 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-1 Options Markets: Introduction Chapter 20

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-2 Buy - Long Sell - Short Call Put Key Elements - Exercise or Strike Price - Premium or Price - Maturity or Expiration Option Terminology

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-3 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>exercise price Put: exercise price>market price At the Money - exercise price and asset price are equal Market and Exercise Price Relationships

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-4 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

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-5 Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options Different Types of Options

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-6 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 on Options at Expiration - Calls

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-7 Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff + Premium Payoffs and Profits on Options at Expiration - Calls

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-8 Payoff Profiles for Calls Payoff Stock Price 0 Call Writer Call Holder

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 20-9 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

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 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

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Payoff Profiles for Puts 0 Payoffs Stock Price Put Writer Put Holder

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill InvestmentStrategyInvestment Equity onlyBuy shares$10,000 Options onlyBuy options$10,000 LeveragedBuy options $1,000 equityBuy 2% $9,000 Yield Equity, Options & Leveraged Equity - Text Example

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill IBM Stock Price $95$105$115 All Stock$9,500$10,500$11,500 All Options$0 $5,000$15,000 Lev Equity $9,270 $9,770$10,770 Equity, Options & Leveraged Equity - Payoffs

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill IBM Stock Price $95$105$115 All Stock-5.0%5.0% 15% All Options-100% -50% 50% Lev Equity -7.3%-2.3% 7.7% Equity, Options & Leveraged Equity - Rates of Return

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Protective Put Use - limit loss Position - long the stock and long the put PayoffS T X Stock S T S T Put X - S T 0

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Protective Put Profit STST Profit -P Stock Protective Put Portfolio

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Covered Call Use - Some downside protection at the expense of giving up gain potential Position - Own the stock and write a call PayoffS T X Stock S T S T Call 0 - ( S T - X)

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Covered Call Profit STST Profit -P Stock Covered Call Portfolio

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 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

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill S T X Payoff for Call Owned 0S T - X Payoff for Put Written-( X -ST) 0 Total Payoff S T - X S T - X Put-Call Parity Relationship

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Long Call Short Put Payoff Stock Price Combined = Leveraged Equity Payoff of Long Call & Short Put

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 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 Arbitrage & Put Call Parity

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 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 Put Call Parity - Disequilibrium Example

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 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

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Optionlike Securities Callable Bonds Convertible Securities Warrants Collateralized Loans

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Exotic Options Asian Options Barrier Options Lookback Options Currency Translated Options Binary Options