I ntroduction to Equit Equity y Derivativ Deriva tives es
© February 2008 - The Derivatives Consulting Group Ltd www.dcgconsultants.com
ourse
gen a
Part 1: Introduction to Equities • • • • •
Types of Stock Dividends Cor Corpora porate te Actio ctions ns Underlyings Mark Market et Inst Instit itut utio ions ns
Part 2: Introduction to Derivatives • • • • •
Definition Origins Asse Assett Clas Classe ses, s, Type Types s & Prod Produc ucts ts Trading ing Methods Sett Settle leme ment nt Me Meth thod ods s
Part 3: Forwards & Futures • • • •
Con Contrac tractt Featu eature res s Valuation Spot vs. Forward The The Dist Distri ribu buti tion on Grap Graph h
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Part 4: Options • • • • •
O tions vs. Forwards Con Contrac tractt Featu eature res s Basi Basic c Opti Option on Valu Valuat atio ion n The Greeks Optio ption n Stra Strate tegi gies es
Part 5: Equity Swaps & Dividend Swaps • • • • •
The Basics Pric Price e Ret Retur urn n vs vs Tot Total al Retu Return rn Bull Bullet et Swap Swaps s vs vs Rese Resets ts Tradi rading ng Strat trateg egie ies s Dividend Sw Swaps
Part 6: Variance, Exotics & Correlation • • • • •
Var Varianc iance e Defi Defin nitio ition n Vari Varian ance ce Deri Deriva vati tive ve Prod Produc ucts ts Exot Exotic ic Term Terms s & Feat Featur ures es Corr Correl elat atio ion n Def Defin init itio ion n Corr Correl elat atio ion n Deri Deriva vati tive ve Pro Produ duct cts s
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I ntroduction to Equity Derivatives
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Stocks a nd shares: The b asics • Why do shares get issued?
• What drives share prices up and down? • Why do people invest in shares?
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Stocks an d sh ares: Shareho lder rights • Part ownership
• Concept of limited liability • Dividends • Common Stock vs Preferred Stock
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Company P ayment Obligations
Company Employees
Premises Loans
Taxes & Svcs
Bonds
Dividends on Ordinary Shares © February 2008 - The Derivatives Consulting Group Ltd www.dcgconsultants.com
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Divide nds: the bas ics • Why are they issued? • • Company obligations re dividends • Dividend dates: declaration, ex-dividend, record & payment •
as vs
oc
v en s
• Regular vs Extraordinary dividends © February 2008 - The Derivatives Consulting Group Ltd www.dcgconsultants.com
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Corpo rate actions •
toc
p its
onso i ations
•
Mergers & Acquisitions
•
Rights Issues
•
Spin-offs
•
Nationalisation
•
Delistin s
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M ergers & Acquisitions: P ros & Cons Pros
-
Increase in sales/revenues ie Procter & Gamble takeover of Gillette Venture into new businesses and markets Profitability of target company Increase market share Decrease competition (from the perspective of the acquiring company) Synergy of resources Enlarge brand portfolio ie L'Oréal's takeover of Bodyshop
Cons
-
Reduced competition and choice for consumers in oligopoly markets Likelihood of price increases and job cuts Cultural integration/conflict with new management Hidden liabilities of target entity
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M ergers & Acquisitions: Top 5 in 2000s
Rank
Y ear
Company A
Company B
Value (USD)
1
2000
AOL
Time Warner
164,747,000,000
2
2007
RBS, Fortis, Santander
ABN AMRO
95,500,000,000
axo
e come
m
ne eec am
,
,
,
4
2004
Royal Dutch
Shell
74,559,000,000
5
2006
AT&T Inc
BellSouth Cor
72 671 000 000
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Equity Underlyings • Shares
• Baskets • ADRs
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Und erlyings: Basket Exam ple Sh a r e
Sh a r e P r i c e
Sh a r e s o f e a c h
Sh a r e s t a r t v a l u e
A
£ 10
2.5
£2 5
B
£ 20
1.25
£2 5
C
£3 0
0.8333
£ 25
D
£4 0
0.625
£25
Total:
£ 10 0
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£100
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Stock Exchang es
Tokyo Stock Exchange
London Stock Exchange
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New York Stock
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Stock Exch ang es: the ba sics • Products
• Primary Market vs Secondary Market • Open Outcry vs Electronic • Clearance Systems
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Stock Exch ang es: its ro les •
The main roles of stock exchanges are:
-
Raising capital for businesses Mobilizing savings for investment Facilitating company growth Redistribution of wealth Creating investment opportunities for small investors Government capital-raising for development projects Barometer of the econom
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Stock Exchan ges: Black M onday • DJIA Drops 22.6% (508 points) • 604.33 million shares traded (a new record) • Previous record set on the previous Friday (338 million • Only half a day of trading on Black Monday overtook this number • Ticker board was so heavily inundated it ran 2 hours behind the market
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Stock Exchang es: Black M onda y (con t’d) P ossible Factors
-
Share Overvaluation? Trade & Budget Deficits?
Resulting Changes
-
Restriction of Programme Trading Introduction of circuit breakers ie the SEC now requires that all exchanges cease trading in the event that one of these circuit breakers is triggered
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I ntroduction to Equity Derivatives Part 2: Introduction to Derivatives
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W hat is a Derivative? • Definition
• Asset Classes • Leverage • Future Settlement
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Creation of a Derivative CHOICE ASSET
INTEREST RATES
EQUITIES
CREDIT
F/X
COMMODITIES
OTHER
TYPE SINGLE
BASKET
INDEX
DERIVATIVE PRODUCTS FORWARD
SWAP
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OPTION
EXOTIC OPTION
CORRELATION
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Derivatives Overview • Long vs Short
• Cash vs Physical
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ETD vs OTC Overview
ETD
OTC
Contract Specifications
Standardised by derivatives exchange
Determined on trade-bytrade basis between parties
Contract
Margin paid into exchange
Paid directly between parties
Contract Flexibility
Freely tradable on exchange Unbreakable unless agreed otherwise by parties
Obligation
by exchange
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between parties
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I ntroduction to Equity Derivatives Part 3: Forwards & Futures
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Forw ards: Contract Specifications • Number of Forwards
• Valuation/Settlement Date • Settlement Terms
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Forw ards vs Futures Overview Futures
Forw ards
Contract Speci ications
Standardised by derivatives exc ange
Determined on trade-bytra e asis etween parties
Contract Payments
Margin paid throughout life of trade into exchange clearin house account
Paid directly between parties at maturity
Contract Flexibility
Freely tradable on exchange Unbreakable unless agreed otherwise by parties
Contract Obligation
Buyer pays seller current market price
Buyer pays seller agreed forward price
Contract Agreement
Agreement of trade verified by exchange
Legal confirmation signed between parties
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Forw ards vs Futures: An example Today
Share price of XYZ Ltd = $100 per share •
Both Bank A and Bank B believe the price will increase over the next year
•
Bank B elects to buy a 1 year futures contract on the derivatives exchange
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Forw ards vs Futures: An example ( cont’d) In one year’s time t ime
Share price of XYZ Ltd = $200 per share •
Bank A obliged to buy shares @ $100 =
•
Bank B obliged to buy shares @ $200 & receives $100 from margin account
•
Bank B net + $100
Both banks net the same amount although the cash flows are slightly different different
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Forw ard Valuatio Valua tion n Forward Forward Price Price = Spot Price Price + (Carry (Carry Cost Cost – Benefit) Benefit)
• Sp Spot ot vs Forwa orward rd Ar Arb bitra itrag ge
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Sp ot o t v s F or o r w a rd rd
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Forw ard Trading Example 1 Forward Price = $105 (ie too high) Today
• •
Borrow $100 from bank & buy shares now Sell forward @ $105
In one year’s time
• • • •
Deliver shares & receive $105 Receive $2 dividends (total receivables $107) Repay the bank your original $100 plus rate @ 5% = $105 Therefore total = + $107 - $105 = + $2
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Forw ard Trading Example 2 Forward Price = $101 (ie too low) Today
• •
Borrow the shares from the stock-borrow market & sell them for $100 Invest $100 in bank
In one year’s time
• • • •
Receive shares & pay $101 Give back these shares to lender & pay $2 dividends (total payments $103) Withdraw your original $100 from bank plus interest @ 5% = $105 Therefore total = - $103 + $105 = + $2
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Forw ard Price Distribution Graph • Forward Price distribution chart assumes that the forward price will not move outside the • Forward Price Distribution is centred around its mean
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Forw ard Price Distribution Graph (cont’d) • Shape of “Normal” Distribution • Normal Distribution is “Bell” shaped
Forward Trading Example
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I ntroduction to Equity Derivatives Part 4: Options
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Options vs. Forw ards
Forward Price
Forward – Buyer obligated to buy at Forward Price
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Call Option – Buyer has the right to buy at Strike Price
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Optio ns: Contr act Speci ficati ons • Option Style
• Number of Options • Strike Price • Expiration Date
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Options: Standard Option Form ulae Call:
N x Max (S – K, 0) –
,
Where: N = Number of Options K = Strike Price of the Underlying S = Price of the Underlying when exercised
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Options: Lon g Call P & L Graph
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Options: Long P ut P & L Graph
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Options: Short Call P & L Graph
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Options: Short P ut P & L Graph
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Option V aluation: the bas ics • Option Value = Intrinsic Value + Time Value
• Time Value • Volatility • Length of Time to Expiry
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Option Valuatio n: The Greeks • Delta • Gamma • Vega • Theta •
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Optio n Strateg ies: The B asic s • Synthetic Forwards
• Straddles • Strangles • Collars
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Option Strategies: Synthetic Fo rw ards • Number Of Option Trades = 2
Seller Buyer Option Type • Usually Net Premium = 0
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Option Strategies: Synthetic Fo rw ards
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Option Strategies: Synthetic Fo rw ards
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Optio n Strategi es: Spre ads • Vertical Spreads
• Diagonal Spreads • Ratio Spreads
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Spre ads: Ver tical Spre ads • Number Of Option Trades = 2
Seller Buyer Strike Price Premium (usually)
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Spre ads: Bull Call Spre ad
Example: • uy tr e a • Sell 350 Strike Call
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Spre ads: Bear Call Spre ad
Example: • e tr e a • Buy 330 Strike Call
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Spre ads: P ut Spread s
Bear Put Spread • Buy 330 Strike Put • Sell 310 Strike Put
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Bull Put Spread • Sell 350 Strike Put • Buy 330 Strike Put
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Spre ads: Ho rizo ntal Spread s • Number Of Option Trades = 2
Seller Buyer Expiration Date Premium (usually)
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Spre ads: Diago nal Sprea ds • Number Of Option Trades = 2
Seller Buyer Strike Price Expiration Date Premium (usually)
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Spre ads: Rati o Spread s • Vertical or Horizontal Spreads
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Optio n Strategie s: Strad dles • Number Of Option Trades = 2
Option Type Premium (usually)
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Optio n Strategie s: Strad dles
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Optio n Strategie s: Strad dles
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Optio n Strategie s: Strang les • Number Of Option Trades = 2
Option Type Strike Price Premium (usually)
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Optio n Strategie s: Strang les
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Optio n Strategie s: Strang les
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Optio n Strategi es: Collars • Number Of Option Trades = 2
Seller Buyer Option Type Strike Price Premium (usually)
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Optio n Strategi es: Collars
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Optio n Strategi es: Collars
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Optio n Strateg ies: Butterfl y • Number Of Option Trades = 2 • Different Com onents: Buy 1 call at (X − a) strike with expiration date Z Buy 1 call at (X + a) strike with expiration date Z
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x-a
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x
x+a
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I ntroduction to Equity Derivatives Part 5: Equity Swaps & Dividend Swaps
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Equity Sw aps: the b asics • Swaps • Equity Leg vs Interest Leg
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Equity Sw aps: Equity Retur n Notional x (Final – Initial / Initial)
Notional = Agreed size of trade Final = Price of the underlying on valuation date Initial = Price of the underlying on start date • Share Swap = No of Shares x (Final – Initial) • Equity Leg vs Forward
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Equity Sw aps: I nterest Retur n Notional x Interest Rate x Day Count Fraction Where: Notional = Agreed size of trade Interest Rate = Floating Rate or Fixed Rate = Fixed Rate = A predetermined rate for all periods Day Count Fraction = Fraction used for rate (ie Act / 360)
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Equity Sw aps: P rice Return vs Total Return • What is Price Return?
• Standard Defaults: Index & Share Swaps
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Equity Sw aps: P rice Return Sw ap Cashflow s
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Equity Sw aps: Total Return Sw ap Cashflow s
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Equity Sw ap P eriods: Bullet Sw ap
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Equity Sw ap P eriods: Resetting Sw ap
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Equity Sw aps: Ap plications •
Avoid transaction costs (including tax)
•
Avoid locally based dividend taxes
•
Avoid limitations on leverage
•
To get around rules governing the particular type of investment that an institution can hold , spreads (risk-neutral position)
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Equity Sw ap: A R eal Life Exam ple Client Situation Situatio n
Bank A Solution
An Italian corporate wants to buy a 500,000 shares of ENI Spa
Client can gain exposure via a swap with nominal of 500,000
BUT they don’t have enough cash
Italian Corporate
Pays/receives ENI Spa performance + pays dividends
Bank A
Equity Swap Buyer
Pays Libor + 50bp
Equity Swap Seller
Client doesn't put up capital and pays financing at Libor + 50bp an ma es 50 p sprea © February 2008 - The Derivatives Consulting Group Ltd www.dcgconsultants.com
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Example of a Y ield Enhancement Trade Client Situation Situatio n
Bank A Solution
- Client has cash to invest - Dividend income it generates is tax exempt
- Bank A sells shares to Spanish bank - Spanish bank writes Bank A an equity swap on the shares - Bank A covers short by borrowing from the street at 92%
Pays/receives performance + 100% of dividends
Bank A
Receives Funding MOD
Borrows
Lender Client receives Fundin Bank A Receives 100% of the dividend but only pays out 92% of manufactured dividend © February 2008 - The Derivatives Consulting Group Ltd www.dcgconsultants.com
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Long Total Return Sw ap w ith Hedges
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Short Total Return Sw ap w ith Hedges
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Dividend Sw ap Cashflow s
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I ntroduction to Equity Derivatives Variance, Exotics & Correlation
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8383
Varian ce: the bas ics • Variance = Volatility2 (σ2) • percentage gain/loss in an underlying's price
• Variance Options • Conditional Variance Swaps
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Varian ce: Varian ce Sw aps • Swap or Forward? •
2
= N FRV = 100 x
⎛
t =1
⎝
Pt ⎞ Pt −1 ⎠
-
2
N
• Index vs Share Variance Swaps • Advanta es © February 2008 - The Derivatives Consulting Group Ltd www.dcgconsultants.com
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Varian ce: Varian ce Sw aps Example Example: • Spot Vol = 18% • Vega = £10,000 • Variance Amount = Vega/(100x2xSpot Vol) = 277.7 • FRV = 22% • Payout = 277.7 x (222 – 182) = £44,432 18%
• FRV = 16% • ayou = . x
–
=-
,
Final Realised Volatility
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Varian ce: Variance Options • Option vs Forward • Pa out = MAX 0 Variance Amount x FRV2 - Variance Strike Price
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Varian ce: Varian ce Options Example Example: • • • •
Desired Strike = 20% (OTM) Spot Vol = 18% Vega = £10,000 Variance Amount = Vega/(100x2xSpot Vol) = 277.7 • Premium = £2000
Strike Price (20%)
Final Realised Volatility
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• FRV = 22% • Payout = 277.7 x (222 – 202) = £23,326 • Profit = £21,236 • FRV = 16% • Payout = Zero • Profit = -£2000
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Varian ce: Condi tional Varian ce Sw aps • Up-Variance
• Corridor Variance Swaps
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Exotics: Option P ayout Form ulae Call:
Notional x M ax [(S – K) / R, 0] –
,
Where: K = Strike Price of the underlying S = Price of the underlying when exercised R = Spot price of the underlying at the time of trade
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Exotics: Fund ed Options • What are Funded Options?
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Exotics: Forw ard Starts & Lookbacks Call Payout:
Max(S-K,0)
Forward Start:
K = Trade Date + 3 months
Lookback:
K = Min(P1, P2, P3) where P1 = Price of underlying on Date 1 P2 = Price of underlying on Date 2 P3 = Price of underlying on Date 3
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Exotics : Asian s Call Payout:
Max(S-K,0)
S = Price of underlying on Expiration Date Asian In: Asian Out:
K = ∑(P / N) OR S = ∑(P / N) where P = Price of underlying on the Asian dates N = Number of Asian valuation days
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Exotics : Compo site • Composite = Cross Option + FX Fluctuation Risk
Call on IBM standard payout: $ = No of Options x Max(S-K,0) Call on IBM composite payout: £ = No of Options x Max(S/Q1-K/Q2,0) where S = Settlement Price K = $ Strike Price Q1 = Prevailing $/£ FX rate at time Strike Price taken Q2 = Prevailing $/£ FX rate at time Settlement Price taken
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Exotics : Qua nto • Quanto = Cross Option - FX Fluctuation Risk
Call on IBM standard payout: $ = No of Options x Max(S-K,0) Call on IBM quanto payout: £ = No of Options x Max(S/Q1-K/Q1,0) where S = Settlement Price K = $ Strike Price Q1 = Prevailing $/£ FX rate at time Strike Price taken
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Exotics : Out Of Curr ency • Out of Currency = Standard Option + Payout FX Conversion
Call on IBM standard payout: $ = No of Options x Max(S-K,0) Call on IBM OOC payout: £ = [No of Options xMax(S-K,0)]/Q2 where S = Settlement Price K = $ Strike Price Q2 = Prevailing $/£ FX rate at time Settlement Price taken
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Exotics : Barr iers • Up-and-out
• Up-and-in • Down-and-in • Rebates
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Exotics: Berm udan & Binary • Bermudan vs American & European
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Exotics: Rain bow Options Worst of/Best Of: Min(Perf1;Perf2)/Max(Perf1;Perf2)
Put on Worst Of: Max(0; Min(Perf1; Perf2)) Outperformance: Max(0; Perf1 - Perf2)
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