Week 2 - Chapter 3

# Week 2 - Chapter 3 - Chapter3:Insurance,Collars,...

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1 FINA0301  Derivatives Faculty of Business and Economics  University of Hong Kong Dr. Tao LIN Chapter 3: Insurance, Collars,  and Other Strategies

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2 Chapter Outline Basic insurance strategies:  insuring a long position: floors;  insuring a short position: caps;  selling insurance Synthetic forwards: put-call parity Spreads and collars: bull and bear spreads; box  spreads; ratio spreads; collars Speculating on volatility: straddles; butterfly  spreads; asymmetric butterfly spreads
3 Long a Call Long a call (strike price K, premium c) Value = 0 when S T ≤ K = - K + [ 1 ]S T when S T > K K -K S T Value FV (Initial cash flows) = - FV(c) < 0 - FV(c)

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4 Short a Call Short a call (strike price K, premium c) Value = 0 when S T K = K + [ -1 ]S T when S T > K K K S T Value FV(c ) FV (Initial cash flows) = +FV(c) > 0
5 Long a Put Long a put (strike price K, premium p) Value = K + [ -1 ]S T when S T ≤ K = 0 when S T > K K K S T Value K-FV(p) FV(p ) FV (Initial cash flows) = - FV(p) <0

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6 Short a Put Short a put (strike price K, premium p) Value = - K + [ 1 ]S T when S T ≤ K = 0 when S T > K K -K S T Value - K+FV(p) FV(p) FV (Initial cash flows) = + FV(p) > 0
7 Long / Short Call / Put Options

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8 Basic Insurance Strategies Insurance strategies using options:  Used to insure long positions ( floors ) Buying put options Used to insure short positions ( caps ) Buying call options Written against asset positions (selling insurance) Covered call Covered put
9  Insuring a Long Position: Floors put  option is combined with a  long  position  in the underlying asset Goal:  to insure against a  fall in the price   of the underlying asset At time 0 Buy one stock  at cost S (long position in the asset) Buy a put  on the stock with a premium p Buy an asset and a put generates a position  that looks like a call!

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10 Example: with a strike price of \$1,000 together
11 Combined Payoff / Profit

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12 Insuring a Short Position: Caps call  option is combined with a  short  position in  the underlying asset Goal: to insure against an  increase in the price  of  the underlying asset At time 0 Short  one stock at price S 0 Buy a call  on the stock with a premium c An insured short position looks like a  put
13 Example short-selling call  option with a strike price of \$1,000

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14 Combined Payoff / Profit
15 Selling Insurance For every insurance  buyer  there must be an  insurance  seller Strategies used to sell insurance Covered writing

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## This note was uploaded on 01/26/2010 for the course FINA 2802 taught by Professor Xia during the Fall '09 term at HKU.

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Week 2 - Chapter 3 - Chapter3:Insurance,Collars,...

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