We were talking about merger arb in a class I had last night, and when we got do deal construction it was mentioned that the different ways can be viewed as different options. For instance a fixed with collar can be a short call, because an upside limit is met, and a long put after the downside limit is met.

What are some other areas where different bigger financial transactions can be broken down to easier to value options?


  • $\begingroup$ The generic formula here is "U = C - P", meaning the underlying is equivalent to a long call and a short put. As @Shane notes, you can do lots of things w/ this equation. EG, a covered call is equivalent to a short put. Positions created this way are called "synthetics". $\endgroup$
    – user59
    Feb 19, 2011 at 14:40

1 Answer 1


I could be wrong, but this question seems to be about taking one set of cash flows and representing it using a set of derivatives. There are an almost unlimited number of applications for this kind of approach. There is an entire field of study dedicated to it: financial engineering.

A good textbook on the subject is "Principles of Financial Engineering" (Neftci 2008), which provides a comprehensive yet understandable framework for understanding how structured products are engineered. It is simplest to consider this in terms of a payoff diagram: when you understand the structure of the object that you're trying to replicate, then you can take various different structures and combine them to match the original. This is especially common around risky credit and mortgages. For instance, Neftci provides numerous examples of how one could break down the risks involved in a risky bond by using a CDS and other swaps.


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