2015 CFAI Mock: Silva case (Derivatives)

Silva case in Application of Derivatives. Q.4

The expected volatility of the S&P 500, relative to market expectations, is least likely to be a factor in the decision to implement:

Strategy A. (Long Call Butterfly) Strategy B. (Long ATM Straddle) Strategy C. (Zero cost collar, long put/short call)

The correct answer they say is C the collar.

I argue that it should be A. A butterfly is pretty much vega-neutral such that any changes in volatility will not change the payoff of the strategy.

The guideline answer is: Strategy C is a collar, which is a directional strategy; that is, its performance is dependent on the direction of the movement of the underlying (in this instance, the S&P 500). The performance of Strategy A (butterfly spread) and Strategy B (straddle) are based on the expected volatility (relative to the rest of the market) of the S&P 500.

I don’t understand that answer given the question- a straddle is also directional (bi-directional payoff)…

Profits for A & B greatly depend on volatility

A - requires stable volatility, hover around that second strike price for maximum profit

B - requires high volatility, the further price moves either way, the more profit gained

C - a defensive position which fully hedges downside & gives up upside (regardless how volatile the price is, you are locked in a range of payoffs) so volatility is really not a big concern

Ok, i am referring to option volatility (implied volatility = one of the components in the black-scholes pricing model)

They should have used a different terminology to talk about this !

Cohiba, I hear ya, but that’s where you’ve gotta be careful and read the question; it specifically says the volatility of the S&P 500.