Spreads

&

Combinations
Derivative Strategies
 Protective Put

 Covered Call

 Bull Spread

 Bear Spread

 Butterfly Spread

 Straddle

 Strangle

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Protective Put = Synthetic Long Call

Profit ($)
15

10

5
70 80 90 100
0
110 120 130 ST ($)
-5
-10 Loss ($) Insurance against fall in price of underlying asset
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Covered Call

Profit ($)
15

10

5
70 80 90 100
0
110 120 130 ST ($)
-5

-10
Loss ($)
Income Strategy. Neutral to moderately bullish
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Problem

If you write a covered call on a $40 stock with an exercise price of $50
for a premium of $2. what will be your maximum gain?

Solution
Covered call means buying a stock and writing a call.
Premium received = 2; Cash paid for buying stock = 40
Maximum gain will be when the option is not exercised and the stock
price reaches 50.
Then stock can be sold for 50 – 40 = 10
So Maximum gain = 10 + 2 = 12

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Bull Call Spread

 Bull : Bullish view. Expects rise in price of underlying asset

 Call : We are dealing with Call Options
 Spread : Combination i.e. more than one option, Long Call & Short Call
 X1 < X2
 Strategy limits upside and downside risk

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Bull Put Spread

 Bull : Bullish view. Expects rise in price of underlying asset

 Put : We are dealing with Put Options
 Spread : Combination i.e. more than one option, Long Put & Short Put
 X1 < X2

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Bear Call Spread

 Bear : Bearish view. Expects decline in price of underlying asset

 Call : We are dealing with Call Options
 Spread : Combination i.e. more than one option, Short Call & Long Call
 X1 < X2

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Bear Put Spread

 Bear : Bearish view. Expects decline in price of underlying asset

 Put : We are dealing with Put Options
 Spread : Combination i.e. more than one option, Short Put & Long Put
 X1 < X2

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Butterfly Spread

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Long Call Butterfly

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Short Call Butterfly

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Long Straddle

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Long Straddle

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Long Strangle

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Deriving the Forward Exchange Rate

 The spot rate HRK/EUR is 7.3000

 Three month interest rates are:
 1% on the Euro
 3% on the Kuna

 A bank today sells a 3-month HRK/EUR forward to

a company with EUR 1Mn and in need of HRK for
a forward exchange rate of 7.3368
 How did the bank compute the forward rate?
 Assume 360 days
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Deriving the Forward Exchange Rate

 A company with EUR 1 million and a need for

HRK in three months should be indifferent,
financially speaking, as to whether it:
 Invests the EUR 1 million for 3 months at 1% and
converts the euros (plus interest) into HRK at the
end of this time, or
 Sells the EUR 1 million spot for HRK, and invests
the HRK at 3% for 3 months

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Deriving the Forward Exchange Rate

OPTION 1 OPTION 2
Sell EUR 1 million spot at 7.30
Invest EUR 1 million at 1% Buy HRK 7.3 million
for 3 months (91 days) Invest HRK for 3 months at 3%

Interest earned HRK

Interest earned EUR 55,358.33
2,527.78 (7.3 million x 3% x 91/360)

Value after 3 months Value after 3 months

EUR 1,002,528 HRK 7,355,358

Forward Exchange Rate: 7.3368

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FRA = Forward Rate Agreement
 An FRA (forward rate agreement) is a contract between two parties to lock in
a forward interest rate, for a period, starting at a specific date in the future.
 For example, a 6 v 9 FRA is a contract that begins 6 months from now and
ends after 9 months from now, i.e., lasts for 3 months.
Notation Effective Date from now Termination Date from now Underlying Rate
1x4 1 month 4 months 4-1 = 3 months LIBOR
1x7 1 month 7 months 7-1 = 6 months LIBOR
0x3 Today (SPOT) 3 months 3-0 = 3 months LIBOR
3x6 3 months 6 months 6-3 = 3 months LIBOR
3x9 3 months 9 months 9-3 = 6 months LIBOR
6 x 12 6 months 12 months 12-6 = 6 months LIBOR
12 x 18 12 months 18 months 18-12 = 6 months LIBOR

 Gains or loss…
Interest Rate Rises Interest Rate Falls
FRA Buyer Winner (Gain $) Loser (Pay $)
FRA Seller Loser (Pay $) Winner (Gain $)
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FRA Example
 Ford has a $20 million Eurodollar deposit maturing in two months that it
plans to roll over for a further six months. The company's treasurer feels that
interest rates will be lower in two months time when rolling over the deposit.
Suppose the current LIBOR6 is 7.875%. How can Ford use an FRA at
7.65% from Citibank to lock in a guaranteed six-month deposit rate when it
rolls over its deposit in two months?
 Ford today can enter into the FRA and guarantee itself a six-month deposit rate
in two months time of 7.65%.
 Specifically, Ford will sell a "2 x 8" FRA on LIBOR at 7.65% to Citibank for a
notional principal of $20 million.
 This means that Citibank has entered into a two-month forward contract on six-
month LIBOR.
 Two months from now, if LIBOR6 is less than 7.65%, Citibank will pay Ford the
difference in interest expense.
 If LIBOR6 exceeds 7.65%, Ford will pay Citibank the difference.

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FRA Example

 If after two months, LIBOR6 has fallen to 7.5%. How

much will Ford receive/pay on its FRA? What will be
Ford's hedged deposit rate for the next six-month
period?
 In this case, Ford will receive from Citibank $20,000,000 x (0.0765 -
0.075)/2 = $15,000, giving it an annualized hedged deposit rate of 7.65%
for the next six months.
 If in two months, LIBOR6 has risen to 8%. How much
will Ford receive/pay on its FRA? What will be Ford's
hedged deposit rate for the next six months?
 Ford will pay Citibank $20,000,000 x (0.08 - 0.0765)/2 = $35,000, giving
it–as before– an annualized hedged deposit rate of 7.65% for the next
six months.

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Problem

An FRA which expires in 30 days is based on a notional

principal of $100,000 and 90 days LIBOR. The rate quoted is
4%. The actual rate 30 days from now is 5%. What is the cash
settlement at expiration?

Solution
Compensation to the long = (.05 - .04) x 90/360 (100,000)
= $ 250
But this compensation will apply at the end of the loan period.
Discounted value = 250/[1+(.05)^(90/360)]
= $246.91

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Problem

Consider a $1 million FRA with a contract rate of 5% on 60 day

LIBOR. If the 60 day LIBOR is 6% at settlement, how much will
the long receive?

Solution
Compensation = (1,000,000) (0.06 -0 .05) (60/360)
= 1,667 at the end of the loan period
= 1667 / [1 + (0.06)^(60/360)] = 1650
at the expiration of the FRA
Ans: $ 1650

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Currency Swap

 A currency swap involves exchanging principal and

interest payments in one currency for principal and
interest payments in another currency.
 It requires the principal to be specified in each of the
two currencies.
 Usually, the principal amounts are exchanged at the
beginning and at the end of the life of the swap.
 Exchange will be on Exercise Date (ED) at the prevailing
spot rate
 Re-exchange will be on Termination Date (TD) at the same
Fx rate as on ED
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Typical Uses of a Currency Swap

 To convert a liability in one currency into a liability in another

currency.

 To convert an investment (asset) in one currency to an

investment in another currency.

 There are four types of basic currency swaps:

 fixed for fixed.

 fixed for floating.

 floating for fixed.

 floating for floating.

 Note: It is the interest rates that are fixed or floating.

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Currency Swap example
Say principal of 1 € is exchange for 1 $

ED 1 EUR Principal exchange on ED Fx rate? Spot = say 1€=$1.3

1.3 USD

USD(on $1.3)
A B interest exchange (a series of them)
EUR (on €1)

$1.3USD
TD Principal re-exchange on TD Spot = say 1€=$1.4
1 EUR

Exchange will be on ED at the prevailing spot rate

Re-exchange will be on TD at the same Fx rate as on ED

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Currency Swap : Example
 ABC Tech enters into currency swap with XYZ Tech for
€10mn on 27th June 2002 when spot rate was
1€=$0.9804
 ABC Tech will pay euros at 4.35% based on Notional
Principal value of €10mn semi-annually for two years.
 XYZ Tech will pay dollars at 6.1% based on Notional
Principal value of $9.804mn semi-annually for two years.
 Notional amounts will be exchanged.
 On termination date, the notional amounts will be re-
exchanged.

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Currency Swaps : Example
ABC Tech

XYZ Tech
Chandrashekar Kupperi 28
 shekar.kupperi@gmail.com

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