R19.P1.T3.FIN_PRODS_HULL_Ch12:Topic:Box Spreads

Discussion in 'P1.T3. Financial Markets & Products (30%)' started by gargi.adhikari, Dec 17, 2016.

  1. gargi.adhikari

    gargi.adhikari Active Member

    In reference to R19.P1.T3.FIN_PRODS_HULL_Ch12:Topic:Box Spreads :-
    The Payoff for a Box Spread at any given point is (K2-K1) ...I do understand that....but what I am missing is that shouldn't the payoff also should also factor in the cost of the Bull and Bear Spreads...? that is the payoff for the Box Spread at any given point should be (K2-K1) -Cost of the Bull/Bear Spread? I might be missing something here...would be very grateful for any help/insight on this....

    For eg: As the price increases beyond the K2, the P/L for the Bull Spread is = (K2- K1) -Cost of the Bull Spread.

    Similarly, As the price falls beyond the K1, the P/L for the Bear Spread is = (K2- K1) -Cost of the Bear Spread.

    Does by "payoff", we are referring to the "Value" of the Box Spread at any point which is (K2- K1) and the "P/L" from the Box Spread at any given point would be (K2 -K1) - the Total Cost of the Box Spread..?


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    Last edited: Dec 17, 2016
  2. ShaktiRathore

    ShaktiRathore Well-Known Member

    Hi ,
    The payoff does not includes the costs or the investment that you have made in the Bull and Bear Spreads therefore the payoff is always K2-K1 here. Similar to call option where the payoff is max(ST-K,0) not max(ST-K,0)-premium.
    thanks
     
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  3. gargi.adhikari

    gargi.adhikari Active Member

  4. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test)

    @gargi.adhikari Agreeing with Shakti. We try to follow Hull's convention which includes a distinction between option payoff and option profit.
    • Payoff is the cashflow upon exercise (ie, for a European option, payoff is the intrinsic value at maturity) and also, therefore, occurs only in the future
    • Profit = future payoff +/- initial premium. Notice this mixing of time intervals. An interesting aspect of the typical option profit is that it tends to ignore the time value of money. Certainly we finance professionals :cool: would use profit = PV(payoff) +/- initial premium, but option profit charts tend not to. I hope that's additive!
     
    Last edited: Dec 27, 2016
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