Swaps • The swap market developed in the late 1970s. • Swap is an agreement between two parties (called counter parties) to exchange payments with each other. • Four general classifications of swaps: – Interest rates – Currencies – Commodities – Equity • Since it is often difficult for individuals to find parties who have need that can be matched with their swaps, swap dealers and brokers have emerged. – Swap dealers: Take the other side of each deal and earn a spread difference for their efforts. – Brokers: Simply match up counter parties and receive a fee for their efforts. • The most popular interest rate swap is the fixed for floating – Where one counterparty exchanges (swaps) her floating interest rate payment to another counterparty for his fixed rate payment. • Swaps are very flexible. They can be constructed to match long-term needs over several time periods, for various amounts and can be tailor made to suit individual company needs. • If properly done, they can control interest rate risks, currency risks and commodity price risks. Swaps • A foreign exchange swap is a trade that combines both a spot and a forward transactions into one deal. – Example: Suppose Citibank wants pounds now. It could enter into a swap agreement with another bank. Under the swap agreement, it will trade dollar to the other bank and in return will receive pounds. After the specified time period, the trade is reversed. Citibank will pay out pounds to the other bank and receive dollars. Futures vs Swaps • Futures are much more standardized and less flexible. • However, futures are openly traded and backed by clearing house at each exchange. Default risk for futures is almost nil. Not so with swaps. They are only as good as the parties and dealers who construct and trade them. Option Hedging Considerations Option Hedging Considerations • To properly hedge with options, a few considerations need to be observed. – The relationship between the change in the price of the underlying futures and the option premium will impact the effectiveness of the hedge. – The relationship between the price of the underlying futures and the cash price (i.e., basis) will affect certain hedge. Delta • The relationship between the change in the option premium and the price of the underlying futures is called delta (Δ). • Delta=Change in the option premium/ Change in the price of the futures • Delta normally ranges between zero and one. – A delta of 0.9 means that when the underlying futures price changes by $1.00, the option premium changes by only $0.90. – Deltas of 1 means perfect correlation between changes of the futures price and the option premium and deltas of 0 means that the option premium did not change when the futures price changes. Delta • Delta (D) is the rate of change of the option price with respect to the underlying Option price Slope = D B A Stock price • As a general rule, delta value increases as the option gets deeper in-the-money and becomes the value of one. • As the option goes deeper out of the money the delta value becomes close to zero. • Delta takes on the values of zero or one as the option approaches maturity when the time value is eroded away and the probability of a significant price moves is effectively zero. • Delta can be calculated after the fact with certainty, but they can serve as a guide for future premium values, if only as an estimate. • General rule of thumb: – If the underlying futures price remains stable, deltas will decrease in value for those premiums with time value- the more time value in a premium, the more the delta will decline. – If the underlying futures price increases, put deltas decrease and call deltas increase. – If the underlying futures price decreases, put deltas increase and call deltas decrease • What do deltas mean for hedger: Delta can serve as guides for what the hedger can expect as price protection. Effects of Delta on Hedging Cash Futures • Nov. 1 Buys corn at $3/bu Buys one put option on Dec. corn at strike price of $3/bu and a premium of $0.10/bu Nov.15 Sells put at a premium Sells corn at $2.90 of $0.15/bu Multiples • A multiple is simply a term applied to an options hedge that contains more than one option contract. Multiples are used to achieve dollar equivalency with an option hedge. – M=1/delta – M = number of option contracts necessary to achieve dollar equivalency. • If the delta is 0.5, then the number of options contracts necessary to achieve dollar equivalency is two. • If the price starts to move, the value of delta will change and thus the size of the multiple will also change Effects of Changing Delta on Hedging Cash Futures • Nov. 1 • Delta=0.5 Buy corn at $3/bu Buy two put option on Dec. corn at strike price of $3/bu and a premium of $0.10/bu Nov.15 Delta=0.95, premium Cash corn at $2.80 $0.195 Sell one put option Nov. 20 Delta=0.95 Cash corn at $2.75 Premium $0.2375 • For an option hedger the most important is not knowing about delta for the options premium (DeltaF) and the underlying futures but a delta for the options premium and the cash market (DeltaC) . Hedging in Practice • Traders usually ensure that their portfolios are delta-neutral at least once a day • Whenever the opportunity arises, they improve gamma and vega • As portfolio becomes larger hedging becomes less expensive • What does it mean to assert that the delta of a call option is 0.7? How can a short position in 1,000 call options be made delta neutral when the delta of each option is 0.7?
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