can someone explain how this provides protection from downside risk?
It seems that if i have a call that expires out of the money the value is zero and i walk. if it expires in the money then i take my payoff. what good does buying the bond do?
As I understand it, you need the proceeds of the bond to cover the purchase of the underlying of the option if the option expires in the money. If the option expires out of the money, you earn the risk-free rate (ie, the return on the bond).
Anyone else?
yes but its yor cash to begin with so unless you invested the cash in something that earned less than the bond you would be in a better position. i think though that the point is the call/bond as a portfolio provodes the downside protection because it ensures that you will not invest and underperfrom…and hence not have a perfect hedge
Also, you need the bond to make the put-call parity equal.
Using a fiduciary call will mean your payoff when the option expires is either the risk-free rate, or the difference between the strike and the underlying plus the risk-free rate.
right. well i just finished the options material up to the BSM and i am happy that it all makes sense. it seems that if you get put call parity and binomial and BSM that you have the lions shrare of options down.
one note though that i found interesting was that CFAI and Schweser use 2 differant formulas to calc the prob of an up move in binomial.
Huh. Just checked and they are the same…
yes sorry they are the same. I was thinking of the way Schweser calcs the size of the down move as 1/U. Doing some examples in CFAI if they give you size of up and size of down. In those i checked and down does not = 1/U
Again, nope. Check that U is not the size of the up move. S(0) x U = S+
U = 1 + Size of up move.
D = 1-size of down move.
This is the old put-call parity.
fiduciary call = protective put
in other words
bond + call = stock + put
You are in the same position either way. Exercising the call with the proceeds of the bond when it matures is equivalent to not exercising the put when you already own the stock. Conversely, exercising the protective put is equivalent to just keeping the cash when the bond matures and walking from the call.
Edit: drakesterling had it.