Options Explained2

Options Explained2

Robert Tompkins

MACm.LAN

© Macmillan Press Ltd, 1994 Softcover reprint of the hardcover 1st edition 1994

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WIP 9HE.

Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

First published in the United Kingdom by MACMILLAN PRESS LTD, 1994 Companies and representatives throughout the world.

Distributed by Macmillan Direct Brunei Road, HoundmiIIs, Basingstoke, Hants RG21 2XS, England.

ISBN 978-1-349-13638-4 ISBN 978-1-349-13636-0 (eBook) DOI 10.1007/978-1-349-13636-0

A catalogue record for this book is available from the British Library.

10 9 8 7 6 5 4 3 2 1 03 02 01 00 99 98 97 96 95 94

While every care has been taken in compiling the information contained in this publication, the publishers and author accept no responsibility for any errors or omissions.

Dedication

This book is dedicated to Stuart David Katz, who not only taught me everything I needed to know about options but also taught me the true meaning of friendship and to my wife, Barbara who taught me the meaning of true love.

v

Contents

Dedication v

Preface xix

1: The Basics of Options 1 Introduction 1 Why Options exist 2 The Two Kinds of Options 3 Defmitions 4 Explanation of Contract Terms 6 Disposition of Option Contracts 8 Exercise and Assignment of Options 11 Why Options are tied to the Underlying Market 12 ProfitILoss Profiles 14 Options as the "Good" and "Bad" Features of the Underlying Asset 15 Splitting a Short Underlying Position into "Good" and "Bad" Parts 17

2: Basic Concepts in Options Pricing 23 In-the-money 24 At-the-money 25 Out-of-the-money 25 The Fundamental Components of an Options Price 25

Intrinsic Value 26 Determining the Time Value 27

The Black and Scholes Model 27 Stochastic Dominance Arguments 28

Assumptions of the Black and Scholes Model 30 European versus American Call Option Prices 33

How Time Value is Estimated from the Black and Scholes Model 34 The Key Element in the Estimation of Time Value from the Black and Scholes Formula 41 Effects of Time on the Price ofan Option 42 The Implications of the Lognormal Distribution 45 The Impact of Volatility on the Price of an Option 45

How Volatility is Measured 46

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Options ExplainetP

Historical Volatility 46 Implied Volatility 47 Forecasted Volatility 48

Impact of Changing Volatility on the Price of a Call Option 48 Impacts of Interest Rates and Dividend on Options 50 Appendix to Chapter 2: Derivation of the Black and Scholes Fonnula 51

3: Advanced Concepts in Options Pricing 55 The Role Option Pricing Models Play in Option Evaluation 56 Option Derivatives Compared to Aeroplane Gauges 57 The Delta Concept 57

Delta as the Measure of Relative Change to the Underlying Asset 58 Delta as the Sloped Relationship between the Option Price and the Price of the Underlying Asset 58 Delta as the Measure of Relative Risk of the Option to a Buying Position in the Underlying Market 60 Delta as the Probability that the Option will Finish In-the-Money at Expiration 61 Uses of Delta 61 Delta Exposures of the Basic Strategies 62 The Concept of Delta Neutral 63 The Problem with the Delta 65

The Concept of Gamma 66 The Measure of Volatility Exposure - The Vega 69 The Exposure of the Option to Time Decay - The Theta 70 The Sensitivity of Options to Interest Rates - The Rho 72 The Gearing of an Option to the Underlying - The Lambda 73 The Appropriate Pricing Models for Options on Foreign Exchange 74

European Options on Spot Currency 74 European Options on Currency Forwards 76 American Options on Foreign Exchange 77 Fonnulae for the Derivatives of the Currency Option Pricing Models 81

Put-Call Parity: The Fundamental Arbitrage Relationship 83 Using Put-Call Parity to Create Synthetic Securities 84 The "Magic" Graphing Rules and Put-Call Parity 86 The Effects of Interest Rates on Options Prices 89

4: Volatility Estimation 95 Introduction to Volatility Analysis 95 Estimation of the Nonnal Distribution 99

Problems in Financial Markets with Nonnal Distributions 104 The Random Walk Hypothesis 105 Volatility as the Standard Deviation III

viii

The Types of Volatility Estimation of Volatility Historically Methods ofDetennining Asset Returns Example of Historical Volatility Estimation Sources of Error in the Volatility Estimate Data Frequency for Estimation of Historical Volatility The Impacts of Economic Days on the Historical Volatility Sample Period for the Estimation of the Historical Volatility Which Prices Should be Used for the Estimation of Volatility Estimation of Seasonal Volatility Estimation of the Implied Volatility Assumptions of the Option Pricing Models Techniques for the Detennination of Implied Volatility Weighting of Implied Volatilities to Detennine a Composite Estimate

5: Advanced Issues in Volatility Estimation The Volatility Matrix Volatility Smiles for Various Markets

Analysis of the Smile Pattern for the FTSE Analysis of the Smile Pattern for US DollarlDeutsche Mark Analysis of the Smile Pattern for US Interest Rates

The Construction of the Volatility Matrix for BTP Options Implications for the Existence of Smiles The Tenn Structure of Volatility

Non Stationarity in the Price Series Non Unifonnity of Volatility Mean Reversion of Volatility Back to some Average

Corrections for the Smile and Tenn Structure of Volatility The Volatility Cone The Super Model for the Pricing of Options Estimation of Forward Volatilities

6: Directional Trading Strategies Possible Viewpoints for the Underlying and Volatility Three Ways to Benefit from an Increase in the Underlying Market

Buying a Crude Oil Futures Contract Buying a Call Option on Crude Oil Futures Buying Calls versus a Stop Loss Strategy with Long Futures Selling a Put Option on Crude Oil Futures Comparison of the Bullish Strategies

Three Ways to Benefit from a Decrease in the Underlying Market Selling a Crude Oil Futures Contract Buying a Put Option on Crude Oil Futures

Contents

113 114 114 117 118 120 124 131 133 134 139 140 142 147

153 154 157 157 158 160 162 170 172 174 175 177 178 179 186 190

195 196 197 198 199 201 203 206 207 208 209

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Options ExplainecJ2

Selling a Call Option on Crude Oil Futures 211 Comparison of the Bearish Strategies 214

Vertical Spreads 215 The Bull Vertical Spread 215 Time Decay and Volatility Sensitivities of a Bull Spread 219 The Bear Vertical Spread 221

Directional Trading Strategies Placement in the Strategy Matrix 224

7: Volatility Trading Strategies 227 How to Make Money from a Change in Volatility 228 The "Pure" Buying Volatility Strategies 232

Buying a Straddle 232 Buying a Strangle 236 Where Long Straddle and Strangles Fit in the Strategy Matrix 240

Leaning Volatility Buying Strategies: Ratio Back Spreads 241 Call Ratio Back Spreads: the Call-Back 241 The Put Ratio Back Spread: The Put-back 245 Where Back Spreads Fit in the Strategy Matrix 248

The "Pure" Selling Volatility Strategies 249 Selling the Straddle 250 Selling the Strangle 254 Buying a Butterfly Spread 258 Buying a Condor Spread 262 Comparison of the Pure Volatility Selling Strategies 266 Where Pure Volatility Selling Strategies Fit into the Strategy Matrix 267

Leaning Volatility Selling Strategies: The Ratio Spreads 267 The Put Ratio Spread 267 The Call Ratio Spread 271 Where Ratio Spreads Fit into the Strategy Matrix 274

The Difference Between Trading Futures and Options 275

8: Option Arbitrage 277 The Types of Arbitrage Strategies 278 Calendar Spreads 278

Long Calendar Spreads 279 Short Calendar Spreads 286

Comparison of all the Volatility Sensitive Strategies 289 Delta Neutral Trading 291 Pure Arbitrage Strategies 298

Practical Applications of Synthetic Transactions 300 The Conversion Arbitrage Strategy 302 The Reversal Arbitrage Strategy 305 The Box Arbitrage Strategy 306

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Contents

Jelly Roll Arbitrage Strategies Where the Arbitrage Strategies Fit in the Strategy Matrix

9: Trading Options Between Markets Inter-Market Trading Strategies in Futures Markets Measuring the Relationship Between Markets - The Correlation Coefficient Inter-market Directional Strategies Using Options The Inter-market Volatility Relationship A Pricing Model for Assessing Intermarket Options Relationships The Concept of the Implied Correlation Application of the Correlation Coefficient in Pricing Cross Currency Options Trading the Volatilities of Stock Options and Stock Index Options The R squared Method for Comparing Stock and Stock Index Volatilties Options on the Spreads Between Markets

10: Option Hedging Strategies The Basic Considerations in Designing a Hedging Strategy Market Conditions: 11 July 1994 The Relationship Between US. Treasury Bonds and T-Bond Futures Hedging Example 1: Buying T -Bond Futures versus Buying Call Options to Hedge a US. Treasury Bond Purchase

Hedge Ratio Determination T-Bond Futures Hedge Result T-Bond Call Options Hedge Result Comparison ofT-Bond Futures and Call Options Hedges if the Cash Market Exposure does not Materialise

The Impact of the Open T-Bond Futures Contracts The Impact of the Open Call Option Positions

Comparison ofT-Bond Futures and T-Bond Options Impacts Hedging Example 2: Buying a Put Option on T-Bond Futures to Protect the Value of a US. Treasury Bond

Complications of Using Options on T-Bond Futures to Hedge a US. Treasury Bond Choosing At-the-Money or Out-of-the-Money Puts Hedge Ratio Determination Conversion of the Option on T-Bond Futures to an Option on the US. Treasury Bond Hedge Results of the Put Purchase

Hedging Example 3: Selling Call Options on T-Bond Futures Against a US. Treasury Bond to Reduce Risk and Enhance Returns

The Choice of the Call Option Strike Price to Sell Hedge Ratio Determination Result of the Covered Call Hedging Strategy

309 316

319 319 320 325 329 333 337 338 339 340 347

355 356 357 358

361 362 363 365

368 368 369 370

371

372 373 373

374 374

375 376 377 377

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Options ExplainecP

The Risks of the Covered Call Hedging Strategy 379 Perfonnance of the Covered Call Hedging Strategy 379

Hedging Example 4: Selling Put Options in Anticipation of the Purchase ofa US. Treasury Bonds 383

Results of the Cash Secured Put Writing Hedging Strategy 383 Sununruy 385

II: Option Portfolio Application 387 Basics of Stock Indices 388 Stock Index Futures Contracts 389 Options on Stock Index Futures Contracts 390 Options on Stock Indices 390 The 90/10 Money Market Strategy 391

The 90/10 Plus Strategy for Option with Futures Style Margining 393 Result of the 90/10 Call Option Buying Strategy 394

The Zero Cost Options Hedging Strategy 398 Zero Cost Option Hedging Strategy with Options on the S&P 100 400 Comparison of the Zero Cost Options Hedge with a Futures Hedge 401

Portfolio Insurance 403 Basic Concepts in Portfolio Theory 403 The Foundations of Portfolio Insurance 404 The Relationship between Portfolio Insurance and Options 408 Reasons for the Use of Portfolio Insurance 408 Portfolio Insurance with Stock Index Futures 409 Portfolio Insurance with Put Options on S&P 500 Futures 410 Cost Comparisons of Various Portfolio Insurance Techniques 411

The Fallacy of Delta Hedging a Stock Portfolio 411 How Options Impact the Beta of a Portfolio 413 Comparison of Alternative Hedging Strategies for Holder of Stock Portfolio 418

12: OTC Interest Rate Options 423 aTC Options on Bonds 424

Examples of Applications for aTC Bond Options 425 Pricing of aTC Bond Options 426 Estimation of the Volatility Input for Options on Bonds 431 Issues in the Pricing ofaTC Options on Bonds 432

Steps Involved in Pricing an aTC Option on Bonds 432 Why Actual aTC Option Prices Differ from Theoretical Values 435 Credit Risk Implications ofaTC Options 437 Impacts ofaTC Bond Options on Bond Duration & Convexity 438

Interest Rate Guarantee Agreements 440 Interest Rate Ceiling, Floor and Collar Agreements 442

Pricing of the Ceiling Rate Agreement 445

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Contents

Hedging a Ceiling Rate Agreement with Eurodollar Futures & Options 447 Risks of the Hedged Positions 448

Options on Interest Rate Swaps 451 The Structure of Swaption Agreements 451 Swaptions vs. Interest Rate Cap Agreements 453 The Logic Underlying Swaption Pricing 453 Present Market Conventions for Swaption Pricing 456

Conclusion for aTC Options on Interest Rates 458

13: Exotic Options 461 General Approaches to Pricing Exotic Options 463

The Analytic Models 463 The Numerical Models 463 Monte Carlo Simulation Models 464

Options Which Allow the Holder to Buy or Sell Another Option 464 Compound Options on Cap Rate Agreements: Captions And Floptions 467

Options Which Vary the Standard Terms of Normal Options 470 Bermudan Option 470

Applications of the Bermudan Option 470 Pricing of the Bermudan Option 471

DigitallBinary Options 471 Applications of the Digital Option 472 Pricing of the Digital Option 473

Pay Later Options 474 Applications of the Pay Later Option 475 Pricing of the Pay Later Option 475

Delayed Options 475 Applications of the Delayed Option 475 Pricing of the Delayed Option 476

Chooser Option 477 Applications of the Chooser Option 477 Pricing of the Chooser Option 478

Power Option 479 Applications of the Power Option 481 Pricing of the Power Option 481

Path-Dependent Options 481 Average Rate Options - The "Asian" Style Option 482

Applications of the Average Rate Option 482 Pricing of the Average Rate Option 482

Average Strike Option 484 Applications of the Average Strike Option 485 Comparison of Average Rate and Average Strike Price Options 485

Maximum/Minimum Options - The "Look Back" Option 486

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Options ExplainetP

Potential Uses for "Look Back" Options Pricing of "Look Back" Options Pricing the "Strike-Bonus" Option

Cliquet or Ratchet Option Applications of the Ratchet Option Pricing of the Ratchet Option

Ladder Option Applications of the Ladder Option Pricing of the Ladder Option

Shout Option Applications of the Shout Option Pricing of the Shout Option

BarrierlKnock Out Option Applications of the Knockout Option Pricing of the Knockout Option

Multi-Factor Options Rainbow Option

Applications of the Rainbow Option Pricing of the Rainbow Option

Basket Option Applications of the Basket Option Pricing of the Basket Option

Spread Option Quanto

Applications of the Quanto Option Pricing of the Quanto Option

Conclusion

487 487 488 489 490 490 490 491 491 492 492 493 493 494 495 496 496 496 497 497 497 497 498 498 498 499 501

14: Risk Management of Options S03 A Brief History of Option Markets 503

Why Options Markets Have Grown Exponentially Since the 1970s 503 An Option Risk Analysis Computer Programme 504

Contract Definitions in the Program 505 Adding Expiration Dates and Strike Prices into the Program 508 A Live Cattle Option Sample Trade Entry Spreadsheet 508 Entry of a Sample Portfolio of Live Cattle Options into the Spreadsheet 510 Comparison of Market Prices with Theoretical Prices 511 Comparison of Gamma Values Across Strike Prices and Maturities 512 Detennination of the Implied Volatility 513 Evaluating the Risks of the Option Portfolio 515 Graphing the Risks of the Option Portfolio 517

Applications of Computer Risk Analysis Programs to the Management of Options Portfolios by Market Makers 522

xiv

Contents

Daily Risk Management Issues 522 Risk Control of Option Books 523 Using Computer Risk Analysis Programs to Choose the Best Strategy 524

IS: Structure of Exchange Traded Options Markets 533 The Clearing House and Its Role 533 The Mechanisms of Margining 534 The Margining of Options at a Typical Options Market 537 Structure of Different Option Markets World-Wide 537

The Philadelphia Stock Exchange 538 Background 538 Membership 538 Clearing 539 Margin Requirements 540 Summary 540

The European Options Exchange 540 Background 540 Membership 540 Clearing 541 Margin Requirements 542 Exercise Procedure 542 Delivery of and Payment for Underlying Value 543 Clearing Fund 543 Summary 543

The Stockholm Options Market (OM) 543 Background 543 Ownership 544 Organisation of Trading 544 The Electronic Market System 544 The Broker Function 545 Clearing 545 Margin Requirements 545 Delivery Capacity 546 Reporting of Deals Closed 546 Summary 546

The Chicago Mercantile Exchange 546 Background 546 Function of the Exchange 547 Organisation of Trading 547 Clearing 548 Performance Bond (Margin) 548 Daily Settlement 548 Summary 549

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Options Explainedl

The Span System Explained How the Risk Arrays are Constructed Examples of Span Initial Margin Calculations The Variation Margin

16: Accounting, Regulation and Taxation Issues for Options Regulations: A Global Survey

xvi

Australia Accounting Regulation Tax

Belgium Accounting Regulation Tax

Canada Accounting Regulation Tax

Denmarlc: Accounting Regulation Tax

France Accounting Regulation Tax

Gennany Accounting Regulation Tax

Hong Kong Accounting Regulation Tax

Irish Republic Accounting Regulation Tax

Italy Accounting Regulation Tax

549 551 551 553

555 555 555 555 555 556 556 557 557 558 558 558 558 558 559 559 559 560 560 560 560 560 561 561 561 562 562 562 563 563 563 563 564 564 564 564 564 564

Contents

Japan 565 Accounting 565 Regulation 565 Tax 566

Luxembourg 567 Accounting 567 Regulation 567 Tax 567

Netherlands 567 Accounting 567 Regulation 5.68 Tax 568

Singapore 569 Accounting 569 Regulation 569 Tax 569

South Africa 570 Accounting 570 Regulation 571 Tax 571

Spain 572 Accounting 572 Regulation 572 Tax 572

Sweden 573 Accounting 573 Regulation 573 Tax 573

Switzerland 574 Accounting 574 Regulation 574 Tax 574

United Kingdom 575 Accounting 575 Regulation 575 Tax 575

United States of America 576 Accounting 576 Regulation 576 Tax 576

Appendix 579

Index 591

xvii

Preface

In almost every human generation, a revolution occurs. Some generations are blessed by beneficial innovations that forever change the world in which they live. Some of us are fortunate enough to witness these events and assume the task to explain their significance. This is the quest I have undertaken with this book. In my generation, the fmancial world experienced such a revolution. Many brilliant minds were able for the first time to discern the basic building blocks which form our fi­nancial markets and then turn these insights into products which touch the lives of us all. My career has been intertwined with the development of one of the most basic building blocks of fmancial markets: that of options.

The Mecca of option markets was Chicago in the 1970s where in April 1973, the Chicago Board Options Exchange opened. For the first time, standardised op­tion contracts were listed on a regulated market open to all. In addition, two profes­sors at the University of Chicago, Fischer Black and Myron Scholes were able to uncover the puzzle of options pricing with a brilliant insight. Fate led me to the University of Chicago in 1976 where I was quickly caught up in the electricity of that time. After earning three degrees from the University, I started my career in the Research Department of the Chicago Mercantile Exchange, where Fred Arditti was leading a team of economists investigating the introduction of options con­tracts on a wide variety of fmancial products and commodities. The opportunity to work with three brilliant fmancial economists, Michael Asay, Rick Kilcollin and Galen Burghardt, allowed me to immerse myself in the options area and help develop products (on currency options, Stock index products and interest rate securities) which would forever change world fmancial markets.

I was also fortunate to have the opportunity to apply these concepts in the mar­ketplace at Harris Trust and Savings Bank and at Continental Illinois National Bank. At Harris, I helped set up one of the first currency option desks in Chicago and later at Continental Illinois, I traded and managing options on interest rate products. At both institutions, I was again fortunate to come into contact with extremely clever colleagues who helped me understand the limitations of options theory.

While my education was comprehensive, I found that the concepts underlying options contracts eluded me. The seminal papers were buried in exotic mathematics which were removed from my daily experiences. Slowly, the common sense of these concepts became uncovered as I read and re-read the seminal papers and combined these concepts with daily trading activity. Then, with extraordinary luck, I was asked to prepare seminars on these markets for banks in America and

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Options ExplainecJ2

Europe. My fIrst seminar in Finland for Postipankki in January 1985 literally changed my life as I could no longer veil options concepts in mathematical terms but had to fmd a common sense explanation for these products. With the assistance of the educational departments from many of the major futures and options ex­changes, a series of seminars were developed that distilled the consistencies among the markets. As this occurred, certain patterns became obvious and the mystery of options was solved for me. Since that frrst course, I have delivered over 300 courses on options in 28 countries worldwide. As these courses were refmed and extended to a wide variety of different underlying instruments, it became even more apparent to me that options contracts were fundamental securities that applied equally well to all markets.

Currently, 22 countries worldwide possess markets for exchange traded options on a range of contracts from energy, metals, commodities, stocks, indices, fIxed income securities, interest rates, and currencies. As will be demonstrated in this book, the concepts which spurred the development of options imply that any risky instrument can have an options market associated with it. Given, the growth of ex­change traded options markets and other related markets, there is little doubt that many more countries will include options in their capital markets in the near future. Yet as I devoured each new option book that came to press, I found that most books were either too technical, hid behind mathematics, were too basic or specialised. Many books would only concentrate on one kind of underlying instrument (like stocks, commodities or fmancial products) and seemed to suggest that the conceptual framework of options depends on the asset that underlies the option. These books failed to recognise that all options are based upon the same fundamental concepts. I felt that a book needed to be written that showed the similarities among options instead of the dissimilarities. In addition, I could fmd no book that could explain the logic behind these products without hiding behind the mathematics. It became apparent that others shared my viewpoint. Many well informed people found the literature on options markets unsatisfying. Books could not answer basic questions such as: Why do options exist, what gives these contracts value and how can these products be used for trading and hedging needs? Furthermore, since these products are so fundamental to an economy, why has their introduction been delayed until this generation only then to grow faster than any other fmancial product in history? In this book, I will examine all these questions and hopefully will provide the reader with satisfactory answers.

To examine these critical issues, I have broken the book into fIve broad areas of coverage. In the frrst three chapters, I will examine options basics and pricing. Each chapter (and throughout this book) will feature a different underlying market with the goal of both explaining the concepts and leading the reader to recognise the overlap that exists among all options markets. Chapter 1 presents basic defmi­tions but differs from other texts by showing how options are created from any un­derlying market by separating that market into "good" and "bad" parts. In Chapter 2, the basics of options pricing are presented, it also features a different explanation

xx

Preface

of the Black and Scholes pricing fonnula; by examining how they solved the pro­blem. For the first time, the tie between the Black and Scholes model and the world of physics is explained without the need to resort to solving partial differential equations. In Chapter 3, the reader is shown how options prices are used by options traders and also a variety of alternative pricing fonnulas are presented. However, rather than emphasising the trivial differences between these fonnulae and the Black and Scholes model, this text explains the similarities shared by these options fonnulae. Finally, I will describe the fundamental relationship between options and their underlying markets (Put-Call Parity) that reaffinns my presentation in Chapter 1, that options are nothing more than an underlying asset split into two parts. To show this, both fonnulae and "magic graphing" rules are presented to help both the mathematically inclined and visually inclined understand this critical concept.

The next major area of coverage will concentrate on volatility estimation. Chapter 4 will introduce the concept of volatility with a review of stochastic proc­esses, nonnal and lognonnal distributions, and estimation techniques for volatility including historical volatility, implied volatility and cyclical volatility. Chapter 5 will examine more esoteric issues in volatility estimation including the tenn struc­ture of volatility, the dispersion of volatility across strike prices (known as the smile), forward volatilities and introduce a new kind of pricing model which may revolutionise the entire world of options. This will lay a foundation for later chapt­ers in the book that will discuss the pricing of interest rate and exotic options and will figure prominently in the subsequent chapter on volatility trading.

The third major area this book will cover includes trading strategies with op­tions. Unfortunately, too many texts overemphasise this area and lead the reader to conclude that options are simply a more sophisticated way to gamble. In Chapter 6, I will present how to use options to benefit from a viewpoint on the movement of the underlying market. However, I will present not only the possible returns from various strategies but will also discuss how options allow the investor to limit his risk exposure. In Chapter 7, I will examine the most fundamental use for options, the trading of volatility. I will present the range of possible strategies and also indi­cate when these are most appropriate. Finally, in Chapter 8, I will review the trad­ing strategies that assure that an equilibrium occurs in these markets. These arbi­trage trades are probably outside the realm of experience of most users of options but must be understood to appreciate the mechanisms within which options pricing works. A new chapter has been added for this edition which examines the trading of options in different markets. This is Chapter 9 that examines the theory and practice of trading options between markets. In this chapter, I will examine the trading opportunities that exist in related interest rate and currency markets and explore the relationships between individual stock options and stock index options. These type of strategies have become more prevalent in derivative markets espe­cially with futures and will for the frrst time be presented here for options.

The fourth area, I will cover is how the investor can use options to manage the risk of his or her investments. Chapter 10 examines how to protect fixed income

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Options ExplainecJ2

securities using options and explains how options and futures contracts compare for managing risk. In Chapter 11, I will examine applications of options to the port­folio manager by discussing how options can be used to revise a portfolio man­ager's risk/return objectives. There I will examine stock index products and show how to achieve guaranteed investment funds, discuss how portfolio insurance works, why to avoid delta "neutral" hedging techniques and how to create options hedging strategies with no cost.

The fifth area to be covered in this book will examine the more esoteric options that have evolved in parallel with the booming success of the exchange traded products. Interest Rate options including OTC options on Bonds, Interest Rate Cap Agreements, Interest Rate Guarantees and Swaptions have all become staple prod­ucts offered by most investment banks. Chapter 12 examines these products with special emphasis on the pricing difficulties of these products and their applications to the end users. Chapter 13 covers the expanding area of exotic options. No area of derivative products has experienced greater growth or mutation as has the realm of exotic options. This chapter will examine both the range of path dependent contingent claims as well as how these products are engineered. A general meth­odology will be presented for pricing all these products which will allow the user to fit new and more complex structures into a framework as these products are devel­oped. Finally, in Chapter 14, I present how to measure and hedge the risk of an op­tion portfolio. With the use of a popular options risk management computer program, the reader will see how all the theoretical concepts presented in Chapter 3 apply in the daily world of the risk manager. In this chapter, I will also show the reader how to choose the best trading strategy using the computer program.

The fmal area I will examine can roughly be categorised as the structure of op­tions markets and the regulatory environment for these products. Chapter 15 re­views how exchange traded options markets work. Specifically I will describe the role of the Clearing House in options markets, how margin works and outline the differences in the structures of four popular options markets around the world. The last chapter, Chapter 16, provides a current review of the regulatory, accounting and tax environments for those countries where options contracts are currently trading.

The goal of this book is to show that the concepts which underlie options are consistent across all markets. I hope that for most readers Options Explained2 will be the only book they will need in order to understand these products and then to apply them to their investment needs.

Since I first put pen to paper in November 1989 for the first edition, many of my staff at Minerva Consulting Limited have been involved in the evolution of the final book. For this edition of the book, Piero Costantini, Alberto ,Parise, and Beth Ragheb have made a superhuman effort to complete the entire update in record time. Many thanks are in order to Miles Davis of Kleinwort Benson Investment Management, who proof-read drafts of this book and provided invaluable sugges­tions. Finally, my wife Barbara was crucial in keeping everything from becoming derailed. Without their help, this book would never have made the deadline we

xxii

Preface

promised to our patient editor, Andrea Hartill. There were also a number of indi­viduals who were kind enough to provide me with data for inclusions in the chapt­ers on volatility analysis. They will be acknowledged at that point in the text where their contribution resides. For the chapter on exotic options, Les Clewlow provided tremendous assistance on the theoretical side. Without his input, there would not have been the complete coverage the chapter required. I also would like to thank Arthur Andersen and Company for their contributions to the fmal chapter of this book which examines the accounting issues world-wide, especially Victor Levy and Philip Broadley in the London office. Any mistakes or errors remaining are solely my own responsibility.

Robert G. Tompkins August 1994

xxiii