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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Chapter 14: Advanced Derivatives and Strategies We look at everything. We don’t get scared because of the complexity involved. But we examine it to death. Arvind Sodhani, treasury, Intel Business Week, October 21, 1994, p. 95 Important Concepts in Chapter 14 The concept of portfolio insurance and its execution using puts, calls, futures and t-bills New and advanced derivatives and strategies such as equity forwards, warrants, equity-linked debt, structured notes, and mortgage securities Exotic options such as digital options, chooser options, Asian options, lookback options, and barrier options Derivatives on electricity and weather Advanced Equity Derivatives and Strategies Portfolio Insurance We can insure a portfolio by holding one put for each share of stock. For a portfolio worth V, we should hold N = V/(S0 + P) puts and shares This will establish a minimum of Vmin = XV/(S0 + P) where X is the exercise price Example: On Sept. 26, market index is 445.75 and Dec 485 put is $38.57. Expiration is Dec. 19. Risk-free rate is 2.99 % continuously compounded. Volatility is .155. Advanced Equity Derivatives and Strategies (continued) Portfolio Insurance (continued) We hold 100,000 units of the index portfolio for V = $44,575,000. We have Vmin = (485)(44,575,000)/(445.75 + 38.57) = 44,637,585 N = 44,575,000/(445.75 + 38.57) = 92,036 This guarantees a minimum return of 1.0014(365/84) - 1 = .0061 per year, which must be below the risk-free rate. Advanced Equity Derivatives and Strategies (continued) Portfolio Insurance (continued) Outcomes Index is 510 at expiration 92,036 shares worth 510 = $46,938,360 92,036 puts worth $0 = $0 Total value = $46,938,360 ( Vmin) Index is 450 at expiration Sell stock by exercising puts so you have 92,036(485) = $44,637,460 (? Vmin) Advanced Equity Derivatives and Strategies (continued) Portfolio Insurance (continued) See Figure 14.1, p. 503. If calls a