The Option Volatility and Pricing Value Pack by Sheldon Natenberg

Author:Sheldon Natenberg
Language: eng
Format: epub
Publisher: McGraw-Hill Education LLC
Published: 2018-10-20T16:00:00+00:00

Protective Calls and Puts

The simplest way to hedge an underlying position using options is to purchase either a put to protect a long position or a call to protect a short position. In each case, if the market moves adversely, the hedger is insulated from any loss beyond the exercise price. The difference between the exercise price and the current price of the underlying is similar to the deductible portion of an insurance policy. The price of the option is similar to the premium that one has to pay for the insurance policy.

Consider an American firm that expects to take delivery of €1 million worth of German goods in six months. If the contract requires payment in euros at the time of delivery, the American firm has acquired a short position in euros against U.S. dollars. If over the next six months the euro rises against the dollar, the goods will cost more in dollars; if the euro falls, the goods will cost less. If the euro is currently trading at 1.35 ($1.35 per euro) and remains there for the next six months, the cost to the American firm will be $1,350,000. If, however, at delivery the euro has risen to 1.45 ($1.45 per euro), the cost to the American firm will be $1,450,000.

The American firm can offset the risk it has acquired by purchasing a call option on euros, for example, a 1.40 call. For a complete hedge, the underlying contract will be €1 million, and the option will have an expiration date corresponding to the date on which payment is required. If the value of the euro begins to rise against the U.S. dollar, the firm will have to pay a higher price than expected when it takes delivery of the goods in six months. But the price it will have to pay for euros can never be greater than 1.40. If the price is greater than 1.40 at expiration, the firm will simply exercise its call, effectively purchasing euros at 1.40. If the price of euros is less than 1.40 at expiration, the firm will let the option expire worthless because it will be cheaper to purchase euros in the open market.

When used to hedge interest-rate risk, protective options are sometimes referred to as caps and floors. A firm that borrows funds at a variable interest rate has a short interest-rate position—falling interest rates will reduce its cost of borrowing, while rising interest rates will increase its costs. To cap the upside risk, the firm can purchase an interest-rate call, thereby establishing a maximum amount it will have to pay for borrowed funds. No matter how high interest rates rise, the borrower will never have to pay more than the cap’s exercise price.

An institution that lends funds at a variable interest rate has a long interest-rate position—rising interest rates will increase its returns, while falling interest rates will reduce its returns. To set a floor on its downside risk, the institution can purchase an interest-rate put, thereby establishing a minimum amount it will receive for loaned funds.

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