Critically evaluate the risk management leadership at AIG. Who dropped the ball?Defend your point of view when you first present it and against other point of views. If there is a view posted that you...

Critically evaluate the risk management leadership at AIG. Who dropped the ball?Defend your point of view when you first present it and against other point of views. If there is a view posted that you already agree with, you may endorse this already posted view, or improve upon it, and proceed to defend it against competing views. Complete all postings/discussion by March 19, 3pm.797px; overflow: hidden; word-break: break-word; color: rgb(61, 61, 61); height: 2000px;”>Chapter 9Online Appendix: Payoff Diagrams for Futures and OptionsAs we have seen, derivatives provide a set of future payoffs based on the price of theunderlying asset. We discussed how derivatives can be mixed and matched to create syntheticfinancial instruments that mimic the behavior of more traditional financial instruments. Payoffdiagrams help to illustrate this concept. This appendix introduces payoff diagrams and explainshow to use them.Futures Contract PayoffsRecall that the buyer of a futures contract agrees to purchase a certain quantity of aparticular commodity or financial instrument at a pre-specified price and time. The seller of thefutures contract promises to deliver the commodity or financial instrument on the appointed datein return for payment at the settlement price. The value of these promises (to the buyer)increases as the price of the underlying asset rises.Figure 9A.1: Payoff from Buying a Futures ContractPayoffProfit→Payoff Functionfor Buyer of aFutures Contract45o←Loss0Price of theUnderlying AssetSettlementPriceFigure shows the payoff to holding the long position in a futures contract. As the price of the underlyingasset rises, the payoff to the buyer of the contract rises one-for-one. That is, a $1 increase in the priceraises the payoff by $1.Figure 9A.1 shows the payoff from buying a futures contract. As the price of theunderlying asset rises above the settlement price, the payoff to the futures contract buyer goes upChapter 9one for one – that is to say, a $1 dollar increase in the price of the underlying asset raises thepayoff to the long position by $1. As the price falls below the settlement price, the value of thelong position falls. In fact, the payoff from purchasing the underlying asset itself is exactly thesame as the payoff from buying a future, since arbitrage forces the futures price to move with theprice of the underlying asset. The crucial difference is that, in buying a futures contract, all thebuyer needs to do is post margin. While buying a futures contract is substantially cheaper thanbuying the underlying asset, it means accepting greater risk.Figure 9A.2: Payoff from Selling a Futures ContractProfit→Payoff45oPrice of theUnderlying Asset←Loss0SettlementPricePayoff Functionfor Seller of aFutures ContractFigure shows the payoff to holding the short position in a futures contract. Asthe price of the underlying asset rises, the payoff to the seller of the contractfalls one-for-one. That is, a $1 increase in the price reduces the payoff by $1.The payoff from selling a futures contract, or taking the short position, is shown inFigure 9A.2. This mirror image of Figure 9A.1 shows that the buyer’s gains are the seller’slosses, and vice versa. Again, the payoff to the short position rises and falls one-for-one with theprice of the underlying asset – a $1 increase in the price of the underlying asset reduces thepayoff to the seller by $1, while a $1 fall in the price raises the payoff by $1.Chapter 9Options PayoffsThere are four ways to invest in options: buying and selling either a put or a call. Wewill begin with the buying of a call option. Remember that buying an option creates rights butnot obligations. Because the buyer need not exercise the option, the loss from owning it cannotexceed the price paid for it. So long as the price of the underlying asset is below the strike priceof the call, the holder will not exercise the option, and will lose the premium initially paid for it.This means that the payoff function is flat, beginning at an underlying asset price of zero andcontinuing to the strike price, with a loss equal to the call premium. As the price of theunderlying asset rises beyond the strike price, the call comes into the money, and the payoffbegins to rise one for one with the price of the underlying asset (see Figure 9A.3).Figure 9A.3: Payoff from Buying a Call OptionProfit→Payoff45oPrice of theUnderlying Asset←Loss0StrikePricePayoff Functionfor Buyer of aCall OptionCallPremiumThe buyers of a call option pays a premium, and then receives a payoff thatrises one-for-one with the price of the underlying asset once the price risesabove the strike price of the option.What benefits the call buyer costs the call writer. So long as the underlying asset priceremains below the strike price of the call, the writer pockets the premium, and the payoff ispositive. But when the underlying asset price rises above the strike price, the writer begins tosuffer a loss. The higher the price climbs, the more the call writer loses, as Figure 9A.4 shows.Chapter 9Figure 9A.4: Payoff from Writing a Call OptionPayoffProfit→CallPremium45o0Price of theUnderlying Asset←LossStrikePricePayoff Functionfor Writer of aCall OptionThe payoff to writing a call option is exactly the opposite of the payoff tobuying one. The writer receives the call-option premium so long as the price ofthe underlying asset remains below the strike price of the call. Once theunderlying asset’s price rises above the strike price, the payoff to option writerfalls one-for-one with the price of the underlying asset.Figure 9A.5: Payoff from Buying a Put OptionProfit→Payoff45oStrikePrice←Loss0PutPremiumPrice of theUnderlying AssetPayoff FunctionBuyer of a PutOptionThe buyer of a put option pays a premium, and then receives a payoff thatstarts to rise once the price of the underlying asset falls below the strike priceof the option. The payoff rises $1 for each dollar that the price of the fallsbelow the strike price.Turning to puts, we can use the same simple process to draw their payoff diagrams. Thebuyer of a put purchases the right to sell a stock at the strike price. Puts have value only whenthe price of the underlying asset is below the strike price. The payoff is highest when the priceof the underlying asset is lowest. As the asset’s price rises, the payoff falls, though it cannot gobelow the premium paid for the put (see Figure 9A.5)Chapter 9Figure 9A.6: Payoff from Writing a Put OptionPayoffPayoff Functionfor writer of aPut OptionProfit→PutPremium45o←Loss0Price of theUnderlying AssetStrikePriceThe payoff to writing a put option is exactly the opposite of the payoff tobuying one. The writer receives the put-option premium so long as the price ofthe underlying asset remains above the strike price of the put. Once theunderlying asset’s price falls below the strike price, the payoff to option writerfalls one-for-one as the price of the underlying asset falls.Writing a put is the reverse of buying one. Again, the writer loses when the holder gains,so the maximum payoff is the premium. The best outcome for an option writer is to have theoption expire worthless, so that it is never exercised. Looking at Figure 9A.6, we can see that theput writer’s losses are highest when the price of the underlying asset is lowest; it declines as theprice rises. So long as the asset price exceeds the strike price, the put writer’s payoff equals thepremium charged to write the put.In this chapter, we learned that buying and selling options and futures in variouscombinations can be planned to create customized risks. Two examples were given. The firstwas the use of options to replicate the payoff pattern of a futures contract. Buying a futurescontract is equivalent to purchasing a call and selling a put, both of which are at the money andhave the same expiration date as the futures contract. Notice how putting Figure 9A.3 on top ofFigure 9A.6 makes the combined payoff a continuous upward-sloping line.The second example was the use of options to bet that a stock’s price would movesignificantly, either up or down. Looking at the payoff diagrams, we see that buying a call yieldsa payoff when the price rises (see Figure 9A.3), while buying a put yields a payoff when theprice falls (see Figure 9A.5). By putting the two together, an investor creates a financialinstrument that loses falls in value when prices are stable (the premium is lost when the pricestays the same), but rises in value when prices are highly volatile.