(Salomon Smith Barney) Exotic Equity Derivatives Manual

June 11, 1999
SALOMON SMITH BARNEY

Equity Derivative Sales August 1998
Randall Fairman, Ph.D.

(212) 723-7877
[email protected]
Salomon Smith Barney
Leon Gross
(212) 723-7877 Exotic Equity
[email protected]
Derivatives Manual
This report may be distributed only Salomon Smith Barney is a service mark of Smith Barney
to persons who have received a Inc. Smith Barney Inc. and Salomon Brothers Inc are affiliat-
copy of the booklet Characteris- ed but separately registered broker/dealers under common
tics and Risks of Standardized Op- control of Salomon Smith Barney Holdings Inc. Salomon
tions, published by the Options Brothers Inc and Salomon Smith Barney Holdings Inc. have
Clearing Corporation. been licensed to use the Salomon Smith Barney service
mark. This report was produced jointly by Smith Barney Inc.
June 11, 1999
Table of Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Legend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Equity Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Stocks of Non-U.S. Issuers: Local Style Swap .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Stocks of Non-U.S. Issuers: Quanto Style Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Stocks of Non-U.S. Issuers: ADR Style Swap. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Swaption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Stocks of Non-U.S. Issuers: Local Style Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Stocks of Non-U.S. Issuers: Local Style Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Stocks of Non-U.S. Issuers: ADR Style Call Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Stocks of Non-U.S. Issuers: ADR Style Put Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Stocks of Non-U.S. Issuers: Quanto Style Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Stocks of Non-U.S. Issuers: Quanto Style Put Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Forward Start Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Forward Start Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Asian Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Asian Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Lookback Call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Lookback Put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Split-fee Call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Split-fee Put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Knock in Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Knock in Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Knock out Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Knock out Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Knock in Call Option: Outside Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Knock in Put Option: Outside Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Knock out Call Option: Outside Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Knock out Put Option: Outside Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Binary Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Outperformance Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Spread Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Better of Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Better of Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Chooser Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Accrual Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Range Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
2
June 11, 1999
Realized Volatility Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

Capped Volatility Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Implied Volatility Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Par Par Asset Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Discount Asset Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
From Options to Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Options by Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
3
June 11, 1999
Introduction
Salomon Smith Barney hopes that investors find this manual to be a useful reference and source of ideas.
The intended audience is experienced institutional and other sophisticated investors. No single person is
likely to trade every one of the structures shown, nor are they appropriate for every investor. Some of
these instruments are extremely complex. Investors should use these financial instruments only if they
fully understand both the instrument and the overall transaction and are able to bear the risks associated
with each instrument and transaction.
These instruments involve significant risks, which are too numerous to describe in this manual. Since
each instrument is unique, and the range of their possible uses is wide, it is impossible to list all of the
factors that may affect the performance of each of these instruments.
Immediately following this Introduction is an important discussion of some of the risk factors relating to
the swaps, options and other instruments described in this manual.
Each financial instrument (some of which are securities and some of which are not) is described in two
pages. The first page is a standard template showing the most important information, including the payoff
formula, maximum risks for the buyer and seller, complexity and variables that influence the value of the
instrument. The second page gives an example of transacting in the instrument.
The manual begins with relatively less complex securities, emphasizing exposure to equity of non-U.S.
issuers: local, quanto and ADR style options and swaps. This is followed by variations on vanilla options:
forward start, Asian, lookback and split-fee options. Barrier options make up the next section, followed
by relative performance options: outperformance, spread, better of and chooser options. Instruments that
give ways of trading volatility are then examined: accrual options, range and volatility swaps. The last
two transactions, par par and discount asset swaps, are discussed as ways of trading credit exposure.
Following the discussion of individual instruments, is a schematic giving the conceptual relationship
among the instruments described and a table to help investors determine the most effective means of im-
plementing a given strategy. A glossary appears at the end to explain some of the terms used throughout
the manual.
Our aim is to make the contents exhaustive, but there are limits. The user can pick and choose features
among the instruments shown to construct new variations; e.g., a quanto style accrual option on the
spread between two assets, with a knock out provision on the accrual option. In addition, instruments
may be customized to meet particular hedging, tax, credit and other needs. Just remember, not every con-
ceivable instrument is tradeable and the more complex and customized an instrument, the more risk it
may entail.
This manual is for information purposes only and is not intended to be complete and is not an offer to buy or sell
any securities or other financial instruments. Salomon Smith Barney or any of their affiliates, directors, represen-
tatives and/or employees, may, at any point in time, hold a long or short position in any of the instruments men-
tioned in this Manual and may purchase or sell any other instruments from time to time as principal or agent.
Salomon, Smith Barney and any other of their affiliates may make markets in securities or other financial instru-
ments described in this Manual (to the extent that a market exists for such instruments which, in many if not
most cases, one may not) as well as in securities of issuers underlying or related to such instruments. This Man-
ual may not be reproduced, distributed or published for any purpose.
4
June 11, 1999
General Risk Factors Associated with Over the Counter Transactions

In common with many other financial transactions, over-the-counter (OTC) derivative transactions, in ad-
dition to providing significant benefits, may involve a variety of significant risks.
The specific risks presented by a particular OTC derivative transaction necessarily depend upon the terms
of that transaction and your circumstances. In general, all OTC derivative, structured note and warrant
transactions involve risks, which include (among others) the risk of adverse or unanticipated market, fi-
nancial, or political developments, risk of counterparty or issuer default and other credit and enforcement
risks, and risk of illiquidity and related risks. In addition, you may be subject to operational risks in the
event that you do not have in place appropriate internal systems and controls to monitor the various risks,
funding and other requirements to which you may be subject by virtue of your activities in OTC deriva-
tives, and other financial markets.
As in any financial transaction, you should ensure that you understand the requirements (including in-
vestment restrictions), if any, applicable to you that are established by your regulators or by your board of
directors or other governing body. You should also consider the legal, tax and accounting implications of
entering into any OTC derivative transaction. To the extent appropriate in light of the specific OTC deriv-
ative and your particular circumstances, you should consider consulting such advisers as may be appro-
priate to assist you in understanding the risks involved. If you are acting in the capacity of financial
adviser or agent, you should evaluate the foregoing matters in light of the circumstances applicable to
your client or principal and any obligations or limitations imposed on you as adviser or agent.
Neither Salomon Smith Barney Inc (Salomon Smith Barney) nor any of their affiliates is acting as an ad-
viser to investors in respect of these instruments or transactions involving these instruments. Investors
should study all materials provided by a proposed Salomon Smith Barney counterparty relating to a par-
ticular transaction and should consider and make an independent determination of the risks associated
with the instrument and of their ability to manage such risks. In particular, you should take steps to under-
stand the assumptions underlying the instrument involved in the particular transaction.
Swap and OTC option transactions permit precise customization to accomplish particular financial and
risk management objectives that might otherwise be unachievable. Customization can, because of the in-
dividualized nature of such transactions, introduce significant liquidity risk and other risk factors of a
complex character. Dealers may not always be willing to make markets in these transactions or terminate
early existing positions The value of an equity swap or OTC option may be established in a variety of
ways. In any transaction, a specific valuation methodology is determined at the outset of that transaction.
The benchmark is usually an exchange or market closing price.
Swaps and OTC options have individually tailored terms and are not transferable prior to maturity. Thus,
the market for these transactions may be illiquid and may not be easily closed prior to termination.
Unlike exchange traded derivative contracts, in which parties have credit risk to an entire clearance sys-
tem, swap and OTC option counterparties incur the credit risk of their counterpart when entering into a
transaction. These transactions are usually subject to a Master Agreement (generally based on the form
prepared by ISDA) which provides, among other things, for payments to be made on a net basis.
Since these swaps and OTC options are not exchange traded, prices and values must be calculated by a
dealer as opposed to an exchange.
Swaps are cash settled financial instruments which derive their value from the value or a component of
the value of, an underlying asset. Parties to a swap do not deliver or receive the underlying asset. Accord-
5
June 11, 1999
ingly, other attributes of an asset subject to a swap, such as voting rights related to that asset are not
passed from one party to the other. In many option transactions, however, parties may elect at the outset
to receive upon option exercise, either the asset underlying the option or the cash value of the option.
In most equity swaps the party receiving asset based returns receives the upside of the asset and pays the
other party any depreciation in the value of the asset and an interest rate. US margin regulations require
option sellers to post eligible margin. Since OTC options are transacted with a dealer and do not involve
a clearinghouse margin deposits are posted with the dealer.
Both OTC and exchange traded options are generally subject to positions limits and reporting require-
ments which may constrain the ability of an investor to use these instruments vehicle.
Cash settled OTC options and swaps may present certain enforceability risks due to local gaming and
bucket shop laws, although certain exemptions from such laws may be available depending upon the
terms of the instrument.
OTC Options may be structured as automatically exercisable or may require the buyer to take affirmative
steps to exercise the option when a threshold has been reached and all conditions to exercise have been
met. Options that are not automatically exercisable, thus, involve monitoring requirements and may in-
volve communication risk.
6
June 11, 1999
Legend
Used to indicate the importance of a factor. Completely filled diamonds indi-
cate the greatest importance.
A plus means that a security is sensitive to the given factor in a positive way:
its value rises with the factor. A minus means that the security is negatively
correlated to the given factor; its value decreases as the factor increases.
Like the solid black plus or minus, but used in cases where the sensitivity
may change under some conditions. For instance, the buyer of a knock out
call option where the barrier is greater than the spot price has a position
which is economically the same as being long the underlying stock until the
stock trades close to the barrier.
Pluses and minuses are overlaid over A and B when there are two underlying
stocks (A and B) to the derivative; e.g., outperformance and spread options.
Plus over the A and minus over the B means that the buyer of the derivative is
AB
+ – economically equivalent to being long stock A and is economically equiva-
lent to being short stock B.
A and B are also used with barrier options to distinguish the period before (B)
the option has knocked in/out and the period after (A) the option has knocked
in/out.
Pluses and minuses are overlaid over U and O for outside barrier options. U
UO
+ – indicates the underlying stock and O is the security used to trigger the barrier.
Plus over the U and minus over the O means that the buyer of the derivative
is economically equivalent to being long the underlying stock and is econom-
ically equivalent to being short the outside barrier stock.
The deltas for accrual options and range swaps depend on where the stock is
trading. L and H mean that the stock is trading at a low or high level, with the
L –
+ H
˚ superimposed plus or minus indicating whether the security is long or short
the underlying in this each case. The space between the L and H is used when
the stock is trading at an intermediate level.
The complexity of the financial instruments is rated on a scale of one to five,

2 3 4 one being the least complex and five the most complex. This rating is some-
1 5 what subjective and is not necessarily an accurate guide to the riskiness of
any strategy. Moreover, the riskiness of any given instrument will depend on
2 3 4
the way in which the instrument is used. A highly complex instrument rated
“5”, if used as a closely correlated hedge can be less risky that a relatively
1 5 simple instrument rated “1” which is used directionally.
7
June 11, 1999
Salomon Smith Barney
Exotic Equity
Derivatives Manual
8
June 11, 1999
Equity Swap
Description Gives economic exposure to stock or index returns.

Motivation Buyer • Gives leveraged exposure to the stock.
• Where no futures are available, swaps may be a good alternative.
• Can be used to give exposure to a basket of stocks in a single transaction.
Seller • Gives leveraged exposure to the stock.

• Can be used as part of a tax management strategy.
Mechanics Equation N × ( S – R ) , where N is the notional size of the trade, S is the stock return over
the life of the swap, and R is a fixed or floating rate, usually LIBOR plus or
minus a spread.
Trade Day No payments by either party.
Expiration Payments are usually exchanged periodically before expiration. One party
receives stock returns, the other receives LIBOR plus or minus a spread.
Key Concepts Total/Price The exchange of payments can be made based on the total return (including divi-
Return dends) or it can be based on the price return only of the stock or index.
Notional The size of the payments are determined by the notional times return.
Reset Longer term swaps generally reset quarterly, with the two parties exchanging pay-
ments based on the previous three months returns. This makes the long term swap
equivalent to a series of three month swaps.
LIBOR LIBOR is generally used as the benchmark for one half of the swap.
Market Risks
Upside Downside
Buyer Unlimited. Unlimited.

Gains rise as the stock price increases. Losses increase as the stock price
falls. Maximum loss occurs if the
stock reaches zero.
Seller Unlimited. Unlimited.

Seller gains as the stock price falls, Losses increase as the stock price
reaching a maximum when the stock rises, without limit.
price is zero.
Sensitivities Delta Complexity

Buyer
+
2 3 4
Seller
– 1 5
Importance
See the discussion of Risk Factors on page 5 of this manual.
9
June 11, 1999
Equity Swap
Example: An investor believes that the stock XYZ will increase in value over the next six months
and acquires the economic equivalent of a long position in the stock with a swap of
$1,000,000 notional. Assume that the stock pays no dividends, so that total return and
price return swaps are economically equivalent. If the stock is trading at $10.00 per share
when the swap is initiated, then the investor will receive payments equal to the returns
above $10.00 he would experience if he held 100,000 shares, while paying out LIBOR +
120 bps on $1,000,000. Assume that payments are exchanged quarterly, so that a total of
two payment exchanges (resets) occur.
The example assumes that stock moves from $10.00 when the swap is initiated, to $13.00
on the first reset date, then to $9.00 at termination. LIBOR is 5.25% for the first quarter
and 5.00% for the second quarter.
First Quarter LIBOR: 5.25%

Stock moves from $10.00 to $13.00
Net payment to investor: $283,875
$300,000 = 100,000 shares x $3.00

Investor SSB
$16,125 = (5.25% + 1.20%) x $1,000,000 / 4
Second Quarter LIBOR: 5.00%

Stock moves from $13.00 to $9.00
Net payment from investor: $420,150
-$100,000 = 100,000 shares x -$1.00

Investor SSB
$20,150 = (5.00% + 1.20%) x $1,300,000 / 4
In the second quarter, the stock price declined, so the investor receives a negative amount.
That is, he must pay the financing cost of $20,150 plus the stock returns of $400,000. The
notional amount on which the LIBOR payment is based grows or shrinks with the stock
price. The value of the portfolio of 100,000 shares grew to $1,300,000, so the payment is
based on that reset notional amount. Also, for the purpose of the example, the LIBOR pay-
ments are based on dividing by four (four payments per year). Since LIBOR is an actual/
360 rate, the actual value would be slightly different.

10
June 11, 1999
Stocks of Non-U.S. Issuers: Local Style Swap
Description Gives economic exposure to stock or index returns. Payments are exchanged in the
local currency, so the investor does have exposure to currency risk.
Seller • Gives leveraged exposure to downside in the stock.

minus a spread. All values are in terms of the local (foreign) currency.
Currency Risk The value of the payments can be more or less, depending on the prevailing cur-
rency exchange rate.
Market Risks Upside Downside

stock reaches zero.

reaching a maximum which the stock rises, without limit.
price is zero.
Sensitivities Delta Currencya Complexity

Buyer
+ –
2 3 4
Seller
– + 1 5
Importance
a. Expressed in USD terms and assuming that the buyer’s swap is in the money. If the dollar weakens and the swap is
in the money, it works to the benefit of the buyer.
11
June 11, 1999
Stocks of Non-U.S. Issuers: Local Style Swap

Example: An investor believes that the Dutch stock XYZ will increase in value over the next six
months and acquires the economic equivalent of a long position in the stock with a swap
of 1,000,000 NLG (Dutch Guilder) notional. Assume that the stock pays no dividends, so
that total return and price return swaps are economically equivalent. If the stock is trading
at 10.00 NLG per share when the swap is initiated, then the investor will receive payments
equal to the returns above 10.00 NLG he would experience by holding 100,000 shares,
while paying out NLG LIBOR + 100 bps on 1,000,000 NLG. Assume that payments are
exchanged quarterly, so that a total of two payment exchanges are made.
The example assumes that stock moves from 10.00 NLG when the swap is initiated, to
13.00 NLG on the first reset date, then to 12.00 NLG at termination. NLG LIBOR is
3.80% for the first quarter and 4.25% for the second quarter.
First Quarter NLG LIBOR: 3.80%

Stock moves from 10.00 NLG to 13.00 NLG
Net payment to investor: 288,000 NLG
300,000 NLG = 100,000 shares x 3.00 NLG

Investor SSB
12,000 NLG = (3.80% + 1.00%) x 1,000,000 NLG / 4
Second Quarter NLG LIBOR: 4.25%

Net payment from investor: 117,063 NLG
-100,000 NLG = 100,000 shares x -1.00 NLG

Investor SSB
17,063 NLG = (4.25% + 1.00%) x 1,300,000 NLG / 4
That is, he must pay the financing cost of 17,063 NLG plus the stock returns of 100,000
NLG. The notional amount on which the LIBOR payment is based grows or shrinks with
the stock price. The value of the portfolio of 100,000 shares grew to 1,300,000 NLG, so
the payment is based on that reset notional amount for the second quarter. Also, for the
purpose of the example, the LIBOR payments are based on dividing by four (four pay-
ments per year). Since LIBOR is an actual/360 rate, the actual value would be slightly dif-
ferent.
The payments are made in the local currency, NLG in this case, so the value of the pay-
ments in USD may vary.

12
June 11, 1999
Stocks of Non-U.S. Issuers: Quanto Style Swap
Description Gives economic exposure to stock or index returns. Payments are exchanged in USD
by converting the payments of the local swap using an exchange rate fixed at swap
initiation, which reduces the currency risk.

minus a spread. The notional value is expressed in USD; other values are in terms
of the local (foreign) currency.
LIBOR LIBOR in the foreign market is used as the benchmark for one half of the swap.
Market Risks
Upside Downside

stock reaches zero.

price is zero.
Sensitivities Delta Complexity

Buyer
+
2 3 4
Seller
– 1 5
Importance
13
June 11, 1999
Stocks of Non-U.S. Issuers: Quanto Style Swap

months and acquires the economic equivalent of a long position in the stock with a swap
of 1,000,000 USD notional. Assume that the stock pays no dividends, so that total return
and price return swaps are economically equivalent. If the stock is trading at 10.00 NLG
(Dutch Guilder) per share and the exchange rate is 2.00 NLG/USD when the swap is initi-
ated, then the investor will receive payments equal to the returns above 10.00 NLG he
would experience if he held 200,000 shares, while paying out NLG LIBOR + 100 bps on
2,000,000 NLG. Assume that payments are exchanged quarterly, so that a total of two
payment exchanges are made.
The example assumes that stock moves from 10.00 NLG when the swap is initiated, to
13.00 NLG on the first reset date, then to 12.00 NLG at termination. USD LIBOR is
5.25% for the first quarter and 5.00% for the second quarter.
First Quarter USD LIBOR: 5.25%

Net payment to investor: 284,375 USD
300,000 USD = 200,000 shares x 3.00 NLG / (2 NLG/USD)

Investor SSB
15,625 USD = (5.25% + 1.00%) x 2,000,000 NLG / (4 x 2 NLG/USD)
Second Quarter USD LIBOR: 5.00%

Net payment from investor: 119,500 USD
-100,000 USD = 200,000 shares x -1.00 NLG / (2 NLG/USD)

Investor SSB
19,500 USD = (5.00% + 1.00%) x 2,600,000 NLG / (4 x 2 NLG/USD)
That is, he must pay the financing cost of 19,500 USD plus the stock returns of 100,000
USD. The notional amount on which the LIBOR payment is based grows or shrinks with
the stock price. The value of the portfolio of 200,000 shares grew to 2,600,000 NLG, so
the payment is based on that reset notional amount. Also, for the purpose of the example,
the LIBOR payments are based on dividing by four (four payments per year). Since LI-
BOR is an actual/360 rate, the actual value would be slightly different.

14
June 11, 1999
Stocks of Non-U.S. Issuers: ADR Style Swap
Description Gives economic exposure to stock or index returns. Payments are exchanged into
USD by converting the level of the stock using a floating exchange rate. The investor
has currency risk on the principal.

the life of the swap, calculated using a floating exchange rate, and R is a fixed or
floating rate, usually LIBOR plus or minus a spread.
Currency Risk The return of the swap is strongly dependant on fluctuations in the exchange rate.
Market Risks
Upside Downside

stock price reaches zero.

price is zero.
Sensitivities Delta Currencya Complexity

Buyer
+ +
2 3 4
Seller
– – 1 5
Importance
a. Expressed in USD terms. For example, if the dollar weakens, it works to the benefit of the buyer.
15
June 11, 1999
Stocks of Non-U.S. Issuers: ADR Style Swap

months and acquires economic equivalent of a long position in the stock with a swap of
1,000,000 USD notional. Assume that the stock pays no dividends, so total return and
price return swaps are economically equivalent. If the stock is trading at 10.00 NLG
(Dutch Guilders) per share and the exchange rate is 2.00 NLG/USD when the swap is ini-
tiated, then the investor will receive payments equal to the returns above 10.00 NLG he
would experience if he held 200,000 ADRs (if they existed), while paying out LIBOR +
100 bps on 1,000,000 USD. Assume that payments are exchanged quarterly, so that a total
of two payment exchanges are made.
The example assumes that the stock moves from 10.00 NLG when the swap is initiated, to
13.00 NLG on the first reset date, then to 12.00 NLG at termination, while the exchange
rate moves from 2.00 NLG/USD to 1.90 NLG/USD on the first reset and 2.05 NLG/USD
at termination. LIBOR is 5.25% for the first quarter and 5.00% for the second quarter.
First Quarter LIBOR: 5.25%

Rate moves from 2.00 to 1.90 NLG/USD
Net payment to investor: 352,796 USD
368,421 USD = (200,000 shares x 13.00 NLG / 1.9 NLG/USD) - 1,000,000 USD
Investor SSB
15,625 USD = (5.25% + 1.00%) x 1,000,000 USD/ 4
Second Quarter LIBOR: 5.00%

Rate moves from 1.90 to 2.05 NLG/USD
Net payment from investor: 218,215 USD
-197,689 USD = (200,000 shares x 12.00 NLG / 2.05 NLG/USD) - 1,368,421 USD
Investor SSB
20,526 USD = (5.00% + 1.00%) x 1,368,421 USD / 4
The notional amount on which the LIBOR payment is based grows or shrinks with the
stock price. The value of the portfolio of 200,000 shares grew to 1,368,421 USD, so the
payment is based on that reset notional amount. In the second quarter, the stock price de-
clined, so the investor receives a negative amount. That is, he must pay the financing cost
of 20,526 USD plus the stock returns of 197,689 USD. Also, for the purpose of the exam-
ple, the LIBOR payments are based on dividing by four (four payments per year). Since
LIBOR is an actual/360 rate, the actual value would be slightly different.

16
June 11, 1999
Swaption
Description An option to enter a swap at levels agreed upon in advance. Economics are similar to
an ordinary call or put.
Motivation Buyer • Gives leveraged exposure, with limited downside.
• Investors profit from long call positions if the volatility of the security underly-
ing the swaption increases.
Seller • Can be sold as a part of a hedging/overwriting strategy or if volatility is expected

to decline.
• Selling options is a way of being paid for implementing targeted sales or buys.
Mechanics Equation If the option is exercised, the buyer will enter into a swap where the initial level of
the stock is assumed to be K , the strike price which is agreed on when the trade is
initiated.
Trade Day Buyer pays the swaption premium.
Exercise Day If the buyer exercises, the buyer and seller enter into the swap.
Expiration The buyer and seller will have made interim and terminal swap payments.
Key Concepts Volatility After moneyness, this is the most important factor determining the value.
Breakeven This is the minimum move needed for the payout of the option to equal the initial
cost.
Market Risks
Upside Downside
Buyer Unlimited. Limited.

Profits to the extent that the stock price If the stock price does not move
moves beyond the strike. beyond the strike, can lose no more
than the premium paid for the option.
Seller Limited. Unlimited.

If the stock price does not move beyond If the stock price moves beyond the
the strike, keeps the premium. strike, potential losses are unlimited.
Sensitivities Deltaa Vega Correlationb Time Complexity

Buyer
? + + –
2 3 4
Seller
? – – + 1 5
Importance
a. Buyer could be long or short depending on the direction of the swap. Delta is as with an ordinary option.
b. If the underlying is an index, then the buyer is long correlation among the stocks in the index.
17
June 11, 1999
Swaption
Example: An investor buys a three month option on a three month swap on 100,000 shares of the
stock XYZ. If the investor exercises the option, he will enter into a swap where he re-
ceives the return of the stock beyond a level which is 10% higher than the stock when the
option is purchased, and will pay out LIBOR plus 150 bps. Economically, this is similar to
a three month call option struck 10% out of the money. Assume that this is offered for
4.65%. If XYZ is trading at $50.00 when the option is purchased, then the strike is 10%
higher, or at $55.00. The dollar cost of the option is $2.33 = $50.00 x 4.65% per share.
Swaption: Possible Scenario
70 70
65 65
XYZ Spot
60 60
55 55
50 50
45 45
JAN FEB MAR APR MAY JUN
98
XYZ Spot
The vertical line indicates the exercise date for the option. XYZ is trading at $57.00 on the
exercise date, which is $2.00 higher than the strike. So the investor exercises the option
and enters into a swap lasting three more months. He will receive the return of 100,000
shares of XYZ beyond $55.00 (and pay out any depreciation below $55.00) and pay out
LIBOR plus 150 bps on the value of the stock when the swap is initiated.
When the swap expires, the closing price of XYZ is $64.25. So the investor receives
$925,000 = 100,000 x ($64.25 - $55.00). When the swap was initiated, three month LI-
BOR stood at 5.90%, so the investor must pay $105,450 = 100,000 x $57.00 x (5.90% +
1.50%) / 4. For the purpose of the example, the LIBOR payments are based on dividing by
four (four payments per year). Since LIBOR is an actual/360 rate, the actual value would
be slightly different.

18
June 11, 1999
Stocks of Non-U.S. Issuers: Local Style Call Option
Description Gives the buyer exposure to the upside in the underlying stock above the strike. The
strike and spot prices are expressed in the local currency, so the investor has expo-
sure to currency risk on any payout.
Motivation Buyer • Gives leveraged exposure to upside in the stock, with limited downside.
ing the option increases.

to decline.
• Selling calls is a way of being paid for implementing targeted sales.
Mechanics Equation F × Max (S – K,0) , where F is the foreign exchange ratio, S is the spot price at
expiration, in local terms, and K is the strike price, in local terms. For a U.S.
investor, F would be expressed in the form USD/Local Currency Unit.
Trade Day Buyer makes a single premium payment.
Expiration The seller will have to make a single payment if the stock is above the strike and
the option is exercised.
Key Concepts Volatility The volatility of the local stock price is important.
Currency Risk Any payout must be converted from local terms to the investor’s currency.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock price If the stock fails to rally, can lose no
rises above the strike. Payment is made more than the premium paid for the
in the local currency. option.

If the stock fails to rally above the strike, If the stock price rises above the
keeps the premium. strike, potential losses are unlimited.
Sensitivities Delta Vega Currencya Correlationb Time Complexity

Buyer
+ + – + –
2 3 4
Seller
– – + – + 1 5
Importance
a. Expressed in USD terms. For example, if the dollars strengthens, it works against the buyer.
b. If the underlying is a foreign index, then the buyer is long correlation among the stocks in the index.
19
June 11, 1999
Stocks of Non-U.S. Issuers: Local Style Call Option

Example: An investor buys a local style call on the U.K.’s FTSE-100. The call has six months to ex-
piration and is struck 5% out of the money. Assume that this is offered for 6.62% of spot,
in GBP. With the FTSE at 4800, this puts the strike at 5040 and the premium is 317.76
GBP. Using an exchange rate of 0.60 GBP/USD, the cost to the U.S. investor is 529.60
USD. At expiration, the dollar payout depends on the exchange rate at that time.
Local Call: USD Payout versus Exchange Rate
1,000 1,000
800 800
Payout (USD)
600 600
400 400
200 200
0 0
4600 4800 5000 5200 5400

USD Payout: 0.50 GBP/USD
USD Payout: 0.60 GBP/USD FTSE Level
The breakeven depends on the prevailing exchange rate at expiration. If the exchange rate
remains at 0.60 GBP/USD, then the break even is 317.76 points above the strike, or
5357.76. If the dollar weakens to 0.50 GBP/USD, then the breakeven decreases to
5309.29 (5040 + 538.58 x 0.50). If the dollar strengthens to 0.70 GBP/USD, then the
breakeven increases to 5417.01 (5040 + 538.58 x 0.70).

20
June 11, 1999
Stocks of Non-U.S. Issuers: Local Style Put Option
Description Gives the buyer exposure to the downside in the underlying stock below the strike.
The strike and spot prices are expressed in the local currency, so the investor has
exposure to currency risk on any payout.
Motivation Buyer • Gives leveraged exposure to downside in the stock, with limited downside.
• Investors profit from long put positions if the volatility of the security underly-
• Hedging a long position in the underlying stock.
Seller • Can be sold if volatility is expected to decline.

• Selling puts is a way of being paid for implementing targeted buys.
Mechanics Equation F × Max (K – S,0) , where F is the foreign exchange ratio, S is the spot price at
expiration, in local terms, and K is the strike price, in local terms. For a U.S.
Expiration The seller will have to make a single payment if the stock is below the strike and
Key Concepts Volatility The volatility of the local stock is important.
Currency Risk Any payout must be converted from local terms to the investor’s currency.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock price If the stock does not fall below the
falls below the strike. Payment is made strike, can lose no more than the pre-
in the local currency. mium paid for the option.

If the stock price does not fall below the If the stock price falls, can lose up to
strike, keeps the premium. the amount of the strike, in local
terms.

Buyer
– + – + –
2 3 4
Seller
+ – + – + 1 5
Importance
21
June 11, 1999
Stocks of Non-U.S. Issuers: Local Style Put Option

Example: An investor buys a local style put on the U.K.’s FTSE-100. The put has six months to ex-
piration and is struck 5% out of the money. Assume that this is offered for 4.00% of spot,
in GBP. With the FTSE at 4800, this puts the strike at 4560 and the premium is 192 GBP.
Using an exchange rate of 0.60 GBP/USD, the cost to the U.S. investor is 320 USD. At
expiration, the dollar payout depends on the exchange rate at that time.
Local Put: USD Payout versus Exchange Rate
800 800
600 600
Payout (USD)
400 400
200 200
0 0
4200 4400 4600 4800

The breakeven depends on the prevailing exchange rate at expiration. If the exchange rate
remains at 0.60 GBP/USD, then the break even is 192 points below the strike, or 4368. If
the dollar weakens to 0.50 GBP/USD, then the breakeven decreases to 4400 (4560 - 320 x
0.50). If the dollar strengthens to 0.70 GBP/USD, then the breakeven increases to 4336
(4560 - 320 x 0.70).

22
June 11, 1999
Stocks of Non-U.S. Issuers: ADR Style Call Option

Description Gives the buyer exposure to the upside in the underlying stock above the strike, in
USD terms, with exposure to currency risk on the level of the underlying stock. ADR
style options are also known as crosses.

to decline.
Mechanics Equation Max (F × S – K,0) , where F is the foreign exchange ratio, S is the spot price at
expiration, in local terms, and K is the strike price, in USD terms. For a U.S.
Key Concepts Volatility The volatility of the local stock price and currency and their correlation are
important.
Currency Risk The level of the underlying stock is determined in part by the exchange rate.
cost.
Market Risks
Upside Downside

Profits to the extent that the dollar price If the stock fails to rally, can lose no
of the stock rises above the strike. more than the premium paid for the
option.

If the stock fails to rally, keeps the pre- If the stock price rises above the
mium. strike, potential loses are unlimited.

Buyer
+ + – + –
2 3 4
Seller
– – + – + 1 5
Importance
b. If the underlying is a foreign index, then the buyer is long correlation among the stocks in the index. Buyer is also
long correlation between the stock and currency returns.
23
June 11, 1999
Stocks of Non-U.S. Issuers: ADR Style Call Option
Example: A U.S. investor buys an ADR style call on the U.K.’s FTSE-100. The call has six months
to expiration and is struck 5% out of the money. Assume that this is offered for 6.96% of
spot, in USD. Using 0.60 GBP/USD as the exchange rate, with the FTSE at 4800 GBP or
8000 USD (4800 / 0.60), this puts the strike at 8400 USD (4800 x 1.05 / 0.60) and the pre-
mium is 556.80 (8000 x 6.96%) USD. The strike is fixed in USD and the underlying
moves with changes in the local index level and the exchange rate.
ADR Style Call: USD Payout versus Exchange Rate
5,000 5,000
4,000 4,000
Payout (USD)
3,000 3,000
2,000 2,000
1,000 1,000
0 0
3000 4000 5000 6000
The breakeven depends on the prevailing exchange rate at expiration. To break even, the
option must pay off at least 556.80 USD. If the exchange rate remains at 0.60 GBP/USD,
then the option pays off above 5040 (8400 x 0.60) points on the FTSE. In this case, the in-
dex must rise 334.08 (556.80 x 0.60) FTSE points above the strike, or to 5374.08. If the
dollar weakens to 0.50 GBP/USD, then the index must rise beyond 4200 (8400 x 0.50)
FTSE points, so the breakeven decreases to 4478.40 (4200 + 556.80 x 0.50). If the dollar
strengthens to 0.70 GBP/USD, then the breakeven increases to 6269.76 (8400 x 0.70 +
556.80 x 0.70).

24
June 11, 1999
Stocks of Non-U.S. Issuers: ADR Style Put Option

Description Gives the buyer exposure to the downside in the underlying stock below the strike, in
USD terms, with exposure to currency risk on the level of the underlying stock. ADR
style options are also known as crosses.
Motivation Buyer • Hedging a long position in the underlying stock.
• Gives leveraged exposure to downside in the stock, with limited downside.

Mechanics Equation Max (K – S × F,0) , where F is the foreign exchange ratio, S is the spot price at
expiration, in local terms, and K is the strike price, in USD terms. For a U.S.
Key Concepts Volatility The volatility of the local stock price and currency and their correlation are
important.
Currency Risk The level of the underlying stock is determined in part by the exchange rate.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock price, If the stock price does not fall, can
in USD terms, falls below the strike. lose no more than the premium paid
for the option.

strike, keeps the premium. the amount of the strike.

Buyer
– + + + –
2 3 4
Seller
+ – – – + 1 5
Importance
a. Expressed in USD terms. For example, if the dollars strengthens, it works to the benefit of the buyer.
b. If the underlying is a foreign index, then the buyer is long correlation among the stocks in the index. The buyer is
also long correlation between the stock and currency returns.

25
June 11, 1999
Stocks of Non-U.S. Issuers: ADR Style Put Option
Example: A U.S. investor buys an ADR style put on the U.K.’s FTSE-100. The put has six months to
expiration and is struck 5% out of the money. Assume that this is offered for 4.75% of
mium is 380.00 USD (8000 x 4.75%). The strike is fixed in USD and the underlying
moves with changes in the local index level and the exchange rate.
ADR Style Put: USD Payout versus Exchange Rate
3,000 3,000
Payout (USD)
2,000 2,000
1,000 1,000
0 0
3500 4000 4500 5000 5500 6000
The breakeven depends on the prevailing exchange rate at expiration. To break even, the
option must payoff at least 380.00 USD. If the exchange rate remains at 0.60 GBP/USD,
then the option pays off below 4560 (7600 x 0.60) points on the FTSE. The index must fall
228.00 (380.00 x 0.60) FTSE points below this level, or to 4332.00. If the dollar weakens
to 0.50 GBP/USD, then index must fall below 3800 (7600 x 0.50) FTSE points, so the
breakeven decreases to 3610.00 (3800 - 380 x 0.50). If the dollar strengthens to 0.70 GBP/
USD, then the breakeven increases to 5054.00 (7600 x 0.70 - 380 x 0.70).

26
June 11, 1999
Stocks of Non-U.S. Issuers: Quanto Style Call Option
Description Gives the buyer exposure to the upside in the underlying stock above the local strike,
with no exposure to currency risk on the payout.

to decline.
Mechanics Equation Max (F × S – K,0) , where F is the foreign exchange ratio, which is fixed for the life
of the option, S is the spot price at expiration, in local terms, and K is the strike
price, in USD terms. For a U.S. investor, F would be expressed in the form USD/
Local Currency Unit.
Key Concepts: Volatility The volatility of the local stock price and currency and their correlation are
important.
Currency Risk Although the exchange rate is fixed, the value of the option is affected by the rate.
cost.
Market Risks
Upside Downside

rises beyond the strike. more than the premium paid for the
option.

mium. strike, potential losses are unlimited.

Buyer
+ + – + –
2 3 4
Seller
– – + – + 1 5
Importance
27
June 11, 1999
Stocks of Non-U.S. Issuers: Quanto Style Call Option

Example: A U.S. investor buys a quanto style call on the U.K.’s FTSE-100. The call has six months
mium is 573.60 USD. The strike is fixed in USD and the underlying is the FTSE level di-
vided by the fixed exchange rate of 0.60 GBP/USD.
Quanto Style Call: USD Payout
800 800
600 600
Payout (USD)
400 400
200 200
0 0
4600 4800 5000 5200 5400
USD Payout FTSE Level
The breakeven is independent of the prevailing exchange rate at expiration. To break even,
the index must rise by approximately 7.17% (the cost of the option) beyond the strike in
local terms. For instance, if the index rises to 5200 FTSE points, then the payoff is 266.67
USD (5200 / 0.60 - 8400). The breakeven for this option is 344.16 (573.60 x 0.60) FTSE
points above the strike in GBP, which is 5384.16 (344.16 + 8400 x 0.60).

28
June 11, 1999
Stocks of Non-U.S. Issuers: Quanto Style Put Option
Description Gives the buyer exposure to the downside in the underlying stock below the local
strike, with no exposure to currency risk on the payout.
Motivation Buyer • Hedging a long position in the underlying stock.
• Gives leveraged exposure to downside in the stock, with limited downside.

Mechanics Equation Max (K – S × F,0) , where F is the foreign exchange ratio, which is fixed for the life
of the option, S is the spot price at expiration, in local terms, and K is the strike
price, in USD terms. For a U.S. investor, F would be expressed in the form USD/
Local Currency Unit.
Key Concepts: Volatility The volatility of the local stock price and currency and their correlation are
important.
Currency Risk Although the exchange rate is fixed, the value of the option is affected by the rate.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock price If the stock price does not fall, can
falls below the strike. lose no more than the premium paid
for the option.

strike, keeps the premium. the amount of the strike.

Buyer
– + + + –
2 3 4
Seller
+ – – – + 1 5
Importance
a. Expressed in USD terms. For example, if the dollars strengthens, it works to the benefit of the buyer.
29
June 11, 1999
Stocks of Non-U.S. Issuers: Quanto Style Put Option
Example: A U.S. investor buys a quanto style put on the U.K.’s FTSE-100. The put has six months
mium is 369.60 USD. The strike is fixed in USD and the underlying is the FTSE level di-
vided by the fixed exchange rate of 0.60 GBP/USD.
Quanto Style Put: USD Payout
1,000 1,000
800 800
Payout (USD)
600 600
400 400
200 200
0 0
4000 4200 4400 4600 4800 5000 5200 5400
USD Payout FTSE Level
The breakeven is independent of the prevailing exchange rate at expiration. To break even,
the index must fall by approximately 4.62% (the cost of the option) beyond the strike in
local terms. For instance, if the index falls to 4400 FTSE points, then the payoff is 266.67
USD (7600 - 4400 / 0.60). The breakeven for this option is 221.76 (369.60 x 0.60) FTSE
points below the strike in GBP, which is 4338.24 (7600 x 0.60 - 221.76).

30
June 11, 1999
Forward Start Call Option
Description Gives the buyer exposure to the upside in the underlying above the strike. The option
is purchased forward; terms are agreed on at trade day, but payment is made at a
future date. In dollar terms, the strike floats until the purchase date, at which time it
becomes fixed.
• The buyer locks in an implied volatility and profits if the volatility of the secu-
rity underlying the option increases.
Seller • Can be sold as a part of a hedging/overwriting strategy.

• The seller locks in an implied volatility and profits if volatility falls.
Mechanics Equation Max (S – K,0) , where S is the price of the underlying at expiration, and K is the
strike price.
Trade Day Neither party makes a payment (as with a futures contract).
Payment Day Buyer makes a single premium payment.
Expiration The seller will have to make a single payment if the underlying closes above the
strike and the option is exercised.
cost.
Market Risks
Upside Downside

rises above the strike. more than the premium paid for the
option.

Sensitivities Deltaa Vega Correlationb Timec Complexity

Buyer
+ + + –
2 3 4
Seller
– – – + 1 5
Importance
a. Until the forward date is reached, the buyer is neither long nor short.
c. Until the forward date is reached, the buyer is neither long nor short.
31
June 11, 1999
Forward Start Call Option

Example: An investor buys a three month at the money call on the stock XYZ six months forward.
Assume that this is offered for 8.45% forward. In six months time, the investor will re-
ceive a three month call with strike equal to the spot price of XYZ at that time, and the
seller will receive 8.45% of the future spot on that date.
Forward Start Call: Possible Scenario
60 60
58 58
56 56
54 54
Price
52 52
50 50
48 48
46 46
JAN FEB MAR APR MAY JUN JUL AUG SEP
98
XYZ Spot
Six months after the trade is initiated, XYZ is trading at $48.00. On that date, the investor
pays $4.06 (8.45% x $48.00) and receives a call with three months to expiration and a
strike of $48.00. Three months later, when the entire trade expires, XYZ is trading at
$59.00. So the investor receives $11.00 = $59.00 - $48.00.

32
June 11, 1999
Forward Start Put Option
Description Gives the buyer exposure to the downside in the underlying below the strike. The
option is purchased forward; terms are agreed on at trade day, but payment is made at
a future date. In dollar terms, the strike floats until the purchase date, at which time it
becomes fixed.
• The buyer locks in an implied volatility and profits if the volatility of the secu-
rity underlying the option increases.
Seller • Selling puts is a way of being paid for implementing targeted buys.
• The seller locks in an implied volatility and profits if volatility falls.
Mechanics Equation Max (K – S,0) , where S is the price of the underlying at expiration, and K is the
strike price.
Trade Day Neither party makes a payment (as with a futures contract).
Payment Day Buyer makes a single premium payment.
Expiration The seller will have to make a single payment if the underlying closes below the
cost.
Market Risks
Upside Downside

for the option.

If the stock price does not fall, keeps the If the stock price falls below the
premium. strike, potential losses are unlimited.
Sensitivities Deltaa Vega Correlationb Timec Complexity

Buyer
– + + –
2 3 4
Seller
+ – – + 1 5
Importance
a. Until the forward date is reached, the buyer is neither long nor short.
c. Until the forward date is reached, the buyer is neither long nor short.
33
June 11, 1999
Forward Start Put Option

Example: An investor buys a three month at the money put on the stock XYZ six months forward.
Assume that this is offered for 7.45% forward. In six months time, the investor will re-
ceive a three month put with strike equal to the spot price of XYZ at that time, and the
seller will receive 7.45% of the future spot on that date.
Forward Start Put: Possible Scenario
55 55
50 50
Price
45 45
40 40
35 35
JAN FEB MAR APR MAY JUN JUL AUG SEP
98
XYZ Spot
Six months after the trade is initiated, XYZ is trading at $40.25. On that date, the investor
pays $3.00 (7.45% x $40.25) and receives a put with three months to expiration and a
strike of $40.25. Three months later, when the entire trade expires, XYZ is trading at
$45.00. Since this is greater than the strike of $40.25, the investor receives nothing. If
XYZ had closed at $35.00, then the investor would have received $5.25 = $40.25 - $35.00.

34
June 11, 1999
Asian Call Option
Description Gives the buyer exposure to the upside in the underlying stock above the strike, with
settlement based on an average stock price over some period.

Mechanics Equation Max (S – K,0) , where S is the level of the underlying at expiration, and K is the
strike price. Either or both can be based on the average stock price over some
period.
Expiration The seller will have to make a single payment if the underlying settles above the
Key Concepts Volatility Asian options are less sensitive to volatility than ordinary options.
Average The average of the stock price can be used to determine the terminal level and/or
the strike. It can be measured over various periods and frequencies.
Path Dependent The value of the option depends on the exact path followed by the stock.
cost.
Market Risks
Upside Downside

rises above the strike. more than the premium paid for the
option.

Sensitivities Delta Vega Correlationa Time Complexity

Buyer
+ + + –
2 3 4
Seller
– – – + 1 5
Importance
a. If the underlying is an index, then the buyer is long correlation among the stocks in the index.
35
June 11, 1999
Asian Call Option

Example: An investor buys an Asian style call on the S&P 500. The call has six months to expiration
and is struck 5% out of the money. The strike is fixed on the trade date (not based on aver-
aging) and the terminal level is taken as the average closing price over the last ten trading
days up to expiration. Assume that this is offered for 6.20% of spot. With the index at 950,
this puts the strike at 997.50 and the cost is 58.90 index points.
Ten Day Averaging Period: Hypothetical Paths
1,060
SPX Level 1,060
1,040 1,040
Average: 1004.10
1,020 1,020
Average: 1015.18
1,000 1,000
980 980
960 960
940 940
Average: 978.50
920 920
2 4 6 8 10
Trade Days
The first path begins well below the strike at 975 and ends about 25 points above the strike
at 1022.89. The average over the ten days is 1004.10, so the option pays out 6.60 (1004.10
- 997.50) index points. If the option were ordinary (not Asian), then the payoff would be
much higher: 25.39 (1022.89 - 997.50) index points. The second path moves in a tight
range, starting at 1005.94 and ending at 1016.71. The average is 1015.18, so the option
pays out 17.68 (1015.18 - 997.50) index points. In the third case, the index moves down
from 1050 to 940 over the ten days, for an average of 978.50, which is below the option
strike. So the option pays nothing in the third case.
The effect of averaging is to make the observed settlement level less volatile. Many inves-
tors use Asian options in case the market makes a large move on the day of expiration.
Sellers of options sometimes like the settlement to be Asian since it makes them easier to
unwind and hence less risky.

36
June 11, 1999
Asian Put Option
Description Gives the buyer exposure to the downside in the underlying stock below the strike,
with settlement based on an average stock price over some period.
• Investors profits from long put positions if the volatility of the security underly-

Mechanics Equation Max (K – S,0) , where S is the level of the underlying at expiration, and K is the
strike price. Either or both can be based on the average stock price over some
period.
Expiration The seller will have to make a single payment if the underlying settles below the
Key Concepts Volatility Asian options are less sensitive to volatility than ordinary options.
Average The average of the stock price can be used to determine the terminal level and/or
the strike. It can be measured over various periods and frequencies.
cost.
Market Risks
Upside Downside

Profits to the extent that stock price rises If the stock fails to rally, can lose no
above the strike. more than the premium paid for the
option.


Buyer
– + + –
2 3 4
Seller
+ – – + 1 5
Importance
37
June 11, 1999
Asian Put Option
Example: An investor buys an Asian style put on the S&P 500. The put has six months to expiration
and is struck 5% out of the money. The strike is fixed on the trade date (not based on aver-
aging) and the terminal level is taken as the average closing price over the last ten trading
days up to expiration. Assume that this is offered for 4.25% of spot. With the index at 950,
this puts the strike at 902.50 and the cost is 40.375 index points.
Ten Day Averaging Period: Hypothetical Paths
920
SPX Level 920
915 915
910 910
905 905
Average: 896.39
900 900
895 895
Average: 897.42
890 890
Average: 907.35
885 885
2 4 6 8 10
Trade Days
The first path begins well below the strike at 888.48, and ends about 15 points higher at
902.79. Although the index closes above the strike, the average over the ten trading days
is 896.39, so the investor receives 6.11 (902.50 - 896.39) index points. The second path
fluctuates from about 12 points below the strike to six points above the strike. The average
is 897.42, so the investor receives 5.08 index points. In the third case, the index begins the
averaging period at 918.54, well above the strike, and trades down to 888.92. The average
is 907.35, so the investor receives nothing. If the option were ordinary (not Asian), then
the payoff would have been positive: 13.58 (902.50 - 888.92) index points.
The effect of averaging is to make the observed settlement level less volatile. Many inves-
tors use Asian options in case the market makes a large move on the day of expiration.
Sellers of options sometimes like the settlement to be Asian since it makes them easier to
unwind and hence less risky.

38
June 11, 1999
Lookback Call
Description Gives the buyer exposure to the upside in the underlying above the strike, with the
payout based on the maximum stock price achieved over the option’s life. For the
buyer, this is like buying the stock at its level at expiration and selling it at the high
over the option’s life.

Mechanics Equation Max (S – K,0) , where S is the maximum price achieved by the underlying over the
life of the option, and K is the strike price.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock rises If the stock fails to rally, can lose no
above the strike. more than the premium paid for the
option.


Buyer
+ + + –
2 3 4
Seller
– – – + 1 5
Importance
39
June 11, 1999
Lookback Call
Example: An investor buys a lookback call on the stock XYZ. The call has six months to expiration
and is struck 5% out of the money. Assume that this is offered for 19.20% of spot. If XYZ
is trading at $50.00, the strike is $52.50 and the cost is $9.60.
Lookback Call: Possible Scenario
64 64
62 62
60 60
58 58
Level
56 56
54 54
52 52
50 50
48 48
5 12 19 26 2 9 16 23 1 8 15 22 29 4 12 19 26 3 10 17 24 31
JAN FEB MAR APR
96
XYZ Spot
The stock sells off initially, then moves to the upside. It first trades above the strike of
$52.50 in early January. Since the option is a lookback, the payoff is the maximum stock
price seen over the six months, minus the strike. Once the stock moves above the strike,
the payoff is certain to be positive. In this case, the maximum of $63.25 is reached in mid
April. So the option’s payoff is $10.75 = $63.25 - $52.50 even though the stock is trading
at $59.00 when the option expires.

40
June 11, 1999
Lookback Put
Description Gives the buyer exposure to the downside in the underlying below the strike, with
the payout based on the minimum stock price achieved over the option’s life. For the
buyer, this is like buying the stock at the lowest price seen in the option’s life and
selling it at the expiration price.

Mechanics Equation Max (K – S,0) , where S is the minimum price achieved by the underlying over the
life of the option, and K is the strike price.
cost.
Market Risks
Upside Downside

for the option.


Buyer
– + + –
2 3 4
Seller
+ – – + 1 5
Importance
41
June 11, 1999
Lookback Put
Example: An investor buys a lookback put on the stock XYZ. The put has six months to expiration
and is struck 5% out of the money. Assume that this is offered for 13.75% of spot. If XYZ
is trading at $50.00, the strike is $47.50 and the cost is $6.875.
Lookback Put: Possible Scenario
75 75
70 70
65 65
60 60
Level
55 55
50 50
45 45
40 40
96
XYZ Spot
The stock sells of almost immediately, then recovers. The low over the life of the option is
reached within the first two weeks and is $43.75. Since the strike is $47.50, the option
pays off $3.75 = $47.50 - $43.75. If this had been an ordinary option, the option would
have paid nothing since the stock closed at $58.75 at expiration.

42
June 11, 1999
Split-fee Call
Description Gives the buyer exposure to the upside in the underlying above the strike, with
increased leverage. Two payments are required. If the buyer chooses not to make the
second payment, the option expires worthless. Also known as compound options.
Motivation Buyer • Gives highly leveraged exposure to upside in the stock, with limited downside.

Mechanics Equation Max (S – K,0) , where S is the price of the underlying when the option expires, and
K is the strike price. The option pays off only if the buyer makes both required
payments.
Trade Day Buyer makes a single premium payment at trade initiation and has the option of
making a second premium payment.
Second Payment If the buyer chooses not to make the second payment, the option expires worth-
less.
Expiration The seller may have to make a single payment if the underlying settles above the
strike.
cost.
Market Risks
Upside Downside

rises beyond the strike. more than the premium paid for the
option.


Buyer
+ + + –
2 3 4
Seller
– – – + 1 5
Importance
43
June 11, 1999
Split-fee Call
Example: An investor buys a split-fee call on the stock XYZ. The call has six months to expiration
and is struck 10% out of the money. Assume that this is offered with an initial payment of
5% and a second payment three months into the option’s life of 8%. This is consistent with
the assumption that an ordinary 10% out of the money call on the same stock is offered for
8.50%. The investor thinks that the stock is likely to make a large jump to the upside, but
wants to pay less for the option in case his view is wrong. In return for paying less up
front, the investor must pay more later if he is right. The costs and strikes are quoted in
terms of the stock’s price on trade day. If XYZ is trading at $50.00, then the strike is
$55.00 and the first premium payment $2.50. The second premium payment (if the inves-
tor chooses to make it) is $4.00.
Split-fee Call: Possible Scenarios
80 80
70 70
60 60
Level
50 50
40 40
30 30
96
XYZ Spot: Path 1
XYZ Spot: Path 2
The vertical line represents the date when the investor must decide whether to make the
second payment of $4.00. Under the first path, XYZ is trading at $60.75 on the decision
date. This puts the option $5.00 in the money, so the investor is willing to make a $4.00
payment. However, the stock trades down over the next three months, closing at $56.00
when the option expires. In this case, the investor receives a payment of $1.00 = $56.00 -
$55.00 on the option.
Under the second path, the stock is trading at $43.00 when the investor must decide
whether to pay another $4.00 on the option. The option is now $12.00 out of the money.
Since a vanilla option with three months to expiration and a strike of $55.00 is only worth
about $1.35 when the stock is at $43.00, the investor does not make the second payment
and the option expires worthless.

44
June 11, 1999
Split-fee Put
Description Gives the buyer exposure to the downside in the underlying below the strike, with
increased leverage. Two payments are required. If the buyer chooses not to make the
second payment, the option expires worthless. Also known as a compound option.
Motivation Buyer • Gives highly leveraged exposure to downside in the stock, with limited downside.

Mechanics Equation Max (K – S,0) , where S is the price of the underlying when the option expires, and
K is the strike price. The option pays off only if the buyer makes both required
payments.
Trade Day Buyer makes a single premium payment at trade initiation and has the option of
making a second premium payment.
Second Payment If the buyer chooses not to make the second payment, the option expires worth-
less.
cost.
Market Risks
Upside Downside

for the option.


Buyer
– + + –
2 3 4
Seller
+ – – + 1 5
Importance
45
June 11, 1999
Split-fee Put
Example: An investor buys a split-fee put on the stock XYZ. The put has six months to expiration
and is struck 10% out of the money. Assume that this is offered with an initial payment of
3% and a second payment three months into the option’s life of 4%. This is consistent with
the assumption that an ordinary 10% out of the money put on the same stock is offered for
5.70%. The investor thinks that the stock is likely to sell off dramatically, but wants to pay
less for the option in case his view is wrong. In return for paying less up front, the investor
must pay more later if he is right. The costs and strikes are quoted in terms of the stock’s
price on trade day. If XYZ is trading at $50.00, then the strike is $45.00 ($50.00 x 90%)
and the first premium payment $1.50 ($50.00 x 3%). The second premium payment (if the
investor chooses to make it) is $2.00 ($50.00 x 4%).
Split-fee Put: Possible Scenarios
60 60
55 55
50 50
Level
45 45
40 40
35 35
30 30
96
XYZ Spot: Path 1
XYZ Spot: Path 2
The vertical line represents the date when the investor must decide whether to make the
second payment of $2.00. Under the first path, XYZ is trading at $42.75 on the decision
date. This puts the option $2.25 in the money, so the investor is willing to make a $2.00
payment. The stock continues to trade down over the next three months, closing at $31.88
when the option expires. In this case, the investor receives a payment of $13.12 = $45.00 -
$31.88 on the option.
Under the second path, the stock is trading at $48.75 when the investor must decide
whether to pay another $2.00 on the option. The option is now $3.75 out of the money.
Since a vanilla option with three months to expiration and a strike of $45.00 is worth
about $1.90 when the stock is at $48.75, the investor does not make the second payment as
the same option could be purchased more cheaply directly. So the split-fee option expires
worthless.

46
June 11, 1999
Knock in Call Option

Description Gives the buyer exposure to the upside in the underlying above the strike, but only if
the stock reaches a barrier level; otherwise, the option expires worthless.
• Since the option has no value until the barrier is breached, the option is cheaper
than a conventional option.
strike price. If the stock price never crosses the barrier, the option has zero value.
strike, the barrier is breached and the option is exercised.
Key Concepts Volatility The volatility of the stock is the most important factor after moneyness.
Barrier If the stock price never crosses the designated barrier, the option expires worth-
less. The barrier can be above or below the stock price at trade initiation. The
price can be compared to the barrier continuously or at expiration.
cost.
Market Risks
Upside Downside

Once knock in occurs, profits to the If the stock fails to rally or the option
extent that the stock price rises beyond never knocks in, can lose no more
the strike. than the premium paid for the option.

If the stock fails to rally or the option If the stock price rises above the
never knocks in, keeps the premium. strike and knock in occurs, potential
losses are unlimited.
Delta vs. Barriera

Sensitivities Bar > Spot Bar < Spot Vega Correlationb Time Complexity
Buyer
+ + BA
BA – + + + –
2 3 4
Seller
– – + 1 5
BA
– – BA
+ –
Importance
a. B indicates the time before knock in and A is for the time after knock in.
47
June 11, 1999
Knock in Call Option

Example: An investor buys a knock in call on the S&P 500. The call has six months to expiration, is
struck at the money and knocks in when the index falls 10% from its initial level. Assume
that this is offered for 0.94%. With the index at 950, this puts the strike at 950, the barrier
at 855 and the premium is 8.93 index points.
Knock in Call: Hypothetical Paths
1,200 1,200
1,100 1,100
1,000 1,000
Level
900 900
800 800
700 700
JUN JUL AUG SEP OCT NOV DEC JAN FEB
97
S&P 500: Hypothetical Path 1
The first path dips down to a low of 721, crossing the barrier at 855 in late June. However,
at expiration, the index is at 876.05. Since the strike is at 950, the option would expire
worthless under the first path.
The second path also knocks in, crossing below the 855 level in early August. At expira-
tion, the level of the index is 1030.78, so the option pays out 80.78 = 1030.78 - 950.00 in-
dex points.

48
June 11, 1999
Knock in Put Option

Description Gives the buyer exposure to the downside in the underlying below the strike, but
only if the stock reaches a barrier level; otherwise, the option expires worthless.
Seller • May be sold as part of a spread strategy; e.g., a knock-in put spread.
• Can be sold if volatility is expected to decline.
strike price. If the stock price never crosses the barrier, the option has zero value.
Barrier If the stock price never crosses some barrier, the option expires worthless. The
barrier can be above or below the stock price at trade initiation. The price can be
compared to the barrier continuously or at expiration.
cost.
Market Risks
Upside Downside

Once the option knocks in, profits to the If the stock fails to rally or the option
extent that the stock price falls below the never knocks in, can lose no more
strike. than the premium paid for the option.
If the stock price does not fall or the If the stock price falls below the
option never knocks in, keeps the pre- strike, potential losses are unlimited.
mium.
Delta vs. Barriera

Buyer
+ – BA
BA – – + + –
2 3 4
Seller
– – + 1 5
– + BA
BA + +
Importance
a. B indicates the time before knock in and A is for the time after knock in.
49
June 11, 1999
Knock in Put Option
Example: An investor buys a knock in put on the S&P 500. The put has six months to expiration, is
struck at the money and knocks in when the index rises 5% from its initial level. Assume
that this is offered for 2.60%. With the index at 950, this puts the strike at 950, the barrier
at 997.50 and the premium is 24.70 index points.
Knock in Put: Hypothetical Paths
1,100 1,100
1,000 1,000
Level
900 900
800 800
700 700
97
The first path never reaches a level greater than 952.53, much less than the knock in barri-
er at 997.50. Under the first path, the option expires worthless even though the level of the
index at expiration is below the strike.
The second path does knock in, crossing above the 977.50 level in mid June. At expira-
tion, the level of the index is 911.40, so the option pays out 38.60 = 950.00 - 911.40 index
points.

50
June 11, 1999
Knock out Call Option

the stock never reaches a barrier level; if it does, then the option expires worthless.
• Since the option has no value if the barrier is breached, the option is cheaper
strike price. If the stock price ever crosses the barrier, the option has zero value.
strike, the barrier is never breached and the option is exercised.
Barrier If the stock price ever crosses the designated barrier, the option expires worthless.
The barrier can be above or below the stock price at trade initiation. The price can
be compared to the barrier continuously or at expiration.
Rebate Knock out options may include provision for a fixed rebate payment if knock out
occurs.
cost.

Profits to the extent that the stock price If the stock fails to rally or the option
rises beyond the strike, assuming knock knocks out, can lose no more than the
out does not occur. premium paid for the option.

knocks out, keeps the premium. strike, potential losses are unlimited.
Delta vs. Barriera

Sensitivities Bar > Spot Bar < Spot Vegab Correlationc Time Complexity
Buyer
+ + –
2 3 4
1 5
Seller
– – +
Importance
a. If the barrier is above the strike price, then the buyer will be short the stock when the stock trades close enough to
the barrier.
b. As with the delta, the holder of the option will be short volatility when the stock price nears the barrier.
c. If the underlying is an index, then the buyer is long correlation among the stocks in the index, unless the stock is
trading close to the barrier.
51
June 11, 1999
Knock out Call Option
Example: An investor buys a knock out call on the S&P 500. The call has six months to expiration,
is struck at the money and knocks out when the index falls 2% from its initial level. The
investor believes that the index is about to shoot up and continue to rise. Assume that this
is offered for 2.15%. With the index at 950, this puts the strike at 950, the barrier at 931
and the premium is 20.43 index points.
Knock out Call: Hypothetical Paths
1,200 1,200
1,100 1,100
Level
1,000 1,000
900 900
800 800
97
In both cases, the investor was correct in his view that the index was headed up in the long
term, but under the first path, the index fell below the barrier at 931 almost immediately.
The option knocked out and expired worthless in the first case.
Under the second path, the low of the index is 950. The 931 level is never reached, so the
option does not knock out. At expiration, the index is at 1128.43, so the option pays out
178.43 = 1128.43 - 950.00 index points.

52
June 11, 1999
Knock out Put Option

only if the stock never reaches a barrier level; if it does, then the option expires
worthless.
strike price. If the stock price ever crosses the barrier, the option has zero value.
Expiration The seller may have to make a single payment if the underlying settles below the
strike, the barrier is never breached and option is exercised.
Barrier If the stock price ever crosses some barrier, the option expires worthless. The bar-
rier can be above or below the stock price at trade initiation. The price can be
compared to the barrier continuously or at expiration.
occurs.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock price If the stock price does not fall or the
falls beyond the strike, assuming knock option knocks out, can lose no more
out does not occur. than the premium paid for the option.

option knocks out, keeps the premium. strike, potential losses are unlimited.
Delta vs. Barriera

Buyer
+ + –
2 3 4
Seller
– – + 1 5
Importance
a. If the barrier is below the strike price, then the buyer will be long the stock when the stock trades close enough to
the barrier.
b. As with the delta, the holder of the option will be short volatility when the stock price nears the barrier.
c. If the underlying is an index, then the buyer is long correlation among the stocks in the index, unless the stock is
trading close to the barrier.
53
June 11, 1999
Knock out Put Option
Example: An investor buys a knock out put on the S&P 500. The put has six months to expiration, is
struck at the money and knocks out when the index rises 2% from its initial level. The in-
vestor believes that the index is about to fall with no recovery. Assume that this is offered
for 1.50%. With the index at 950, this puts the strike at 950, the barrier at 969 and the pre-
mium is 14.25 index points.
Knock out Put: Hypothetical Paths
1,100 1,100
1,000 1,000
Level
900 900
800 800
700 700
97
In both cases, the investor was correct in his view that the index was headed down in the
long term, but under the second path, the index rose above the barrier at 969 almost imme-
diately. The option knocked out and expired worthless in the first case.
Under the first path, the high of the index is 952.53. The 969 level is never reached, so the
option does not knock out. At expiration, the index is at 876.05, so the option pays out
73.95 = 950.00 - 876.05 index points.

54
June 11, 1999
Knock in Call Option: Outside Barrier

a second security reaches a barrier level; otherwise, the option expires worthless.
• The choice of assets tailors the option to the investor’s view.
strike price. If the second security never crosses the barrier, the option has zero
value.
Barrier If the second security never crosses some barrier, the option expires worthless.
The price can be compared to the barrier continuously or at expiration.
cost.
Market Risks
Upside Downside

If the option knocks in, profits to the If the stock fails to rally or the option
extent that the stock price rises above the never knocks in, can lose no more

never knocks in, keeps the premium. strike and the barrier is breached,
potential losses are unlimited.
Delta vs. Outside Barriera

Buyer
+ – UO
UO + + + + –
2 3 4
Seller
– + UO – – + 1 5
UO – –
Importance
a. The buyer is always long the underlying stock and could be long or short the second security, depending on where
the knock in barrier is set.
b. The buyer is long volatility in both assets.
c. If the underlying is an index, then the buyer is long correlation among the stocks in the index. The buyer is also long
correlation among the stocks in the second security if it is an index. If the barrier is above the spot price of the second
security, the buyer is long correlation between the underlying and second security; otherwise short.
55
June 11, 1999
Knock in Call Option: Outside Barrier
Example: An investor buys a knock in call on the S&P 500. The call has six months to expiration, is
struck at the money and knocks in when the NDX (Nasdaq 100) index rises 5% from its
initial level. The investor believes that a rally in the NDX will signal a rally in the S&P
500. Assume that this is offered for 7.40% of the S&P 500 spot. With S&P 500 at 950 and
the NDX at 1040, this puts the strike at 950 (S&P 500), the barrier at 1092 (NDX) and the
premium is 70.30 S&P 500 index points.
Knock in Call with Outside Barrier: Hypothetical Paths
1,200 1,200
1,100 1,100
Level
1,000 1,000
900 900
800 800
97
S&P 500: Hypothetical Path
NDX: Hypothetical Path
The high of the NDX over the life of the option is 1153.87, so the option knocked in,
crossing the 1092 level for the first time in mid June. If this level had never been crossed,
the option would have expired worthless.
Since the option knocked in, the call becomes an call on the S&P 500 struck at 950. Since
the S&P 500 traded at 1030.78 at expiration, the option’s payout is 80.78 = 1030.78 -
950.00 S&P 500 index points.

56
June 11, 1999
Knock in Put Option: Outside Barrier
only if a second security reaches a barrier level; otherwise, the option expires worth-
less.
strike price. If the second security never crosses the barrier, the option has zero
value.
Barrier If the second security never crosses the designated barrier, the option expires
worthless. The price can be compared to the barrier continuously or at expiration.
cost.

If the option knocks in, profits to the If the stock fails to rally or the option
extent that the stock price falls below the never knocks in, can lose no more

If the stock fails to rally or the option If the stock price falls below the
never knocks in, keeps the premium. strike and the option knocks in,
potential losses are unlimited.

Buyer
– + UO
UO – – + + –
2 3 4
Seller
+ – UO – – + 1 5
UO + +
Importance
a. The buyer is always short the underlying stock and could be long or short the second security, depending on where
b. The buyer is long volatility in both the underlying and outside asset.
c. If the underlying is an index, then the buyer is long correlation among the stocks in the index. The buyer is also long
correlation among the stocks in the second security if it is an index. If the barrier is above the spot price of the second
security, the buyer is long correlation between the underlying and second security; otherwise short.
57
June 11, 1999
Knock in Put Option: Outside Barrier
Example: An investor buys a knock in put on the S&P 500. The put has six months to expiration, is
struck at the money and knocks in when the NDX (Nasdaq 100) index falls 5% from its
initial level. The investor believes that a sell-off in the NDX is a sign that the S&P 500
will sell off as well. Assume that this is offered for 5.50% of the S&P 500 spot. With S&P
500 at 950 and the NDX at 1040, this puts the strike at 950 (S&P 500), the barrier at 988
(NDX) and the cost is 52.25 S&P 500 index points.
Knock in Put with Outside Barrier: Hypothetical Paths
1,300 1,300
1,200 1,200
1,100 1,100
Level
1,000 1,000
900 900
800 800
700 700
97
The low of the NDX over the life of the option is 897.02, so the option knocked in, cross-
ing the 988 level for the first time in mid June. If this level had never been crossed, the op-
tion would have expired worthless.
Since the option knocked in, the put becomes a put on the S&P 500 struck at 950. Since
the S&P 500 traded at 911.40 at expiration, the option’s payout is 38.60 = 950.00 - 911.40
S&P 500 index points.

58
June 11, 1999
Knock out Call Option: Outside Barrier
a second security never reaches a barrier level; if it does, the option expires worth-
less.
strike price. If the second security ever crosses the barrier, the option has zero
value.
Barrier If the second security ever crosses some barrier, the option expires worthless. The
barrier can be above or below its price at trade initiation and the price can be com-
pared to the barrier continuously or at expiration.
occurs.
cost.

Profits to the extent that the stock price If the stock fails to rally or the option
rises above the strike, assuming knock knocks out, can lose no more than the
out does not occur. premium paid for the option.

knocks out, keeps the premium. strike, potential losses are unlimited.

Buyer
+ – UO
UO + + + + –
2 3 4
Seller
– + UO
UO – – – – + 1 5
Importance
a. The buyer is always long the underlying stock and could be long or short the second security, depending on where
b. The buyer is always long volatility in the underlying and will generally be short volatility in the second asset.
c. If the underlying is an index, then the buyer is long correlation among the stocks in the index. The buyer is also
short correlation among the stocks in the second security if it is an index. If the barrier is above the spot price of the
second security, the buyer is short correlation between the underlying and second security; otherwise long.
59
June 11, 1999
Knock out Call Option: Outside Barrier

Example: An investor buys a knock out call on the S&P 500. The call has six months to expiration,
is struck at the money and knocks out when the NDX (Nasdaq 100) index rises 5% from
its initial level. This makes sense if the investor believes that the S&P 500 is poised to
show outstanding returns, while the NDX shows modest gains at most. Assume that this is
offered for 0.50% of the S&P 500 spot. With the S&P 500 at 950 and the NDX at 1040,
this puts the strike at 950 (S&P 500), the barrier at 1092 (NDX) and the premium is 4.75
S&P 500 index points.
Knock out Call with Outside Barrier: Hypothetical Paths
1,200 1,200
1,100 1,100
Level
1,000 1,000
900 900
800 800
97
The high of the NDX over the life of the option is 1153.87, so the option knocked out,
crossing the 1092 level for the first time in mid June. As a result, the option expired worth-
less.
If the option had not knocked out, the put would have paid off 80.78 = 1030.78 - 950.00
since the S&P 500 was trading at 1030.78 at expiration.
Another strategy that may make sense is buying calls that knock out if the yield on the 30
year bond rises by a certain amount, the idea being that when bond yields are rising, inves-
tors must be selling bonds and buying stock.

60
June 11, 1999
Knock out Put Option: Outside Barrier

only if a second security never reaches a barrier level; if it does, the option expires
worthless.
strike price. If the second security ever crosses the barrier, the option has zero
value.
Barrier If the second security ever crosses the designated barrier, the option expires
worthless. The barrier can be above or below its price at trade initiation and the
price can be compared to the barrier continuously or at expiration.
occurs.
cost.

Profits to the extent that the stock price If the stock price does not fall or the
falls below the strike, assuming knock option knocks out, can lose no more
out does not occur. than the premium paid for the option.

option knocks out, keeps the premium. strike, potential losses are unlimited.

Buyer
UO
– – UO
– + + + –
2 3 4
Seller
UO
+ + UO
+ – – – + 1 5
Importance
a. The buyer is always short the underlying stock and could be long or short the second security, depending on where
b. The buyer is long volatility in the underlying and short volatility in the second asset.
c. If the underlying is an index, then the buyer is long correlation among the stocks in the index. The buyer is also
short correlation among the stocks in the second security if it is an index. If the barrier is above the spot price of the
second security, the buyer is short correlation between the underlying and second security; otherwise long.
61
June 11, 1999
Knock out Put Option: Outside Barrier
Example: An investor buys a knock out put on the S&P 500. The put has six months to expiration, is
struck at the money and knocks out when the NDX (Nasdaq 100) index falls 5% from its
initial level. This makes sense if the investor believes that the S&P 500 is about to decline,
while any declines on the NDX are modest. Assume that this is offered for 0.50% of the
S&P 500 spot. With the S&P 500 at 950 and the NDX at 1040, this puts the strike at 950
(S&P 500), the barrier at 988 (NDX) and the premium is 4.75 S&P 500 index points.
Knock out Put with Outside Barrier: Hypothetical Paths
1,200 1,200
1,100 1,100
1,000 1,000
Level
900 900
800 800
700 700
97
The low on the NDX over the life of the option is 1040. The option never knocked out
since the NDX never fell below 988. The S&P 500 was trading at 911.40 when the option
expired, so the payoff is 38.60 = 950.00 - 911.40 S&P 500 index points.

62
June 11, 1999
Binary Option
Description Gives the buyer exposure to movement of the underlying to a specific level. If the
level is reached, then the buyer receives a fixed payment. Also called a digital
option.
Motivation Buyer • Allows the buyer to receive payments based on precise targets.
Seller • Seller is paid up front for taking the view that stock will not reach a certain level.
• May be sold to pay for other options.
Mechanics Equation If the stock price moves beyond the strike, holder receives a fixed payment. The
stock price can be compared to the strike on a close-to-close or intraday basis, or
the strike can be compared to the stock price at expiration.
Expiration The seller will have to make a single payment if the underlying reaches the level
of the strike.
Exercise Style When (and if) the barrier is breached, the holder of the option may receive pay-
ment immediately or at the maturity of the option. If payment is made immedi-
ately, the option is American; otherwise, European.
Market Risks
Upside Downside
Buyer Limited. Limited.

Potential upside is the fixed payment if If the target is not reached, can lose
the stock reaches the target. no more than the premium paid for
the option.
Seller Limited. Limited.

If the target is not reached, keeps the pre- Can lose no more than a fixed
mium. amount.
Delta vs. Barriera

Buyer
+ – + + –
2 3 4
Seller
– + – – + 1 5
Importance
a. If the strike is above the stock price, the buyer is long the stock; if the strike is below the stock, the buyer is short.
63
June 11, 1999
Binary Option
Example: An investor buys a binary option on the stock XYZ. The option has six months to expira-
tion with the barrier 20% higher than the stock’s level on trade day. Assume that this is of-
fered for 50% of the potential payoff. If XYZ is trading at $50.00, the strike is $60.00
($50.00 x 120%). If the stock ever trades at $60.00 or above at any time over the option’s
life, the investor immediately receives the payoff and the option expires. Since payment is
made immediately, this is an American style option. The investor wants to receive
$100,000 if the stock reaches $60.00, so the option costs 50% of this amount, or $50,000.
Binary Option: Possible Scenarios
80 80
70 70
60 60
Level
50 50
40 40
30 30
96
XYZ Spot: Path 1
XYZ Spot: Path 2
Under the first path, the investor was right: the stock did trade higher than $60 at some
point in the option’s life. In early February, the stock first traded above the strike. At that
point, the investor immediately receives a payment of $100,000 and the option expires.
At no point during the second path did the stock ever trade as high as $60.00. In this case,
the investor receives nothing and the option expires worthless.

64
June 11, 1999
Outperformance Call Option
Description Gives the buyer leveraged exposure to the upside in the outperformance of one asset
over another, where the relative performance is expressed in percent.
Motivation Buyer • Gives leveraged exposure to outperformance, with limited downside.
• The two assets can be chosen to precisely reflect the investor’s views.
Seller • Sellers take in premium and keep it if stock fails to outperform.
Mechanics Equation N × Max (R A – R B – K,0) , where R A and R B are the returns of the two stocks over
the life of the trade, K is the strike price and N is the notional size. The strike
and returns are expressed in percent. The buyer anticipates that stock A will out-
perform stock B.
Expiration The seller will have to make a single payment if stock A outperforms stock B by
at least K percent.
Key Concepts Volatility The volatilities of the two stocks are important.
Correlation If the stocks have high correlation, the option has less value.
Total/Price The return of the stocks can be based on total returns (including dividends) or it
Return can be based on the price return only.
Breakeven This is the minimum degree of outperformance needed for the payout of the
option to equal the initial cost.
Market Risks
Upside Downside

Profits to the extent that stock A outper- If the outperformance is less than the
forms stock B beyond the strike. strike, can lose no more than the pre-
mium paid for the option.

If outperformance is limited, the seller If stock A outperforms stock B,
keeps the premium. potential losses are unlimited

Buyer
AB
+ – + – –
2 3 4
Seller
– + + 1 5
BA
– +
Importance
a. Buyer is long stock A and short stock B.

b. Buyer is short correlation between the two stocks. If either underlying is an index, then the buyer is long intra-index
correlation in the underlying indices.
65
June 11, 1999
Outperformance Call Option

Example: An investor buys a $1,000,000 notional call on the outperformance of ABC over XYZ.
The call has six months to expiration and is struck 5% out of the money. If the volatility of
the stock is about 40% and the correlation is 0.50, this might be offered for 8.97%. The
dollar cost is then $89,700 and the return of ABC must be greater than those of XYZ by at
least five percentage points for the buyer to receive any payout.
Outperformance Call: Stock Performance
80 80
70 70
Spot Price
60 60
50 50
40 40
MAR APR MAY JUN JUL AUG
97
ABC Spot
XYZ Spot
Stock ABC rose from $46.75 to $66.125 while XYZ rose from $55.625 to $70.50 over the
life of the option. This translates to returns of 41.44% for ABC and 26.74% for XYZ. The
payout on the option is then $97,000 = $1,000,000 x (0.4144 - 0.2674 - 0.0500).
If the two stocks had fallen in value with ABC losing less value than XYZ, the payout
could still be positive. For instance, if ABC lost 10% of its value while XYZ lost 20%,
then the payout would be $50,000 = $1,000,000 x (-0.10 - (-0.20) - 0.05).
To breakeven, stock A must outperform stock B by at least 13.97%, since there must be
5% outperformance to receive any payout, and an additional 8.97% of outperformance so
as to receive the amount paid for the option.
An outperformance put is the same thing as an outperformance call. The expectation that
A will outperform B is the same as the expectation that B will underperform A.

66
June 11, 1999
Spread Option
Description Gives the buyer leveraged exposure to the upside in the outperformance of one stock
over another, where the relative performance is expressed in dollar terms.
Motivation Buyer • Gives leveraged exposure to outperformance, with limited downside.
• The two assets can be chosen to precisely reflect the investor’s views.
Seller • Sellers take in premium and keep it if stock fails to outperform.
Mechanics Equation N × Max (m A S A – m B S B – K,0) , where S A and S B are the prices of the two stocks
at expiration, m A and m B are the number of shares of each stock, K is the strike
price and N is the notional size. The buyer anticipates that stock A will outper-
form stock B.
Expiration The seller will have to make a single payment if stock A outperforms stock B by a
margin greater than the strike.
Key Concepts Volatility The volatilities of the two stocks are important.
Correlation If the stocks have high correlation, the option has less value.
Share Ratio The number of shares of stock A and stock B ( m A and m B ) also determines
whether the option is in or out of the money.
Breakeven This is the minimum degree of outperformance needed for the payout of the
option to equal the initial cost.
Market Risks
Upside Downside

Profits to the extent that stock A outper- If the outperformance is less than the
forms stock B beyond the strike. strike, can lose no more than the pre-
mium paid for the option.
If outperformance is limited, the seller If stock A outperforms stock B,
keeps the premium. potential losses are unlimited

Buyer
AB
+ – + – –
2 3 4
Seller
– + + 1 5
BA
– +
Importance
a. Buyer is long stock A and short stock B.

b. Buyer is short correlation between the two stocks. If either underlying is an index, then the buyer is long intra-index
correlation in the underlying indices.
67
June 11, 1999
Spread Option
Example: An investor buys a call on the outperformance of ABC over XYZ, using three shares of
ABC for every two shares of XYZ. The call has six months to expiration and is struck
$10.00 out of the money. If the volatility of the stock is about 40% and the correlation is
0.50, this might be offered for $28.01 for every three shares of ABC and two shares of
XYZ. The investor wants exposure to 30,000 shares of ABC and 20,000 shares of XYZ,
for a total cost of $280,900 ($28.09 x 30,000 / 3).
Spread Option: Stock Performance
160 160
140 140
Spot Price
120 120
100 100
80 80
60 60
MAR APR MAY JUN JUL AUG
97
ABC Spot
XYZ Spot
Stock ABC rises from a spot price of $72.50 to $103.75 at expiration while XYZ moves
from $99.50 to $136.50. At expiration, three shares of ABC are worth $311.25 and two
shares of XYZ are worth $273.00. The value of the ABC shares is $38.25 ($311.25 -
$273.00) more than the value of the XYZ shares. Since the strike is $10.00, the investor
receives $28.25 for every three shares of ABC and two shares of XYZ. Since the exposure
was to 30,000 shares of ABC, the total payout is $282,500 ($28.25 x 30,000 / 3).
Although the spot prices of the two stocks are important when the trade is initiated, at ex-
piration, the return of the stocks over the life of the option is not important. Only the prices
of the two stocks are needed to determine the payout. This is unlike an outperformance
option.
To break even, the value of three shares of ABC must exceed the value of two shares of
XYZ by at least $38.01, where this includes the premium of $28.01 and an additional $10
due to the strike.
A spread put option is the same thing as a spread call option. The expectation that A will
outperform B is the same as the expectation that B will underperform A.

68
June 11, 1999
Better of Call Option
Description Gives the buyer exposure to the upside of one of two or more stocks above the strike.
At expiration, the single stock with the greatest return is used to determine the pay-
off.
Motivation Buyer • Gives leveraged exposure to upside in the stocks, with limited downside.
• The buyer does not have to decide which of several stocks will show the best
performance. The option does it for him.
Seller • Can be sold as a part of a hedging/overwriting strategy, especially when an

investor believes that an entire sector will show negative to mediocre returns.
Mechanics Equation N × Max (S – K,0) , where S is the return at expiration of the underlying stock with
the highest return, K is the strike price, expressed in percent and N is the
notional size.
Expiration The seller will have to make a single payment if any of the underlying stocks
experienced returns greater than the strike.
Correlation The greater the correlation among the underlying stocks, the less the value of the
option exceeds the value of an ordinary call option.
cost.
Market Risks
Upside Downside

Profits to the extent that one of the If all the stocks fail to rally, can lose
stocks’ price rises beyond the strike. no more than the premium paid for
the option.

If all the stocks fail to rally, keeps the If any of the stocks rise above the

Buyer
+ + – –
2 3 4
Seller
– – + + 1 5
Importance
a. The buyer is always long all of the underlying stocks.

b. If the underlying is an index, then the buyer is long correlation among the stocks in the index. The buyer is always
short correlation between the underlying stocks.
69
June 11, 1999
Better of Call Option

Example: An investor buys a three month better of call struck 10% out of the money with a notional
size of $10,000,000. There are two stocks underlying the call: XYZ and ABC. Assume
that this is offered for 5.95%. A call on a single one of these stocks might be offered for
about 4.65%. The investor believes that the stocks are going to rally, and is willing to pay
a bit more since he is uncertain which of the two will show the greatest returns. The dollar
cost is then $595,000 = $10,000,000 x 5.95%.
Better of Call: Possible Scenario
54 XYZ Spot ABC Spot 30
53 29
28
52 27
51 26
25
50 24
49 23
120 Better of the Two Returns 120
115 115
110 110
105 105
100 100
95 95
2 9 16 23 30 6 13 20 27 6 13 20 27
XYZ Spot JAN FEB XYZ Returns
ABC Spot 98 ABC Returns
XYZ is trading at $50.00 and ABC at $25.00 when the option is purchased. The graph
shows the path of their two spot prices and which of the two has shown the greatest return
on any given date.
At expiration, XYZ is trading at $51.00 and ABC is at $28.25. This puts the return of XYZ
at 2% ($51.00 / $50.00) and of ABC at 13% ($28.25 / $25.00). ABC had the best returns
over the three months, so the payoff of the option is $300,000 = $10,000,000 x (13% -
10%).

70
June 11, 1999
Better of Put Option
Description Gives the buyer exposure to the downside of one of two or more stocks below the
strike. At expiration, the single stock with the lowest return is used to determine the
payoff.
Motivation Buyer • Gives leveraged exposure to downside in the stocks, with limited downside.
• The buyer does not have to decide which of several stocks will show the worst
performance. The option does it for him.
Seller • Seller believes that none of the stocks is the basket is likely to fall.
• Can be sold as a part of a collaring or spreading strategy.
Mechanics Equation N × Max (K – S,0) , where S is the return at expiration of the underlying stock with
the lowest return, K is the strike price, expressed in percent, and N is the
notional size.
Expiration The seller will have to make a single payment if any of the underlying stocks
experienced returns lower than the strike.
Correlation The greater the correlation among the underlying stocks, the less the value of the
option exceeds the value of an ordinary put option.
cost.
Market Risks
Upside Downside

Profits to the extent that one of the If none of the stocks’ price falls, can
stocks’ price falls below the strike. lose no more than the premium paid
for the option.

If none of the stocks’ price falls, keeps If any of the stocks’ price falls below
the premium. the strike, potential losses are unlim-
ited.

Buyer
– + – –
2 3 4
Seller
+ – + + 1 5
Importance
a. The buyer is always short all of the underlying stocks.

b. If the underlying is an index, then the buyer is long correlation among the stocks in the index. The buyer is always
short correlation between the underlying stocks.
71
June 11, 1999
Better of Put Option

Example: An investor buys a three month better of put struck 10% out of the money with a notional
size of $10,000,000. There are two stocks underlying the call: XYZ and ABC. Assume
that this is offered for 4.00% A put on a single one of these stocks could be offered for
about 3.30%. The investor believes that the stocks are going to fall, and is willing to pay a
bit more since he is uncertain which of the two will fall the most. The dollar cost is then
$400,000 = $10,000,000 x 4.00%.
Better of Put: Possible Scenario
54 XYZ Spot ABC Spot 26
52 25
50 24
48 23
46 22
44 21
42 20
105 Lesser of the Two Returns 105
100 100
95 95
90 90
85 85
80 80
2 9 16 23 30 6 13 20 27 6 13 20 27
XYZ Spot JAN FEB XYZ Returns
ABC Spot 98 ABC Returns
XYZ is trading at $50.00 and ABC at $25.00 when the option is purchased. The graph
shows the path of their two spot prices and which of the two has shown the lowest return
on any given date.
At expiration, XYZ is trading at $44.13 and ABC is at $21.25. This puts the return of XYZ
at - 11.74% ($44.13 / $50.00) and of ABC at -15% ($21.25 / $25.00). ABC had the lowest
returns over the three months, so the payoff of the option is $500,000 = $10,000,000 x
(15% - 10%).

72
June 11, 1999
Chooser Option
Description Gives the buyer exposure to the upside or downside, at the investor’s choice, of a
stock beyond the strike. On some fixed date prior to expiration, the investor must
decide whether the chooser option is to be a call or a put.
Motivation Buyer • Gives leveraged exposure to moves in the stock, with limited downside.
• The buyer does not have to decide which direction the stock will take when the
option is purchased. This is similar to a straddle, but cheaper.
Seller • Sellers profit if the volatility of the security underlying the option declines.
Mechanics Equation Max (S – K C,0) if the investor chooses a call, or Max (K P – S,0) if the investor
chooses a put, where S is the stock price at expiration, K C and K P are the strike
prices in each case.
Decision Date This is the date when the holder must decide whether the option is to be a call or
put. No payments are made on this date.
Expiration The seller will have to make a single payment if the stock moved in the direction
chosen by the investor (up if call chosen, down if put chosen) and the option is
exercised.
cost.
Market Risks
Upside Downside

Profits to the extent that the stock price If the stock price does not move in
moves in the direction chosen by the the chosen direction, can lose no
investor. more than the premium paid for the
option.

At best, keeps the premium. If the stock price moves in the direc-
tion chosen by the buyer, potential
losses are unlimited.

Buyer
? + – –
2 3 4
Seller
? – + + 1 5
Importance
a. Before the investor chooses call or put, he will be long if the stock has risen, short if it has fallen. Once the choice
is made, sensitivities are as for a vanilla option.
73
June 11, 1999
Chooser Option
Example: An investor buys a six month chooser option on the stock XYZ struck 5% out of the mon-
ey on both sides. Three months after the option is purchased, the investor must choose
whether he wants a call or a put. Assume that this is offered for 15.75%. A six month
strangle with strikes 5% out of the money on each side on the same stock might cost
17.75%. When the chooser option is purchased, XYZ is trading at $50.00, so the strikes
are $52.50 and $47.50 and the dollar premium is $7.88 = $50.00 x 15.75%, somewhat less
than the premium of a comparable straddle.
Chooser Option: Possible Scenarios
55 55
50 50
XYZ Spot
45 45
40 40
35 35
98
XYZ Spot: Hypothetical Path 1
XYZ Spot: Hypothetical Path 2
The vertical line indicates the date when the investor must choose whether the option is to
be a call or put. Under the first path, the investor chose a put since the stock has fallen to
$44.50, which is below the lower strike. At expiration, XYZ is trading at $45.50. Since
this is less than the put strike, the investor receives $2.00 = $47.50 - $45.40, which is less
than the breakeven.
Under the second path, XYZ is trading at $49.75 on the decision date. Comparing the val-
ue of a three month call struck at $52.50 to a put struck at $47.50, the investor finds that
the call is worth more, so he chooses the call. At expiration, the stock is trading at $38.75.
This is far below the strike of the call, so the investor receives nothing.

74
June 11, 1999
Accrual Option
Description The buyer is paid a fixed amount for each day that the underlying trades within some
range.
Motivation Buyer • Allows the buyer to receive payments based on a precise range.
• When the trade is initiated, the buyer is short volatility.
Seller • Seller is paid up front for taking the view that the stock will soon move outside
the range.
• A seller is using one of the few ways an investor can be paid to be long volatil-
ity.
Mechanics Equation N × P , where P is the dollars paid for every day within the range and N is the
number of days during which the stock traded in the range. The range in which
payments are made is usually fixed for the life of the option. Payments may be
made at expiration or quarterly.
Expiration The seller makes a series of payments, one for each day the stock trades in the
range.
Breakeven For an accrual option, this is the number of days the stock must trade in the range
for the buyer to recoup the cost of the option.
Market Risks
Upside Downside

Maximum upside occurs if the stock If stock immediately moves outside
trades in the accrual range every day of the accrual range, can lose no more
the option’s life. than premium paid for the option.

If the stock moves out of the accrual Can lose no more than the amount
range, keeps the premium. due if the stock trades in the range
every day of the option’s life.
Sensitivities Deltaa Vegab Correlationc Time Complexity

Buyer
L + –H
– L
+ H + –H
+ L + –
Seller
L– H ˚
– +H
+ L – +H
– L – + 1
2 3 4
5
Importance ˚
a. When the stock price is low (close to or below the lower bound), the buyer is short. When the stock price is high
(close to or above the upper bound), the buyer is short.
b. If the stock is outside the range, the buyer is long vega; otherwise short.
c. If the underlying is a stock index, then the buyer is long or short correlation, according as he is long or short vega.
75
June 11, 1999
Accrual Option
Example: An investor buys an accrual option on the S&P 500. The option has six months to expira-
tion and pays $5,000 for each day that the index closes in the range from 10% below to
25% above the current spot on the index. With the index at 950, the buyer will receive
$5,000 for every day that the index trades in the range 855 (950 x 90%) to 1187.50 (950 x
125%). Assume that this is offered for $472,500. For the investor to break even, the S&P
500 must trade within the accrual range for 95 (472,500 / 5,000) trading days.
Accrual Option: Possible Scenarios
1,400 70
1,300 60
S&P 500 Level
50
1,200
Day Count
40
1,100
30
1,000
20
900 10
800 0
96
Trading Days within Range
The horizontal lines show the accrual range. For every day for which the index closes in
this range, the investor collects $5,000. Except for a few days, the index spends the first
two and a half months within the range. It then moves out of the range and doesn’t return
until near the end of the six months. The total number of days in which the index closed
within the range is 62, so the investor receives 310,000 = 62 x $5,000, which is 33 days
short of the breakeven.

76
June 11, 1999
Range Swap
Description Swap is based on the realized range (high minus low) of the underlying over the
swap’s life. If the range is wider than the strike, the buyer receives the difference; if
narrower, the seller receives the difference.
Motivation Buyer • Allows the buyer to go long the high vs. low volatility of the underlying.
• Unlike some other ways of buying volatility, there is no upfront cost to being
long volatility.
Seller • The seller must expect the underlying to trade in a tight range.
Mechanics Equation The buyer receives N × ( H – L – K ) , where N is the notional size of the trade, H
is the high and L is the low of the underlying over the life of the swap and K is
the strike for the range. Both H and L are expressed in percent terms, relative to
the level of the underlying at trade initiation. If this value is negative, the buyer
pays the seller.
Trade Day Buyer makes no premium payments.
Expiration Payment could flow from the buyer to seller or seller to buyer, depending on
whether the range is more or less wide than K .
Key Concepts Volatility This is the most important factor determining the strike.
Market Risks
Upside Downside

If the range of the underlying exceeds the Can lose no more than the notional
strike, upside is unlimited. times the strike if the range is zero.

Can make no more than the notional Potential losses are unlimited if the
times the strike if the range is zero. range of the underlying exceeds the
strike.

Buyer
L– H
+ + + –
Seller
L –
+ H ˚ – – + 1
2 3 4
5
Importance ˚
a. When the stock price is low (close to or below the lower bound), the buyer is short. When the stock price is high
(close to or above the upper bound), the buyer is short.
b. If the underlying is a stock index, then the buyer is long or short correlation, according as he is long or short vega.
77
June 11, 1999
Range Swap
Example: An investor goes short the range of the S&P 500 for six months via a range swap with a
notional value of $100,000 per percentage point. Assume that this is offered at a strike of
24%. If the range of the index is less than 24%, then the investor receives $100,000 times
the difference between 24% and the actual high minus low range. If the range is more than
24%, then he must pay $100,000 times the difference.
Range Swap: Possible Scenarios
1,100 1,100
1,000 1,000
900 900
Level
800 800
700 700
600 600
98
The first path is obviously less volatile. The high over the six months of the option’s life is
1043.52 and the low is 920.44. The range is then 123.08 = 1043.52 - 920.44 index points
or 12.96% = 123.08 / 950.00. This is less than 24%, so the investor receives $1,104,000 =
$100,000 x (24.00 - 12.96).
The second path had a much wider range. The high was 979.60 and the low was 685.12.
So the range is 294.48 = 979.60 - 685.12 index points or 31.00% = 294.48 / 950.00. Since
this is higher than 24%, the investor must pay $700,000 = $100,000 x (31.00 - 24.00).

78
June 11, 1999
Realized Volatility Swap
Description Swap is based on the realized volatility of the underlying over the swap’s life. If the
volatility is greater than the strike, the buyer receives the difference; if less, the seller
receives the difference.
Motivation Buyer • Allows the buyer to go long the realized volatility of the underlying.
Seller • The seller must expect the volatility to be lower than the strike.
• Holders of convertible securities (for instance) can sell volatility through a swap
as a hedge.
Mechanics Equation The buyer receives N × ( V – K ) , where N is the notional size of the trade, V is
the realized volatility of the underlying, calculated over the life of the swap, and
K is the strike. If this value is negative, the buyer pays the seller. V is given by
∑ ( log r )
1 2
252 × ----- i
M
i=1
where M is the total number of trading days over the swap’s life and r i is the
return on day i .
Trade Day Buyer and seller make no premium payments.
whether realized volatility is more or less wide than K .
Key Concepts Volatility Implied volatility is the most important factor determining the strike and the
mark. As time passes, and more of the realized volatility is known, the implied
volatility becomes less important.
Market Risks
Upside Downside

If the volatility of the underlying exceeds Can lose no more than the notional
the strike, the upside is unlimited. times the strike if the volatility is
zero.

times the strike if the volatility is zero. volatility of the underlying exceeds
the strike.

Buyer
o + + –
2 3 4
Seller
o – – + 1 5
Importance
a. Since volatility is calculated close-to-close, there can be a small intraday delta.

b. The buyer is long realized volatility. Initially, the mark will be most sensitive to implied volatility.
c. If the underlying is a stock index, then the buyer is long correlation among the stocks in the index.
79
June 11, 1999

Example: An investor goes short the volatility of the S&P 500 for one year via a volatility swap with
a notional value of $100,000 per percentage point. Assume that this is offered at a strike of
20%. If the volatility of the index is less than 20%, then the investor receives $100,000
times the difference between 20% and the realized volatility. If the volatility is more than
20%, then he must pay $100,000 times the difference.
Volatility Swap: Possible Scenarios
1,060 17
1,040
16
Realized Volatility
1,020
S&P 500 Level
15
1,000
980 14
960
13
940
12
920
900 11
98
Realized Volatility
The graph shows both the index level and the realized volatility. The volatility is calculat-
ed on a rolling basis with the first day fixed. So, the high of 16.74% includes only the first
four days of data and the value reported at the end of May (12.42%) includes the returns of
the first five months.
The realized volatility over the entire period is 11.70%. Since this is less than the strike of
20%, the investor receives an amount proportional to the difference. This is $830,000 =
$100,000 x (20.00 - 11.70).

80
June 11, 1999
Capped Volatility Swap

Description Swap is based on the realized volatility of the underlying over the swap’s life. If the
volatility is greater than the strike, the buyer receives the difference; if narrower, the
seller receives the difference. The amount that could be paid by the seller is capped
at a fixed level.
Motivation Buyer • Allows the buyer to go long the realized volatility of the underlying.
Seller • The seller must expect the volatility to be lower than the strike. The cap reduces
the risk to the seller.
as a hedge.
Mechanics Equation The buyer receives N × ( Max ( C, V ) – K ) , where N is the notional size of the
trade, V is the realized volatility of the underlying, calculated over the life of the
swap, C is the cap and K is the strike. If this value is negative, the buyer pays the
seller. V is given by
M
∑ ( log r )
1 2
252 × ----- i
M
i=1
where M is the total number of trading days over the life of the swap and r i is
the return on day i .
whether realized volatility is more or less wide than K .
Key Concepts Volatility Implied volatility is the most important factor determining the strike and the
mark. As time passes, and more of the realized volatility is known, the implied
volatility becomes less important.
Market Risks
Upside Downside

If the volatility of the underlying exceeds Can lose no more than the notional
the strike, then the upside is limited by times the strike if the volatility is
the cap. zero.

Can make no more than the notional Potential losses are limited by the
times the strike if the volatility is zero. cap.

Buyer
o + + –
2 3 4
Seller
o – – + 1 5
Importance
a. Since volatility is calculated close-to-close, there can be a small intraday delta.

b. The buyer is long realized volatility. Initially, the mark is most sensitive to the implied volatility. Once the cap is
exceeded, the buyer and seller are neutral relative to realized volatility.
c. If the underlying is a stock index, then the buyer is long correlation among the stocks in the index.
81
June 11, 1999

Example: An investor goes short the volatility of the S&P 500 for one year via a volatility swap with
a notional value of $100,000 per percentage point and a cap at 30%. Without the cap, this
might be offered at a strike of 20%. With the cap at 30%, assume that this is offered at a
strike of 19%. If the volatility of the index is less than 19%, then the investor receives
$100,000 times the difference between 19% and the realized volatility. If the volatility is
more than 19%, then he must pay $100,000 times the difference, up to a maximum of
$1,100,000 ($100,000 x (30 - 19)).
Capped Volatility Swap: Possible Scenarios
1,000 25
980
20
Realized Volatility
960
S&P 500 Level
940
15
920
900
10
880
860 5
840
820 0
JUN JUL AUG SEP OCT NOV
97
S&P 500: Closing Prices
Realized Volatility
The graph shows both the index level and the realized volatility. The volatility is calculat-
ed on a rolling basis with the first day fixed. So, the low of 4.40% includes only the first
three days of data and the value reported at the end of August (15.72%) includes the re-
turns of the first three months.
The realized volatility over the entire period is 20.54%. Since this is more than the strike
of 19%, the investor must pay an amount proportional to the difference. This is $154,000
= $100,000 x (20.54 - 19.00). Because the swap is capped at 30%, the most the investor
could have owed is $1,100,000 = $100,000 x (30 - 19).

82
June 11, 1999
Implied Volatility Swap
Description Swap is based on the implied volatility of a fixed maturity of the underlying over the
swap’s life. If implied volatility is greater than the strike, the buyer receives the dif-
ference; if narrower, the seller receives the difference.
Motivation Buyer • Allows the buyer to go long the implied volatility of the underlying.
Seller • The seller must expect the implied volatility to be lower than the strike.
as a hedge.
Mechanics Equation The buyer receives N × ( V – K ) , where N is the notional size of the trade, K is
the strike and V is the implied volatility of the underlying, of a fixed duration;
e.g., three month implied volatility. If this value is negative, the buyer pays the
seller.
whether implied volatility is more or less wide than K .
Key Concepts Volatility The level and term structure of implied volatility is the most important factor
determining the strike.
Market Risks
Upside Downside

If the implied volatility of the underlying Can lose no more than the notional
exceeds the strike, then the upside is times the strike if the implied volatil-
unlimited. ity is zero.

times the strike if the implied volatility is implied volatility of the underlying
zero. exceeds the strike.
Sensitivities Vegaa Correlationb Time Complexity

Buyer
+ + –
2 3 4
Seller
– – + 1 5
Importance
a. The buyer is long implied volatility.

b. If the underlying is a stock index, then the buyer is long correlation among the stocks in the index.
83
June 11, 1999

Example: An investor goes long the three month implied volatility of the S&P 500 via an implied
volatility swap with a notional value of $100,000 per percentage point and three months to
expiration. Assume that this is offered at a strike of 24.50%. If, three months after initia-
tion of the swap, the three month implied volatility of the index is more than 24.50%, then
the investor receives $100,000 times the difference between 24.50% and the implied vola-
tility. If the volatility is less than 24.50%, then he must pay $100,000 times the difference.
Implied Volatility Swap: Possible Scenarios
28 28
27 27
Volatility (%)
26 26
25 25
24 24
9 16 23 30 6 13 20 27 6 13 20 27 3
JAN FEB MAR
98
S&P 500: Three Month Implied Volatility
Three month implied volatility begins the swap at a level of 25.85%. The hypothetical
course of three month implied ends at 25.01%, meaning that at the beginning of April, im-
plied volatility for options expiring three months later, at the start of July, stands at
25.01%. Since the investor was long implied volatility, he receives $51,000 = $100,000 x
(25.01 - 24.50).

84
June 11, 1999
Par Par Asset Swap
Description The buyer receives LIBOR plus a spread depending on the credit rating of the con-
vertible bond, while the seller keeps any optionality of the convert.
Motivation Buyer • Buyer is paid for assuming credit exposure.
Seller • The seller keeps any optionality built into the convert.
• By eliminating the credit exposure, the leverage of the convert is increased.
Mechanics Trade Day Buyer delivers the par amount to the seller and the seller delivers the physical
bond to the buyer.
Reset Dates Buyer passes the convert coupons through to the seller, while receiving LIBOR
plus a spread on the par amount.
Expiration The buyer returns the bond to the seller and receives back the par amount from the
seller. Terms if the company calls early or defaults are subject to negotiation when
the swap is initiated.
Key Concepts Credit Risk If the company that issued the bond defaults, the buyer will suffer severe losses.
Market Risks
Upside Downside
Buyer Limited. Unlimited.

Receives a LIBOR enhanced return If the bond defaults, could lose as
assuming no default. much as par.
Seller Unlimited. Limited.

The optionality kept by the seller could At worst, pays out the LIBOR
lead to unlimited returns. enhancement with no additional
upside.
Sensitivities Deltaa Vegab Complexity

Buyer
o o
2 3 4
Seller
? ? 1 5
Importance
a. The optionality embedded in the convert may make the seller long or short the underlying stock.
b. If the convert has an embedded option, the seller is likely to be long volatility.
85
June 11, 1999
Par Par Asset Swap
Example: An investor buys a par par asset swap on the XYZ convertible bond on a total par value of
$10,000,000. The bond pays a 6% coupon and has six months of call protection remain-
ing. The investor is to receive 150 bps over LIBOR.
Overall Picture of Par Par Asset Swap
SSB
Swap Initiation Swap Termination
LIBOR + on
Par Amount
Convert Par Amount Fixed Convert Par Amount Convert

Coupons
Investor
Payment Flows over Life of Swap
Trade Initiation • Buyer delivers $10,000,000 to seller and receives an equivalent number of
bonds in return.
First Reset • LIBOR is at 5.75%.

• The buyer receives $150,000 (6% x $10,000,000 / 4) in quarterly coupons.
These are passed through to the seller.
• The seller pays the buyer $181,250 ($10,000,000 x (5.75% + 1.50%) / 4).
Termination • LIBOR is at 5.50%.

• The buyer receives $150,000 (6% x $10,000,000 / 4) in quarterly coupons.
These are passed through to the seller.
• The seller pays the buyer $175,000 ($10,000,000 x (5.50% + 1.50%) / 4).
• The company called the convert, so the swap terminates. As a result, the
buyer returns the bonds to the seller and the seller returns the $10,000,000 par
amount to the buyer.

86
June 11, 1999
Description The buyer receives the fixed coupon of a convertible bond, in return for the market
value of an equivalent vanilla bond. The value the buyer receives at maturity or early
conversion accretes up to the par value.
Motivation Buyer • Buyer is paid for assuming credit exposure.
Seller • The seller keeps any optionality built into the convert.
• By eliminating the credit exposure, the leverage of the convert is increased.
Mechanics Trade Day Buyer delivers the market value of an equivalent vanilla bond to the seller and the
seller delivers the physical bond to the buyer.
Reset Dates Buyer keeps any convert coupons.
Expiration The buyer returns the bond to the seller and receives the accreted value of the
amount paid on the trade day, where accrual occurs at a fixed rate agreed to on the
trade date. Terms if the company calls early or defaults are subject to negotiation
when the swap is initiated.
Key Concepts Credit Risk If the company that issued the bond defaults, the buyer will suffer severe losses.
Market Risks
Upside Downside
Buyer Limited. Unlimited.

Receives a fixed above market return. If the bond defaults, could lose as
much as the entire amount delivered
on the trade date.
Seller Unlimited. Limited.

The optionality kept by the seller could At worst, pays out the agreed upon
lead to unlimited returns. fixed rate with no additional upside.
Sensitivities Deltaa Vegab Complexity

Buyer
o o
2 3 4
Seller
? ? 1 5
Importance
a. The optionality embedded in the convert may make the seller long or short the underlying stock.
b. If the convert has an embedded option, the seller is likely to be long volatility.
87
June 11, 1999
Example: An investor buys a discount asset swap on the XYZ convertible bond on a total par value
of $10,000,000. The bond pays a 6% coupon quarterly and has six months of call protec-
tion remaining. The investor is to receive a yield to maturity of 7.50% (continuous com-
pounding), with maturity to occur in one year.
Overall Picture of Discount Asset Swap
Swap Initiation Seller Swap Termination
Convert Market Value Accrued Value Convert
Investor
Fixed Convert
Coupons
Payment Flows over Life of Swap
Trade Initiation • Buyer receives bonds with total par value of $10,000,000 from the seller. In
return, he pays $8,704,785.06, which is given according to the formula below.
– 0.075  –0.075 × 3 ⁄ 4 – 0.075 ⁄ 2 – 0.075 ⁄ 4 – 0.075 
10, 000, 000e – 150, 000  e +e +e +e 
The value of 150,000 appears because that is the amount of each coupon and
there are four coupons, the first coupon occurring in a quarter of a year and the
last a year in the future.
First Reset • The buyer receives $150,000 (6% x $10,000,000 / 4) in quarterly coupons.
Termination • The buyer receives another $150,000 in quarterly coupons.

• The company called the convert, so the swap terminates. As a result, the
buyer returns the bonds to the seller and the seller returns the accrued value of
the bond. This is $9,340,251.31 as given below.
– 0.075 ⁄ 2  – 0.075 ⁄ 2 – 0.075 ⁄ 4 
10, 000, 000e – 150, 000  e +e 
The company called early, so there are two coupons remaining in the calcula-
tion.

88
June 11, 1999
From Options to Swaps

Vanilla Variations
Digital Options Forward Start Option
Binary Option Asian Option
Knock in Option Lookback Option
Knock out Option Split-fee Option
Chooser Option
Digital Options /Relative Value
Knock out Option: Outside Barrier
Relative Value
Better of Option
Knock in Option: Outside Barrier Spread Option
Outperformance Option
Option
Foreign Stocks
Option: Local Style
Option: Quanto Style
Option: ADR Style
Accrual Option
Swaption
Swap: Local Style Range Swap
Swap: Quanto Style
Swap: ADR Style
Swap
Convert Swap Volatility Swaps

Par Par Asset Swap
Discount Asset Swap
89
June 11, 1999
Options by Strategy
Path Dependent
Foreign Stocks
Relative Value
Max Leverage
Amer or Euro
Lower Cost
Directional
Lower Vol
Finance
Foreign Option: Local Style ✔ ✔ ✔
Foreign Option: Quanto Style ✔ ✔ ✔
Foreign Option: ADR Style ✔ ✔ ✔
Swap ✔ ✔ ✔ ✔
Foreign Swap: Local Style ✔ ✔ ✔ ✔ ✔
Foreign Swap: Quanto Style ✔ ✔ ✔ ✔ ✔
Foreign Swap: ADR Style ✔ ✔ ✔ ✔ ✔
Asian Option ✔ ✔ ✔ ✔
Outperformance Option ✔ ✔ ✔
Spread Option ✔ ✔ ✔
Knock in/out Option ✔ ✔ ✔
Knock in/out Option: Outside Barrier ✔ ✔ ✔ ✔
Lookback Option ✔ ✔ ✔ ✔
Split-fee Option ✔ ✔
Binary Option ✔ ✔
Accrual Option ✔ ✔
Range Swap ✔ ✔
Realized Volatility Swap ✔ ✔
Capped Volatility Swap ✔ ✔
Implied Volatility Swap ✔
Forward Start Option ✔ ✔
Better of Option ✔ ✔ ✔
Chooser Option ✔ ✔
Swaption ✔ ✔
Par Par Asset Swap ✔ ✔
Discount Asset Swap ✔ ✔
90
June 11, 1999
Glossary
American: Options with American style exercise may be exercised prior to expiration. If an option is exercised
early, the holder receives the option’s intrinsic value. However, for very complex options, intrinsic
value may be difficult or impossible to define. See European.
Barrier: When the value of an asset crosses a barrier, some aspect of an option becomes active or inactive.
For example, a knock out call option with a barrier at $30 becomes worthless if the stock price ever
trades up or down to $30. Knock in and knock out options are called barrier options.
Breakeven: A breakeven scenario is one where the holder of an option receives as much or more on the option
payout as was originally paid for the option.
Correlation: A statistical measure of the extent to which two or more assets are expected to have similar returns.
High correlation (near 1.0) means that returns of the two assets should be similar. Correlation near -
1.0 means that returns should be opposite in sign. When assets have high positive correlation, the
volatility of the basket is higher.
Close-to-close: Barriers and high/lows can be measured on a close-to-close basis or throughout the day. When mea-
surements are made close-to-close, only the closing price is needed to value the option; asset prices
during the day are irrelevant. See intra-day.
European: Options with European style exercise can only be exercised at expiration. See American.
Hedge: Hedging changes the risk profile of a portfolio. Strategies may be done at a credit, no cost or at a
premium. Some valid hedging strategies may actually increase risk under some circumstances.
Implied Volatility: By holding all other determinants of an options value constant, the price of an option can be made
to correspond to a single volatility, referred to as the implied volatility.
Intra-day: Barriers and high/lows can be measured on a close-to-close basis or intra-day. When measurements
are made close-to-close, only the closing price is needed to value the option; asset prices during the
day are irrelevant. With an intra-day option, the high would be taken as the highest level seen at any
time during the day. See close-to-close.
Intrinsic Value: For in the money vanilla options, this is the difference between the strike and underlying asset
level. For more complex options, the intrinsic value may be difficult or impossible to define.
Moneyness: The degree to which an option is in or out of the money.
Notional: The total value of the assets underlying an option or swap.
Overwrite: Selling calls on a portfolio held by the investor. If the asset rises at a modest rate or falls, the strat-
egy improves on a simple buy and hold strategy. Overwriters underperform in a strong bull market.
See targeted buy/sell.
Path Dependent: Options whose value depends on asset prices prior to the option’s expiration are path dependent.
Examples include barrier options, accrual options, range swap.
Premium: Amount paid for an option.
Realized Volatility: The actual historical volatility of an asset, as measured by taking the annualized standard deviation
of the natural logarithm of returns.
Rebate: If an option expires worthless (or knocks out), its terms may include a provision for the investor to
receive a cash rebate.
91
June 11, 1999
Targeted Buy/Sell: Selling options is a way for investors to be paid for taking views on where a stock will be an attrac-
tive buy or sell. An investor who sells calls is willing to sell stock at the strike; if he sells puts, then
he is willing to buy stock at the strike. In both cases the investor is paid for this willingness. See
overwrite.
92

(Salomon Smith Barney) Exotic Equity Derivatives Manual

Uploaded by

Copyright:

Available Formats

(Salomon Smith Barney) Exotic Equity Derivatives Manual

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

(Salomon Smith Barney) Exotic Equity Derivatives Manual

Uploaded by

Copyright:

Available Formats

June 11, 1999

SALOMON SMITH BARNEY

Randall Fairman, Ph.D.

Realized Volatility Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

General Risk Factors Associated with Over the Counter Transactions

The complexity of the financial instruments is rated on a scale of one to five,

Salomon Smith Barney

Description Gives economic exposure to stock or index returns.

Seller • Gives leveraged exposure to the stock.

Trade Day No payments by either party.

Buyer Unlimited. Unlimited.

Seller Unlimited. Unlimited.

Sensitivities Delta Complexity

See the discussion of Risk Factors on page 5 of this manual.

First Quarter LIBOR: 5.25%

$300,000 = 100,000 shares x $3.00

Second Quarter LIBOR: 5.00%

-$100,000 = 100,000 shares x -$1.00

See the discussion of Risk Factors on page 5 of this manual.

Stocks of Non-U.S. Issuers: Local Style Swap

Seller • Gives leveraged exposure to downside in the stock.

Trade Day No payments by either party.

Market Risks Upside Downside

Buyer Unlimited. Unlimited.

Seller Unlimited. Unlimited.

Sensitivities Delta Currencya Complexity

See the discussion of Risk Factors on page 5 of this manual.

Stocks of Non-U.S. Issuers: Local Style Swap

First Quarter NLG LIBOR: 3.80%

300,000 NLG = 100,000 shares x 3.00 NLG

Second Quarter NLG LIBOR: 4.25%

-100,000 NLG = 100,000 shares x -1.00 NLG

See the discussion of Risk Factors on page 5 of this manual.

Stocks of Non-U.S. Issuers: Quanto Style Swap

Seller • Gives leveraged exposure to downside in the stock.

Trade Day No payments by either party.

Buyer Unlimited. Unlimited.

Seller Unlimited. Unlimited.

Sensitivities Delta Complexity

See the discussion of Risk Factors on page 5 of this manual.

Stocks of Non-U.S. Issuers: Quanto Style Swap

First Quarter USD LIBOR: 5.25%

300,000 USD = 200,000 shares x 3.00 NLG / (2 NLG/USD)

Second Quarter USD LIBOR: 5.00%

-100,000 USD = 200,000 shares x -1.00 NLG / (2 NLG/USD)

See the discussion of Risk Factors on page 5 of this manual.

Stocks of Non-U.S. Issuers: ADR Style Swap

Seller • Gives leveraged exposure to downside in the stock.

Trade Day No payments by either party.

Buyer Unlimited. Unlimited.

Seller Unlimited. Unlimited.

Sensitivities Delta Currencya Complexity

See the discussion of Risk Factors on page 5 of this manual.

Stocks of Non-U.S. Issuers: ADR Style Swap

First Quarter LIBOR: 5.25%

Second Quarter LIBOR: 5.00%

See the discussion of Risk Factors on page 5 of this manual.

Seller • Can be sold as a part of a hedging/overwriting strategy or if volatility is expected

Trade Day Buyer pays the swaption premium.