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1 Chapter 15 Options Markets. 2 Option Terminology Buy - Long Sell - Short Call Option: gives its holder the right to purchase an asset for a specified.

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Presentation on theme: "1 Chapter 15 Options Markets. 2 Option Terminology Buy - Long Sell - Short Call Option: gives its holder the right to purchase an asset for a specified."— Presentation transcript:

1 1 Chapter 15 Options Markets

2 2 Option Terminology Buy - Long Sell - Short Call Option: gives its holder the right to purchase an asset for a specified price before or on a specified expiration date. Put Option: gives its holder the right to sell an asset at a specified price before or on a specified expiration date. Key Elements – Exercise or Strike Price – Premium or Price – Maturity or Expiration

3 3 Market and Exercise Price Relationships In the Money - exercise of the option would be profitable Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable Call: market price

4 4 American vs European Options American - the option can be exercised at any time before expiration or maturity European - the option can only be exercised on the expiration or maturity date

5 5 Different Types of Options Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options

6 6 Payoffs and Profits on Options at Expiration - Calls Notation Stock Price = S T Exercise Price = X Payoff to Call Holder ( S T - X) if S T >X 0if S T < X or Max {S T – X, 0} Profit to Call Holder Payoff - Purchase Price

7 7 Payoffs and Profits on Options at Expiration - Calls Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X or Min {X – S T, 0} Profit to Call Writer Payoff + Premium

8 8 Profit Stock Price 0 Call Writer Call Holder Profit Profiles for Calls

9 9 Payoffs and Profits at Expiration - Puts Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X or Max {X-S T, 0} Profit to Put Holder Payoff - Premium

10 10 Payoffs and Profits at Expiration - Puts Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X or Min {S T - X, 0} Profits to Put Writer Payoff + Premium

11 11 Profit Profiles for Puts 0 Profits Stock Price Put Writer Put Holder

12 12 Exercise in class 1. You purchase one IBM July 120 call contract for a premium of $5. You hold the option until the expiration date when IBM stock sells for $123 per share. You will realize a ______ on the investment. A)$200 profit B)$200 loss C)$300 profit D)$300 loss 2. You purchase one IBM July 120 put contract for a premium of $5. You hold the option until the expiration date when IBM stock sells for $123 per share. You will realize a ______ on the investment. A)$300 profit B)$200 loss C)$500 loss D)$200 profit

13 13 Exercise in class A call option on Brocklehurst Corp. has an exercise price of $30. The current stock price of Brocklehurst Corp. is $32. The call option is __________. A)at the money B)in the money C)out of the money D)none of the above

14 14 Equity, Options & Leveraged Equity - Text Example InvestmentStrategyInvestment Equity onlyBuy shares$8,000 Options onlyBuy options$8,000 LeveragedBuy options $1,000 equityBuy 2% $7,000 Yield

15 15 Equity, Options & Leveraged Equity - Payoffs Microsoft Stock Price $75$80$100 All Stock$7,500$8,000$10,000 All Options$0$0$16,000 Lev Equity $7,140$7,140 $9,140

16 16 Equity, Options & Leveraged Equity - Rates of Return Microsoft Stock Price $75 $80$100 $75 $80$100 All Stock-6.25% 0% 25% All Options-100% -100%100% Lev Equity % %14.25%

17 17 Put-Call Parity Relationship S T X Payoff for Call Owned 0S T - X Payoff for Put Written-( X -S T ) 0 Total Payoff S T - X S T - X

18 18 Payoff of Long Call & Short Put Long Call Short Put Payoff Stock Price Combined = Leveraged Equity

19 19 Arbitrage & Put Call Parity Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. C - P = S 0 - X / (1 + r f ) T If the prices are not equal arbitrage will be possible

20 20 Put Call Parity - Disequilibrium Example Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% Maturity =.5 yr X = 105 C - P > S 0 - X / (1 + r f ) T > (105/1.05) 12 > 10 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative

21 21 Put-Call Parity Arbitrage ImmediateCashflow in Six Months PositionCashflowS T 105 Buy Stock-110 S T S T Borrow X/(1+r) T = Sell Call+17 0-(S T -105) Buy Put S T 0 Total 2 0 0

22 22 Option Strategies Protective Put Long Stock Long Put Covered Call Long Stock Short Call Straddle (Same Exercise Price) Long Call Long Put

23 23 Exercise in class 1 You buy one Chrysler August 50 call contract and one Chrysler August 50 put contract. The call premium is $4.25 and the put premium is $5.00. Your highest potential loss from this position is __________. A)$75 B)$925 C)$5,000 D)unlimited 2 An investor purchases a long call at a price of $2.50. The expiration price is $ If the current stock price is $35.10, what is the break even point for the investor? A)$32.50 B)$35.00 C)$37.50 D)$37.60

24 24 Option Strategies Spreads - A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration Vertical or money spread Same maturity Different exercise price Horizontal or time spread Different maturity dates

25 25 Exercise in class You buy one Chrysler August 50 call contract and one Chrysler August 50 put contract. The call premium is $4.25 and the put premium is $4.50. Your strategy is useful if you believe that the stock price __________. A)will be lower than $41.25 in August B)will be between $41.25 and $58.75 in August C)will be higher than $58.75 in August D)either a or c


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