Profit and pay-off diagrams will be used a great deal in this chapter.

A profit diagram shows the profit at maturity calculated from a range of asset values (Figure 6.1).

A pay-off diagram illustrates the pay-off at maturity (what a contract pays out at maturity) for a range of asset values (Figure 6.2).

Introduction

A trader hears that VIY telecom company is undertaking research into a new design of mobile telephone. The price today of a VIY share is £2.45 and on the basis of what he hears, the trader expects the share price to rise. The delivery price for a six-month forward contract on a VIY share is £2.52, but the dealer expects the share price to rise by more than 7p. The trader enters a six-month forward contract on 100,000 VIY shares.

Unfortunately, the research was unsuccessful and six months later the company, having invested heavily in the project, declares a profits warning. The share price drops to £2.17. On delivery day, the dealer pays £252,000 to buy shares whose value is £217,000. Not a good deal. The situation is illustrated by a profit diagram (Figure 6.3).

In the same sort of way, if the trader had entered a forward contract to sell shares and by delivery day the price of the shares had risen above the delivery price, the trader would be in the position of having to sell shares at below their present value.