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Options and Options Markets Supplemental Chapter 2

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Options Derivative Assets – assets whose value is derived by the value of another assets (the underlying asset). Call Option - the right to buy an asset at a pre-specified price and time.

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Options Options are a contract between two parties: a buyer and a seller. Two types of options: Calls Puts

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Options Call Options – grant the buyer (holder) the right to buy the underlying asset at a pre-specified price. Put Options – grant the buyer (holder) the right to sell the underlying asset at a pre-specified price. Long vs. short positions Strike (exercise) price – pre-specified price stated in the option contract.

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Options Options: Limited life – typically expire within 1 year of the initial trading date. Exchange traded equity options expire on the third Friday in the expiration month. European Options can be exercised on their maturity date only. American Options can be exercised at any time prior to expiration. Note: The terms European and American describe to excise options, and not where they are traded.

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Call Options On 3/29/01 IBM closed at 96.18, a call option expiring in May with a strike of 115 traded at $1.40 premium on that same day. As IBMs price increases so does the premium on the option. Options purchased on organized exchanges can be sold for a profit. If the call buyer holds until the maturity date, she can elect to exercise the option or let it expire. That decision will depend on the selling price of IBM on the options maturity date.

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Call Option At maturity, the buyers payoff will equal: C T =Max(S T -X,0) Where: T = Option expiration date C T = Calls Value on the expiration date S T = Selling Price of the underlying stock on T X= Options Strike

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Call Option Profit ($) Stock Price 115 116.40 -1.40 S T -X Payoff ($) Stock Price 115 116.40 -1.40 S T -X At the Money Out-of-the Money In-the Money Profits / Payoff for the Call Buyer

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Call Option Profit ($) Stock Price 115116.40 1.40 X- S T Profits / Payoff for the Call Seller Payoff ($) Stock Price 115 -1.40 X-S T

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Put Options A put option grants the buyer the right to sell stock at the exercise price prior to maturity. On 3/29/01 IBM closed at 96.18, a put option expiring in May with a strike of 115 traded at $18.90 premium on that same day. Buying a put option will allow an investor to set the floor on a stocks selling price. If the put buyer holds until the maturity date, she can elect to exercise the option or let it expire. That decision will depend on the selling price of IBM on the options maturity date. However, when exercising her option the put buyer must deliver the shares to the put seller.

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Put Option At maturity, the buyers payoff will equal: P T =Max(X- S T,0) Where: T = Option expiration date P T = Puts Value on the expiration date S T = Selling Price of the underlying stock on T X= Options Strike

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Put Option Profits / Payoff for the Put Buyer Profit ($) Stock Price 115 -18.90 X- S T 96.10 $115-$18.90 = $96.10 Payoff ($) Stock Price 115 X- S T At the Money In-the Money Out-of-the Money 115

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Put Option Profits / Payoff for the Put Seller Payoff ($) Stock Price 115 -115 S T- X Profit ($) Stock Price 96.10115 18.90 S T -X -96.10

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Options Markets Chicago Board Options Exchange (CBOE) Contract maturities and strikes are determined by the exchange (for options traded on organized exchanges), not the individual buyers and sellers. Benefits of trading on the options market: – Protection against default risk – For CBOE, insured by Options Clearing Corp (OCC). – Liquidity

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© 2008 Pearson Education Canada13.1 Chapter 13 Hedging with Financial Derivatives.

© 2008 Pearson Education Canada13.1 Chapter 13 Hedging with Financial Derivatives.

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