Options option valuation determinants of option pricing; option price sensitivities option trading strategies the Greek letters

Derivative securities as a whole have become increasingly important in the management of risk and this chapter details the use of options in that vein. A review of basic options puts and calls is followed by a discussion of fixed-income, or interest rate options. The chapter also explains options that address foreign exchange risk, credit risks

Long position in an option is synonymous

with: Holder, buyer, purchaser, the long
Holder of an option has the right, but not the obligation to exercise the option

Short position in an option is synonymous

with: Writer, seller, the short
Obliged to fulfill terms of the option if the option holder chooses to exercise.

A call provides the holder (or long position) with the right, but not the obligation, to purchase an underlying security at a prespecified exercise or strike price.
Expiration date: American and European options

The purchaser of a call pays the writer of the call (or the short position) a fee, or call premium in exchange.

If the price of the bond underlying the call option rises above the exercise price, by more than the amount of the premium, then exercising the call generates a profit for the holder of the call. Since bond prices and interest rates move in opposite directions, the purchaser of a call profits if interest rates fall.

Zero-sum game:
The writer of a call (short call position) profits when the call is not exercised (or if the bond price is not far enough above the exercise price to erode the entire call premium). Gains for the short call position are losses for the long call position. Gains for the long call position are losses for the short call position.

Since the price of the bond could rise to equal the sum of the principal and interest payments (zero rate of interest), the writer of a call is exposed to the risk of very large losses. Recall that losses to the writer are gains to the purchaser of the call. Therefore, potential profit to call purchaser could be very large. (Note that call options on stocks have no theoretical payoff limit at all). Maximum gain for the writer occurs if bond price falls below exercise price.

Buy a call

Write a call

X X

A put provides the holder (or long position) with the right, but not the obligation, to sell an underlying security at a prespecified exercise or strike price.
Expiration date: American and European options

The purchaser of a put pays the writer of the put (or the short position) a fee, or put premium in exchange.

If the price of the bond underlying the put option falls below the exercise price, by more than the amount of the premium, then exercising the put generates a profit for the holder of the put. Since bond prices and interest rates move in opposite directions, the purchaser of a put profits if interest rates rise.

Zero-sum game:
The writer of a put (short put position) profits when the put is not exercised (or if the bond price is not far enough below the exercise price to erode the entire put premium). Gains for the short position are losses for the long position. Gains for the long position are losses for the short position.

Since the bond price cannot be negative, the maximum loss for the writer of a put occurs when the bond price falls to zero.
Maximum loss = exercise price minus the premium

Buy a Put (Long Put)

Write a Put (Short Put)

X X

Many smaller FIs constrained to buying rather than writing options.

Economic reasons
Potentially large downside losses for calls. Potentially large losses for puts Gains can be no greater than the premiums so less satisfactory as a hedge against losses in bond positions

Regulatory reasons
Risk associated with writing naked options.

Hedging with futures eliminates both upside and downside Hedging with options eliminates risk in one direction only

Hedging with Futures

Gain 0
X

Bond Portfolio
Bond Price Purchased Futures Contract

Loss

Weaknesses of Black-Scholes model.

Assumes short-term interest rate constant Assumes constant variance of returns on underlying asset. Behavior of bond prices between issuance and maturity
Pull-to-par.

Credit spread call option

Payoff increases as (default) yield spread on a specified benchmark bond on the borrower increases above some exercise spread S.

Digital default option

Pays a stated amount in the event of a loan default.

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