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**FINC3240 International Finance**

Chapter 5 Currency Options

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What is an option? A derivative security that gives the holder (buyer) the right to buy or sell an underlying asset at a specified price (“exercise price”) on or before the option expiration date.

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**Two types of options: Call vs. Put options**

Call option Gives holder the right to buy an asset at a specified exercise price on or before a specified expiration date. Put option Gives holder the right to sell an asset at a specified exercise price on or before a specified expiration date. There are two main types of options: call and put options

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**Exercise price Exercise price**

For a call option, it is the price set for buying the underlying asset. For a put option it is the price set for selling the underlying asset. Exercise price is also called the strike price.

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Option premium Options are financial assets. If you want an option, you have to buy it from an option seller (counterparty). The purchase price or cost of an option is the option premium. The option seller earns the option premium. The option premium is an immediate expense for the buyer and an immediate return for the seller, whether or not the holder (buyer) ever exercises the option.

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Examples At March 1, XYZ stock’s spot price = $95. A trader buys a call option on XYZ at strike (exercise) price = $100/share. The right lasts until August 15, and the price (option premium) of this call option is $2.5/share. At March 1, ABC stock’s spot price = $100. A trader buys a put option to on ABC at strike (exercise) price = $105/share. The right lasts until August 15, and the price (option premium) of this put option is $8.2/share.

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**The long and short If you buy an option, then you are**

“long the option” or “long option” or you have a “long position”. If you sell an option, then you are “short the option” or “short option” or you have a “short position”. Example: if you buy a call option, you are “long call”.

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Options Features There are always two positions in each option contract: Long for the buyer vs. Short for the seller (1) Buying a Call → Long a Call (2) Selling a Call → Short a Call (3) Buying a Put → Long a Put (4) Selling a Put → Short a Put

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**Positions Buyer (Long) Seller (Short) Call**

- Right to buy the underlying (i.e. to exercise the option) - Pays the premium - Obligation to sell the underlying, if buyer exercises the option - Receives the premium Put - Right to sell the underlying (i.e. to exercise the option) - Obligation to buy the underlying, if buyer exercises the option

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Options trading (1) Option contracts are traded in two types of markets: Over-the-counter (OTC) markets Exchanges, such as: Chicago Board Options Exchange (CBOE) Chicago Mercantile Exchange (CME) International Securities Exchange Option Clearing Corporation (OCC) Options contracts traded on exchanges are standardized by allowable maturity dates and exercise prices for each listed option. Each stock option contract provides the right to buy or sell 100 shares of stock (except when stock splits occur after the contract is listed and the contract is adjusted for the terms of the split). Option Clearing Corporation (OCC), the clearinghouse for options trading, is jointly owned by the exchanges on which stock options are traded. The OCC places itself between options traders, becoming the effective buyer of the option from the writer and the effective writer of the option to the buyer. All individuals, therefore, deal only with the OCC, which effectively guarantees contract performance. When an option holder exercises an option, the OCC arranges for a member firm with clients who have written that option to make good on the option obligation. The member firm selects from among its clients who have written that option to fulfill the contract. The selected client must deliver 100 shares of stock at a price equal to the exercise price for each call option contract written or must purchase 100 shares at the exercise price for each put option contract written. Because the OCC guarantees contract performance, option writers are required to post margin to guarantee that they can fulfill their contract obligations. The margin required is determined in part by (i) the amount by which the option is in the money, and (ii) whether the underlying asset is held in portfolio.

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Options trading (2) OTC Option contract can be customized to needs of trader. Difficult to trade. Secondary market illiquid. Exchanges Option contracts are standardized by maturity dates and exercise price. Easy to trade. Secondary market is liquid. If you need a customized option and don’t anticipate trading it, then OTC is suitable. If you desire the ability to trade quickly and cheaply and you don’t need customization then Exchanges are suitable. The OTC market offers the advantage that the terms of the option contract – the exercise price, maturity date, and number of shares committed – can be tailored to the needs of the traders. The costs of establishing an OTC option contract, however, are relative high. Options contracts traded on exchanges are standardized by allowable maturity dates and exercise prices for each listed option. Standardization of the terms of listed option contracts means all market participants trade in a limited and uniform set of securities. This increases the depth of trading in any particular option, which lowers trading costs and results in a more competitive market. Exchanges offer two benefits: ease of trading, which flows from a central marketplace where buyers and sellers or their representative congregate, and a liquid secondary market where buyers and sellers of options can transact quickly and cheaply.

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**Options on IBM June 7, 2004 Source: Wall Street Journal Online Edition, June 8, 2004.**

This figure shows both call and put options listed for each exercise price and expiration date. The three sets of columns for each option report closing price, trading volume in contracts (1 contract = 100 shares of stock), and open interest (number of outstanding contracts).

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**Underlying asset Individual stocks Stock market indexes Futures**

S&P 100, S&P 500, DJIA, Nikkei 225, FTSE 100 etc. Futures Foreign currency Treasury bonds, Treasury notes And many others. Index options: An index option is a call or put based on a stock market index such as the S&P500 or the NYSE index. Index options are traded on several broad-based indexes as well as on several industry-specific indexes. Futures options: give holders the right to buy or sell a specified futures contract, using as a futures price the exercise price of the option. The terms of futures options contracts are designed in effect to allow the option to be written on the futures price itself. Foreign currency options: a currency option offers the right to buy or sell a quantity of foreign currency for a specified amount of domestic currency. Currency option contracts call for purchase or sale of the currency in exchange for a specified number of U.S. dollars. Contracts are quoted in cents or fractions of a cent per unit of foreign currency. Interest rate options: options on treasury notes, bonds, bills, CDs, GNMA pass-through certificates. Options on several interest rate futures also are traded.

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Option exercise (1) To “exercise a call option” means the buyer uses the option to buy the underlying asset at the exercise price. To “exercise a put option” means the buyer uses the option to sell the underlying asset at the exercise price. This is not about physical education.

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**Option exercise (2) Question: When do you exercise an option?**

Answer: Simple. Only when it’s optimal to do so. That is, when you are better off exercising the option. Question: What if exercising the option does not make me better off? Answer: Simple. Don’t exercise. After all, it’s just an option. Tell student that I will explain what “better off” means later. Roughly speaking, “better off” means that you are able to buy low and sell high, i.e., your buying/purchase price is lower than your selling price. Just remember the rule, “buy low, sell high”.

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**American vs. European options**

American option: Holder has the right to exercise the option on or before the expiration date. European option: Holder has the right to exercise the option only on the expiration date.

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**Payoffs of a Call Option**

Long Call at $20 Short Call at $20

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**Profit/Loss of a Call Option**

Long Call at $20 Short Call at $20

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**Profit/Loss of Long and Short on Call Option**

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Payoffs of a Put Option Long Put at $20 Short Put at $20

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**Profit/Loss of a Put Option**

Long Put at $20 Short Put at $20

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**Profit/Loss of Long and Short on Put Option**

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**Call Option’s Payoff/Profit at Expiration**

Payoff for a Long Call: Profit for a Long Call: payoff – option premium Payoff for a Short Call: Profit for a Short Call: option premium + payoff

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**Put Option’s Payoff/Profit at Expiration**

Payoff for a Long Put: Profit for a Long Put: payoff – option premium Payoff for a Short Put: Profit for a Short Put: option premium + payoff

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Example A trader short a Call at X=20 with a premium of $5. At maturity, the stock price is 30. What is the profit/loss to this trader? Profit/Loss = 5 + [-(30-20)] = = -5 A trader long a Put at X=30 with a premium of $5. At maturity, the stock price is 15. What is the profit/loss to this trader? Profit/Loss = (30-15) - 5 = = 10

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**Call option: Payoff & Profit at expiration**

Consider a call option on a share of IBM stock with an exercise price of $80 per share. Suppose this call option expires on July 16, 2004 and today is the expiration date. The current call option premium is $5. Are you better off exercising the option? What is the payoff from the option exercise? What is the profit from the option exercise? What is the breakeven point for this call option (that is, the stock price at which profit is zero)? Answer these questions if IBM’s stock price is (a) 95 (b) 76 (c) 81. We look at payoff (value) and profit at expiration.

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**Payoff & profit diagram of call option holder at expiration**

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**Payoff & profit diagram of call option writer at expiration**

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Call Review Which of the following statements about the value (i.e., payoff) of a call option at expiration is false? A short position in a call option will result in a loss if the stock price exceeds the exercise price. The value of a long position equals zero or the stock price minus the exercise price, whichever is higher. The value of a long position equals zero or the exercise price minus the stock price, whichever is higher. A short position in a call option has a zero value for all stock prices equal to or less than the exercise price. Bkm chp 14 q1 Answer: C. This statement describes the payoff of the long put option, not the long call option.

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**Put option: Payoff & Profit at expiration (1)**

Consider a put option on a share of IBM stock with an exercise price of $80 per share. Suppose this put option expires on July 16, 2004 and today is the expiration date. The current put option premium is $3. Are you better off exercising the option? What is the payoff from the option exercise? What is the profit from the option exercise? What is the breakeven point for this put option? Answer these questions if IBM’s stock price is (a) 73, (b) 78 and (c) 81.

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**Payoff & profit diagram of put option holder at expiration**

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**Payoff & profit diagram of put option writer at expiration**

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Put Review Consider a put option written on ABC Inc.’s stock. The put option’s exercise price is $80. Which of the following statements about the value (payoff) of the put option at expiration is true? The value of the short position in the put is $4 if the stock price is $76. The value of the long position in the put is -$4 if the stock price is $76. The long put has value when the stock price is below the $80 exercise price. The value of the short position in the put is zero for stock prices equaling or exceeding $76. BKM Chp 14 q2 Answer: C, just by applying the formula for payoff. A is wrong because the short position’s value is -$4 since the put will be exercised. Thus the writer will buy (take delivery) at $80 and sell at $76. Value = 76 – 80 = -4. B is wrong because the long position’s value is $4 since the put will be exercised. Thus the put holder will exercise the option, buy the stock at $76 and simultaneously deliver (sell) the stock at $80 to the put writer. The payoff = 80 – 76 = 4. D is wrong because the payoff of the short position is negative between $76 and $80 and only equal zero for $80 or more.

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Practice Questions To be assigned on the course website

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**Moneyness (1) An option (call or put) is:**

In the money (ITM) if exercising it produces a positive payoff to the holder At the money (ATM) if the asset price and exercise price are equal. Out of the money (OTM) if exercising it produces a negative payoff to the holder. We can describe an option in terms of its moneyness.

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**Moneyness (2) ST < X ST = X ST > X Call options Out of the money**

At the money In the money Put options

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**Moneyness questions (1)**

Consider two call options written on ABC Inc.’s stock. The first call, C1, has an exercise price of $50. The second call, C2, has an exercise price of $70. Both calls have the same expiration date. Today is the expiration date. C1 is in the money while C2 is out of the money. Which of the following is true about ST, the stock price on the expiration date? ST > $50 ST > $70 $70 > ST > $50 ST < $50 Use the information about moneyness to find the statement which best fits the moneyness of the two options. Within this range, C1 has a positive payoff (sell at more than $50, but buy at $50) while C2 has a negative payoff (sell at less than $70 and buy at $70). Thus C1 is ITM and C2 is OTM. E.g., suppose ST = 60. C1’s payoff = 60 – 50 = 10 > 0 so ITM. C2’s payoff = 60 – 70 = -10 < 0 so OTM. Answer: C. This explains why C1 is ITM and C2 is OTM. is wrong because it does not explain while C2 is OTM. is wrong because C2 is OTM so stock price cannot be greater than $70. D) Is wrong because C1 is ITM, so stock price must exceed $50.

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**Moneyness questions (2)**

Consider two put options written on XYZ Inc.’s stock. The first put, P1, has an exercise price of $20. The second put, P2, has an exercise price of $35. Both puts have the same expiration date. Today is the expiration date. P1 is out of the money while P2 is in the money. Which of the following is true about ST, the stock price on the expiration date? ST < $20 ST < $35 $20 < ST < $35 ST > $35 Use the information about moneyness to find the statement which best fits the moneyness of the two options. Answer: C. Within this range, P1 has a negative payoff (sell at $20, but at more than $20) while P2 has a positive payoff (sell at $35 and but at less than $35). Thus P1 is OTM and P2 is ITM. E.g., suppose ST = 25. P1’s payoff = = -5 < 0 so OTM. P2’s payoff = 35 – 25 = 10 > 0 so ITM. Is wrong because P1 is OTM. Is wrong because it does not explain why P1 is OTM. So it’s not complete. d) Is wrong because P2 is ITM, so ST must be less than $35.

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**How to close a position? 1. reverse trading before expiration**

2. execute the option 3. wait for expiration

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**Protective Put Strategy**

Portfolio consisting of a put option and the underlying asset. Guarantees that minimum portfolio value (payoff) is equal to the put’s exercise price. Rationale: you want to maintain the value of the portfolio at a certain minimum level. The payoff shows that whatever happens to the stock price, you are guaranteed a minimum value equal to the put option’s exercise price because the put gives you the right to sell the share for the exercise price even if the stock price is below that value.

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**Protective put: Payoff & profit at expiration**

S0 = initial asset price, and P = put option premium. Cost of the position = asset price + put premium = S0 + P ST ≤ X ST > X Payoff of stock ST Payoff of put X – ST Total payoff X Profit X – (S0+P) ST – (S0 + P) Explain how you derive the payoffs and profits.

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**Payoff & profit of protective put position at expiration**

The figure illustrates the payoff and profit to the protective put strategy. The solid line is the part C is the total payoff. The dashed line is displaced downward by the cost of establishing the position, S0 + P. notice that the potential losses are limited. Profit = payoff – cost of position = Payoff - (S0 + P) Notice that loss is limited to X – (S0 + P).

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Currency Options A contract that is associated with a right to buy or sell a currency until after a specific date with a predetermined price (strike price) and amount. There are Call options and Put options. The buyer of a Call option has the right, not the obligation, to buy a currency. The buyer of a Put option has the right, not the obligation, to sell a currency. 43

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**Contingency (payoff) Graphs for Currency Options**

1. Contingency Graph for a Buyer of a Call Option 2. Contingency Graph for a Seller of a Call Option 3. Contingency Graph for a Buyer of a Put Option 4. Contingency Graph for a Seller of a Put Option

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**Contingency Graphs for Currency Options**

Insert exhibit 5.6 page 123

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**Currency Call Options Premium**

Factors Affecting Currency Call Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency

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**Currency Put Options Premium**

Factors Affecting Currency Put Option Premiums a. Level of existing spot price relative to strike price b. Length of time before the expiration date c. Potential variability of currency

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**Call Options Application**

Hedge payables (Example on page 135) Pike Co. orders Australian goods and makes a payment in Australian dollars (A$) upon delivery. This company can buy an A$ call option that locks in a maximum rate. If at the maturity date the A$’s value remains below the strike price, Pike can purchase A$ at the prevailing spot rate and simply let its call option expire. If the A$’s value rises above the strike price, Pike will execute the option and buy A$ at the strike price.

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**Call Options Application**

A payment in A$1,000,000 will be delivered (paid out) at the end of June. On March 1, an option on A$100,000 that expires on June 28 has a strike price of $ Pike Co. buys 10 A$ Call options on March 1 and pay premium of $ On June 28, If the spot rate is $0.9050, Pike purchases A$ at the prevailing spot rate, and simply let its call options expire. If the spot rate is A$1.050, Pike executes the options and buy A$ at the strike price, $

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**Put Options Application Hedge receivables**

ABC Co. will receive payment in C$2,000,000 at the end of September. On March 1, an option on C$10,000 that expires on September 28 has a strike price of $ ABC Co. buy 200 C$ Put options on March 1 and pay $ premium. On September 28, If the spot rate is $0.9400, ABC executes the options and sell C$ at the strike price, $ If the spot rate is $0.9600/$, ABC sells C$ at the prevailing spot rate, $0.9600, and simply let its put options expire.

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**Speculation with Call Options (1) example on page 137, Mr. Jim**

Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. Jim buys one Call option on June, 1 with premium of $0.0120/BP Just before expiration, spot rate=$1.4100/BP. Q1: Will the investor exercise the Call option? Yes. He exercises the Call option and then sell pounds with spot rate of $1.4100/BP. Q2: What is his profit/loss? ( )/BP more details in the textbook

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**Speculation with Call Options (2) Q&A 19**

Call option premium=$0.03/C$ Strike price=$0.75/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.

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**Speculation with Put Options (1) example on page 140**

Strike price=$1.4000/BP Settlement date=December, 31 Contract amount=31,250 BP No brokerage fees. One investor buy one Put option on June, 1 with premium of $0.0400/BP. Spot rate on June,1 =$1.3900 Just before expiration, spot rate=$1.3000/BP. Q1: Will the investor exercise the Put option? Yes. He will buy pounds from spot market at $1.3000/BP and then execute the put option. Q2: What is his profit/loss? ( )/BP more details in the textbook

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**Speculation with Put Options (2) Q&A 20**

Put option premium=$0.02/C$ Strike price=$0.86/C$ Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date.

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Problems An investor traded two options on euro. The first call option has an exercise price of $ The second put option has an exercise price of $ Both options have the same expiration date. Today is the expiration date. At what price will the investor receive positive payoff from his portfolio? Use the information about moneyness to find the statement which best fits the moneyness of the two options. Answer: C. Within this range, P1 has a negative payoff (sell at $20, but at more than $20) while P2 has a positive payoff (sell at $35 and but at less than $35). Thus P1 is OTM and P2 is ITM. E.g., suppose ST = 25. P1’s payoff = = -5 < 0 so OTM. P2’s payoff = 35 – 25 = 10 > 0 so ITM. Is wrong because P1 is OTM. Is wrong because it does not explain why P1 is OTM. So it’s not complete. d) Is wrong because P2 is ITM, so ST must be less than $35.

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**Protective put 1 S0 = initial currency price P = put option premium**

Cost of the position = currency price + put premium = S0 + P ST ≤ X ST > X Payoff of currency ST Payoff of put X – ST Total payoff X Explain how you derive the payoffs and profits.

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Protective put 2 You currently manages 1 million euro cash. Today’s spot rate is $1.100/euro. You expect that in the coming year euro will depreciate against US $. You buy a 12-month euro put option with a strike of $1.000 and a premium of $0.0300/euro. After 3 months, the prevailing spot rate is $0.9500/euro. (1)How much is the payoff (value) of your portfolio? (2)If the prevailing spot rate is $0.8000/euro, how much is the payoff of your portfolio? (3) what about $1.3000?

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Homework 6 Chapter 5 Q&A: 6,7,10,11,12,13,21,22.

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Options Markets: Introduction

Options Markets: Introduction

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