Exotic Options and Trading Strategies Workbook and Reference Guide

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SECTION 1 OPTIONS BASICS

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Options 1.1. Definition and Features An options contract gives the holder the right, but not the obligation, to buy or sell a given underlying product at a fixed price on a given date in exchange for a premium. The following is key terminology for options contracts: Term Meaning Strike price Expiration Writer Premium Call option Put option Exercise Life of option Exercise period American Option European Option Bermudan Option In the money Price at which the option buyer has the right to buy or sell the underlying. Date and time on which the holder/buyer of the option loses the right to buy or sell. The option seller is also known as the option writer The amount paid by the option buyer to the option writer for the right. Buyer has the right to buy the underlying Buyer has the right to sell the underlying Process of deciding and advising option seller/writer of intention to exercise the right under the option As exercise period - time until expiration As life of option - time until expiration Can be exercised at any time in a given period Exercise on expiration date only Exercise on a given range of dates. Given current market rates it is likely that the option will be exercised. A call option is in the money when the strike price is below the current market price. A put option is in the money when the strike price is above the current market price Given current market rates it is unlikely that the option will be exercised. When the strike price is equal to the current market price The price of the underlying at which neither a profit nor a loss is made. This occurs where underlying price - premium=strike price Where the writer of a call option does not hold the underlying stock or the right to buy the underlying stock if the buyer of the option exercises his right then he is said to be exposed, uncovered or naked Where the writer of a call option holds the underlying stock or holds a hedge to buy the underlying stock if the buyer exercises against him he is said to be covered.

Out of the money At the money Breakeven Price Naked options

Covered options

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Term Assignment

Meaning Act by which the exchange designates an option writer for fulfilment of his obligation to sell or buy the underlying asset under an exchange traded contract.

At the Money, Out of the Money, In the Money The most profitable time to exercise an option is when it is In the Money. The following table shows how an option contract moves in and out of the money as the price of the underlying moves:
4 3 Profit or Loss 2 1 0 -1 -2 -3 -4 Profit or Loss 16 3 17 2 18 1
At the money

In the Money

Out Of the Money

19 0

20 -1

21 -2

22 -3

Underlying Price

Options may be standardised Exchange Traded Contracts (XTC) or customised Over the Counter (OTC) contracts. Exchange traded contracts may be exposed to daily margin calls where the exchange takes a proportion of the value of the loss as a deposit from the buyer. Exchange members and brokers charge commission to their clients to conduct the trades on their behalf. Exchanges include: LIFFE (London International Financial Futures and Options Exchange CBOT: Chicago Board of Trade CME: Chicago Mercantile Exchange. A more detailed list is included as an Appendix. Exchange traded options usually have expiry out to 2 years. Over the counter options can be written for any period but typically not more than 10 years. OTC options include caps, collars and floors, which are covered in a separate section. The risk for option writers can be limitless especially where naked options are sold. These occur where the writer does not hold the underlying and is therefore exposed to movements in the market price. Underlying includes Currencies Interest rates such as 3 month libor

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Securities Swaps (see separate section on swaptions) Futures In the financial times on Weds 23rd October the following prices were quoted for three-month Eurodollar options on CME. As per the contract specifications detailed below this gives the Expiry Months - the actual buyer the right to buy one Eurodollar futures contract on CME.
date is specified by the exchange

Strike Price 98.125 98.25 98.375 98.5

Calls Nov 0.13 0.06 0.04 0.02

Dec 0.06 0.1 0.07 0.04

Jan -

Puts Nov 0.03 0.09 0.19 0.29

Dec 0.05 0.13 0.22 0.32

Jan 0.28 -

The premium for the option. For example the premium for a December option with a strike price of 98.375 is $0.22

Note Eurodollars are time deposits denominated in U.S. dollars that are deposited in commercial banks outside the U.S., and they have long served as a benchmark interest rate for corporate funding. The Eurodollar futures contract on CME represents an interest rate on a three-month deposit of $1 million. Option Premiums Option premiums are calculated according to the value it has. The value is split into 2 parts: Intrinsic Value The difference between the underlying and the strike prices For a call option: Intrinsic Value = Underlying price - strike price For a put option: Intrinsic Value = strike price - underlying price Intrinsic value is always > zero Time Value This is the amount of the premium which represents the risk to the writer that he option will move in the money before expiry Time Value = Premium - Intrinsic Value The time value of the option is at its highest value on trade date and decreases/decays to zero on expiry date. Note an at the money option or out of the money option premium is entirely time value as the intrinsic value is zero.

Settling Options Once an option has been traded a premium is payable. Further amounts are then only payable if the option is exercised. The nature of the settlement can either by physical or cash:

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Physical: this means that the option is actually delivered. So if the option is on an equity the seller/writer of the option must deliver to the buyer/holder of the option the defined equity in return for cash representing the strike x number of shares agreed in the option. Cash: For some products the physical delivery of the underlying is not feasible, for example and interest rate option. Therefore cash is settled for the difference between the market rate and the option rate based on the agreed notional. It should be noted that cash settlement can also be agreed even though physical settlement is possible. Taking the example of the equity option again. Assume that the option is to buy 100 BP shares for 12 on 31/1/03. On the exercise date the market price is 15 therefore the holder of the option exercises his right to buy but request cash settlement. The option writer will therefore pay the option holder 100 x (15- 12) to settle the option. Pricing Options The value of an option is dependent on the following factors: Strike price Underlying price As the price of the underlying rises the premium of a call option will increase and the premium for a put option will fall. As the price of the underlying falls the premium of a put option will increase and the premium of a put option will fall. Time to expiry The premium for an option will be higher for options with a longer period to expiry as there is more opportunity for the option to move In the Money. Rate of movement of the underlying price - volatility This measures the rate at which the underlying price fluctuates. It is the most important factor in option valuations. Volatility is considered in terms of historical volatility and implied volatility. Historical volatility considers historical prices over time and is used to estimate future volatility Implied volatility is the future volatility level as quoted by the market. Interest rates These generally play a relatively insignificant role in the value of options. This element relates to the cost of carry of the option - i.e. the cost of funding the option purchase or the opportunity cost. There is an inverse relationship. If interest rates are falling then the premium rates will rise because the buyer of the option must be compensated for the lost opportunity of investing the option premium at higher rates

Volatility As noted above this measures the rate at which the underlying price fluctuates. It is the most important factor in option valuations. Volatility is considered in terms of historical volatility and implied volatility. Volatilities are quoted as percentages and represent the standard deviation of the underlying. The confidence level of the volatility forecast being correct for one standard deviation (1) either side of the mean is 68%, 2= 95%, 3 = 99.7%.

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For example the Euro interest rates for one year are 3.5% and the one-year volatility is forecast at 10%. Therefore the standard deviation is 0.35 and for two standard deviations 0.70. This gives the following interest rate ranges: Confidence Range 1 2 3 4 5 6 68.27% 95.45% 99.73% 99.99% 99.9999% 99.9999998% 3.15%-3.85% 2.8%-4.2% 2.45%-4.55% 2.1%-4.9% 1.75%-5.25% 1.4%-5.6%

95% confidence

68% confidence

2.8

3.15

3.5

3.85

4.2

Over the counter options are quoted in terms of volatility whereas XTC options are quoted in terms of premiums as seen above. The higher the volatility the higher the premium as the underlying price is more likely to move away from the strike price.

Margin Margins are charged as a form of security to the exchange or broker on XTC options. They are normally set as a percentage of the full value of the options. There are two types: Initial margin is the amount of money, which a customer must deposit in his account whenever he establishes an options position. These margins must be deposited for both long and short positions. Initial margins normally range from 5 to 20 percent of the full value of the options contracts. After depositing initial margin requirements, if the market

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moves in the customer's favour, the amount in excess of the initial margin requirements may either be withdrawn or used for margining additional positions. Maintenance or variation margin. If the market moves against the customer, they will be required to deposit additional monies in their account. This is known as maintenance or variation margin. A maintenance margin call is issued when the customer's account value falls below the maintenance margin requirement, usually about 75% of the initial margin requirement. When this happens, the customer will have to deposit sufficient funds to bring the balance in his account back up to the level of initial margin requirements. Maintenance margin calls can be met by cash deposits, deposits of Treasury Bills, transfer of funds from a related account, liquidation of positions, market appreciation or any combination of the above. During periods of extreme volatility or for very large positions, accounts can be called for margin at any time. This type of call must usually be met immediately by either a wire transfer or the liquidation of positions. Both Initial and variation margins are calculated based on the value of the portfolio, which will establish a series of possible market movements to the option portfolio and take the worst-case outcome. The variation margin is calculated as follows: Variation Margin = number of contracts x number of ticks moved since last margin call x tick value These tick values are specified in the contract specifications, which are drawn up by the relevant exchanges. Margin Calculation Methods The most widely used is SPAN (Standard Portfolio Analysis of Risk), which applies to all LIFFE contracts, to all US futures exchanges (e.g. CME, CBOT, NYBOT) and to many overseas futures exchanges (e.g. MATIF, SIMEX). Basic Trading Strategies Each option strategy has a different profit profile. The four basic strategies are: Buy a call Buy a put Write/Sell a call Write/Sell a put These are explained below:

Buy a call

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An investor believes that an American equity will increase in price. He does not currently have the cash to buy the stock. Therefore he buys a European call on the stock with a strike price of

Price of underlying 9 6 5 4 3 2 1 0 10 11 12 13 14 15 16 17 18

Profit/Loss

Premium.
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Break even price $13

Out of the money Strike price

In the money

$12 three months hence. A premium of $1 is charged. The profit/value profile is: If the price of the underlying is $12 or less the option holder will do nothing. If the holder were to exercise the option he would be buying the stock for more than he could buy it in the cash market. He does not exercise and he loses only the price of the option the premium At an underlying price of $13 the option holder exercises the option as he can now buy at $12 and sell at $13 at a profit of $1. This offsets the premium giving a net profit of nil known as the breakeven point. At an underlying price of $14 the option holder makes a gain of $1 being the price at which underlying could be sold ($14) less the strike price at which he will buy the underlying ($12) less the premium ($1). The profit rises by $1 for every $1 rise in the underlying price. Buy a put A UK company sells products to the US. It receives payment in USD. On 1 May 2006 it receives an order for goods worth $100,000, which will be paid for on 1 December 2006. The current exchange rate is $1.40 dollars per pound or 0.7143 pounds per dollar for which it would get 71,429. It buys a put option to sell dollars on 1 December for 0.7143 pounds per dollar. The premium is 3,000

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20000

15000

10000

5000

Premium.
-5000 /$ profit/loss

1 0.5263 15,797

2 0.5556 12,873

3 0.5882 9,605

4 0.6250 5,929

5 0.6667 1,762

6 0.7143 -3,000

7 0.7692 -3,000

8 0.8333 -3,000

9 0.9091 -3,000

10 1.0000 -3,000

Break even price 0.6843

In the money Strike price 0.7143

Out of the money

If the /$ exchange rate (the underlying) is 0.7143 or more the option holder does not exercise the option as it can sell them dollars for more in the market. It loses only the price of the option - the premium. The breakeven point is at 0.6843 pounds to the dollar as at this point if the option holder exercises the option it will receive 71,429 giving him a net profit of 68,429 which is the same price as if it did not have the option and sold his dollars at the current spot price of 0.6843. As the price of sterling to the dollar falls its gain increases. On the other side of these buy options is the seller. Their profiles are as follows: Sell a call A trader sells a call to an investor who believes that an American equity will increase in price. The details are that he sells a European call on the stock with a strike price of $12 three months hence. A premium of $1 is charged. The profit/value profile is:

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2 1

Premium.
0 9 profit or loss -1 -2 -3 -4 -5 -6 10 11 12 13 14 15 16 17 market price 18

Break even price $13 Out of the money In the money

Strike price

Until the investor exercises the option the trader is in profit as he keeps the premium. Once the investor exercises the option (any price after $12) the traders profit is eroded until a price of $13 or more. At a price of $15 the trader makes loss of $2, as he must sell to the option buyer for $12 but has to buy in the market for $15, a loss on covering the trade of $3 against which he sets his premium of $1. In fact the loss potential for the trader, if he does not already hold the underlying asset, is unlimited. The writing/selling of uncovered or naked options as these are known is an extremely risky business for this reason. Unsurprisingly the traders position is the mirror of the investors. Sell a put A trader sells to a UK company a put option to sell dollars on 1 December for 0.7143 pounds per dollar. The premium is 3,000

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5000

Premium.
0

Profit or loss

-5000

-10000

-15000

-20000 /$ Profit/Loss

1 0.5263 -15,797

2 0.5556 -12,873

3 0.5882 -9,605

4 0.6250 -5,929

5 0.6667 -1,762

6 0.7143 3,000

7 0.7692 3,000

8 0.8333 3,000

9 0.9091 3,000

10 1.0000 3,000

Market rate

Break even price 0.6843 In the money Strike price 0.7143 Out of the money

Until the company exercises the option the trader is in profit as he keeps the premium. Once the company exercises the option (any price below 0.7143) the traders profit is eroded until a price of 0.6843 or less. At a price of 0.5 the trader makes loss of 18,429, as he must buy $100,000 from the option buyer for 0.7143 pounds to the dollar, which costs 71,429. The best he can sell his dollars for is 0.5 for which he receives 50,000. In fact the loss potential for the trader if he does not already hold the underlying asset is significant. However in this case he is limited to the cost of the sterling of 71,429 as the price cannot go below zero. Again the option seller/writers position is the mirror of the buyers. The Greeks Each of the factors influencing the value of options is named a Greek letter as follows: Greek Symbol Influence Calculation Delta Gamma or Change in price of the underlying Change in delta Change in premium Change in Underlying Price Change in Delta Change in Underlying Price

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Greek Vega (not actually a Greek letter so also Epsilon, Lappa) Theta Rho

Symbol

Influence Change in the volatility of the underlying instrument price Change in time to expiry Change in interest rate to fund the underlying instrument

Calculation Change in Premium Change in Volatility

Change in Premium Change in time to expiry Change in Premium Change in cost of funding

Creation of Contracts Like futures exchange traded option contracts are defined by the exchange on which they are to be traded. The following is the contract specification for the against $ Option on LIFFE. The specifications for any contracts can be found from the website of the exchange concerned Unit of trading 25000 Delivery/expiry months Delivery/Exercise/expiry day March, June, September, December Exercise on any business day. Delivery on the third business day after the exercise day. Expiry at 17.00 on the last trading day 16.02 3 business days before third Wednesday of expiry month US $ per pound 0.01cents per ($2.5) 08.34-16.02

Last Trading Day Quotations Minimum price movement (tick size and value) Trading Hours

Exchange traded options are traded in a pit by brokers on an open outcry system as for futures. Open outcry simply means that the bid and offer price and volumes are shouted out into the pit for anyone to hear. OTC options are agreed individually between two parties, typically a bank and their client. All details are agreed in writing via a confirmation. Uses As shown in the examples: Hedging To provide protection against adverse price movements in the interest rate, currency and securities markets. Speculation/Trading

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Making gains by buying and selling options. Profit and loss is made because of movement in the price of the underlying. Income and Valuation Income Profit and loss is made according to value of the options, which in turn will vary according to the price of the underlying. For an option buyer the only cost may be the premium if the option is not exercised. The option seller receives premium income. The potential costs are limitless if naked options are written. Value Exchange Trade Options: In the case of XTC options the value is the current price of the option as quoted by the exchange, which will be, derived using the same methodologies as described for OTC options. Over The Counter Options: The valuation of options is complicated and further detailed training must be obtained by anyone involved in the checking of the valuation of options. The value of options depends on the following factors: Current market price of the underlying asset - the higher the current price the more likely it is that a call option will be exercised as the strike price is more likely to be below the current price. Strike price - the lower the strike price the more likely it is that a call option will be exercised. Time to maturity - the longer the period to the maturity the more likely the option will be exercised as there is more time for the option to move in the money Volatility of the underlying - this measure the extent to which the price moves. The more volatile the underlyings price the more likely it is that the strike price will fall below the market price in the case of a call option. Whether the option is American or European Style - with an American style option the buyer has more opportunity for the option to be in the money

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SECTION 2- TRADING STRATEGIES

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Complex Trading Strategies

Complex trading strategies are combinations of two or more simple strategies.

Straddle
Simultaneously buying or selling of options of different types for the same strike price Long Straddle:- Buying a call and a put at the same time for the same strike Long Straddle payoff Profits Buy a Put Buy a call
Break even -put Break even - Call

Profits

Zero Losses

Price of underlying

Losses A long straddle will make losses if at the time of exercise/Expiry the strike price is near the market price. This is because the investor has bought exposure to both the options. A long straddle will make a profit if there is a large movement in either direction

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Short Straddle:-Selling a call and a put at the same time for the same strike Short Straddle Payoff

Profits Strike Price

Sell a put Profits Zero

Losses

Sell a Call

Losses

The short straddle will be profitable if the underlying price is close to the strike price at the time of expiry. If there is a large movement in the underlying price in either direction the straddle will result into a loss

Straddle Example/Excercise let's assume that IBM is currently trading at $100 per share. Due to a significant event that will occur this month (an expected news event, earnings release, etc.), an investor might believe that the stock will move at least 10% in either direction. In this example, let's assume that both the IBM 100 put options and IBM 100 call options are trading at $3 each. To take advantage of this the investor would enter into a straddle trade by purchasing both the IBM 100 put for $3 and the IBM 100 call for $3 (for a total of $6 out of pocket). Draw the payoff diagram of the straddle Calculate the profit or loss if The market price had risen 10%

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The market price had fallen by 15% If the market price moved by 2 %

Reasons for trading the straddle Investor is trading on volatility. A long straddle useful when the investor is expecting a large movement in underlying price in either side but is not sure which direction the same will be in. A short straddle will be useful when the investor is expecting a small movement in the underlying price in either of the directions

Strangle
Definition: - Buying or selling of option of different types with different strikes Long Strangle: - Buy a call with high strike price and put with low strike price Profit Profile

Profits
Put Strike Call Strike Put break even Call break even

Buy a call

zero

Underlying price

Buy a put

Losses

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A long strangle will make a profit if there is a large movement in the price of the underlying in the either direction. If the underlying price is in between the two prices or close to the same the strangle will lead to a loss Short Strangle Sell a call with high strike and a put with low strike Short Strangle Payoff
Profits
Put Break even Put Strike Call strike Call break even

Sell a put zero

Sell a call

Losses

A short strangle will be profitable if the underlying price is close to or in between the two strike prices. However if there is a large movement in the underlying price in either of the direction a short strangle position will be at a loss Reasons for trading in Strangles Investor is trading on volatility. A long straddle useful when the investor is expecting a large movement in underlying price in either side but is not sure which direction the same will be in. A short straddle will be useful when the investor is expecting a small movement in the underlying price in either of the directions The underlying price movement has to be greater than in case of a strangle, hence the premium paid by the buyer of the strangle will be lower

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Strangle Example/Excercise Reliance is currently trading at 325. The investor expects a big jump in prices due to de - merger of the company but is not sure how the same will affect the price He buys a call at 360 and a put at 300. He pays a premium of Rs.10/share on call and 5/share on put. The contract size is 200 shares. Answer the following 1. When will the investor start making profit? 2. When will he make a loss? 3. What is his breakeven point? 4. If at the time of expiry reliance was trading at the following prices calculate net profit or a loss a. b. c. d. e. 380 370 350 335 310

Spreads
Definition- Buying or selling of options of the same type with different strike price Long Call Spreads:- Buy a call with low strike price and sell a call with high strike price. Also known as bull call spreads. The expiry and the underlying should be same Bull spreads have limited profit potential. The risks are also limited to the premium paid Bull call spread Payoff A bull call spread will be profitable if the underlying price is greater than the breakeven point. The breakeven point for the bull call spread will be the lower strike + premium. This can be better explained by way of an example Assume XYZ Stock is trading at 102.50. You buy 1 XYZ Apr 100 call at a premium of Rs.9 and sell XYZ Apr 110 call at Rs.5. The net cost of the spread is Rs.4.

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The maximum risk is Rs.4. The maximum gain will be the spread (110-100) premium = Rs.6. Breakeven point will be at 104 ( Lower strike + premium). If the price remains at 102.50 the investor will exercise the call hence will gain 2.5. The buyer of the high strike will not exercise the call. This will result in a total loss of 1.5 If the market price is 108 again the investor will exercise the long call and gain Rs.8 The short call will not be exercised. Resulting in a net profit of 8-4 = Rs.4 If the price is 99 neither options will be exercised resulting in a net loss of 4 If the price is more than 110 both the long and the short calls will be exercised. The investor will pay and receive on both hence the maximum gain the investor can have is 6.

Profits Buy a Call

Sell a Call

Losses

Reasons for trading in Bull spreads Investor expects that the price will rise up to a certain level Wants to minimize the premium cost.

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Log Put Spread:- Buy one put with high strike price and sell another put with a low strike price. The expiry and the strike for both should options being the same. Long put spreads are also called bear spreads. Bear spreads have limited profit potential. The risks are also limited to the premium paid Bear Spread payoff Profits

Sell a put

Buy a Put

Losses

The payoff from the long put spread can be better understood by way of an example. QRS stock is currently trading at 63.75 an investor is expecting a fall in the prices from 63.75 to 60.00 hence he buys a bear spread. He buys a put at 65 premium of 5.5 and sells a put at 60 for a premium of 3.25. The net cost of the put to the investor is 2.25 The Maximum gain will be spread minus the premium = 2.75 Breakeven will be higher strike premium If on the expiration date the stock is trading at 63.75 the long put will be exercised. The gain from the same will be 1.25. The net loss will be 1.00. The

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short put will not be exercised as the strike price is less than the market price, hence option is not in the money. At 62.75 There will be no profit no loss AT 60.00 The long put will be exercised. The gain from exercise being 5. Net profit being 2.75 At 59 both the puts will be exercises and the investor will pay on one put and receive on another o o o o o On long call he received 6 On short call he pays 1 Net receipt 5 Less the net premium paid of 2.25 Net gain of 2.75

Thus his profits are limited to 2.75. Reason .for trading in Bear Spreads Investor expects that the price will rise up to a certain level Wants to minimize the premium cost.

Spreads Exercise 1. How is a bull call spread created? 1. Buy a short-term call and sell a long-term call 2. Buy a call with a higher strike price and sell a call with a lower strike price 3. Buy a call with a lower strike price and sell a call with a higher strike price 2. Which of the following is an example of a bear put spread? 1. Buy 1 CDE Aug 120 put @ 7.50 Sell 1 CDE Aug 110 put @ 4 2. Buy 1 LMN 85 put @ 2 Sell 1 LMN 90 pt @ 3.75 3. Buy 2 JQQ 35 puts @ 2.25 Sell 1 JQQ 40 put @ 5 3. Assume you purchase the following bull call spread: Buy 1 STS 40 call 3.75 Sell 1 STS 45 call 1.75

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4. If the price of STS stock is $39 at expiration, what is the profit or loss from this bull call spread? 1. Profit of 3 2. Profit of 2 3. Loss of 2 4. Loss of 3.75

5. Assume you purchase the following bear put spread: Buy 1 EFG May 95 put @ 6.50 Sell 1 EFG May 85 put @ 2.25 If the price of EFG stock is $84 at expiration, what is the profit or loss from this bear put spread 1. Profit 6.50 2. Profit 5.75 3. Loss 4.25 4. Loss 2.25 6. Assume you purchase the following bull call spread Buy 1 ABC Nov 60 call 5.75 Sell 1 ABC Nov 65 call 3.50 If the price of ABC stock is $64 at expiration, what is the profit or loss from this bull call spread? 1. Profit 2.75 2. Profit 1.75 3. Loss 2.25 4. Loss 2.75

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SECTION 2- Exotic Options

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Average/Asian options
Definition :- An option whose payoff depends on the average of the underlying over the life of the option Can be Average Price:- The payoff is difference between the strike and average of the underlying price. Average Strike:- An option where the strike rate equals the average of the underlying index over the life of the option. The Strike is not set on onset. It is derived as the average of the underlying price. On expiration the current underlying price is compared with the average calculated and the payoff is determined Example:A multinational GBP based company has a large flow of foreign currency receipts over the year. While each individual receipt is difficult to forecast and only small, over the year the total USD income equals in excess of USD 25 million. The current spot rate is 1GBP = 1.50USD. Given the random timing of the cashflows and the small individual size, traditional FX options have proved to be impractical. The company can consider using an Average Rate Strike Option. The company is comfortable that the total income in one year will exceed USD 25 million. The company could purchase a 1 yr USD 25mm Weekly Average Strike Rate Put option at say 1.75%. Each week the USD/GBP spot rate would be noted from an agreed source at an agreed time. The strike rate for the option is then set at the end of the year at the calculated average rate and used to calculate the value of the option: USD 25,000,000 * (Spot at Maturity - Average Strike) * days/365 Assuming the average strike equals 1.43 and the USD/GBP spot rate at maturity is 1.60, the option payout would equal: USD 25,000,000 * (1.60 - 1.43) * 365/365 = USD 4,250,000 or GBP 2,656,250 The company achieves a general hedge against a falling USD at a reasonable cost.

Advantages Lower premium Customised General protection of small regular cash flows Accurate reflection of the underlying price over a period.

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Useful ways of protecting a series of cash flows against rate moves when the dates of receipts cannot be accurately predicted. Disadvantages General protection rather than specific

Barrier Option
Definition:-Barrier options are a family of options that either come alive or die when predetermined trigger points (barriers) are reached. Most available options can be adapted to be barrier options There are two major types Knock Ins and Knock Outs. Knock In options come alive when the barrier is reached. They can be Down and in: - Will come alive when the underlying price falls to a barrier level Up and in: - Will come alive when the underlying price rises to the barrier level Knock out options die when the barrier is reached. Down and out: - Will die when the underlying price falls to a barrier level Up and out: - Will die when the underlying price rises to the barrier level The barrier can be any tradable variable and may or may not be directly related to the underlying of the original option. These can be call or a put These can be either European or American options The Barrier can be either Inside Barrier: - Where the barrier relates to the price of the underlying asset Outside side barrier: - Where the barrier relates to price of another asset Pricing

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The price of a barrier option depends upon the probability of the barrier being reached, and the value of the underlying option if it is reached. They are therefore very sensitive to volatility. Advantages Cheaper than standard options Flexibility in setting the barrier level and thus the cost of the option Can be linked to any underlying Customised to clients exposures Disadvantages The rate protection is contingent upon an "independent" event

Binary options
Payout in case is fixed amount if the option is in the money at the time of expiration. Binary is zero or one, there are only two possibilities. Similarly in binary options if the option is in the money at the time of expiry then a fixed sum is paid. The level of underlying is irrelevant. They are also known as digital option Digital Options are relatively common. As volatility increases the digital options become cheaper compared to the conventional options as the there is only a fixed payout

Digital options can be Cash or nothing - Where the cash is paid if the option is in the money Asset or nothing: - Payoff is an asset if the option is in the money One Touch Digital: - If the barrier is reached anytime during the life of the option then buyer receives the payout 2 days after the expiry Instant one touch: - Buyer received a payout 2 days after the barrier is reached Digital Knock in: - Combination of digital and knock in. A fixed payoff if the option is in the money at the time of expiry and the barrier has been reached Digital Knock out: - Combination of digital and knock out. A fixed payoff if the option is in the money at the time of expiry and the barrier has not been reached

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Ladder Options
Definition :- With a Ladder option, the strike is periodically reset when the underlying trades through specified trigger levels, at the same time locking in the profit between the old and the new strike. The trigger strikes appear as rungs on a ladder. Ladder options can be structured to reset the strike in either one or both directions. The Ladder option is also known as a Ratchet option and Lock-In option. Example An investment fund that is bullish on the USD wants to buy USD calls. If the fund buys a European call it can only exercise the option at the maturity date. If it buys an American call though, it will face the problem of when to exercise the option. The fund decides to buy a Ladder Option with a strike of 1.65 and a ladder with rungs starting at 1.65, going upwards in steps of 5 pf to a maximum of 1.80. Now every time USD/DEM reaches a new rung, the strike will be reset to that rung and a 5 pf profit locked in. So if during the lifetime of the deal USD/DEM reaches its high at 1.7620, the highest rung reached will be 1.75 and the strike will thus be set accordingly, while the profit of 10 pf (1.75-1.65) will be locked in. At expiry the fund will receive the greater of (a)closing spot less original strike, and (b) highest rung reached less original strike. If in our example, the highest level was 1.7620 but the rate closes at 1.53, the fund will receive 10 pf only. If however the spot closes at 1.762, the fund will receive 11.2 pf. Pricing A Ladder Option can be viewed as a series of Knock-In and Knock-Out call and put options each struck at a different ladder level. Our above example is made up by combining a 165 call and a series of bought and sold Knock-In Puts (see "FX Knock-In Options"). Advantages Less risky than traditional options as profits locked in as underlying performs No need to constantly watch the underlying market levels Ladder options are applicable for risk averse option buyers as profits are progressively locked in without losing the option position. Disadvantages

More expensive than a normal option

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Cliquet Options
Defination :- A Cliquet Option settles periodically and resets the strike at the then spot level. It is therefore a series of at-the-money options, but where the total premium is determined in advance. A Cliquet can be thought of as a series of "pre-purchased" at-the-money options. The payout on each option can either be paid at the final maturity, or at the end of each reset period. Example A three year Cliquet Call on the FTSE with annual resets is a series of three annual atthe-money spot calls. The initial strike is set at say 3000. If at the end of year one, the FTSE closes at 3300, the first call matures 10% in-the-money and this amount is paid to the buyer. The call strike for year 2 is then reset at 3300. If at the end of year 2, the FTSE closes at 2900, the call will expire worthless. The call strike for year 3 is then reset at 2900. The alternative strategy would be to buy a one year at-the-money call and at the end of year one, buy another at-the-money one year call, and so on. The difference is that the cost of the Cliquet is known in advance, whereas the future cost of at-the-money calls is unknown. If volatility is LOWER than expected, the Cliquet will be more expensive than buying the calls annually, if volatility is HIGHER than expected, the Cliquet will be cheaper. A Cliquet option is therefore more attractive when volatility is expected to RISE. The major advantage of the Cliquet, is that the probability of some payout is high. Over the 3 year period, the chance that the market will close lower for three consecutive years, is much lower than the probability that the market will close lower at the END of three years i.e. there is a high probability that even if the market closes lower after three years, that it will have closed higher in at least one of the three years. Pricing A Cliquet is a series of at-the-money options. We can calculate the expected value of these options by generating the implied forward volatility curve (some methodology as generating implied forward interest rates. See "Implied Forwards"). The Cliquet premium is the present value of the premiums for the option series. A Cliquet call is always more expensive than a straight at-the-money call with the same final maturity. The number of reset periods is determined by the buyer in advance. More resets make the option more expensive. A Coupe is a cheaper alternative to the Cliquet (see "Coupe Options").

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The Cliquet is suitable for investors with a medium term investment horizon. It is less risky than ordinary medium term options, as there is less specific risk i.e. the reset facility gives the buyer a "second" and "third" chance. This increases the chance of payout, but must be balanced with the higher premium cost. As a series of "pre-purchased" options, the Cliquet is attractive to passive investors as it requires no intermediate management. They have traditionally been attractive to retail and private investors when embedded in deposits and bonds (see "Structured Assets ") as they provide a low risk (capital guaranteed) exposure to equity and Bond markets. Sophisticated investors use Cliquets to take advantage of future assumptions about volatility. Advantages There is a "second chance" as the strike is periodically reset Ideal medium term, passive investment Locks in the future cost of volatility Disadvantages More expensive than straight options with same final maturity

Lookback Options
Definition: - At maturity the buyer can "lookback" and set the most favorable strike to maximize profit between strike and maturity. Lookback Options are also known as Hindsight Options. There are two types of Lookback option: Set a strike at the start: - At maturity, the buyer can "lookback" over the life of the option and choose the most favorable exercise point to maximize profit between strike and exercise. Set a strike at maturity: - At maturity the buyer can "lookback" and set the most favorable strike to maximize profit between strike and maturity. Lookback Options are also known as Hindsight Options. Example An investor expects a sharp rise in the CAC 40 over the next year. A straight 1 year call with an at-the-money spot strike of 1900 would cost 236 points. A Lookback call strike 1900 would cost 343 points but would give the investor the opportunity to lookback at maturity and select the highest point reached by the CAC 40 as the exercise point thus maximizing profit. If the CAC 40 is higher than 1900 at any time over the year, the investor is assured of some payout. The lookback feature is thus very attractive to

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investors as it gives the buyer the best possible payout. However, Lookback options are generally very expensive. Pricing Since the option will always choose the highest profit available, the major determinant of the option price will be the volatility of the underlying. The more volatile the underlying, the higher the probability that the underlying will move dramatically enough to allow the investor a significant profit, therefore the higher the volatility the more expensive the Lookback. Lookback Options are applicable for risk averse investors unsure about timing of the move in the underlying. They are lower risk as there is a high probability of return. However, they do involve a larger upfront premium. Advantages

The buyer will always be able to lock in the most favorable profit that appeared during the life of the option

Disadvantages

The Lookback Option will require higher premiums than conventional options

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