Spread

1. Spread Spreads are created by combining long and short positions in one or two calls or puts in the underlying instruments such as stocks, bonds, commodities, indices, and interest rates. The spreads are intended to reduce risk as well as to limit the potential profit provided that the investor’s expectations materialize. The following sections provide an example of various spreads using real market data on various derivative instruments traded in the organized exchanges in the United States and United Kingdom. Bull spreads Bear spreads Butterfly spreads Box spreads Short straddle Long straddle Strips Straps

2. Bull Spreads: Bull spreads are produced when an individual buys one call option at a given strike price, while simultaneously selling another call at a higher strike price as compared to the call purchased. • For example, consider buying a Eurodollar futures option at the strike price of 98.25 implying a 1.75 percent interest rate on the Eurodollar December futures for 17.7 basis points or paying $442.50 per contract, while simultaneously selling Eurodollar December futures at a strike price of 98.50 for 8.7 basis points or receiving a $217.50 premium. The behavior of this bull spreads is presented as follows:

4. Profit in the long call: $1,875 less premium of $442.50 =$1432.50 • Short call loses $1032.50 • Total profit = $400 • The maximum profit will be no more than $400 even interest rate drops to zero theoretically. • The payoff of the above bull spreads assuming the interest rate in the underlying Eurodollar futures increase say by 75 basis points in the next three months is as follows: • The long call at strike price of 98.25 expires worthless: -$442.50 • The short call at strike price of 98.50 expires: + $217.50 • The profit of bull spreads: - $225

5. Bear spreads are created when investors buy a put option at the higher strike price and simultaneously sell a put at a lower strike price. • The upside potential is limited in this case as well as the downside risk is truncated at the strike price of the put option purchased.

6. Consider a gold mining firm that is concerned about falling gold prices under $325/ounce in the next three months. It buys 325 December put futures at $10.40/ounce and finances the purchase of the puts by simultaneously selling December 310 put futures for $3.70/ounce as seen in Exhibit 10.2.

8. A butterfly spread strategy involves buying a call at strike price of E1, buying a second call at a higher strike price of E3 while selling two calls short mid point of E1and E3 at E2. For example, consider buying December 64 copper futures call at COMEX for 5 cents and December 72 at 1.10 cents (see Exhibit 10.2), while selling two December 68 calls short for 2.5 cents.

10. Long put - Long call - PV (Strike price of futures) = - Futures price Short put + Long call + PV (Strike price of futures) = + Futures price

11. Example: The treasurer of Dupont wishes to hedge the company’s exposure to currency risk for DM250 million payables to BMW in one year. The spot rate and the one-year forward rate are DM3.2/dollar. The treasurer wishes to buy calls on U.S. dollars and simultaneously sell puts in U.S. dollars at the strike price of DM3.2/dollar. The above strategy produces a synthetic long forward price of deutsche mark/dollar assuming the premium of the call and put are equal to $.017/deutsche mark