A well-known bit of derivatives magic — a great, simple party trick that derivatives structurers can use to impress their friends — is that if you give me $100 today, I can invest $91 of it in two-year Treasury notes paying 4.75% interest, and in two years I will have $100.1 And I can invest the other $9 in two-year at-the-money2 call options on the S&P 500 stock index, options that gain value if the S&P goes up over those two years. Those options cost, let’s say, 13% of the price of the S&P today,3 so spending $9 on options will get me an option on about $70 worth of the index. And so I can offer you the following trade:
If stocks go up, you get the gains (well, 70% of them). If stocks go down, you don’t get the losses. What a great trade!