Financial Engineering

Financial Engineering
• Options
• Forwards
• Futures
• Currency swap
 Options
• Long call

• Short call

• Long Put

• Short put
 Options
•In finance, an option is a derivative financial instrument that establishes a
contract between two parties concerning the buying or selling of an asset
at a reference price during a specified time frame.

•During this time frame, the buyer of the option gains the right, but not
the obligation, to engage in some specific transaction on the asset, while
the seller incurs the obligation to fulfill the transaction if so requested by
the buyer.

•The price of an option derives from the value of an underlying asset

(commonly a stock, a bond, a currency or a futures contract) plus a
premium based on the time remaining until the expiration of the option.
Other types of options exist, and options can in principle be created for
any type of valuable asset.
Type of Options---Three Major
American options: can be exercised any moment prior
to maturity.

European options: can be exercised only at expiration

time.

Bermudan options: can be exercised on “FEW Specific

Dates” prior to expiration.
 Cash flows of basic Options
• Long Call

•Short Call

•Long Put

•Short Put
 Options
Long Call
 Options
Short Call
 Options
Long Put
 Options
Short Put
 Caplets and Florets (Options)
• A cap is a series of calls, designed to limit the risk
because of fluctuations in foreign exchange. These
options have individual components that are called
caplets.

• An currency floor is a series of puts, designed to

protect against the risk of currency fluctuations.
 Determination of Value of Financial
Instruments

Option Valuation is done via Two Methods

• Black-Scholes

• Binomial Model
 Determination of Value of Financial
Instruments

Binomial Model

Binomial Model is also called Two State Model:

•A Binomial distribution model has two outcomes or

states.

•The probability of up or down movement is governed

by the binomial probability distribution.
 Determination of Value of Financial
Instruments
Consider a Stock---S on which call options are available

The call has one period remaining before it expires.

The begininning of the period is today and is referred to

as time 0.
 Determination of Value of Financial
Instruments

Binomial Model Formula

•The formula for Option ( C ) is developed by constructing a risk less

portfolio of stock and options.

•Remember ------------Risk less portfolio will give risk free rate of return.

•The risk less portfolio is called a HEDGE PORTFOLIO.

•Risk less portfolio consists of h shares stocks and a single written

Call.
 Determination of Value of Financial
Instruments

The current value of the portfolio:

V=h*S- C

At Expiration the portfolio can have two values:

Vu = h * Su – Cu Or
Vd = h * Sd – Cd

As model based on fact that risk less portfolio will give risk free rate of return then:

Vu = Vd…………..Thus Hedge portfolio of h stocks is

h = (Cu – Cd)/ (Su – Sd )……………….eq. (1)

 Determination of Value of Financial
Instruments
If the potential current value grows at the risk free rate, its value at the option’s
expiration will Vt = V *(1+r) i.e.

(h * S – C) * (1+r)

The above stated reflects:

(h*S-C)*(1+r) = h*Su – Cu….value of h from eq. (1)

C = (p*Cu + (1-p)*Cd) / (1+r)……….where p = (1+r-d)/(u-d)

First we find the values of call Option Cu and Cd at end of the period. Then we
find the value of call option at the beginning of the period.
 Determination of Value of Financial
Instruments
Two Period Binomial Model:

Cu = (pCu2 + (1-p) * Cud)/ (1+r)

Cd = (pCud + (1-p) * Cd2)/ (1+r)

Hedge ratio changes at end of Period 1

h = (Cu – Cd)/ (Su – Sd)

hu = (Cu2 – Cud)/ (Su2- Sud),
Hd= (Cud-Cd2)/(Sud- Sd2)

First we find the values of Cu2, Cud and Cd2 then find the values of Cu, Cd and
then eventually C.
 Determination of Value of Financial
Instruments
Binomial Model - Put Option

•The principles are essentially the same as hedging with calls,

but instead of selling call to hedge a long position in stock, we
are buying puts.

•The hedge portfolio is built by buying h shares and buying

one put.

•The negative value of the hedge portfolio simply reflects the

opposite moment of the puts to stock.
 Determination of Value of
Financial Instruments
Black Scholes

•The Black–Scholes model of the market for a particular equity makes the
following explicit assumptions:

•The risk-free interest rate exists and is constant and same for all maturity dates.

•The short selling of securities with full use of proceeds is permitted.

•It is possible to borrow and lend cash at a known constant risk-free interest rate.

•The price follows a Geometric Brownian motion with constant drift and
volatility.
 Determination of Value of Financial
Instruments
•There are no transaction costs.

•The stock does not pay a dividend (see below for extensions to
handle dividend payments).

•All securities are perfectly divisible (i.e. it is possible to buy any

fraction of a share).

•There are no restrictions on short selling.

•There is no arbitrage opportunity

 Determination of Value of
Financial Instruments
Put Option Valuation: It can be calculated by two ways

•Using Put option valuation method.

Using Put – Call Parity method.

 Determination of Value of
Financial Instruments
Put Option Valuation: It can be calculated by two ways

•Using Put option valuation method.

•Using Put – Call Parity method.

 Determination of Value of Financial
Instruments
•P= Ke^(-rt)N(-d2)-SN(-d1)

Put Call Parity

•P = C + Ke^(-rt)- S
 Put call parity
Put Call Parity

Pay Off

Portfolio A Portfolio B

Portfolio Name Assets St <= X St => X

Long Stock (So) St St

A
Long Put (P) (strike price X) X -St 0
Net Payoff
X St

Long Call (strike price X) 0 St - X

B
Long Bond with face value of X X X

Net Payoff X St
 Put call parity
Long bond as present value of X /e^(rt)

Total Investment in Portfolio A So + P

Total Investment in Portfolio B C + X / (e^rt)

From above we see that pay off from portfolio A equals payoff from portfolio B and so following

can be concluded

So + P = C + X / (e^rt)…………………………This is put call parity

 Determination of Value of
Financial Instruments
Put Call Parity is a relationship between European Put
and Call Options have identical assets, strike prices and
time to maturity.

Price of Call Option – Price of Put Option = Price of

Underlying Asset – Present value of exercise price -
Present value of Dividend.

(if we know either call or put then the other one can be
valued from put-call parity equation.
 Option Time Value
Option Time Value

•Black-Scholes

•Binomial Model
 Option Time Value
•Option value “Likelihood” finishing in the money.

•Higher the expiration date---the longer the time to

exercise ----the higher the option value.

•Option value never lower than Intrinsic value.

•Before expiration option’s market value would exceed

intrinsic value by an amount called time value of option.
 Option Time Value
The value of an option consists of two components

•Intrinsic value: value of an option is the value if the

option is exercised now.

For a long call option: value = Max [ (S – K), 0 ]

For a long put option: value = Max [ (K – S), 0 ]

•time value

Time value = Option Value – Intrinsic Value

Variables in Black – Scholes Models
Delta of an Call Option (N(d1)): Delta is a measure of the
sensitivity of the calculated option value has to small changes in the share
price. The Delta of an option tells you by how much the premium of the option
would increase or decrease for a unit change in the price of the underlying
asset.
Variables in Black – Scholes Models
Delta of an Call Option (N(d1)): Delta is a measure of the
sensitivity the calculated option value has to small changes in the share price.
The Delta of an option tells you by how much the premium of the option would
increase or decrease for a unit change in the price of the underlying asset.
 Delta and Gamma Hedging

Remember in binomial we calculated the hedge ratio.

This hedge ratio was the number of stocks we will long
for one call option. The similar is delta. Delta tell us
how many shares we will long for one short call.
 Delta and Gamma Hedge
So delta of 0.5 means we will long 500 shares for 1000
short calls. This way we can hedge delta.

But remember delta hedging works for only small

changes in stock price and so we stock price changes in
significant delta hedging doesn’t work.

So we can use Gamma (change in delta) to hedge

portfolios.
 Delta and Gamma Hedging
It is impossible to be both delta and gamma hedged by
holding only the stock and option. This is because the risk
associated with the option’s gamma must be eliminated by
another instrument.

The delta of stock is 1.0, but it’s gamma is zero. Thus, the
stock cannot hedge the option’s gamma risk.

What we require is an instrument that has a non zero

gamma—specially another option.
Delta and Gamma Hedging
hs × ∆s – 1000 × ∆1 + hc × ∆2 = 0 ……equation 1

To gamma hedge we must meet the following condition

-1000 × Γ1 + hc × Γ2 = 0

hc = 1000 × (Γ1 / Γ2 ) ………………..equation 2

Using equation 2 in equation 1

hs =1000 × ( ∆1 –(Γ1 / Γ2 ) × ∆2 )…..equation 3

Black – Scholes European Model
The option may not be exercised prior to its expiration date.

The price changes of the underlying asset are log normally

distributed.

The risk-free rate of interest is fixed over the life of the

option.

Dividend payments are not discrete: rather, the underlying

asset yields cash flows on a continuous basis.
Black – Scholes American Model
The option may be exercised prior to its expiration date.

The price changes of the underlying asset are log

normally distributed.

The risk-free rate of return is fixed over the life of an

option.

Dividend payments are not discrete: rather, the

underlying asset yields a continuous constant amount.
Variables in Black – Scholes Models
Gamma of an Call Option: Gamma is a measure of the
calculated delta’s sensitivity to small changes in the share
price. The Gamma of an option predicts as to how much
the delta of an option would increase or decrease for a unit
change in the priceGamma
of asset.
(change in N(d1)
12

10

8
Gamma (change in N(d1)
6

0
0 100 200 300 400 500 600 700 800
Variables in Black – Scholes Models
Theta of an Option: Theta measures the calculated
option values sensitivity to small changes in time till
maturity.

Theta tells you how much value the option would lose
after one day, with all the other parameters remaining
the same.
Variables in Black – Scholes
Theta of Call Option Value
Models
180.0

160.0

140.0

120.0

100.0 Call Option Value

80.0

60.0

40.0

20.0

0.0
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00
Variables in Black – Scholes Models
Vega of an Option: Vega measures the calculated
option value’s sensitivity to small changes in volatility.

Vega indicates how much the option premium would

change for a unit change in annual volatility of asset
(stock price).
Variables in Black- Scholes Models
Call Option Value
120.0

100.0

80.0

Call Option Value

60.0

40.0

20.0

0.0
20.00% 40.00% 60.00% 80.00% 100.00% 120.00% 140.00% 160.00% 180.00% 200.00%
Variables in Black – Scholes Models
Rho of an Option: Rho is defined as the rate of change
in the value of option premium to the domestic
interest.
Variables in Black- Scholes
Call Option Rho (interest rate sensitivity)
Models
120.00

100.00

80.00

Call Option Rho (interest rate

sensitivity)
60.00

40.00

20.00

0.00
2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00%
Hedging with Options
 Options are used as strategic measure with other
options and/or stocks, bonds as combinational
strategies or as hedging tool for any given position.

 Series of put or call options as well as combination of

put-call options can be used to build hedged portfolio.
Type of Option Trades
As discussed earlier 4 primary kinds of Option Trades
are as follows:

Long Call
Short Call
Long Put
Short Put
Option Based Hedging Strategies
There are 3 basic kinds of Strategies

 Bullish Strategies

 Bearish Strategies

 Neutral Strategies
Option Based Hedging Strategies
Bullish Strategies

Bullish options strategies are employed when the

options trader expects the underlying stock price to
move upwards.

It is necessary to assess how high the stock price can go

and the time frame in which the rally will occur in
order to select the optimum trading strategy.
Option Based Hedging Strategies
In context of our course we will study 7 Kinds of bullish options.

Long call

Short put

Covered Call

Protective Put

Call Bull Spread

Put Bull Spread

Straps
Long Call Net Profit
250

200

150

Net Profit
100

50

0
0 50 100 150 200 250 300 350 400

-50
Short Put Net Profit
20

0
0 50 100 150 200 250 300 350 400

-20

Net Profit
-40

-60

-80

-100
Covered Call
Covered Call portfolio is generated by long position on
asset and short call options.

Money managers/mutual fund managers/portfolio

managers use this method to generate consistent
income.
Covered Call
Covered Call concept is governed by the facts stated
below:

Stock should be hold for over a long period of time

and every month or so sell out-of-the money call
options.

stock are bought long time ago before options are

written and hence the stock price can be far away from
the purchase price of stock.
Covered Call
Maximum loss: Unlimited on the downside.

Maximum Gain: Limited to premium of call option.

When to use: to generate consistent income from

stock when we anticipate the stock price to go up for
certain period of time because of changes in the
market/industry.
Covered Call Net Profit
20

0
0 50 100 150 200 250 300 350 400

-20

-40
Net Profit
-60

-80

-100

-120

-140
Protective Put
Protective Put is achieved by Long position on stock and long
position on Put option. The pay off is limited to the
premium paid for the option.

Maximum loss is limited to Premium Paid on Put Option.

Maximum gain: Unlimited as market rallies.

When to use: when we anticipate that the stock is overpriced

and we believe that market correction will happen soon.
Protective Put net profit
200

150

100

50 net profit

0
0 50 100 150 200 250 300 350 400

-50

-100

-150
Options Spread Strategy
Options spread strategy stands for taking a position in
two or more options of the same stock type be it call or
put.

Options spread have 3 categories:

1. Vertical Spread
2. Horizontal Spread
3. Diagonal Spread
Options Spread Strategy
Options spread have 3 categories:

1. Vertical Spread---option spread created by combination

of options (either call or put) having different strike
prices but the same time to expiration.
2. Horizontal Spread---option spread created by having
options of same strike prices but different time to
maturity.
3. Diagonal Spread---option spread created by having
options of different strike prices and different time to
maturity.
Options Spread Strategy
There are 3 types of Bull Spreads:

Both calls out of the money.

One call initially in the money and one call initially

out of the money.

Both calls initially in the money.

Call Bull Spread
The call bull spread is created by long one call option
with a low strike price and one short call with a higher
strike price.

Both options have same time to maturity.

Call Bull Spread
Maximum Loss: limited to premium paid for the long
option minus the premium received for the short
option.

Maximum gain: limited to the difference between the

two strike prices minus the net premium paid for the
spread.
Call Bull Spread Net Profit
35

30

25

20

15
Net Profit
10

0
0 50 100 150 200 250 300 350 400
-5

-10

-15
Put Bull Spread
The put bull spread is created by long one put option
with a low strike price and one short put with a higher
strike price.

Put Bull spread has the same pay off as the call Bull
Spread.
Put Bull Spread
Maximum Loss: limited to the difference between the
two strike prices minus the net premium paid for the
spread.

Maximum Gain: the premium received for the short

option minus premium paid for the long option
Put Bull Spread Net Profit
10

0
0 50 100 150 200 250 300 350 400

-5

-10 Net Profit

-15

-20

-25

-30

-35
Straps
Strap strategy implemented when investor expects
that the probability of stock price increase is relatively
higher then the probability of stock price decrease.

Strap consists of long position in two calls and one put

with same Exercise Price and Expiration price.
Strap net profit/loss
200

150

100

net profit/loss
50

0
0 50 100 150 200 250

-50

-100
Short Call Option
Long Put net profit
100

80

60

net profit
40

20

0
0 50 100 150 200 250

-20
Call Bear Spread
When we anticipate that the market will go down then
we create Call Bear Spread.

Call Bear Spread is created by Shorting one call option

with a low strike price and long one call option with
higher strike price.
Call Bear Spread
Maximum loss: limited to difference between the two
strikes minus the net premium.

Maximum Gain: limited to the net premium received

for the position (short call premium received – long
call premium paid).
Call Bear Spread Net Profit
15

10

0
0 50 100 150 200 250 300 350 400
-5
Net Profit
-10

-15

-20

-25

-30

-35
Put Bear Spread
The put bear spread is created by short one put option
at lower strike price and long one put option at higher
strike price.

A put bear spread has the same payoff as the call bear
spread as both strategies hope for a decrease in market
prices.
Put Bear Spread Net Profit
35

30

25

20

15
Net Profit
10

0
0 50 100 150 200 250 300 350 400
-5

-10

-15
Strips
When we anticipate that the probability of market
going down is relatively higher than the probability of
market going up.

 Strip is combination of one long call option and two

long put options with same Exercise price and date of
Expiration.
Strips net profit/loss
200

150

100

net profit/loss
50

0
0 50 100 150 200 250

-50

-100
Neutral Strategies
Neutral strategies in options trading are employed
when the options trader does not know whether the
underlying stock price will rise or fall.

Also known as non-directional strategies, they are so

named because the potential to profit does not depend
on whether the underlying stock price will go upwards
or downwards. Rather, the correct neutral strategy to
employ depends on the expected volatility of the
underlying stock price.
Neutral Strategies
Long straddle
Short straddle
Long strangle
Short strangle
Call time spread
Put time spread
Call ratio vertical spread
Put ratio vertical spread
Neutral Strategies
Long call butterfly
Short call butterfly
Long put butterfly
Short put butterfly
Box spread
Condor spread
Long Straddle
It is formed by buying one call option and one put option at
the same strike price.

Maximum loss: limited to total premium paid for the call and
put options

Maximum gain: Unlimited as the market moves in either

direction

When to use: when we are bullish on volatility but are unsure

of market directions.
long straddle net profit loss
100

80

60

40 net profit loss

20

0
0 50 100 150 200 250

-20

-40
Short Straddle
Short straddle is formed by combination of short call
and short put.

Maximum loss: unlimited as the market moves in

either direction

Maximum gain: limited to eth net premium received

for selling the option.
Short straddle net profit loss
40

20

0
0 50 100 150 200 250

-20 net profit loss

-40

-60

-80

-100
Long strangle
Formed by Buying one call with lower strike price and
buying one put option at higher strike price.

Maximum loss: limited to the total premium paid for

the all and put options.

Maximum gain: unlimited as the market moves in

either direction.
Long Strangle net profit loss
100

80

60

net profit loss

40

20

0
0 50 100 150 200 250

-20
Short strangle
Formed by short one call option with a lower strike
price and short one put option with a higher strike
price.

Maximum loss: unlimited as the market moves in

either direction.

Maximum gain: limited to the net premium received

for selling the options.
Short strangle net profit loss
40

20

0
0 50 100 150 200 250

-20 net profit loss

-40

-60

-80

-100
Call Time Spread
Formed by short one call option and long one call
option where the time to maturity is higher for long
call option than short call option.
 Call Time Spread
10

0
0 2 4 6 8 10 12

-5

-10 shortcall profit loss

long call exercise
-15 net profit loss

-20

-25

-30

-35
Put Time Spread
Formed by short one put and long one put where the
time to maturity for long put is higher than the time to
maturity for short put.
Put Time Spread
80

60

40

20
net profit loss
long put exercise
shortputprofit loss
0
1 2 3 4 5 6 7 8

-20

-40

-60
Call Ratio Vertical Spread
Formed by long one IN THE MONEY CALL option and
short two Out of the Money call options.
Call Ratio Vertical Spread net profit loss
50

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

-50

net profit loss

-100

-150

-200

-250
Put Ratio Vertical Spread
Formed by short two OUT OF THE MONEY
OPTIONS and Long one IN THE MONEY OPTION.
Put Ratio Vertical Spread net profit loss
40

20

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

-20 net profit loss

-40

-60

-80

-100
Long call butterfly
Formed by short two AT THE MONEY call options and
long one IN THE MONEY cal option and long one
OUT OF THE MONEY CALL Option.

Maximum Loss: Limited to the ATM strike less the

ITM strike less the net premium paid for the spread.

Maximum Gain: Limited to the net premium received

from the spread.
Long call butterfly
Short call butterfly
Long two ATM call options, short one ITM call option
and short one OTM call option.

Maximum Loss: Limited to the net difference between

the ATM strike less the ITM strike less the premium
received for the position.

Maximum Gain: Limited to the net premium received

for the option spread.
Short call butterfly
Long put butterfly
Long two ATM put options, short one ITM put option
and short one OTM put option.

Maximum Loss: Limited to the net difference between

the ATM strike less the ITM strike less the premium
received for the position.

Maximum Gain: Limited to the net premium received

for the option spread.
Long put butterfly
Sell two ATM put options, buy one ITM put option
and buy one OTM put option.

Maximum Loss: Limited to the ATM strike less the

ITM strike less the net premium paid for the spread.

Maximum Gain: Limited to the net premium received

from the spread.
Long put butterfly
Short put butterfly
Long two ATM put options, short one ITM put option
and short one OTM put option.

Maximum Loss: Limited to the net difference between

the ATM strike less the ITM strike less the premium
received for the position.

Maximum Gain: Limited to the net premium received

for the option spread.
Short put butterfly
Box Spread
 box spread is a combination of positions that has a certain
(i.e. riskless) payoff, considered to be simply "delta neutral
interest rate position".

In box spread, the profit and loss made is independent of the
movement in the stock price and is neutral option strategy.

a bull spread constructed from calls (e.g. long a 50 call, short

a 60 call) combined with a bear spread constructed from puts
(e.g. long a 60 put, short a 50 put), has a constant payoff of
the difference in exercise prices.
Condor Spread
Formed by combination of two options bought at the
extreme strike prices and two are sold at two
intermediate strike prices.

Two types of Condor Spread: Long condor and short

condor.
Long condor
Formed by

Long ITM Option

Short ITM Option
Short OTM Option
Long OTM Option
Long condor
Short condor
Formed by combination of

Short ITM Option

Long ITM Option
Long OTM Option
Short OTM Option
Short condor
 Currency Options
The currency options are derivative contracts that grant
the purchaser the right but not the obligation to trade a
currency futures contract at a predetermined date in the
future at a prearranged price (strike price), regardless of
where the underlying market is trading.
GOLDEN RULES OF USING CURRENCY
OPTIONS
LONG CURRENCY CALL
Short currency call
Long currency put
Short currency put
 Interest rate options
The definition of option remains same. The options on
interest rate will have interest rate as underlying asset just
like stock options and currency options.

The options including long call, short call, long put and
short put have same payoff structure apart from the fact
that reference asset is Interest rate not stock or currency.

The reward in terms of cash flows is calculated on notional

principal amount on which the interest rate options are
bought.
 LONG INTEREST RATE CALLS
Profitability from Long call on interest rate =

Notional Principal × Max (0, LIBOR – EXERCISE

STRIKE RATE) × (Days/365)
LONG INTEREST RATE CALL
SHORT INTEREST RATE CALL
LONG INTEREST RATE PUT
 LONG INTEREST RATE PUT
Profitability from Long put on interest rate =

Notional Principal × Max (0, EXERCISE STRIKE RATE -

LIBOR) × (Days/365)
SHORT INTEREST RATE PUT