MONASH

BUSINESS
SCHOOL

BFF3651 Week 10

Risk Management:
Options
 Unit Learning Outcomes
• On successful completion of this unit, you should be able to:
– explain the role of treasury operations in an international
or a local bank
– describe how risk management processes work
– demonstrate the application of hedging techniques used in
banks' treasury operations
– apply critical thinking, problem solving and presentation
skills to individual and/or group activities dealing with
treasury management and demonstrate in an individual
summative assessment task the acquisition of a
comprehensive understanding of the topics covered by
BFF3651.

MONASH
BUSINESS
SCHOOL
 Resources
• Lecture note
• Saunders and Cornett’s Financial Institution
Management Chapter 23 (Options)

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Option: a contract that gives the holder the right, but not the
obligation, to buy or sell an underlying asset at a prespecified price
for a specified time period.
• Types: Put and Call
• Rapid growth in options markets
• Trading process: similar to futures contracts
– Taking an option position: place an order to buy or sell a stated
number of call or put option contracts with a stated expiration
date and exercise price.
– The order is directed to a representative on the appropriate
exchange for execution.
– Once an option price is agreed, the two parties send the details
of the trade to the option clearinghouse, which breaks up trades
into buy and sell transactions and takes the opposite side of
each transaction—becoming the seller for every option contract
buyer and the buyer for every option contract seller.

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 1: Buying a Call Option: Taking long position
• Long position in an option is synonymous with: Holder, buyer,
purchaser, the long.
• Gives the purchaser the right (but not the obligation) to buy the
underlying security (e.g., bond) at a prespecified exercise or strike
price ( X ).
• The buyer of the call option must pay the writer or seller an
upfront fee known as a call premium ( C ). This premium is an
immediate negative cash flow for the buyer of the call, who
potentially stands to make a profit if the underlying bond’s price
rises above the exercise price by an amount exceeding the
premium.
• If the price of the bond never rises above X, the buyer of the call
never exercises the option. In this case, the option matures
unexercised. The call buyer incurs a cost, C, for the option, and no
other cash flows result.

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Buying a Call Option on a Bond: Taking long position
• If the price of the bond underlying the option rises to price B, the
buyer makes a profit of , which is the difference between the bond
price ( B ) and the exercise price of the option ( X ) minus the call
premium ( C ).
• If the bond price rises to A, the buyer of the call has broken even
in that the profit from exercising the call ( A – X ) just equals the
premium payment for the call ( C ).
• As interest rates fall, bond prices rise and the call option buyer has
large profit potential.

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Buying a Call Option on a Bond: Taking long position
• If rates rise so that bond prices fall below the exercise price X, the
call buyer is not obliged to exercise the option.
• Thus, the losses of the buyer are truncated by the amount of the
up-front premium payment ( C ) made to purchase the call option.

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 2: Writing a Call Option: Taking a short position
• Short position in an option is synonymous with: Writer, seller, the short
– Obliged to fulfill terms of the option if the option holder chooses to
exercise
• The writer or seller receives an up-front fee or premium ( C ) and must
stand ready to sell the underlying bond to the purchaser of the option at
the exercise price, X.
• When interest rates rise and bond prices fall, there is an increased
potential for the writer of the call to receive a positive profit. This profit
has a maximum equal to the call premium ( C ) charged up front to the
buyer of the option.

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 2: Writing a Call Option on a Bond: Taking a short
position
• When interest rates fall and bond prices rise, the writer has an
increased potential to take a loss.

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 3: buying (or taking a long position in) a put option
• The buyer of a put option on a bond has the right (but not the
obligation) to sell the underlying bond to the writer of the option
at the agreed exercise price ( X ).
• In return or this option, the buyer of the put option pays a
premium to the writer ( P ).
• When interest rates fall and bond prices rise, the probability that
the buyer of a put will lose increases.
• If rates fall so that bond prices rise above the exercise price X, the
put buyer does not have to exercise the option.
• Thus, the maximum loss is limited to the size of the up-front put
premium ( P ).

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 3: buying (or taking a long position in) a put option
• When interest rates rise and bond prices fall, the buyer of the put
has an increased probability of making a profit from exercising the
option.
• Thus, if bond prices fall to D, the buyer of the put option can
purchase bonds in the bond market at that price and put them
(sell them) back to the writer of the put at the higher exercise
price ( X ).

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 4: Writing a Put Option on a Bond
• The writer or seller receives a fee or premium ( P ) in return for
standing ready to buy bonds at the exercise price ( X ) if the buyer
of the put chooses to exercise the option to sell.
• If interest rates fall and bond prices rise, the writer has an
enhanced probability of making a profit. The put buyer is less
likely to exercise the option, which would force the option writer to
buy the underlying bond. However, the writer’s maximum profit is
constrained to be equal to the put premium ( P ).

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Strategy 4: Writing a Put Option on a Bond
• If interest rates rise and bond prices fall, the writer of the put is
exposed to potentially large losses (e.g., π p, if bond prices fall to
D
• Writing a put option is a strategy to take when interest rates are
expected to fall. However, profits are limited and losses are
potentially unlimited.

MONASH
BUSINESS
SCHOOL
Basic features and strategies of Options

MONASH
BUSINESS
SCHOOL
 Basic features and strategies of Options
• Zero-sum game
• Gains for the short position are losses for the long position
• Gains for the long position are losses for the short position
• Since the price of the bond could rise to equal the sum of the
principal and interest payments (zero rate of interest), the writer of
a call is exposed to the risk of very large losses
• Since the bond price cannot be negative, the maximum loss for the
writer of a put occurs when the bond price falls to zero
• Style of execution:
• American style: can be exercised at any time until expiry.
• European style: can only be exercised on expiry.

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Writing versus buying options
• Many smaller FIs constrained to buying rather than writing
options
• Economic reasons
– Let assume, a treasurer is long in bonds and hedge interest rate
risk by writing call options.
– If bond price increases, on balancesheet profit will be offset by
off balancesheet loss.
– If bond price decreases, off balancesheet profit will not be
sufficient to offset on balancesheet loss.
– An attractive alternative to sell call is buy put option. Why?

MONASH
BUSINESS
SCHOOL
 Writing versus buying options
• Writing versus buying options
• Many smaller FIs constrained to buying rather than writing
options
• Regulatory reasons
– Risky because of large loss potential

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Futures vs Options

• Hedging with futures eliminates both upside and downside risk.

• Futures: Payoff function is symmetric
• Options: Payoff function is asymmetric
• The hedge with the put option contract (long in put) completely
offsets losses but only partly offsets gains.
• If the FI loses value on the bond due to an interest rate increase
(on balancesheet), a gain on the put option contract offsets the
loss.
• However, if the FI gains value on the bond due to an interest rate
decrease (on balancesheet), the gain is offset only to the extent
that the FI loses the put option premium.

MONASH
BUSINESS
SCHOOL
 Futures vs Options

• Actual Bond Options

• In 2015: No trading of interest rate options in CBOE
• Most options are traded over the counter.
• Many FIs prefer to use Futures.
• Futures: liquidity, credit risk, homogeneity, and marking-to-market
features, information efficiency

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Option contracts and hedging risk

• The mechanics of hedging a bond or bond portfolio:

• Valuation model: Black-Scholes model and Binomial Model
• Weaknesses of Black-Scholes model
• Assumes short-term interest rate constant
• Assumes constant variance of returns on underlying asset
• Behavior of bond prices between issuance and maturity
– Pull-to-par: The tendency of the variance of a bond’s price or
return to decrease as maturity approaches.

MONASH
BUSINESS
SCHOOL
 Option contracts and hedging risk
• Binomial Model:
• Example: Your FI purchases a $100 zero-coupon bond with 2 years
to maturity, at BP0 = $80.44. This means YTM = 11.5%.

•
( )

• Assume FI may have to sell at t=1. Current yield on 1-year bonds

is 10% and forecast for next year’s 1-year rate is that rates will rise
to either 13.82% or 12.18%.
• If r1=13.82%, BP1= 100/1.1382 = $87.86
• If r1=12.18%, BP1= 100/1.1218 = $89.14
• If the 1-year rates of 13.82% and 12.18% are equally likely,
expected 1-year rate = 13% and E(BP1) = 100/1.13 = $88.50.
• To ensure that the FI receives at least $88.50 at end of 1 year, buy
put with X = $88.50.

MONASH
BUSINESS
SCHOOL
 Option contracts and hedging risk
• Binomial Model:
• At t = 1, equally likely outcomes that bond with 1 year to
maturity trading at $87.86 or $89.14

MONASH
BUSINESS
SCHOOL
 Option contracts and hedging risk
• Binomial Model:
• Value of put at t=1: Max[88.5-87.86, 0] = 0.64
Or, Max[88.5-89.14, 0] = 0
• At t=1: The option is worth: [.5(.64) + .5(0)] = $0.32

• Value at t=0: P = [.5(.64) + .5(0)]/1.10 = $0.29

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk

• Hedging interest rate risk on the balance sheet

∆
•
•
• = FI’s Duration gap
• A = Asset size
∆
•
• k=Leverage ratio (L/A)
• A positive duration gap will cause a loss on-balance-sheet net
worth when interest rates rise.
• A put option position might generate profits that just offset the
loss in net worth due to an interest rate shock.
• Put option value increases if interest rate increases.

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk

• Hedging interest rate risk on the balance sheet

• = x )
• = the number of $100,000 put options on T-bond contracts to
be purchased (the number for which we are solving)
• = the change in the dollar value for each $100,000 face value T-
bond put option contract.
• =

• = the change in the value of a put option for each $1 change in

the underlying bond. This is called the delta of an option ( ), and
its absolute value lies between 0 and 1. For put options, the delta
has a negative sign since the value of the put option falls when
bond prices rise
• =

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk

• Hedging interest rate risk on the balance sheet

• =How the market value of a bond changes if interest rates rise
by one basis point
• -MD X dR; -MD X B
∆
• =- −D X B as D/1+R = MD
∆
• = x[ DXB ]
• The term in brackets is the change in the value of one $100,000
face-value T-bond put option as rates change, and Np is the
number of put option contracts.

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk

• Hedging interest rate risk on the balance sheet

•
∆ ∆
• x[ DXB ]=
• x[ DXB ]=[ ]
• =

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk
• Hedging interest rate risk on the balance sheet
• Example:
• Rates are expected to rise from 10 to 11 percent over the next six
months, which would result in a $2.09 million loss in net worth to
the FI.
∆
• = -(5-0.9x3)x 100x 0.01/1.1 = -2.09
million
• .5, D = 8.82 for the bond underlying the put option contract
• B= the current market value of $100,000 face value of long-term
Treasury bonds underlying the option contract= $97,000.
• = = (5-0.9x 3)x 100/(0.5 x 8.82 x 97,000) = 537.672
contracts
∆
• = x [ DXB ] =537 x [0.5 x 8.82 x 97,000 x
0.01/1.1] = $2.09 million

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk
• Hedging interest rate risk on the balance sheet

• T-bond put option premiums are quoted at $2½ per $100 of face value
for the nearby contract or $2,500 per $100,000 put contract.
• Cost = x Put premium per contract = 537 x $2,500 = $1,342,500

MONASH
BUSINESS
SCHOOL
 Hedging interest rate risk

• Hedging interest rate risk on the balance sheet

• Basis risk:
• =

• br = ∆

• Assuming br = 0.92, NP = (5-0.9x 3)x 100/(0.5 x 8.82 x 97,000x

0.92) = 584.4262 contracts

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Hedging foreign exchange risk

• Example: Let assume, an U.S firm has investment in Canadian dollar

= C$100 million
• In future, Canadian dollar may depreciate.
• Current exchange rate = US$0.7570 /C$1.
• After depreciation in three months time, expected exchange rate =
US$0.7390 /C$1.
• Buy a three-month Canadian dollar put option with exercise price:
US$0.7751 /C$1.
• Each Canadian dollar futures option contract is C$100,000 in size
• Without basis risk, number of contracts = C $100million/
C$0.1million = 1000 contracts.
• Assume: put premium = $0.0181 per C$1. Since each Canadian dollar
futures option contract is C$100,000 in size, the cost would have been
$1,810 per contract.

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Hedging credit risk

• Hedging credit risk on the balance sheet

• Credit spread call option: a call option whose payoff increases as
the (default) risk premium or yield spread on a specified
benchmark bond of the borrower increases above some exercise
spread, S.
• An FI concerned that the risk on a loan to that borrower will
increase can purchase a credit spread call option to hedge the
increased credit risk.

MONASH
BUSINESS
SCHOOL
 Hedging credit risk

• Hedging credit risk on the balance sheet

• Digital default option: an option that pays a stated amount in the
event of a loan default (the extreme case of increased credit risk).
• A treasurer of an FI can purchase a default option covering the par
value of a loan (or loans) in its portfolio.
• In the event of a loan default, the option writer pays the par value
of the defaulted loans.
• If the loans are paid off in accordance with the loan agreement, the
default option expires unexercised. As a result, the FI will suffer a
maximum loss on the option equal to the premium (cost) of buying
the default option from the writer (seller).

MONASH
BUSINESS
SCHOOL
 Hedging catastrophic risk

• Hedging catastrophe risk with call spread options

• Call spread: A call option on the loss ratio incurred in writing
catastrophe insurance with a capped (or maximum) payout.
• For an option premium, the insurer can hedge a range of loss ratios
that may occur
• Loss ratio: the ratio of losses incurred divided by premiums written
• The insurer buys a call spread to hedge the risk that the loss ratio
on its catastrophe insurance may be anywhere between 50 percent
and 80 percent.
• If the loss ratio ends up below 50 percent (perhaps because of a
mild hurricane season), the insurance company loses the option
premium.
• For loss ratios between 50 percent and 80 percent, it receives an
increasingly positive payoff. For loss ratios above 80 percent, the
amount paid by the writers of the option to the buyer (the insurer)
is capped at the 80 percent level.
MONASH
BUSINESS
SCHOOL
 Hedging catastrophic risk

Hedging catastrophe risk with call spread options

MONASH
BUSINESS
SCHOOL
 Learning Objectives
• Our discussion will focus on
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL
 Caps

• Hedging with options: Caps

• A call option on interest rates, often with multiple exercise dates.
• If interest rates rise above the cap rate, the seller of the cap—
usually a bank compensates the buyer—for example, another FI—
in return for an up-front premium.
• Similar to buying insurance against an (excessive) increase in
interest rates.

MONASH
BUSINESS
SCHOOL
 Caps

• Hedging with options: Caps

• Assume that an FI buys a 9 percent cap at time 0 from another FI
with a notional face value of $100 million. The cap agreement
specifies exercise dates at the end of the first year and the end of
the second year. That is, the cap has a three-year maturity from
initiation until the final exercise dates, with exercise dates at the
end of year 1 and year 2. Thus, the buyer of the cap would demand
two cash payments from the seller of the cap if rates lie above 9
percent at the end of the first year and at the end of the second
year on the cap exercise dates..

MONASH
BUSINESS
SCHOOL
 Floor
• Hedging with options: Floor
• Buying a put option on interest rates.
• FI manager who buys a floor is concerned about falling interest
rates.
• If interest rates fall below the floor rate, the seller of the floor
compensates the buyer in return for an up-front premium.
• Floor agreements can have one or many exercise dates.
• Assume that an FI buys a 4 percent floor at time 0 from another
FI with a notional face value of $100 million. The agreement
specifies exercise dates at the end of the first year and the end of
the second year. Thus, the buyer of the floor would demand two
cash payments from the seller if rates lie below 4 percent at the
end of the first year and at the end of the second year on the cap
exercise dates.

MONASH
BUSINESS
SCHOOL
 Conclusion
– Basic features and strategies of Options
– Writing versus buying options
– Futures vs Options
– Hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk
– Hedging catastrophic risk
– Caps and Floor

MONASH
BUSINESS
SCHOOL