Paper
Journal of Derivatives & Hedge Funds (2007) 13, 107–124. doi:10.1057/palgrave.jdhf.1850069
Pricing, value-at-risk and dynamic properties of re-settable strike-price puts
Practical applications
This paper provides details of the pricing and hedging characteristics of re-settable strike-price puts as compared to plain vanilla puts and makes explicit the differences between the two. Examples are provided of exposures that arise for issuers of re-settable strike-price puts, either as separate instruments or as instruments that are embedded in investment products, such as protected index notes. This paper also provides guidance to practitioners concerning the need to hedge re-settable strike-price puts differently than plain vanilla puts when the time to reset of the option is small and the underlying is near S*, a key value defined in the paper. Specifically, the gamma of the re-settable strike-price put is much greater than the gamma of the plain vanilla put, so a delta hedge for the former likely will need to be reset more frequently than for the latter, particularly near the reset date.
Michael L McIntyre1 and David Jackson2
Correspondence: , Eric Sprott School of Business, Carleton University, 1125 Colonel By Drive, Ottawa, Ontario, Canada K1S 5B6. Tel: +1 613 520 2600 ext. 2514, Fax: +1 613 520 4427; E-mail: mmcintyr@sprott.carleton.ca
1Michael L. McIntyre is an associate professor in the Eric Sprott School of Business at Carleton University. Prior to entering academia, he worked as a Chartered Accountant and in corporate banking with a major Canadian bank.
2David Jackson is an assistant professor in the Eric Sprott School of Business at Carleton University. Prior to entering academia, he worked as an engineer, primarily in instrumentation and developing special purpose computer-based data acquisition and control systems.
Received 21 May 2007; Revised 21 May 2007.
Abstract
This paper considers a particular type of re-settable strike-price put contract. This class of contract is important because it has come into widespread use as an embedded feature of investment vehicles such as segregated-funds investments and protected index notes. Holders of short positions in these contracts face a potential liability that crystallises if contracts mature at a time when market prices are below strike prices. This leads naturally to questions concerning the hedging behaviour of these products, and the value-at-risk associated with positions in them. We address these questions in this paper.
Keywords:
derivatives, re-settable strike-price puts, hedging, value-at-risk
