Advanced Financial Mathematics

Chapter 3
Insurance strategies using derivatives
These notes are greatly inspired from the book Derivatives Markets
3.1 Basic insurance strategy
Options can be used to insure
• A long position Floors chặn dưới

• A short position Caps chặn trên

• Options can be written to insure a long/short position in the

underlying selling insurance

Chapter 3-Advanced Financial Mathematics-UEH-F2023 3

Floor

Définition: A floor is the combination of

• a long position in the underlying asset
• a long position in a put option (purchased put option).

Goal: insure a long position in the underlying

Chapter 3-Advanced Financial Mathematics-UEH-F2023 4

Payoff and profit of a floor
• Payoff: S(T) + max(K- S(t),0)=max (K, S(T))

• Profit:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 5

Floor diagram

𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 6

Example
A stock has an initial value of $50. It is assumed that the price of a put
option with a strike price of $40 is $3 with a maturity of 6 months.
For what value of the stock do we break even (i.e. zero profit) by
establishing a floor? We assume that the risk-free interest rate is 0%.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 7

Example
Solution:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 8

Remarks

Chapter 3-Advanced Financial Mathematics-UEH-F2023 9

See Table 3.1 and Fig. 3.1 in DM
Chapter 3-Advanced Financial Mathematics-UEH-F2023 10
Cap
Definition: A cap is the combination of
• a long position dans une call option (purchased call option)
• a short position in the underlying.
Goal: insure a short position in the underlying.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 11

Payoff and profit of a Cap
• Payoff :

• Profit :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 12

Cap diagram

𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 13

Remarks

Chapter 3-Advanced Financial Mathematics-UEH-F2023 14

 Selling insurance

• Covered writing: selling the option when holding a long position in the
underlying (covered option)

• Naked writing: Selling an option without holding the underlying (uncovered

option)

Chapter 3-Advanced Financial Mathematics-UEH-F2023 15

Covered call option-selling a cap
• A covered call option is the combination of the following two
éléments:
• Short position in the call option
• Long option in the underlying
• Payoff of a covered call option:

• Profit of a covered call option :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 16

Covered call option

𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 17

Chapter 3-Advanced Financial Mathematics-UEH-F2023 18
Covered put option-selling a floor
• Covered put option is the combination of
• a short position in the put option
• a short position in the underlying
• Covered put option payoff :

• Covered put option profit:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 19

Covered put option diagram

𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 20

Synthetic Forward
Un forward can be constructed from a combination of two options
having the same maturity and the same strike
• Long position in a call option
• Short position in a put

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾, 𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 21

Synthetic forward payoff

• Initial cost :

• Payofff:

• Profit:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 22

Standard Forward vs synthetic forward
standard forward Synthetic forward

t =0

t=T

Chapter 3-Advanced Financial Mathematics-UEH-F2023 23

Remarks
• If 𝐾𝐾 <𝐹𝐹0,𝑇𝑇 :

• If 𝐾𝐾 >𝐹𝐹0,𝑇𝑇 :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 24

Synthetic forward diagram

𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 25

Call-Put parity
• Taking expectation of the synthetic forward under the risk-neutral
measure 𝑷𝑷∗ we obtain:

𝑬𝑬∗ 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = 0.

• For discrete interest rate we have:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 26

Example
Suppose that the price of a stock is $19, and the price of a European
call option with a 3-month expiration on the same asset, with a strike
price of $20, is $1. If the risk-free interest rate is 4% per year, what is
the price of a put option with the same characteristics as the call?

Chapter 3-Advanced Financial Mathematics-UEH-F2023 27

Absence of arbitrage

Unique price principle: If two strategies provide the same value

at maturity, then they must have identical associated costs

Chapter 3-Advanced Financial Mathematics-UEH-F2023 28

Proof of the Put-Call parity

Chapter 3-Advanced Financial Mathematics-UEH-F2023 29

Spreads and collars
Spreads involve combinations of options of the same type, either only
call options or only put options.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 30

Bull spread
• The term "bull spread" implies that the investor anticipates an
increase in the value of the underlying asset.

• The bull spread can be designed in two ways.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 31

Bull spread with call options

• Buy a call option of strike price 𝐾𝐾1

• Sell another call option of strike price 𝐾𝐾2 , with 𝐾𝐾1 < 𝐾𝐾2 ,
• Two options have the same maturity T.

General rule: For call options, the price of the option decreases as its
strike price increases, i.e.
𝐶𝐶 𝐾𝐾1 , 𝑇𝑇 > 𝐶𝐶 𝐾𝐾2 , 𝑇𝑇 , 𝑖𝑖𝑖𝑖 𝐾𝐾1 < 𝐾𝐾2

Chapter 3-Advanced Financial Mathematics-UEH-F2023 32

Payoff and profit of a Bull spread
• Initial cost:

• Payoff:

• Profit :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 33

Example 3.2 in DM
To speculate on an increase in the value of the underlying asset, you can buy a call option with a
strike price of K1 = $40, with a maturity of T = 3 months, at a price of C(K1, T) = $2.78. It is possible
to reduce the cost of the position (and thus the potential profit) by selling a call option with a strike
price of K2 = $45 and a price of C(K2, T) = $0.97, with the same maturity.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 34

 Diagram of a Bull spread
Consider three scenarios 𝑆𝑆𝑇𝑇 < 𝐾𝐾1 , 𝐾𝐾1 < 𝑆𝑆𝑇𝑇 < 𝐾𝐾2 , 𝐾𝐾2 < 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 35

Diagram of a Bull spread (with call options)
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 36

Bull spread with put options
• Buy a put option with strike 𝐾𝐾1
• Sell another put option with strike 𝐾𝐾2 , where 𝐾𝐾1 < 𝐾𝐾2
• Two option have the same maturity

General rule: The price of a put option increases as its strike price
increases :
𝑃𝑃 𝐾𝐾1 , 𝑇𝑇 < 𝑃𝑃 𝐾𝐾2 , 𝑇𝑇 if 𝐾𝐾1 < 𝐾𝐾2 .

Chapter 3-Advanced Financial Mathematics-UEH-F2023 37

Payoff and Profit
• Initial cost:

• Payoff:

• Profit :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 38

Diagram of a Bull spread (with put options)
P𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 39

Example
Suppose that the call options with the same underlying asset and the same
expiration date, T = 1 year, are offered with strike prices of $50 and $60. The call
options cost $10 and $3 respectively. The annual risk-free interest rate is 𝑟𝑟_𝑓𝑓 =
5%.
• Construct a bull spread involving these options.
• What is the minimum and maximum profit you could make?
• At what value of the underlying asset will you break even?

Chapter 3-Advanced Financial Mathematics-UEH-F2023 40

Solution

Chapter 3-Advanced Financial Mathematics-UEH-F2023 41

Bear spread
• The term "bear spread" implies that the investor anticipates a
decrease in the value of the underlying asset.

• The bear spread can be designed in two ways, just like it was the case
with the bull spread.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 42

Bear spread with call options
• Sell a call option with strike price 𝐾𝐾1
• Buy another call option with strike price 𝐾𝐾2 , 𝐾𝐾1 < 𝐾𝐾2 .
• Two options have the same maturity.

• Initial cost:

• Payoff:

• Profit :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 43

Diagram of a Bear Spread with call options
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 44

Bear Spread with put options
• Sell a put option with strike price 𝐾𝐾1
• Buy another option with strike price 𝐾𝐾2 , 𝐾𝐾1 < 𝐾𝐾2 .

• Initial cost:

−𝑃𝑃 𝐾𝐾1 , 𝑇𝑇 + 𝑃𝑃 𝐾𝐾2 , 𝑇𝑇

• Payoff:

• Profit:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 45

Diagram of a bear spread with put options
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 46

Ratio spreads
• A Ratio Spread involves buying n call options with a strike price 𝐾𝐾_1
and selling m call options with a strike price 𝐾𝐾_2 where n ≠ m.
• The same goes for hedging strategies with put options, regardless of
whether the position is long or short.
• This allows the investor to create a strategy with zero initial cost, as
opposed to bull spreads and bear spreads, which typically involve a
non-zero initial cost.
• However, the position associated with this type of strategy is not
always clearly long or short, as demonstrated in the following
example.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 47

Exemple
Consider two call options with the same underlying asset and the same
expiration date, with strike prices of $50 and $60, respectively, and
costing $10 and $5, respectively.

• Establish a zero-cost initial strategy to capitalize on a potential slight

increase in the value of the underlying asset.
• What happens if the value of the underlying asset goes down? And if
it increases significantly?

Chapter 3-Advanced Financial Mathematics-UEH-F2023 48

Solution

Chapter 3-Advanced Financial Mathematics-UEH-F2023 49

 3.3.4 Box spread
• Buye a call (long) : 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾1 , 𝑇𝑇
• Buy a put (long) : 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾2 , 𝑇𝑇
• Sell a second call (short) : −𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 , 𝑇𝑇
• Sell a second put (short : −𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾1 , 𝑇𝑇

𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾1 , 𝑇𝑇 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 , 𝑇𝑇 + 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾2 , 𝑇𝑇 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾1 , 𝑇𝑇
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 (𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶) 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 (𝑃𝑃𝑃𝑃𝑃𝑃)

𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾1 , 𝑇𝑇 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾1 , 𝑇𝑇 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 , 𝑇𝑇 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾2 , 𝑇𝑇
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐾𝐾1 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐾𝐾2

Chapter 3-Advanced Financial Mathematics-UEH-F2023 50

 Box spread payoff
• Initial cost :

• Payoff

• Profit

Considering the following 3 scenarios:

𝑺𝑺𝑻𝑻 < 𝑲𝑲𝟏𝟏 ;

𝑲𝑲𝟏𝟏 < 𝑺𝑺𝑻𝑻 < 𝑲𝑲𝟐𝟐 ;

𝑲𝑲𝟐𝟐 < 𝑺𝑺𝑻𝑻 :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 51
Construction of the box spread payoff

Chapter 3-Advanced Financial Mathematics-UEH-F2023 52

 Collars
• A collar can be constructed by buying a put option with strike 𝐾𝐾1 and by
selling a call option with strike price 𝐾𝐾2 > 𝐾𝐾1 .
• Initial cost:
• Payoff
• Profit:
• Collar length is defined by the difference between the two strike prices
𝑲𝑲𝟐𝟐 − 𝑲𝑲𝟏𝟏 .

Chapter 3-Advanced Financial Mathematics-UEH-F2023 53

Payoff and profit of a collar
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 54

Collared stock
One will say that a stock or any financial security is covered by a collar if
one owns the underlying security as well as the collar associated with
it, as long as the initial value of the underlying asset remains within the
collar.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 55

Provenance du graphique de valeur à
l’échéance de l’action couverte d’un collar

Chapter 3-Advanced Financial Mathematics-UEH-F2023 56

Diagram of a collared stock
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 57

Zero-cost collar
• A zero-cost collar will be referred to as having an initial cost equal to
0, which implies having a call option and a put option at the same
strike price, which is 𝑃𝑃 𝐾𝐾1 , 𝑇𝑇 = 𝐶𝐶 𝐾𝐾2 , 𝑇𝑇 .
• This is generally possible if 𝐾𝐾1 < 𝐹𝐹0,𝑇𝑇 < 𝐾𝐾2 .

Chapter 3-Advanced Financial Mathematics-UEH-F2023 58

Example 3.5 in DM
You own an asset with a current price of $40, and you want to purchase insurance. You buy a put option (in
the money) and sell a call option (out of the money). The results are summarized in the following table 3.6.

Compared with Bull spread in Example 3.2 and Table 3.5.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 59
Speculating on volatility
• One will speculate on the volatility of the underlying asset, or in other
words, on the magnitude of its value fluctuations in the future.
• Sometimes, the goal will be to protect against high volatility and
large price swings, while other times it will be to profit from them.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 60

Straddles
• A straddle involves buying a call option and a put option with the same
strike price, typically equal to the initial price of the underlying asset (by
default unless stated otherwise).

• Initial cost:

• Payoff:

• Profit:

• This strategy corresponds to the purchase of a straddle.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 61
Diagram of a Straddle
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

+ 𝑃𝑃(𝐾𝐾, 𝑇𝑇)𝑒𝑒 𝑟𝑟𝑟𝑟

𝐾𝐾 𝑆𝑆𝑇𝑇 𝐾𝐾 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 62

Written straddle
• The opposite position would be selling a straddle, which is often
referred to as "writing a straddle:

𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = −𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = −𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾

Chapter 3-Advanced Financial Mathematics-UEH-F2023 63

Diagram of a written straddle
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

+ 𝑃𝑃(𝐾𝐾, 𝑇𝑇)𝑒𝑒 𝑟𝑟𝑟𝑟

𝐾𝐾 𝑆𝑆𝑇𝑇 𝐾𝐾 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 64

 Strangles
A strangle is indeed similar to a straddle, with the key difference being that the
strike prices of the options in a strangle are different. In a strangle strategy:

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 , 𝑇𝑇 + 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾1 , 𝑇𝑇

• Initial cost :

• Payoff :

• Profit :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 65

Diagram of a strangle
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 66

Written strangles
This strategy is to sell a strangle, often referred to as "writing a
strangle." When you write a strangle, your positions are reversed
compared to buying a strangle.
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = −𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = −𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾1 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾2

Chapter 3-Advanced Financial Mathematics-UEH-F2023 67

Diagram of a written strangle
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 68

Butterfly spreads
A Butterfly spread is indeed a combination of a written Straddle (with strike price
𝐾𝐾2 ) and a purchased Strangle (with strike prices 𝐾𝐾1 , 𝐾𝐾3 ), where
𝐾𝐾1 < 𝐾𝐾2 < 𝐾𝐾3

• 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾3 + 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾1 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 + 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾2
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝐾𝐾1 ,𝐾𝐾3 ) 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝐾𝐾2 )

• Butterfly spread is considered as a combination of a Bull spread (with put options)

and a Bear spread (with call options)

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾3 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 + 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾1 − 𝑃𝑃𝑃𝑃𝑃𝑃 𝐾𝐾2
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠(𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶,𝐾𝐾2 ,𝐾𝐾3 ) 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠(𝑃𝑃𝑃𝑃𝑃𝑃,𝐾𝐾1 ,𝐾𝐾2 )

Chapter 3-Advanced Financial Mathematics-UEH-F2023 69

Cost and Profit of a Butterfly spread
• The initial cost will be negative (you receive money initially) because
the straddle sold generates more income than the cost of the strangle
purchased.
• Initial cost :
𝐶𝐶 𝐾𝐾3 , 𝑇𝑇 + 𝑃𝑃 𝐾𝐾1 , 𝑇𝑇 − 𝐶𝐶 𝐾𝐾2 , 𝑇𝑇 + 𝑃𝑃 𝐾𝐾2 , 𝑇𝑇
• Payoff :

• Profit :

Chapter 3-Advanced Financial Mathematics-UEH-F2023 70

Diagram of a Butterfly spread
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

𝐾𝐾1 𝐾𝐾2 𝐾𝐾3 𝑆𝑆𝑇𝑇 𝐾𝐾1 𝐾𝐾2 𝐾𝐾3 𝑆𝑆𝑇𝑇

Chapter 3-Advanced Financial Mathematics-UEH-F2023 71

 Example
Construct a butterfly spread by combining a bull spread (with call options) and
a bear spread (with call options).

Solution:

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾1 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 + −𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾3
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠(𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶,𝐾𝐾1 ,𝐾𝐾2 ) 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠(𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶,𝐾𝐾2 ,𝐾𝐾3 )

= 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾1 − 2𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾2 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐾𝐾3

Chapter 3-Advanced Financial Mathematics-UEH-F2023 72

Asymmetric Butterfly spreads
• An asymmetric Butterfly spread consistes of a combination of n Bull spreads
(𝐾𝐾1 , 𝐾𝐾2 ) and of m Bear spreads (𝐾𝐾2 , 𝐾𝐾3 ) with 𝑛𝑛 ≠ 𝑚𝑚.
• In the standard butterfly spread (symmetric) introduced before, we have 𝑛𝑛 =
𝑚𝑚 (and 𝑛𝑛 = 𝑚𝑚 = 1).

Chapter 3-Advanced Financial Mathematics-UEH-F2023 73

Figure 3.15 in DM

n=2, m=8

Chapter 3-Advanced Financial Mathematics-UEH-F2023 74

Asymmetric Butterfly spread with zero value at
maturity pour 𝑺𝑺𝑻𝑻 < 𝑲𝑲𝟏𝟏 and 𝑲𝑲𝟑𝟑 < 𝑺𝑺𝑻𝑻 .
Problem: find n and m in an asymmetric Butterfly spread, to obtain zero value
at maturity for 𝑆𝑆𝑇𝑇 < 𝐾𝐾1 and for 𝐾𝐾3 < 𝑆𝑆𝑇𝑇 :
• If 𝐾𝐾3 < 𝑆𝑆𝑇𝑇 :
0 = 𝑛𝑛 𝐾𝐾2 − 𝐾𝐾1 − 𝑚𝑚 𝐾𝐾3 − 𝐾𝐾2

𝑛𝑛
⇒ =?
𝑚𝑚
• Remarks:

Chapter 3-Advanced Financial Mathematics-UEH-F2023 75

Example
A butterfly spread consists of call options with a maturity of T=1 year
and strike prices of $55, $60, and $75. It initially costs $8. The annual
risk-free interest rate is 5%.
• Determine the values of n and m that result in a zero value at
maturity for 𝑆𝑆𝑇𝑇 < 𝐾𝐾1 and 𝐾𝐾3 < 𝑆𝑆𝑇𝑇 .
• Determine the values of the underlying asset that lead to zero profit
and the value of the underlying asset that maximizes the profit.

Chapter 3-Advanced Financial Mathematics-UEH-F2023 76

Solution

Chapter 3-Advanced Financial Mathematics-UEH-F2023 77

Summary

Chapter 3-Advanced Financial Mathematics-UEH-F2023 78