7.

Chapter Seven: Introduction to Derivative Securities and Markets

7.1. Introduction
Assets are traded in the cash or spot market. It is sometimes advantageous to enter into a
transaction now with the exchange of asset and payment at a future time. The advantages here
include: risk shifting, price formation and investment cost reduction. A derivative instrument is
an instrument whose value depends directly on, or is derived from, the value of another security or
commodity, called the underlying asset. Derivatives include options, as well as forward and futures
contracts. Options offer the buyer the right without obligation to buy or sell at a fixed price up to or
on a specific date. Forward and Futures contracts, on the other hand, are agreements between two
parties whereby the buyer agrees to purchase an asset from the seller at a specific date at a price
agreed to now. Forward contracts are the right and full obligation to conduct a transaction involving
another security or commodity - the underlying asset - at a predetermined date (maturity date) and
at a predetermined price (contract price). Futures contracts are similar, but subject to
‘standardization’ and daily settling-up process.

7.2. Option Contracts

An option contract gives the holder the right-but not the obligation-to conduct a transaction
involving an underlying security or commodity at a predetermined future date and at a
predetermined price (In general terms an option contract gives the holder the right, but not the
obligation to do something).Options are generally valuable; the phrase "we are out of options" is
surely a sign of trouble. In investment context options are a valuable tool in managing portfolio risk.
Most options in the developed world are traded on exchanges with the underlying assets being
commodities (such as in CBOE PHLX and CME in the US) or securities (such as in the NYSE and
AMEX in the US). Options on assets other than stock are also widely traded. They include:
 Index options which have a stock index such as the S&P 500 or DJIA as the underlying
asset. Since indices are undeliverable, the options written on them are settled in cash
instead of delivery of the index,
 Futures options which give the holder the right to buy or sell a specified futures contract.
(Remember futures contracts are obligations to buy or sell, not options),
 Foreign currency options which give the holder the right but not the obligation to buy or
sell a specified amount of a specific foreign currency for a specific amount of time
There are some other options which are not listed in exchanges. They include Exotic Options
which are mainly products of financial engineering with payoffs that are more diverse than on plain
vanilla options – whose value at any particular point of time depends only on the prevailing price of
the underlying asset. Some exotic options include:
 Compound options are options on options
 Asian options are options whose payoff depends upon the average price of the underlying
asset during at least some portion of the life of the option
 Barrier options have payoffs that depend not only on some asset price at expiry, but also
on whether the underlying asset price has crossed through some "barrier". For example, a
down and out option expires worthless if the stock price falls below a certain amount at any
time before expiry
 Lookback options have payoffs that depend in part on the minimum or maximum price of
the underlying asset during the life of the option
 Currency-translated options have either asset or exercise prices denominated in a
foreign currency
 Binary options have fixed payoffs that depend on whether a condition is satisfied by the
price of the underlying asset
 Digital options have fixed payoff amount regardless of how deep in the money the contract
is at expiration

Chapter 7: Options and Swaps Page 1 of 14

Many securities have explicit or implicit options attached. To value these option-like securities, it
is important to recognize their optionality. The following are just a few examples:
 Callable Bonds are bonds that allow the issuer the option to buy the bonds back from the
investor, typically for par value plus one year’s interest. When the investor bought the
bonds in the first place, he got a better coupon rate (or a lower price) than investors in
otherwise identical bonds. This price difference was the value of call option
 Convertible Securities are bonds that allow the bondholder the option to buy a certain
number of shares of the issuer’s stock; the exercise price is the surrender of the bond.
When the investor bought the bonds in the first place, he got a worse coupon rate or a paid
a higher price than investors in otherwise identical bonds. This price difference was the
value of conversion option
 Warrants are call options issued by the firm. The only difference between warrants and
other call options is that when warrants are exercised, the firm issues new shares, which
dilute the claims of existing shareholders
 Collateralized loans whereby the borrower who pledges collateral to get a loan also gets a
call option on the collateral. The borrower has the right but not the obligation to buy the
collateral back, the exercise price of the option is the payoff of the loan, and the maturity of
the call is the maturity of the loan.
 Levered Equity and Risky Debt in which the stockholder in a levered firm gets a call
option on the assets of the firm. The stockholder has the right but not the obligation to buy
the assets of the firm, the exercise price of this call option is the payoff of the loans, and the
maturity of the call is the maturity of the loans.

7.3. Option Contracts, Positions and Clearing

Exchange traded options are “structured” or standardized. For example NYSE traded options are
written on 100 shares of a specific stock; they expire on Saturday following the 3rd Friday of
expiration month and the exercise style and settlement procedures are also specified. American
options can be exercised at any time up to and including the expiration date; European options
can ONLY be exercised at the expiration date. Most traded options in the U.S. are American style.
Foreign currency options and some stock index options are the exceptions to this rule.
To ensure that parties to option’s contracts fulfill their obligations, a central clearing facility is used
in option trading. The clearing facility places itself between options traders, becoming the effective
buyer of the option from option sellers and the effective seller of the option to option buyers. The
clearing house thus absorbs the risk of counterparty default. (In the U.S. the Option Clearing
Corporation (OCC) is the issuer and clearing facility for all U.S. exchange-listed securities
options. It operates under the jurisdiction of the Securities and Exchange Commission (SEC),
which oversees securities market in the U.S.)
There are two types of options: puts and calls. A PUT (CALL) option gives you the right, but not
the obligation to SELL (BUY): (Q) shares of a specified stock; at a specific price (the exercise or
strike price) and within or at the end of a specific period of time (the maturity). A handy way to
remember this is that if you exercise your put option, you are putting it onto somebody while if you
exercise your call option, you are "calling in" the shares.
Buying an option is taking a long position while selling an option is taking a short position. A
long call involves buying/holding a call option while a short call involves selling/writing a call option.
Similarly, a long put involves buying/holding a put option while a short put involves selling/writing a
put option.
Table 1 gives a hypothetical Wall Street Journal option price quotes for Call and Put options on
YGX stock as on, say, 10th of September.

Chapter 7: Options and Swaps Page 2 of 14

Table 1: Hypothetical Example of a Wall Street Journal Option Price Quotes for YGX Stock
on 10th September
Recent Strike Expiration CALL Option PUT Option
Price Price Month Volume Last Price Volume Last Price
138.25 130 October 364 15.25 107 5.25
138.25 130 January 112 19.50 420 9.25
138.25 135 July 1365 4.75 2431 0.8125
138.25 135 August 1231 7.25 94 5.50
138.25 140 July 1826 1.75 427 2.75
138.25 140 August 2193 6.50 58 7.50

Let us take the highlighted row as an example. It tells us that:

i. Recently the underlying asset (i.e. IBM) stock traded at $ 138.25
ii. The option in question has a strike (exercise) price of S135.00
iii. July is the expiration month for the option
iv. On this day 2,365 call options with this exercise price were traded.
v. The CALL option with a strike price of S135.00 is trading for $4.75; Since this option is on
100 shares of stock, buying this option would cost $475.00 plus commissions.
vi. On this day 2,431 PUT options with this exercise price were traded.
vii. The PUT option with a strike price of S135.00 is trading for $0.8125; Since this option is on
100 shares of stock, buying this option would cost $81.25 plus commissions.

7.4. Option Value, Payoff and Profit Profiles

7.4.1. Option Value
If immediate exercise of an option is profitable, the option is said to be in-the-money. A call option
is in-the-money if the exercise price of the option is less than the current price of the stock while a
put option is in-the-money if the exercise price of the option is more than the current price of the
stock. In Table 1 the call option is in-the-money by $3.25 (i.e. $138.25-$135.00) while a put option
with the same exercise price is out-of-the-money. The value by which the option is in-the-money is
also known as the intrinsic value of the option. (An option is out of the money when exercise
would be unprofitable while it is at-the-money when the exercise price and the security’s price are
equal)
Buying a call is bullish: if the stock price goes up above the exercise price, the holder of a call
option profits. Buying put options is bearish: the holder of a put option profits from declines in
the stock price. Columns 5 and 7 give the premium (price) of the options given their exercise
prices and expiration dates. The prevailing market price is not a variable in an option contract but it
does influence the level of the premium.
At expiration an option is either in-the-money or out-of-the-money. A call option is in-the-money if
the exercise price of the option is less than the current price of the stock. That is, you can make
money by exercising the option and pay the exercise price then turn to the market and sell the
stock at a higher price. A put option is in-the-money if the exercise price of the option is more than
the current price of the stock. It is worthwhile to exercise an option only if it is in-the-money.
As pointed out, options have two sources of value: intrinsic value and time value. The payoff that
would accrue from immediate exercising an option is the intrinsic value of an option. It represents
the value that the buyer could extract from the option if he or she exercised it at that particular time.
Consider an option with an exercise price X. If at expiration the option is in the money and stock’s
price is ST then the option’s payoff is the absolute value of ST –X. If at expiration the option is not
in-the-money the option expires worthless, hence a zero payoff.
Here is a simple example based on the information in Table 1: If you are holding a call option with
an exercise price of $135 on a share that is currently trading at $138.25, the call option has $3.25
worth of intrinsic value. If the price is below $135 the option has no intrinsic value since it will not
be exercised.

Chapter 7: Options and Swaps Page 3 of 14

The time value of an option, also known as the speculative value, is the difference between the
option premium (i.e. the price of the option) and the intrinsic value of the option. If the above call
option is selling for $4.75 the time value of the option is $1.50 (i.e. $4.75 minus $3.25). Notice that
though the PUT option is out-of-the-money its price is not zero (or negative!). The entire price in
this case represents the time value of the option.

The intrinsic value is the pay-off of an option. Figure 1 presents an example of a call option’s pay-
off and market price – hence also the time value. In the figure, the horizontal axis represents the
market price of the security at time T (ST) while the vertical axis represents the payoff accruing to
the option holder if it is exercised at the exercise price (X). Note that an option has intrinsic value
only when it is in-the-money and that the presentation of the pay-off does not take into account the
initial premium.

Figure 1: The Pay-off Profile for an American Call Option

Market value
Time value
Pay-off ST-X

{ Intrinsic Value
} Price of
the asset
Out-of-the Money X In-the-money
Loss

7.4.2. Option Payoff and Profiles

The option profit profile considers both the pay-off and the initial premium (i.e. the amount used
in establishing a long position or derived from a short position). Let’s use an example. Consider an
option on TBX share with an exercise price (X) of shs 500. A call option is selling at a premium of
shs 100 while a put option is selling at a premium of shs 50. For an investor buying a call option,
the premium (price) paid to acquire the option (shs100) is a committed cost and it represents the
loss accruing to the holder if, at expiration, the option is not in-the-money and hence not exercised.
Thus, if at expiration date the stock’s price (ST) is below the exercise price (shs 500) the call option
holder’s loss is equal to the amount paid to acquire the option (shs100) and does not depend on
the extent to which the prevailing price is below the exercise price X. Once the price passes the
shs 500 mark the option is in-the-money giving a net profit to the option holder equal to the intrinsic
value of the option (ST-E) minus the option’s cost. The line in Figure 2(a) (horizontal at negative
shs 100 and sloping upward to the right after shs 500) represents the loss or profit to the holder of
a call option. This line is the option’s profit profile (The options’ profit profiles are often referred to
as “hockey sticks” because they look like the sticks used to play hockey!)
A short position (i.e. selling an option) reverses the situation such that the pay-off for short position
is the negative of the counterpart long position. These are summarized as follows:

Table 2: Summary of Option Pay-offs

LONG POSITION SHORT POSITION
CALL Max[ST-X, 0] Min[-(ST-X), 0]
PUT Max[X-ST, 0] Min[-(X-ST), 0]

Chapter 7: Options and Swaps Page 4 of 14

 7.4.3. Option Profit and Profiles

To get the profits one needs to deduct the premium from the long position pay-offs or add the
premium to the short position pay-offs.

We saw above that a put option is in-the-money when at expiration the price of the underlying
stock is below the exercise price. Figures 2c and 2d show the profit profiles for long and short put
option positions respectively. Notice that an investor selling a call option with an exercise price of
shs 500 for shs 100 has a profit profile similar to the line in Figure 2b (horizontal at positive shs 100
and sloping down to the right after shs 500).

Figure 2: Profit Profiles

2 (a) Long-CALL 2 (b) Short-CALL

Profit Profit
Profit or loss from buying a
CALL with an exercise Profit or loss from selling a
price of shs 500 for shs 100 CALL with an exercise
price of 500 for 100
100
0 0
ST ST
100
500
Loss 500 Loss 600
600

2 (c) Long-PUT 2 (d) Short-PUT

Profit Profit
Profit or loss from buying Profit or loss from selling a
a PUT with an exercise PUT with an exercise price
450 price of 500 for 50 of 500 for 50

0 ST 0 ST
50
100
Loss
Loss 450 500 450 500
450

Three things are worth noting in the payoff profile. First, once the security’s price passes the
exercise price, the profit or loss changes one-for-one with change in security’s price. Second, for a
call option and a put option with the same exercise price, the profit line from buying a call option
“mirrors” the profit line from selling a call (with the horizontal axis being the mirror). Third the profit
or loss from a put option is limited while that of a call is not. For example, if you have a long
position in a put option with a strike price, the maximum payoff is X which is when a worthless
security is sold to the put writer for X.

CONCEPT CHECK 1: Draw the option profit profile for selling a put option with an
exercise price of shs 600 for shs 50)

Chapter 7: Options and Swaps Page 5 of 14

 7.5. Option Strategies
7.5.1. An Overview
The option profiles show that the profit from an option depends on the price of the underlying
security. On the one hand, the holder of a call option, for example, profits if the stock price goes up
above the exercise price. On the other hand, when the call option is not in the money, the holder’s
loss is limited to the cost of acquiring the option. This has some major implications. First, buying an
option may be viewed as a substitute for buying (for a call option) or selling short (for a put option)
the underlying asset. Second, which builds on the first, is that options can be seen as levered
equity – that is borrowing money to buy a stock can have a similar payoff to a call option. Third, by
combining puts and calls with various exercise prices, almost any payoff profile can be achieved.
Below are some option strategies

7.5.2. Protective Put

This strategy involves buying a put option for a security that an investor is holding and is employed
by a holder of a security who is interested in limiting the downside risk arising from movement in
the price of the security. Consider an investor who has just bought a stock for shs 400. His
potential profit or loss is given by the broken line in Figure 4. Notice that a gain is achieved when
the price rises above the purchase price while a loss results when the price falls below the
purchase price. If the investor buys a put option for the same stock with an exercise price of shs
500 for shs 50 the option’s profit profile is given by the double-line (sloping down to the right up to
shs 500 and horizontal at negative 50). Since the investor owns both the stock and a put option on
the stock, his overall profit profile involves combining the two profiles with the end result being a
profile represented by the solid line (horizontal at shs 50 and sloping upward to the right from shs
500 in figure 3 below)

Figure 3: Protective Put Strategy

Buy the Stock at 400

450

Protective Put Strategy has

downside protection and
upside potential
0
Buy a put with
400 500 Exercise price of
500 for 50

-400
Since at the onset the investor is buying both the stock (at S0) and a put option (at P0) the initial
investment is equal to S0 + P0 (or shs 450 in the above example). If at the expiration date (which is
also the end of the investor’s investment horizon) the prevailing price (ST) is greater than the
exercise price (X) the put option is out of the money: the option expires and the investor sells the
stock at market price and gets ST. The investor’s profit is ST – (S0 + P0) or ST –450. If at the
expiration date ST < X, the put option is in the money: the investor exercises the option giving a
profit of X – (S0 + P0) or 50 (i.e. 500-450). Put differently, X is the lower limit of ST since when the
stock is at any price below X the put option is in the money and exercising it guarantees the price
X. Thus the lowest payoff is 50.
In general, a protective put in effect puts a downside limit (equals to X - S0 - P0) on investor’s
holding but also leaves the upside potential open (as ST – S0 - P0). The upside pay off however,
falls short of the one realizable from holding only the stock by an amount equal to the cost of
acquiring the put option.

Chapter 7: Options and Swaps Page 6 of 14

 7.5.3. Covered Call and Covered put
A covered call strategy involves writing a call option on a security held. The motivation is to pocket
the option premium without much downside risk. Consider the investor in the above example. Now
suppose instead of buying a put option, the investor sells a call option with an exercise price of
shs. 500 for shs.100. The profit profiles for this strategy are shown in Figure 4 below. The
investor’s position is covered in the sense that he also has a long position in the stock. If the price
rises above the exercise price and the option is exercised against him, he will have the stock to
meet his obligation in the option contract. The investor’s downside losses are also reduced by the
amount he pockets from writing the call option. The worst thing that can happen to the writer of a
covered call is that the stock price goes to zero, wiping out the writer’s investment in the firm but
leaving him with the proceeds from selling the call option.
In effect, a covered call limits both upward potentials (to X+ C0-S0) and downward losses (to C0-S0)
Figure 4: Covered Call Strategy

Buy the stock at 400 Covered Call

200
100
0

300 500

400 Sell a Call with an

-300 Exercise price of
500 for 100
-400

A covered put strategy involves writing a put option with an offsetting short position in the
underlying security. When the put option is exercised against the writer, the security is used to
close the short position. On the other hand, a writer of a naked put does not have an offsetting
short position in the security for hedging purpose.

7.5.4. Other Option Strategies

7.5.4.1. Straddle
A straddle involves buying or selling both a call and a put option on a security, each with the same
exercise price and the same expiration date. Buying a put and a call creates a long straddle
position while selling a put and a call leads to a short straddle position. A long straddle is useful
for investors who believe that the stock will move a lot in price but are uncertain about the direction
of the move. Suppose you believe an important court case that will make or break a company is
about to be settled and the market is not yet aware of the situation. The stock will either double in
value if the case is settled favorably or will drop by half if the settlement goes against the company.
Figure 5, which is based on the earlier example (X=500, P0=50 andC0 =100), shows that a long
straddle will do well regardless of the outcome because its value is highest when the stock price
makes extreme upward or downward moves from the exercise price. However, the price must
deviate substantially from the exercise price – specifically the deviation must exceed the combined
cost of the put and call options for a profit to be made.

Chapter 7: Options and Swaps Page 7 of 14

Figure 5: Long Straddle: Buy a Call and a Put (X=500)

Buy a Call with an

Exercise price of
500 for 100
Long Straddle

0
100
150 350 Buy a Put with an
450 600 Exercise price of
500 500 for 50
650
This long straddle only makes money if the stock price moves shs 150 away from shs 500. A short
straddle is often taken by investors who believe that the stock price will not change much before
expiration.
CONCEPT CHECK 2: Graph the profit and payoff diagram for a short straddle with
P0=50, C0=100 and X=500)

Strips and Straps are variations of straddle. A strip is two puts and one call on a security with the
same exercise price and expiration date. A strap is two calls and one put.

7.5.4.2. Strangle
A strangle is like a straddle – consisting of a put and a call option on the same underlying asset
and with the same expiration date – but with different exercise prices. Typically the put option will
have a lower exercise price while the call will have a higher exercise price. . The payoff pattern is
similar to that of a straddle but with a flat bottom (for a long strangle) or a flat top (for a short
strangle)

7.5.4.3. Spreads
Spreads are combinations of two or more call options (or two or more puts) on the same stock with
different exercise prices or maturity dates. A long spread involves combining short and long calls
on the same stock and with the same expiration date – but not necessarily with the same strike
price. Figure 7 shows a long spread position involving buying a call with an exercise price of shs.
500 for shs.100 and simultaneously selling a Call with an Exercise price of shs. 550 for shs 50.

Figure 7: Long Spread Position

Profit
Buy a call with an
exercise price of
500 for 100
LONG CALL SPREAD
50
0 Combined Payoff
-50
-100
Sell a Call with an
Loss 500 Exercise price of
600 550 for 50
550
The concept of butterfly spread relates to [at least] three prices one of which is misaligned such
that one of the prices serves as pivot while the other (two) prices represent the tips of the wings.
The misalignment is not expected to last for long and the wings of any (butterfly) spread created
will ultimately flap bringing all of the prices into line.
Chapter 7: Options and Swaps Page 8 of 14
 7.6. Levered Equity Position and the Put-Call Parity
7.6.1. Levered Equity Position

Simply stated, levered equity position involves borrowing to buy a stock. Consider an investor, A,
borrowing an amount, S0, at interest rate, rf , to be repaid at time T such that the total repayment
equals X. The borrowed amount, S0, is then used to buy a stock. At time T investor A’s payoff is
equal to the amount realizable from selling the stock, ST, minus the loan repayment X. (i.e. at any
given price level the payoff is ST-X). With a fully levered position, investor A is able to set up the
position with no cash outlay of his own. This, however, requires that S0= X/(1+ rf)T a condition
which may be difficult to satisfy in real life because, latter on, X is to denote a known quantity
representing a specific strike price. To generalize we relax the fully levered position and assume
that investor A borrowed an amount X/(1+ rf)T, which is different from the price of the stock (S0) but
has repayment amount (at time T) that is equal to the exercise price. Thus, Investor A’s cash outlay
(equity) that is needed to set up a position guaranteeing an amount ST-X at time T is equal to S0-
X/(1+ rf)T
Using options it is possible to create a position with a payoff that is equal to the price of the stock at
expiration, ST, minus the options’ exercise price, X. This is how it is done: Consider an investor B
who buys a call option on a stock and simultaneously writes (sells) a put option on the same stock.
Both options have the same exercise price (X) and expiration date (T). The investor pays C0 to buy
the call option and pockets P0 from the put option sold making the necessary cash outlay needed
to set up the position equal to C0-P0. If at expiration the stock’s price (ST) is above the exercise
price the call option is in-the-money giving a payoff of ST-X while the put option is out of the money
with a zero payoff. If at expiration the stock’s price (ST) is equal or below the exercise price the put
option will be exercised giving the investor a loss (negative payoff) of X-ST while the call option
expires worthless. The payoff pattern for investor B’s position can be summarized as follows:

PAYOFF \ If at expiration the stock’s price (ST) is ST≤X ST>X

Payoff of the written put (X-ST)* 0
Payoff of the call option held 0 ST-X
TOTAL ST-X ST-X
*The brackets indicate minus

The payoff pattern for investor B shows that the position from buying a call option and
simultaneously writing (selling) a put option on the same stock with the same exercise price (X)
and expiration date (T) is always equal to ST-X. This is also the payoff pattern for investor A, who
has a levered position.

7.6.2. The put-call Parity

The equality of the payoffs of the two investors has one major implication: Because the payoffs are
identical the cash outlay needed to set up the positions must also be equal. This is the essence of
the PUT-CALL parity.
 With a fully levered position, investor A is able to set up the position with no cash outlay of
his own. This means that investor B need no own funds to set up her position. The relation
C0-P0 =0 or specifically C0=P0, therefore, holds1. Here the Put-Call parity has the form
C0=P0
 Since full levered position is not always possible for investor A, we assume A also has
equity in the investment. This makes A’s cash outlay equal to S0-X/(1+ rf)T with the Put-Call
Parity taking the form: C0  P0  S 0  X (1  r ) T . Since the price of stock changes
continuously, the practice is to assume continuously compounding interest.

1
To get a clear picture draw the profit profile diagrams for a portfolio with a long call and a short put. You will get the
same payoff profile as fully levered equity.
Chapter 7: Options and Swaps Page 9 of 14
 Box 1: Continuous Compounding
Continuous compounding is generally used when working with option valuation.
Suppose the annual interest rate is r% and it compounds semi annually. The gross
2 2
 r  r
value of TZS1.00 is 1   and the equivalent annual rate is estimated as 1    1
 2  2
Similarly the future value interest factor for T years with semi-annual compounding is
qT
 r
2T
 r
1   . The latter expression is generalized as 1   if interest is assumed to
 2  q
compound q times per annum. With continuous compounding q is a very large value
 r
which makes the expression 1   very close to unit (1) and qT a very large number.
 q
With some few mathematical assumptions and manipulations our general expression
is now reduced to e rT .
To practice, work on the following concept checks:
 What is the present value of shs 100 to be received in three months if the
required return is 8%, with continuous compounding?
 What is the future value of shs 500 to be received in nine months if the
required return is 4%, with continuous compounding?

Put-Call Parity with Continuously Compounding Interest

With continuously compounding interest, the equality of the cash outlays implies that2:
C0  P0  S 0  Xe  rt which is also written as C0  P0  Xe  rt  S 0 This relationship is the
essence of the put-call parity theorem: If it is violated arbitrage opportunities will exist.
The relationship can be rearranged in different ways. This rearrangement that represents the
philosophical justification for the put-call parity is:
C0  Xe  rt  P0  S 0
This expression implies that, at the onset of the strategy, the right to buy a stock, C0, coupled with
the ability to buy the stock (represented by the present value of the exercise price, XerT) must be
equal to the right to sell a stock, P0, coupled with the ability to sell that stock, S0. Thus, in a market
equilibrium it must be the case that the option prices are set such that C0  Xe  rt  P0  S 0
Otherwise riskless portfolio with positive payoff exist.
The Put-Call Parity is a very important concept and is critical to the valuation of many different
types of derivative securities. Given the value of a call option, we can use put-call parity to value a
put option as: P0  C0  Xe  rt  S 0 or a call option C0  P0  S 0  Xe  rt depending on the
information at hand.
The critical concept for option strategy is the replicating portfolio intuition. The idea is that we can
replicate the payoffs of a call with a levered equity position. Since we can value the levered equity,
we can value the call. The replicating portfolio intuition also gives us Put-Call parity and much
more.

2
Notice that we are using t (and not T) to denote the time remaining until the option contract expires which, assuming
annual interest rate, is expressed as a fraction of a year
Chapter 7: Options and Swaps Page 10 of 14
Figure 8: Put Call Parity
Buy the Stock at 400
Profit
Buy the Stock at 400
financed with some
debt
Sell a put with an
P0 exercise price of 400

0 Buy a call with an

exercise price of
-C0 400 for C0

400
-[400-Xe-rT] 400+C0
-[400- P0]
-400

CONCEPT CHECK 5:
a) Consider a call option that sells for shs.67.30 written on a stock price whose price
is shs. 500; the strike price is shs 450; the stock pays no dividends; the risk-free
rate is 10%; the volatility is 28%; and the maturity is 3 months. What must the
value of a put option written on the same stock with the same maturity, and
exercise price be?
b) You have found the following information: Share price = shs. 600; Exercise price =
shs. 650; Call price = shs.30; Put price = shs. 70; and expiration is in 6 months.
What is the risk-free rate implied by these prices?

7.7. Introduction to Swaps

7.7.1. An Overview
A swap may be defined as an agreement between two parties to exchange cash flows related to a
specific underlying obligation at an agreed period of time. The agreement defines the date when the
cash flows are to be paid and the way that they are to be calculated. The parties may need to enter
into such agreement due to market conditions and company’s risk profile. However, for a successful
swap, both parties should be able to perceive it as beneficial. Swap arrangements may be made
with or without involvement of an intermediary.
Financial swaps are now used by multinational companies, commercial banks, world organizations,
and sovereign governments to minimize currency and interest rate risks. These swaps compete with
other exchange risk management tools, such as currency forwards, futures, and options, but they
complement these other instruments.
Parallel and back-to-back loans attained prominence in the 1970s when the British government
imposed taxes on foreign currency transactions to prevent capital outflows. A parallel loan refers to
a loan which involves an exchange of currencies between four parties, with a promise to re-exchange
the currencies at a predetermined exchange rate on a specified future date. In a parallel loan, the
parties consist of two pairs of affiliated companies: for example, two multinational parent companies
and two affiliates in two different countries.
A back-to-back loan refers to a loan which involves an exchange of currencies between two parties,
with a promise to re-exchange the currencies at a specified exchange rate on a specified future date.
Back-to-back loans involve two companies domiciled in two different countries.
A number of problems of parallel and back-to-back loans limit their usefulness as financing tools.
 It is difficult to find counterparties with matching needs.
 One party is still obligated to comply with such an agreement even if another party fails to
do so.
Chapter 7: Options and Swaps Page 11 of 14
  Such loans customarily show up on the books of the participating parties.
Currency swaps can overcome these problems fully or partly, and this explains their rapid growth.
Currency swaps largely resolve the problem of matching needs because they are arranged by
specialized swap dealers and brokers who recruit prospective counterparties.
With currency swaps, the right of offset is usually embodied in the agreement. With currency swaps,
the principal amounts usually do not show up on the participants' books.
 Salomon Brothers arranged the first currency swap in August 1981 with the World Bank
and IBM as counterparties.
 The first interest rate swap was put together in London in 1981, and its use spread to the
United States the next year.
 The swap concept was extended in 1986 when the Chase Manhattan Bank introduced the
commodity swap.
 In 1989, Bankers Trust introduced the first reported equity swap. Equity swaps are the
newest type of swap and are a subset of a class of instruments known as synthetic equity.
Equity swaps generally function as an asset swap that converts the interest flows on a bond
portfolio into cash flows linked to a stock index.

The main types of swaps are Interest rate and the Currency swaps. Others which may fall under
either interest rate or currency swap or combination of both includes amortizing swap, step-up swap,
deferred/forward swap, cross currency swap, extendable swaps, puttable swaps, swaption,
differential swap and equity swaps.
 Interest Rate Swap is an arrangement commonly used to alter the exposure to interest rate risk,
caused by fluctuations in interest rates. The most common interest rates swap is plain vanilla
coupon swap, where parties agree to exchange interest payments on a “notional” amount of
principal at regular interest payments dates throughout the life of the swap, usually from fixed to
floating, or from floating to fixed.
 Currency Swap in its simplest form, involves exchanging principal and interest payments in one
currency for principal and interest payments in another currency. The principals are exchanged
at the beginning and the end of the swap life, at agreed exchange rates. This arrangement is
useful where the parties have different borrowing opportunities, e.g., one party has an advantage
in borrowing in a particular currency say $, but needs a £ loan, and another is interested in a $
loan, but has advantage in borrowing £. The two parties can enter into a swap agreement, borrow
at advantageous currency and exchange the principals. This usually happens when the parties
need to finance foreign projects/subsidiaries. A currency swap arrangement has advantage that
it fixes (lock-in) the exchange rate, enable investors to access funds in different currencies and
provides a right of set-off of any non-payment between the parties.
 Amortizing Swap is a swap arrangement in which the principal reduces in a predetermined way
throughout the term of the swap, usually corresponding to the amortization schedule on a loan.
 In a Step-Up Swap the principal increases in a predetermined way that might be designed to
correspond to draw-down on a loan agreement.
 Deferred/Forward Swap refers to the arrangement where the parties do not begin to exchange
interest payments until some future date.
 Cross Currency Swap is an agreement to exchange a fixed interest in one currency for a floating
interest rate in another currency. It's actually a combination of interest rate swaps and currency
swaps.
 Extendable Swap is a swap arrangement whereby one party has an option to extend the life of
the swap beyond the specified period.
 In Puttable swap one party to the swap agreement has an option to early termination of the
swap.
 Swaption arrangement provides one party with the right at a future time to enter into a swap
where a predetermined fixed rate is exchanged for floating. It is actually an option on swaps.

Chapter 7: Options and Swaps Page 12 of 14

 In Differential swaps a floating interest rate in the domestic currency is exchanged for a floating
exchange rate in a foreign currency, with both interest rates being applied to the same domestic
principal.
 Equity Swaps refer to agreements to exchange dividends and capital gains realized on equity
index for either a fixed or floating rate of interest. It can be used by portfolio managers to convert
returns from a fixed/ floating investment to the returns from investing in an equity index or vice
versa.

7.7.2. Mechanics of Interest Rate Swaps

Interest rate swaps can be designed to suit the market conditions and risk profiles of the swap
counterparts, with or without presence of intermediaries. In many cases, due to difficulty of having
coinciding needs for the counterparts, usually the service of swaps intermediaries is resorted to, for
a payment, which is a cut of the ‘Locked-in saving’.
The simplest of the interest rate swaps is the plain Vanilla swap, where, for example, one party has
an advantage in borrowing fixed rate but would like to borrow at floating rate, mainly as a result of
his/her risk assessment, and simultaneously another party has advantage in borrowing at a floating
rate, but prefers fixed rate loan. In this case, as long as the principal amounts involved coincide,
each party can borrow at the advantageous rate and then swap the interest payments.
It may as well happen that one party has advantage in both fixed and floating rate over the other
party, but still a swap may be beneficial if (s)he borrows at the rate with a greater comparative
advantage and swap the interest obligations. A few examples are given in the concept checks below:

CONCEPT CHECK 13:

Company A can borrow from the market at a fixed rate of 10% or floating rate of T-Bill rate
+ 1%. Company B, on the other hand, can borrow from the market at a fixed rate of 12%
or T-Bill rate + 0.5%. The treasurer of company A believes that T-Bill rate is going to fall,
and he thus prefers a floating rate debt. The treasurer of company B, on the other hand,
believes that the T-Bill rate is going to rise, and thus prefers a fixed rate loan. Design a
swap arrangement that is beneficial to both companies

This Concept Check has been solved for you

A swap arrangement can be designed such that in addition to their obligations to the market,
company A pays company B T-Bill + 0.5%, and company B pays company A 10.5% on the notional
amount per annum. In this case, the swap is beneficial to both companies, since the net payoff
after transforming their interest obligations are lower than what they would have paid had
they gone straight to the market. The net payoffs after the swap are as given in the table
below:

Payment/Receipt Company A Company B

Payment (The debt Market) 10% T-Bill rate + 0.5%.
Payment (swap) T-Bill + 0.5% 10.5%
Receipt (swap) (10.5%) (T-Bill + 0.5%)
Net payment T-Bill 10.5%
In this case, company A has managed to transform its interest obligation from floating to
fixed, but paying less than it would have paid had it gone straight to the market for a floating
rate loan. The same situation happens for company B.

Chapter 7: Options and Swaps Page 13 of 14

CONCEPT CHECK 14: Company AAA and company BBB face the following borrowing
positions in the market:
Company Fixed rate Floating rate
AAA 6% T-Bill + 0.25%
BBB 7.25% T-Bill + 0.5%

Design a swap that is equally beneficial to both companies, without a presence of any
intermediary if company AAA desires a floating rate debt and company BBB desires a fixed
rate debt.
Solution
In this case, since company AAA has advantage in both floating (0.25%) and fixed (1.25%), the
comparative advantage is greater in fixed rate. By borrowing fixed and swapping the interest
with BBB, there will be a ‘locked-in saving’ of 1% (1.25%-0.25%). Since the desired swap is to
be equally beneficial to both parties, then the ‘locked-in saving’ will be shared at 0.5% each.
The net payoffs will thus be such that each party has transformed the interest obligations
with a saving of 0.5% compared with going straight to the debt market. This can be summarized
in the following table:

Payment/Receipt Company AAA Company BBB

Payment (The debt Market) 6% T-Bill rate + 0.5%.
Payment (swap) T-Bill 6.25%
Receipt (swap) (6.25%) (T-Bill)
Net payment T-bill – 0.25 6.75%

CONCEPT CHECK 15: Companies X and Y have been offered the following rates per
annum on loans with the same principal amounts:

Company Fixed rate Floating rate

X 12% T-Bill + 0.1%
Y 13.40% T-Bill + 0.6%

Company X requires a floating rate loan, whereas company Y requires a fixed rate loan.
Design a swap that will net a bank acting as an intermediary a 0.1% p.a. and that will
appear equally attractive to both parties.

Solution
In this case, since company X has advantage in both floating (0.5%) and fixed (1.4%), the
comparative advantage is greater in fixed rate. By borrowing fixed and swapping the interest
with Y, there will be a ‘locked-in saving’ of 0.9% (1.4%-0.5%). However, due to the presence of
an intermediary, the amount available to be shared between company X and Y is reduced by the
remuneration to the intermediary, thus the available saving is 0.8% (0.9% - 0.1%). Since the
desired swap is to be equally beneficial to both parties, then the ‘locked-in saving’ will be shared
at 0.4% each. The net payoffs will thus be such that each party has transformed the interest
obligations with a saving of 0.4% compared with going straight to the debt market.

Chapter 7: Options and Swaps Page 14 of 14