Table Of ContentHun~
O~tions
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Robert Tompkins
M
stockton
press
© Macmillan Publishers Ltd, 1991
All rights reserved. No part ofthis publication may be
reproduced or transmitted, in any form or by any
means, without permission.
Published in the United States and Canada by
STOCKTON PRESS, 1991
257 Park Avenue South,
New York, N.Y. 10010, USA
ISBN 978-1-56159-042-1
First published in the United Kingdom by
MACMILLAN PUBLISHERS LTD, 1991
Distributed by Globe Book Services Ltd
Brunei Road, Houndmills
Basingstoke, Hants RG21 2XS
ISBN 978-0-333-56910-8 ISBN 978-1-349-12800-6 (eBook)
DOI 10.1007/978-1-349-12800-6
A catalogue record for this book
is available from The British Library.
Typeset by Input Typesetting Ltd, Wimbledon, London SW19 8DR
Contents
Dedication vii
Preface ix
1 Basics of Options on Bund Futures 1
Why options exist 1
The two kinds of options 3
Disposition of options contracts 5
Exercise and assignment of options 8
Why options are tied to the underlying market 9
Options as the good and bad features of the underlying asset 12
Splitting a short underlying position into good and bad parts 15
2 Basic Concepts in Options Pricing 20
In-the-money 20
At-the-money 21
Out-of-the-money 21
Fundamental components of an options price 21
3 Advanced Concepts in Options Pricing 43
Role of option pricing models in option evaluation 43
Option derivatives 44
The appropriate pricing model for options on bund futures 57
Put-call parity: the fundamental arbitrage relationship 57
Effects of interest rates on option prices 64
4 Directional Trading Strategies 68
Possible viewpoints for the underlying Bund futures market and
volatility 68
Vertical spreads 82
5 Volatility Trading Strategies 90
How to make money from a change in volatility 90
Bund Options
The 'pure' buying volatility strategies 94
Leaning volatility buying strategies: ratio back spreads 99
'Pure' selling volatility strategies 105
Leaning volatility selling strategies: ratio spreads 118
Difference between trading Bund futures and Bund options 124
6 Option Arbitrage 125
Calendar spreads 125
Delta neutral trading 130
Pure arbitrage strategies 138
7 Option Hedging Strategies 152
Basic considerations in designing a hedging strategy 152
Relationship between Bundesanleihen and Bund futures 154
Example 1: buying Bund futures against call options 157
Example 2: buying a put option on Bund futures 167
Example 3: selling call options on Bund futures against a
Bundesanleihe 172
Example 4: selling put options 177
8 Bond Option Portfolio Application 181
90/10 money market strategy 181
90/10 plus strategy for options on Bund futures 183
Zero cost options hedging strategy 186
Portfolio insurance 190
Fallacy of delta hedging a Bundesanleihe 199
Comparison of alternative hedging strategies for the holder of a
Bundesanleihen portfolio 201
9 Risk Management of Bond Options 206
A Bund option risk analysis computer program 207
Bund option sample trade entry spreadsheet 211
Applications of computer risk analysis programs to the
management of Bund option portfolios by market makers 221
How to reduce the risk of the Bund option portfolio 221
10 Operations, Accounting and Taxation Issues for Bond Options 224
The clearing house and its role 224
Mechanisms of margining 225
Margining of Bund options on the LIFFE 228
Accounting and taxation of options on Bund futures in the UK 232
Accounting and taxation of Bund options in Germany 238
Dedication
This book is dedicated to my divine mother, without whose direct inter
vention this book would never have been written.
Preface
In 1989 and 1990, the German Capital Markets reached a milestone as
regulations were clarified regarding the use of derivative products for German
Institutional and private clients.
London and Frankfurt (and to a lesser degree Paris) began intense compe
tition with the introduction of futures and options contracts on a variety of
underlying German financial instruments.
The London International Financial Futures Exchange (LIFFE) concen
trated on offering futures and options contracts on interest bearing underlying
assets such as Bundesanleihen (German Government Bond) and 90 day
Deutschmark deposits (EuroDM). The Marche a Terme Des Instruments
Financiers (MATIF) offered futures and options on the EuroDM as well.
The Frankfurt competition, the Deutsche TerminbOrse (DTB), initially con
centrated on equity related products such as stock options and stock index
futures. In a direct affront to LIFFE, they then introduced Bund futures and
plans to offer options on Bund futures in 1991.
As these products were so heavily restricted by the German authorities
(and in fact were actively discouraged), the German investment community
and other potential users of German derivative products found it unnecessary
to acquire any expertise in these products. With the change in the regulations,
many individuals have found that a gap exists for German language instruc
tion about these markets. My firm, Minerva Consulting Limited, has settled
into a niche, training institutions in Germany about these markets. Over the
last two years, we have held over 45 workshops for institutions in both
Germany and Austria with particular interest being shown in workshops on
Bund options.
To the best of my knowledge, no book on Bund options is available.
Furthermore, while a few texts on options are available in German, most
are pitched at post-graduate level (these books are generally based upon
doctoral theses). This book will emphasize the practical approach to the use
of these products, and enough theory to understand the concepts critical to
these applications.
The recent unification of East and West Germany also has important
implications for the risk management of German fixed income instruments
ix
Bund Options
such as Bundesanleihen. The substantial financing needs required to rebuild
East Germany will lead to a much larger issuance of German Government
Debt. A comparable situation occurred in the United States during the 1970s
and 1980s as the U.S. Government's budgetary deficits resulted in increased
issuance of Treasury Debt and also led to increased volatility in these mar
kets. Because of these factors, options on U.S. Bonds became one of the
most actively traded option contracts in the world. I am convinced that the
German Debt market is poised for a similar period of increased volatility
and that options on Bund futures will soon join U.S. T-bond options as one
of the most actively traded option contracts in the world. What I have
attempted to do in this book is to prepare the English and German investment
community for what will probably be a 'rough ride' in the Bundesanleihen
market and to show how to use options on Bund futures to smooth that ride.
Since I first put pen to paper in November 1989, many of my staff have
been involved in the evolution of the final book. I would like to thank
Michael Addor, Adrienne McConnell, Christine Schloder and Andrew Loose
for their assistance in 1989 and 1990. But the final and successful completion
of the book was due to the superhuman efforts of my current employees,
Sonja Kohler, Torsten Bohler and Stephanie Garcia-y-Costa. Without their
help, this book would never have made the deadline we promised to our
patient editor, Andrea Hartill. I would also like to thank Arthur Andersen
& Company for their contributions to the final chapter which examines the
accounting issues in the United Kingdom and Germany and especially Victor
Levy in London and Jtirgen Jung in Frankfurt who lent their expertise to
this chapter. Finally, I would like to express my special thanks to my brother
Timothy, who helped tum my illegible .first draft into correct English. Any
mistakes or errors remaining are solely my responsibility.
Robert G. Tompkins
August 1991
X
1· Basics of Options on Bund
Futures
Obviously, the best way to become familiar with trading options on Bund
futures is to trade them. As happens in many fields, a book can serve as a
useful guide to new concepts and later provide a perspective once experience
has been gained - but there can be no substitute for the experience itself. I
have written this, therefore, as a guidebook and not as a textbook, to assist
and accompany the reader as he learns, applies and trades the financial
products described hereafter. Additionally, I hope to help develop an under
standing of the mechanics of how option trading works and thereby also
help potential market traders anticipate and benefit from the experiences
encountered in the actual market.
The material for this book derived from an extensive series of Bund options
courses I developed and taught in Germany during 1989 and 1990. As in the
courses, I have arranged the text into a progression of topics with the
objective of giving the reader a sufficient understanding of these products
and their markets to be able to trade competently in them.
I begin by describing what options are and what they can do, and by
defining the terminology commonly used in the industry. Then, theoretical
topics such as option pricing and arbitrage are examined, followed by a
practical explanation of how to use options, including trading approaches,
hedging strategies and portfolio applications. This leads finally to an exami
nation of general risk management within the context of options and a review
of the accounting implications of option trading in the United Kingdom and
Germany.
WHY OPTIONS EXIST
Options serve several purposes. On a purely speculative level they offer
investors a limited risk wager. Buying options is analogous in some ways to
playing roulette. In roulette, what one risks on each spin of the wheel is
simply the cost of the chips placed on the table. But at the same time,
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