Question

Propose TWO option combination strategies that involve more than one option

contract for the USD variable rate loan (USD 20m), for all relevant risks

faced by this portfolio. OceanaGold’s management has expressed a desire to

retain some of the upside benefits that hedging with options can permit but

without paying a lot of money in option premiums. That is, your recommended

strategies should provide a “reasonably effective” hedge but keep the option

premium payment limited to a “reasonable amount” (it does not have to be zero!).

As the strategist, it is up to you what you consider “reasonable” for this purpose.

You must also describe the benefits and possible shortcomings of your proposed

option strategies. You must use actual option data to illustrate your option

strategies and to hypothetically demonstrate their benefits and shortcomings.

Calculate the number of contracts required for each strategy and provide the

strike prices and total premium costs.

Answer 1

Various combination of options strategies ( exotic options) allow us to hedge our risk. For reducing the downward risk, we can use any of the following two strategies.

1. Bull Call Spread : This strategy involves buying a lower strike (usually ITM/ATM) call option and selling a higher strike (OTM) call option. By using this strategy the risk is reduced to the difference of premium (NET Premium), this strategy has limited profit and limited loss profile. It is advisable to go with this strategy when we are moderately bullish on the underlying.

2. Long Call Butterfly spread : This strategy is a 3 Legged (involved 3 options). In this strategy, we should buy two lots of ATM call, and should sell one lot of OTM Call and Sell One lot of ITM call. The distance of OTM and ITM should be equal from ATM to make a perfect butterfly spread. This strategy provide limited loss and limited profit potential and conservative in nature. It generate profit when market is moderately bullish.