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CHAPTER 20 Options Markets: Introduction. Buy - Long Sell - Short Call Put Key Elements – Exercise or Strike Price – Premium or Price – Maturity or Expiration.

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Presentation on theme: "CHAPTER 20 Options Markets: Introduction. Buy - Long Sell - Short Call Put Key Elements – Exercise or Strike Price – Premium or Price – Maturity or Expiration."— Presentation transcript:

1 CHAPTER 20 Options Markets: Introduction

2 Buy - Long Sell - Short Call Put Key Elements – Exercise or Strike Price – Premium or Price – Maturity or Expiration Option Terminology

3 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 Figure 20.1 Stock Options on IBM

5 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 American vs. European Options

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

7 Notation Stock Price = S T Exercise Price = X Payoff to Call Holder (S T - X) if S T >X 0if S T < X Profit to Call Holder Payoff - Purchase Price Payoffs and Profits at Expiration - Calls

8 Payoff to Call Writer - (S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff + Premium Payoffs and Profits at Expiration - Calls

9 Figure 20.2 Payoff and Profit to Call Option at Expiration

10 Figure 20.3 Payoff and Profit to Call Writers at Expiration

11 Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X Profit to Put Holder Payoff - Premium Payoffs and Profits at Expiration - Puts

12 Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X Profits to Put Writer Payoff + Premium Payoffs and Profits at Expiration – Puts Continued

13 Figure 20.4 Payoff and Profit to Put Option at Expiration

14 InvestmentStrategyInvestment Equity onlyBuy shares$10,000 Options onlyBuy options$10,000 Calls plus billsBuy options $1,000 Buy 3% $9,000 Yield Equity, Options, & Bills

15 IBM Stock Price $95$105$115 All Stock$9,500$10,500$11,500 All Options$0 $5,000$15,000 Calls plus bills $9,270 $9,770$10,770 Payoffs

16 IBM Stock Price $95$105$115 All Stock-5.0%5.0% 15% All Options-100% -50% 50% Calls plus bills -7.3%-2.3% 7.7% Rates of Return

17 Figure 20.5 Rate of Return to Three Strategies

18 Table 20.1 Value of Protective Put Portfolio at Option Expiration

19 Figure 20.6 Value of a Protective Put Position at Option Expiration

20 Figure 20.7 Protective Put versus Stock Investment (at-the-money option)

21 Table 20.2 Value of a Covered Call Position at Expiration

22 Figure 20.8 Value of a Covered Call Position at Expiration

23 Straddle (Same Exercise Price) Long Call and Long Put 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 Option Strategies

24 Table 20.3 Value of a Straddle Position at Option Expiration

25 Figure 20.9 Value of a Straddle at Expiration

26 Table 20.4 Value of a Bullish Spread Position at Expiration

27 Figure Value of a Bullish Spread Position at Expiration

28 Buy one call and write one put Payoff S T X Call owned0S T – X Put written-(X – S T ) 0 Total payoff S T – X S T – X Since the payoff on (call + put) options is equal to leveraged equity, their prices must be equal: C – P = S 0 – X/(1 + r f ) T Put Call Parity Derivation

29 If the prices are not equal arbitrage will be possible or C – P = S 0 – X/(1 + r f ) T Put Call Parity

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

31 Table 20.5 Arbitrage Strategy

32 Optionlike Securities Callable Bonds Convertible Securities Warrants Collateralized Loans

33 Figure Values of Callable Bonds Compared with Straight Bonds

34 Figure Value of a Convertible Bond as a Function of Stock Price

35 Exotic Options Asian Options C = Max[mean S – X, 0] Look-back Options C = Max [S max – X, 0] Digital Options C = $100 if S T > X 0 if S T < X

36 Barrier Options Down-and-Out Barrier Options C = Max[S T – X, 0] if S t > B 0 if S t < B Down-and-In Barrier Options C = Max[S T – X, 0] if S t < B 0 if S t > B


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