Risk Management - Derivatives

Derivatives:

Forwards

Options

Put-Call Parity

Risk Management:

Regulatory Framework:

"Floors and Caps"

Now let us make the switch to Insurance and introduce Floors and Caps.

Definition (Floor)
A Floor is the combination of owning an asset and owning a put option on that asset. A Floor provides insurance against a falling asset price.

Here the put option guarantees a minimum sales price of the asset while having the asset's value at time t=0 as strike price. Let us look at an example:

Example (Floor)
An investor buys an asset for the price of $ 500. He also buys a 6-month put option on this asset (with strike price K = $ 500) for $ 25.88. The risk free rate is 6 % convertible semiannually.

In our example we have:

Exhibit FL.1: A payoff and profit table

where Cost = ($ 500 + $ 25.88) * 1,03 = $ 541.66

The corresponding profit diagram is:

Exhibit FL.2: A Floor

When the asset price in 6 months is less than $ 500, you loose $ 41.66, no matter what is the price of the asset. That means you are insured against a decline in the price of the asset.

When you short an asset, you borrow the asset and sell, hoping to replace them at a lower price and profit from the decline. Thus, a short seller will experience loss if the price rises. He can insure his position by purchasing a call option to protect against a higher price of repurchasing the asset. The combination of short sale and purchased call option is called a cap.

Definition (Cap)
A cap is the combination of a purchased call option on an asset and a short position on the asset itself.

The call option provides insurance for the short position. Here is an example:

Example (Cap)
Short an asset for $ 500 and purchase a 6-month call option (with strike price of K = $ 500) for a premium of $ 46.90. The risk-free rate is 6 % convertible semiannually.

In our example we have:

Exhibit FL.3: A payoff and profit table

where Cost = ( - $ 500 + $ 46.70 ) * 1.03 = - $ 466.90

The corresponding profit diagram is:

Exhibit FL.4: A Cap

When the asset price in 6 months is more than $ 500, you loose $ 33.10, no matter what is the price of the asset. That means you are insured against an increase in the price of the asset.