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chapter 3

# chapter 3 - Chapter 3 Insurance Collars and Other...

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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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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
Long a Call 3 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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Short a Call 4 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
Long a Put 5 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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Short a Put 6 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
Long / Short Call / Put Options 7

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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 8
Insuring a Long Position: Floors A 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 0 (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! 9

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Example: S&R index and a S&R put option with a strike price of \$1,000 together 10
Combined Payoff / Profit 11

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Insuring a Short Position: Caps A 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 12
Example: short-selling the S&R index and holding a S&R call option with a strike price of \$1,000 13

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

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chapter 3 - Chapter 3 Insurance Collars and Other...

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