Structure Product Creation - Collar Strategy

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Interpretation of risk and improvements

For investor, risk of this strategy is increasing with stock price increase and also approaching to the expiration date. To better demonstrate our composite creation, we plot a graph of risk for our last example. We can easily see that one can hedge the risks generated from the market volatility within a certain range of +100% to -100%.

For better hedge the maximum risks as well as earn more profit, we can improve the collar strategy by two means:

- Combined calendar spread with collar and write call options with longer expiry date, thus cutting the costs.

- Long put option that is out-of-money, changing the strike price. However, it is worth mentioning that it is also a trade-off between the retun and risk. When we trade out-of-money put, the potential gain will be much higher at the cost of more risk bearing.

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Graph of Risk

[pic 5]

For banks, as the seller of the products they have to face the potential market risks that the underlying price may move toward adverse direction. Therefore, it is wise for banks to resell the options in global market, thus transferring the risks and earning the spread. If not, holding to maturity can leave them exposed to market volatility risk. Banks may also buy other derivatives products to hedge out the risk, although in this case the overall profits will decrease.

4. Pricing and profit margin

The price for this strategy is quite straightforward. Using current price of the underlying stock TXN, plus the purchase price of call option, minus the short price of put option with the same expiration date we can find the price for this product. As is mentioned above, if the option premiums for puts and calls can be offset, investors will achieve a costless strategy. But most of the time because buying a put which is at the money or out of the money costs more than earning from selling a call option with same expiration date, possible difference between two option premiums appears as losses when the stock price falls.

To issue this product, bank has the opposite positon with investors, therefore it is

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supposed to sell the put options and but the call options. Profit margin are generated for banks when the price of underlying increase, in this case banks will earn profits from longing the call option and the premium of put option. Similarly, the issuer will lose money when the stock price falls.

The profit margin for banks shows that it is a bullish positon with no limitations on the profit and losses, so it may earn a lot from a dramatic increase of the share price, as well as suffer a big loss from a sharp drop. Because the implied volatility here is neutral as the shorting option will increase in value but also increase the value of the longing option. There’s opportunity for investors and issuers to gain profit from this strategy.

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Appendix

Graph1: Position creation from simulator[pic 6]

Graph 2: Pay-off table

[pic 7]

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Graph3: Maximum Risks plot

[pic 8]