
91 95 1 -3 2
92 95 1 -2 1
93 95 1 -1
0
94 95 1 0 90 92 94 96
95 95 1 1 -1

96 95 1 1 -2
97 95 1 1 -3
98 95 1 1
-4
99 95 1 1
100 95 1 1 -5
tion in Put Option: max(K - ST, 0) - Premium

94 96 98 100 102

ition in Put Option: Premium - max(K - ST, 0)

94 96 98 100 102
Company A
No. of Share 1000
Price $28
Note: The investor is concerned about a possible share price decline in the next 2 months and wants protecti
Choice The investor could buy ten July put option contracts on the company’s stock with a strike price of $27.5
Each contract 100 shares
K $27.50
Premium/Option Price $1

Premium Shares Total Put Contract

Hedging St $1 100 10

Stock PriceK Premium Quantity Payoff (Option)

20 27.5 1 1000 6500
21 27.5 1 1000 5500
22 27.5 1 1000 4500
23 27.5 1 1000 3500
24 27.5 1 1000 2500
25 27.5 1 1000 1500
26 27.5 1 1000 500
27 27.5 1 1000 -500
28 27.5 1 1000 -1000
29 27.5 1 1000 -1000
30 27.5 1 1000 -1000
31 27.5 1 1000 -1000
32 27.5 1 1000 -1000
33 27.5 1 1000 -1000
34 27.5 1 1000 -1000

Min -1000
t 2 months and wants protection
ock with a strike price of $27.50.

Total Cost Comment

$1,000 The strategy costs $1,000 but guarantees that the shares can be sold for at least $27.50 per share during the life

Payoff (Stock) Comment

-8000 Even though the cost of stock is $20 but you could still sell it at $27.5
-7000
-6000
-5000
-4000 Hedging Using Options
-3000 8000
-2000 6000
-1000 4000
0
2000
1000
0
2000 20 21 22 23 24 25 26 27 28 29 30 31 32 33
-2000
3000
4000 -4000
5000 -6000
6000 -8000
-10000
-8000
Payoff (Option) Payoff (Stock)
0 per share during the life of the option.

9 30 31 32 33 34

ock)
A speculator considers that a stock is likely to increase in value over the next 2 month
Current Sto $20
A 2-month call option with a $22.50 strike price is currently selling for $1.
K $22.50
Premium $1.00
The speculator is willing to invest $2,000.
One alternative is to purchase 100 shares;
The other involves the purchase of 2,000 call options (i.e., 20 call option contracts)

Buy 100 shares

Buy 20 call option

Learning
Leverage the position with Option ST K
15.5 22.5
16.5 22.5
17.5 22.5
18.5 22.5
19.5 22.5
20.5 22.5
21.5 22.5
22.5 22.5
23.5 22.5
24.5 22.5
25.5 22.5
26.5 22.5
27.5 22.5
InvestmentDecember stock price
$15 $27
$2,000 -500 $700
$2,000 -2000 7000

Premium QuantiOption PayStock Payoff

1 2000 -2000 -450 Speculation Using Options
1 2000 -2000 -350 10000
1 2000 -2000 -250
1 2000 -2000 -150 8000

1 2000 -2000 -50

6000
1 2000 -2000 50
1 2000 -2000 150 4000
1 2000 -2000 250
1 2000 0 350 2000

1 2000 2000 450

0
1 2000 4000 550 15.5 16.5 17.5 18.5 19.5 20.5 21.5 22.5 23.5 24.5 25.5 2
1 2000 6000 650 -2000
1 2000 8000 750
-4000
Using Options

21.5 22.5 23.5 24.5 25.5 26.5 27.5

Let us consider a stock that is traded on both the New York Stock Exchange and the London Stock Exchange
Suppose that the
An arbitrageur stock
could price is $140 in
simultaneously buyNew
100York andof£100
shares in London
the stock at aYork
in New timeand
when
sell the exchange
them rate
in London toisobtain
$1.4300 per pound.
a risk-free
profit of

Total Share 100

LSE Stock Price (£ ) 100
Rate $ 1.43
LSE $ 143.00
NYSE $140
Difference $ 3.00
Calculation $ 300.00

Learning
Arbitrage opportunities such as the one just described cannot last for long.
As arbitrageurs buy the stock in New York, the forces of supply and demand will cause the dollar price to rise.
Similarly, as they sell the stock in London, the sterling price will be driven down.
Very quickly the two prices will become equivalent at the current exchange rate.
edon
rate
toisobtain
$1.4300 per pound.
a risk-free

price to rise.