Chapter Ten

Options and Swaps

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consent of McGraw-Hill Education.
 Options 1

• An option is 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.
• A call option is an option that gives the purchaser the right, but not
the obligation, to buy the underlying security from the writer of the
option at a prespecified price on or before a prespecified date.
• A put option is an option that gives the purchaser the right, but not
the obligation, to sell the underlying security to the writer of the
option at a prespecified price on or before a prespecified date.

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 Profit Diagrams for Call Options

Access the long description slide. 10-3

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 Profit Diagrams for Put Options

Access the long description slide. 10-4

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 Options 2

The Black-Scholes option pricing model (the model

most commonly used to price and value options) is a
function of:
• the spot price of the underlying asset.
• the exercise price on the option.
• the option’s exercise date.
• the price volatility of the underlying asset.
• the risk-free rate of interest.

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 Options 2

The intrinsic value of an option is the difference

between an option’s exercise price and the underlying
asset price.
• the intrinsic value of a call option = max{S − X, 0}.
• the intrinsic value of a put option = max{X − S, 0}.

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 Option Intrinsic Value and Time Value
Figure 10–9 The Intrinsic Value versus the Before-Exercise Value of a Call Option

Access the long description slide. 10-7

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 Option Price Quote Example

• The May call is in the money (positive intrinsic value) and the call
premium is $3.30 × 100 = $330 (contracts are for 100 shares).
• The intrinsic value of the call (S-X) is ($8.79 − $6.00) × 100 = $279.
• The time value of the call is $330 − $279 = $51.
• The May put is out of the money and the put’s intrinsic value (X-S) is 0.
• The put still has time value, however, equal to $0.45 × 100 = $45.
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 The Options Clearing Corporation

• The Options Clearing Corporation (OCC) is a private agency that

guarantees that the terms of an option contract will be fulfilled if
the option is exercised.
• The OCC issues and clears all option contracts trading on U.S.
exchanges.
• Note that the exchanges and the OCC are all subject to regulation
by the Securities and Exchange Commission (SEC).
Visit the OCC at: www.optionsclearing.com.

• In Pakistan, all options contracts traded on exchanges are issued

and cleared by the Pakistan Mercantile Exchange Limited (PMEX)
and regulated by the Securities and Exchange Commission of
Pakistan (SECP).

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 Why Options?

• A basic question asked by investors is: “Why buy stock

options instead of shares in the underlying stock?”

• To answer this question, we compare the possible outcomes

from these two investment strategies:
• Buy the underlying stock.

• Buy options on the underlying stock.

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 Call and Put Options
• A call option is an option that gives the purchaser the
right, but not the obligation, to buy the underlying
security from the writer of the option at a
prespecified price on or before a prespecified date.
• A put option is an option that gives the purchaser the
right, but not the obligation, to sell the underlying
security to the writer of the option at a prespecified
price on or before a prespecified date.

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 Example: Buying the Underlying Stock
versus Buying a Call Option, I.
• Suppose 3M (MMM) is selling for $140 per share and call
options with a exercise price of $140 are $5 per share.

• [Minnesota Mining and Manufacturing Company]

• Investment for 100 shares:

• MMM Shares: $14,000
• One listed call option contract: $500

• Suppose further that the option expires in three months.

• Finally, let’s say that in three months, the price of MMM shares
will either be $150, $140, or $130.

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 Example: Buying the Underlying Stock
versus Buying a Call Option, II.
• The dollar and percentage returns given these MMM prices:
Buy 100 MMM Shares ($14,000 Buy One Call Option ($500
Investment): Investment):

Dollar Profit: Percentage Dollar Profit: Percentage

Return: Return:

Case 1: $150 $1,000 7.14% $500 100%

Case 2: $130 -$1,000 -7.14% -$500 -100%

Case 3: $140 $0 0% -$500 -100%

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 Why Options? Conclusion
• Whether one strategy is preferred over another is a
matter for each individual investor to decide.
• That is, in some instances, investing in the
underlying stock will be better. In other instances,
investing in the option will be better.
• Each investor must weight the risk and return
trade-off offered by the strategies.
• It is important to see that call options offer an
alternative means of formulating investment
strategies.

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 Why Options? Conclusion
• Versus buying 100 shares:
• The dollar loss potential with call options is lower.

• The dollar gain potential with call options is lower.

• The positive percentage gains with call options is

higher.
• As a percentage, you can lose more of your
investment using options.

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 Stock Index Options
• An option on a stock market index.
• A stock market index is a statistical measure that tracks the
performance of a group of stocks representing a particular market,
sector, or investment style.
• The most popular stock index options are options on the S&P 100,
S&P 500, and Dow Jones Industrial Average.
• KSE-100 index for PK
• Because the actual delivery of all stocks comprising a stock index
is impractical, stock index options have a cash settlement
procedure.
• That is, if the option expires in the money, the option writer simply pays the
option holder the intrinsic value of the option.
• The cash settlement procedure is the same for calls and puts.
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 Options 2

The intrinsic value of an option is the difference

between an option’s exercise price and the underlying
asset price.
• the intrinsic value of a call option = max{S − X, 0}.
• the intrinsic value of a put option = max{X − S, 0}.

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 Options_OTM, ITM and ATM
Out of the money
• An option that will not produce a profit, if exercised.
• The strike price isn’t favorable and you would lose
money if you exercised the option.
• OTM options are contracts that currently have no
intrinsic value because they can't currently be
exercised for a profit.

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 Options_OTM, ITM and ATM
Out of the money
• OTM options hold value, based on their potential to
turn profitable before their expiration date if the
market moves in their favor.
• Some investors prefer buying out of the money
options because they're cheaper and offer a higher
potential return.

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 Options_OTM, Example
Call Option (Out of the Money)
• Stock price: $90

• Call option strike price: $100

• Option price (premium): $2

This is a call option, which gives you the right to buy the stock at
$100.
But the current market price is only $90, so why would you pay
$100 for something you can buy for $90?
• So, this option is out of the money by $10.

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 Options_OTM, Example
If the stock stays below $100, the option expires worthless, and
you lose the $2 you paid.
❖ You’d only start making money if the stock goes above $102
(because you paid $2 for the option, so you need to cover
that cost first).
❖ A call option is out of the money when the stock price is
below the strike price.
❖ A put option is out of the money when the stock price is
above the strike price.

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 OPTIONS MARKETS

Q 3:
• An investor buys a call at a price of $4.50 with an
exercise price of $40. At what stock price will the
investor break even on the purchase of the call?

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 OPTIONS MARKETS

• Break-even Stock Price = Exercise Price+Call Premium

• The price has to be at least as much as the sum of the

exercise price and the premium of the option to
breakeven: $40 + $4.50 = $44.50

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 Features of OTM Options
Key features are:
❖ Not worth exercising now. If an OTM option is exercised now
the holder will lose money because the strike price hasn't been
reached.
❖ Time is important. The further away the expiration date is the
better it is. There is still a chance they can move into a
profitable position before they expire.
❖ Cheaper. OTM options cost less than ITM and ATM options
with the same expiration date and hitting the strike price often
requires a significant price move.

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 Options_ITM and ATM
Out of the money
• OTM options hold value, based on their potential to
turn profitable before their expiration date if the
market moves in their favor.
• Some investors prefer buying out of the money
options because they're cheaper and offer a higher
potential return.

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 Option Markets
• The Chicago Board of Options Exchange (CBOE) opened in 1973 as
the first exchange devoted solely to the trading of stock options.
• Options on futures contracts began trading in 1982.
• An American option can be exercised at any time before (and on)
the expiration date.
• A European option can be exercised only on the expiration date.
• The trading process for options is similar to that for futures
contracts.

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 Characteristics of Actively Traded
Options 1

Table 10–5 Characteristics of Actively Traded Options

Type of Option Exchange* Contract Traded

Stock options CBOE Stock options

Blank AM Stock options

Blank NASDAQ OMX PHLX Stock options

Blank NASDAQ OMX BX Stock options

Blank NY Stock options

Stock index options CBOE Dow Jones Industrial Average

Blank CBOE Nasdaq 100

Blank CBOE Russell 2000

Blank CBOE S&P 100 Index

Blank CBOE S&P 500 Index

Blank AM S&P Midcap

Blank NASDAQ OMX PHLX Gold/Silver

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 Characteristics of Actively Traded
Options 2

Type of Option Exchange* Contract Traded

Financial futures options: CBOT T-bonds
Interest rate
Blank CBOT T-notes
Blank CBOT T-notes—5 year
Blank CME Eurodollar
Currency CME Japanese yen
Blank CME Canadian dollar
Blank CME British pound
Blank CME Swiss franc
Blank CME Euro FX
Stock index CBOT DJIA
Blank CME S&P 500 Index
*CBOE = Chicago Board Options Exchange; AM = American Exchange; NASDAQ OMX PHLX = Philadelphia Stock
Exchange; NASDAQ OMX BX = Boston Stock Exchange; NY = NYSE Archipelago Exchange; CBOT = Chicago Board
of Trade; CME = Chicago Mercantile Exchange.
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 Options Concluded
The underlying asset on a stock option is the stock of a publicly traded
company.
The underlying asset on a stock index option is the value of a major stock
market index (Example: DJIA or S&P 500).
The underlying asset on a futures option is a futures contract.
Credit spread call options.
• The value of a credit spread call option increases as the default (risk)
premium or yield spread on a specified benchmark bond of the borrower
increases above some exercise spread.
• A digital default option pays a stated amount in the event of a loan
default.

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 Swaps 1

A swap is an agreement between two parties to exchange a series of cash

flows for a specific period of time at a specified interval.
A plain vanilla interest rate swap is an exchange of fixed-interest
payments for floating-interest payments by two counterparties.
• The swap buyer makes the fixed-rate payments in an interest rate swap
transaction.
• The swap seller makes the floating-rate payments in an interest rate swap
transaction.
• No principal is exchanged.

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 Swaps 2

A currency swap is a swap used to hedge against exchange rate risk from
mismatched currencies on assets and liabilities.
• Usually associated with borrowing money.
• The exchanges can be at a fixed or a variable rate of interest as negotiated
in the contract, but the exchanges occur at a known currency exchange
rate.
• Used to hedge exchange rate risk from mismatched currencies of assets
and liabilities.

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 Fixed-Fixed Pound/Dollar Currency
Swap

Access the long description slide. 10-32

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 Swaps Concluded
Credit default swaps (CDS) allow financial institutions to hedge credit
risk.
• Total return swaps involve swapping an obligation to pay interest at a
specified fixed or floating rate for payments representing the total return
on a loan (interest and principal value changes) of a specified amount.
• Can be used to hedge credit exposure, but contain an element of interest rate risk
as well as credit risk.

• In a pure credit swap, the financial institution lender will send (each swap
period) a fixed fee or payment (like an insurance premium) to the
counterparty, but if the FI lender’s loan or loans do not default, it receives
nothing back from the counterparty.
• A pure credit swap is similar to buying credit insurance and/or a multiperiod credit
option.
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 Swap Markets
• Swaps are not standardized contracts.
• Swap dealers (usually financial institutions) keep markets liquid by
matching counterparties or by taking positions themselves.
• Unlike futures and options markets, swap markets were historically
governed by very little regulation.
• The International Swaps and Derivatives Association (ISDA) is an
association among 56 countries that sets codes of standards for
swap documentation.

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 Swaps
• An agreement between two parties to
exchange assets or a series of cash flows for a
specific period of time at a specified interval.
• Allow firms to better manage their interest
rate, foreign exchange, or credit risks.
• Basic principle involves the transacting parties
restructuring their asset or liability cash flows
in a preferred direction.

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 Swaps Definitions

• Interest rate swap

• Currency swap
• Notional principal
• Swap buyer
• Swap seller

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 Swaps Definitions
Interest rate swap
An exchange of fixed interest payments for floating
interest payments by two counterparties.

✓ Note that swap transactions are often facilitated by a

swap dealer, who will act as the required
counterparty for a fee.

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 Swaps Definitions
Assume Paul prefers a fixed-rate loan and has
loans available at a floating rate (SOFR + 0.5%)
or at a fixed rate (10.75%).

Mary prefers a floating rate loan and has loans

available at a floating rate (SOFR + 0.25%) or at
a fixed rate (10%).

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 Fixed-For-Fixed Swaps
• For example, an American firm can take out a
loan in the United States at a 7% interest rate
but requires a loan in yen to finance an expansion
project in Japan, where the interest rate is 10%.
• At the same time, a Japanese firm wishes to
finance an expansion project in the U.S., but the
interest rate is 12%, compared to the 9% interest
rate in Japan.

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 Fixed-For-Fixed Swaps
✓ Each party can benefit from the other's
interest rate through a fixed-for-fixed
currency swap.
✓ In this case, the U.S. firm can borrow U.S.
dollars for 7%, then lend the funds to the
Japanese firm at 7%.
✓ The Japanese firm can borrow Japanese yen
at 9%, then lend the funds to the U.S. firm
for the same amount.
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 Fixed-For-Floating Swap
• An advantageous arrangement between two
parties (counterparties), in which one party pays
a fixed rate, while the other pays a floating rate.

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 Fixed-For-Floating Swap
• For example, Company A can take out a loan with
a one-year term in the U.S. for a fixed rate of
8% and a floating rate of Libor + 1% (A would
prefer a fixed rate).

• On the other hand, Company B can obtain a loan

on a one-year term for a fixed rate of 6%, or a
floating rate of Libor +3%, (B prefers a floating
rate.

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 Fixed-For-Floating Swap
• Through an interest rate swap, each party can
swap its interest rate with the other to obtain its
preferred interest rate

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 Fixed-For-Floating Swap
▪ The exchange of interest rates for the mutual
benefit of the exchangers.

▪ The exchangers take advantage of interest rates

that are only available, for whatever reason, to
the other exchanger by swapping them.

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 Fixed-For-Floating Swap
▪ The two legs of the swap are a fixed interest
rate, say 3.5%, and a floating interest rate, say
LIBOR + 0.5%.
▪ In such a swap, the only things traded are the
two interest rates, which are calculated over a
notional value.
▪ Each party pays the other at set
intervals(semi-annually) over the life of the
swap.
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 Fixed-For-Floating Swap
• For example, one party may agree to pay the other
a 3.5% interest rate calculated over a notional
value of $1 million,
• the second party may agree to pay LIBOR + 0.5%
over the same notional value.

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 Notional amount

• It is important to note that the notional

amount is arbitrary (imaginary) and is not
actually traded.

• This is also called a plain vanilla swap.

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Types of Interest Rate Swaps
• Plain Vanilla Swap
• an exchange of fixed-rate for floating-rate payments and
the notional principal amount is the same.
• Bullet Swap
• where the payments are made in a single lump sum (a
“bullet”) rather than periodically. This is the single
exchange of cash flows at the end of the contract term,
rather than throughout the life of the swap.
• Amortizing Swap
• where the notional principal amount decreases in a
predetermined way over the life of the swap.

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Types of Interest Rate Swaps
• Accreting Swap
• where the notional principal amount increases in a
predetermined way over the life of the swap.
• Roller Coaster Swap
• where the notional principal amount increases or
decreases over the life of the swap.
• Basis Rate Swap.
• Both parties exchange floating rate payments, based on
different MM reference rates.
• Constant Maturity Swap (CMS)
• To have the floating rate tied to a long-term rate such as
two years T Bills and the other party pays a floating rate
e.g. LIBOR.
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 Fixed-Floating Rate Swap
Money Center Bank Thrift

10%
Short-Term Assets fixed Long-Term Assets
(C&I indexed loans) (fixed-rate mortgages)

Long-Term Liabilities Short-Term Liabilities

(5-year, 10% notes) LIBOR + 2% (1-year CDs)

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 Swaps Definitions

Currency swap
• A swap used to hedge against exchange rate risk from
mismatched currencies on assets and liabilities.

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 Swaps Definitions
Swap buyer
By convention, a party that makes the fixed rate
payments in an interest rate swap transaction.
Swap seller
By convention, a party that makes the floating rate
payments in an interest rate swap transaction.
Notional principal
• The principal amount involved in a swap

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 Swap Transactions
Direct arrangement of swap
Floating-Rate Payments
Money Center Bank Thrift
Fixed-Rate Payments

Swap arranged by third-party intermediary (swap agent)

Floating-Rate Floating-Rate
Payment Payment
Money Center Bank Swap Agent Thrift
Fixed-Rate Fixed-Rate
Payment Payment

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 Risk/Return Characteristics of a
Swap
Interest Rates Interest Rates
Decrease Increase

Floating-Rate Gain Loss

Payer

Fixed-Rate Loss Gain

Payer

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 Interest Rate Swap Market
• Initial motivation was borrower exploitations of
perceived credit arbitrage opportunities.
• An efficient market for altering cash flow
characteristics of assets or liabilities.
• Commercial banks and investment banking firms
take positions in swaps.

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 Primary Determinants of Swap
Spreads
• Swap Spread
• difference between the swap’s fixed rate and the rate on a
Treasury whose maturity matches that of the swap
• Key Determinants
• for maturities of less than five years, it is the cost of
hedging in the Eurodollar CD futures market
• for maturities of more than five years, it is largely driven by
credit spreads in the corporate bond market

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 Other Factors Influencing the Level
of Swap Spreads
• The level and shape of the Treasury yield curve
• The relative supply of fixed and floating-rate
payers
• The level of asset-based swap activity
• Technical factors affecting swap dealers

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 Swaptions
• Grants the option buyer the right to enter into an
interest rate swap at a future date.
• Types of Swaptions
• payer swaption
• receiver swaption

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 Applications
• Asset/Liability Management
• Debt Issuance

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 Applications
• Swaps are used in asset/liability management to
lock in interest rate spreads.
• Example:
• Take two parties, one a bank with fixed-rate assets
and variable-rate liabilities and an insurance
company with a fixed-rate liabilities and variable
rate assets.
• Both parties have an asset/liability mismatch.
© 2019 McGraw-Hill Education.
 • A swap agreement would provide that the insurance
company makes
• variable payments to the bank (either directly or through
an intermediary) and
• that the bank provides fixed payments to the insurance
company either directly or through the same intermediary.
• In effect the bank now has fixed-rate liabilities and the
insurance company has variable-rate ones,
• both now matching their asset cash flow characteristic.

© 2019 McGraw-Hill Education.

 • A second use of swaps is to take advantage of capital market
inefficiencies where creditworthiness is concerned,
• Example:
• Assume Company A is a low-risk firm, and company B is a
higher-risk one. Clearly debt issues of both firms should
reflect the difference.
• But suppose that in the floating-rate market the quality
spread is 50 basis points and in the fixed-rate one it is 150
basis points (a market inefficiency).
• The parties can take advantage of the 100 point difference.

© 2019 McGraw-Hill Education.

 • Company A pays the floating rate to Company B,
while Company B pays the fixed rate to Company A.
• Company B then benefits from a lower floating rate.
• Company A benefits in that it can apply the higher
fixed rate returns from B against its floating rate
costs.
• So both gain along with a possible intermediary who
benefits from fees in the arrangement.

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 Credit default swaps (CDS)

• a financial contract whereby a buyer of corporate or

sovereign debt in the form of bonds attempts to
eliminate possible loss arising from default by the
issuer of the bonds.
• This is achieved by the issuer of the bonds insuring the
buyer’s potential losses as part of the agreement.
• It protects lenders in the event of default on the part of
the borrower by transferring the associated risk in
return for periodic income payments.

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 Credit default swaps (Example)
• In a credit default swap (CDS), two counterparties
exchange the risk of default associated with a loan
(e.g. a bond or other fixed-income security) for
periodic income payments throughout the life of the
loan.
• In the event that the borrowing party (the issuer)
does default, the insuring counterparty agrees to pay
the lender (bondholder) the par value in addition to
lost interest.

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 Credit default swaps (Example)
• The bondholder (lender) seeks protection against the
risk that the issuing company (borrower) might
default. The insuring counterparty hedges that the
issuing company will not default, and will ultimately
profit from the income payments without having to
compensate the bondholder for the par value and
remaining interest.

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 Credit default swaps (Example)
• To illustrate, suppose Bob holds a 10-year bond issued by
company XYZ with a par value of $1,000 and a coupon
interest amount of $100 each year.
• Fearful that XYZ will default on its bond obligations, Bob
enters into a CDS with Steve and agrees to pay him income
payments of $20 (similar to an insurance premium) each year
commensurate with the annual interest payments on the
bond.
• In return, Steve agrees to pay Bob the $1,000 par value of the
bond in addition to any remaining interest on the bond ($100
multiplied by the number of years remaining).
• If XYZ fulfills its obligation on the bond through maturity after
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10 years, Steve will make a profit on the annual $20
payments.
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 Option Price Quote Example Long
Description
The underlying stock price is $8.79. The expiration of May has a
strike of 6.00. The expiration of January has a strike price of
7.50. The call information provides the last, volume, and open
interest figures. The put information provides the same
information.

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 Option Intrinsic Value and Time Value
Long Description
The horizontal axis displays the stock price and the vertical axis
displays the value (option premium). A blue dashed line that increases
in a concave up manner shows the before exercise price and a solid
blue line with a positive slope passes through the point ($50, 0) and
remains vertically lower than the exercise price. The intrinsic value is
the difference between the stock price and the exercise price. The
graph displays that at a stock price of $60 the intrinsic value is $10, the
additional time value is $2.50, bringing the value to $12.50.

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 Fixed-Fixed Pound/Dollar Currency
Swap Long Description
The U.S. financial institution swaps a fixed-rate dollar asset of $200
million, 6% coupon for a fixed rate pound liability, 100 million pounds,
6% coupon.

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 End of Discussion
•
For further details, please read the book.

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