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Questions and Answers
What occurs when Basis Risk increases during a long hedge?
What occurs when Basis Risk increases during a long hedge?
In the context of hedging, what is the primary purpose of a short hedge?
In the context of hedging, what is the primary purpose of a short hedge?
How does Basis Risk impact a short hedge when prices increase?
How does Basis Risk impact a short hedge when prices increase?
What does the Synthetic Call equation "C = P + So - PV(X)" represent?
What does the Synthetic Call equation "C = P + So - PV(X)" represent?
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In arbitrage, what is the appropriate action when a derivative is underpriced?
In arbitrage, what is the appropriate action when a derivative is underpriced?
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What does a Covered Call strategy involve?
What does a Covered Call strategy involve?
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What is the key characteristic of a Strap strategy?
What is the key characteristic of a Strap strategy?
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What is the effect of implied volatility on the Black Scholes model?
What is the effect of implied volatility on the Black Scholes model?
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Which of the following best describes a Protective Put?
Which of the following best describes a Protective Put?
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Which option accurately defines a Straddle strategy?
Which option accurately defines a Straddle strategy?
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Study Notes
Basis Risk
- The difference between the spot price and futures price
- Increases when the spot price moves higher relative to the futures price
Impact of Basis Risk on Long Hedge
- A long hedge aims to benefit from price increases by locking in a lower purchase price
- Increased basis risk reduces the benefit of a long hedge as potential gains from the futures contract may not fully offset the increased spot price
Impact of Basis Risk on Short Hedge
- A short hedge aims to benefit from price decreases by locking in a higher selling price
- Increased basis risk benefits a short hedge as the futures position loses less than the increase in spot price, making the short position more favorable
Implied Volatility
- Assumes the options market price reflects the stock's current volatility
- The implied volatility is derived from the Black-Scholes model
Synthetic Call
- A synthetic call creates the same payoff as a call option, but at a lower cost:
- Long put
- Long stock
- Short risk-free bond
Synthetic Put
- A synthetic put creates the same payoff as a put option:
- Long call
- Short stock
- Long risk-free bond
Short Hedge:
- Strategy used when you believe prices will decrease
- You take a short position in futures
Long Hedge:
- Strategy used when you believe prices will increase
- You take a long position in futures
Arbitrage
- Identify price discrepancies between derivative markets and underlying assets
- Overpriced derivatives: Short the derivative, borrow and buy the underlying asset
- Underpriced derivatives: Long the derivative, short sell the underlying asset and invest the proceeds
Synthetic Strategies:
- If you short a derivative because it is overpriced, you go long a synthetic
- If you long a derivative because it is underpriced, you go short a synthetic
Futures and Option Position Relationship
- Long position in futures is equivalent to a long call
- Short position in futures is equivalent to a long put
Options Strategies
-
Straddle/Strangle: A straddle is a strategy that allows for the potential to profit from price movements in either direction of the underlying asset. A strangle achieves the same thing but uses different strike prices for the call and put
- Long call
- Long put
- Both with same exercise price and time to expiration
-
Protective Put:
- Long put
- Long stock
- You are bullish, but hedging against potential price decreases
-
Covered Call:
- Short call
- Long stock
- You are bearish, but hedging against potential price increases
-
Strap:
- Two long calls
- One long put
- Bullish strategy, maximum profit unlimited, minimum capped
-
Strip:
- Two long puts
- One long call
- Bearish strategy, maximum unlimited, minimum determined by price differential
Spreads
-
Bull Spread: Buying one call with a lower strike price and selling one call with a higher strike price
- Profit when the underlying asset price rises
- Limited profit, but also capped risk
-
Bear Spread (using Calls): Buying one call with a higher strike price and selling one call with a lower strike price
- Profit when the underlying asset price falls
- Limited profit, but also capped risk
-
Bear Spread (using Puts): Buying one put with a higher strike price and selling one put with a lower strike price
- Profit when the underlying asset price falls
- Limited profit, but also capped risk
Time Spreads
- Creating spreads involves changing the time to expiration of the options
- This allows for opportunities to profit from expectations of volatility changes in the underlying asset
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Description
Explore the concepts of basis risk and its impact on long and short hedges. Understand how basis risk affects price locking strategies and learn about implied volatility and synthetic calls. This quiz will test your knowledge of risk management in finance.
