derivatives

Hi

I'm hoping someone can help me here - the three questions are more cid specific but I see some of the posts have been answered by students who have passed st6 and I suppose they could be st5 relevant.


(1) When dealing with options does a payoff diagram include the option premium or not? As I understand it a profit/loss diagram takes the option premiums into account but the payoff diagram just basically uses intrinsic value and ignores the option premiums?

(2) How would you describe the following strategy?

(a) name the strategy
(b) sketch the pay-off diagram
(c) state the trader’s most likely reason for executing the strategy

Buy one call option with a strike price of £950 at £60 and sell three call
options with a strike price of £1,050 at £16.60 each. All options have the
same expiry date.

(3) Explain whether delta would be positive or negative for a short put
trading position. A short put trading position means that the trader has
sold a put option.

Thanks!

 

Hi

(1) i remember in ST6 most diagrams had an allowance for premiums (when stated), but i remember one question where the examiner makes an approximate allowance. general feeling is allow for premiums, unles stated otherwise.
if in doubt, could make assumption (allow for premiusm) and write down assumption.

(2) see SA5 April 2007, i presume you have seen it, or do you not undertsand the answer. this is a common spread strategy. another example of this strategy is Cid 1999.
however, i have seen several derivatives boosk describe thsi strategy as a "call ratio spread" (not a butterfly like the examiner has)

(3)again SA5 april 2007.long put = -ve delta so short put = +ve delta,
many examples of deltas for short positions can be found in old CiD papers (be wary September 2005 paper, solution states the postion as long puts (-ve delta) when most of us on this board interpreted it as short puts (+ve delta).

 

Hi

Thanks very much for the quick reply examstudent. I know the questions are from sa5 april 2007, I did not want to bias any answers to my post.

(1) From the various texts I have read I gather that there is a difference between a profit/loss diagram and a payoff diagram. Granted, the examiner did define what he meant by the diagram but I still have my doubts as to whether the examiner is correct.

(2) I thought that a butterfly spread has limited loss from downside movements and upside movements of S_T (If I look at Hull), I presume that's where the word butterfly comes from - that specific shape. In this question if S_T rapidly increases the holder of the strategy will make a large loss, and I was therefore unsure of whether I could still call this a butterfly spread.

(3) The examiner clearly is making the same mistake as in the CID, but this sort of thing could lose a student marks even though they are correct. I seem to be harping about the same things as I did in the CID? How can the examiners still be getting this wrong? This is so frustrating...

 

MTM

(2) agree with the "butterfly" thing as shape is well known, cant understand why examiner has called it that, i have read this startegy before as a a ratio spread.

(3) i didnt see the answer in SA5 and I assumed the examiner had remarked the "short put has positive delta. i assume you share this view too
i am surprised at this answer..
i wonder if anyone else can explain that solution in april 2007 sa5 (gareth?????)

 

Examiner's solution follows....

Option premiums consist of intrinsic value and time value. Intrinsic
value for a put option is the amount by which the exercise price
exceeds the price of the underlying asset. Time value is a function of
the likelihood of the option being exercised. It tends to zero as the
expiry date of the option approaches.
Holding time constant a price change in the underlying asset will only
affect its intrinsic value. For a put option, the premium will increase as
the price of the underlying asset decreases. Hence delta will be
negative. Whether the trader is short or long of the option is irrelevant
to the delta.

Don't you love the last sentence...

 

As far as ST5 is concerned:

(1) I would always include the option premium unless there was an explicit indication in the question not to do so

(2) I too would describe the strategy outlined as a ratio spread. However, terms such as this are not mentioned in the ST5 Core Reading and so you should not be required to know them. The strategy will make an overall profit if the share price at expiry lies in the range £960.20 to £1094.90, ie if the share price is not very volatile.

The overall payoff function is:
S < 950: -£10.20
950 < S < 1050: S - £960.20
S > 1050: -2S + 2189.80

(3) As a put has a negative delta, I would always say that a short put position has a positive delta if asked!

 

OMG, this is why investment banks don't like actuaries - even our examiners are clueless on derivatives.

 

Whatever the inadequacies of actuaries and they do seem to be fairly useless, they are unlikely to bring the world's monetary system crashing down. Investment bankers on the other hand .....

 

You could write an amusing article for the actuary magazine by collecting together all the examiner's misunderstandings about derivatives from past ST5/ST6/CID/ACID papers...

Why on earth don't we get people qualified in this area to write the exam papers? As an organisation this is embarrassing.

 

You'll need more than one article - instead an entire issue!