Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Basics of Financial Options Lecture No. 42 Chapter 13 Contemporary Engineering Economics Copyright © 2016

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Chapter Opening Story Travel is adventure. Prepare for the unexpected. o Have you ever considered about buying a trip insurance? o You want to minimize the downside risk in case of cancelation or change in your travel plan. o Can we think something like this in protecting your investment in business?

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Financial Option Theory Call option: A right (not obligation) to purchase a stock at a predetermined price (exercise/strike price) before or on the date specified (maturity date) Put option: A right (not obligation) to sell a stock at a predetermined price before or on the date specified Main issues o What is the value of this option? o How do you price this option?

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved The Language of Options CallPut Buy The right to buy the underlying item at the strike price until the expiration date The right to sell the underlying item at the strike price until the expiration date Sell Selling the right to buy the underlying item from you at the strike price until the expiration date; known as writing a call Selling the right to sell the underlying item to you until the expiration date; known as writing a put

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Process of Buying and Selling a Financial Option

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Option Notation The following notation will be used throughout the remainder of this text: o S 0 = Underlying asset price today o S T = Underlying asset price at expiration o K = Exercise price o T = Time to expiration o r = Risk-free rate o q = Continuous dividend yield

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Financial Options Terminologies The Contracting Parties o Option seller o Taking a short position o Option buyer o Taking a long position The Right or Obligation o Option buyer o Right to purchase o Option seller o Obligation to sell Option Premium o Underlying asset (S) o Strike or exercise price (K) o Maturity (T) o Option premium (C) o Intrinsic value o Time value

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Financial Option Terminologies (continued) Types of financial option o American option o An option that can be exercised earlier than its maturity date o European option o An option that can be exercised only at the maturity date Payoff (S = stock price, C = option premium) o At the money, if S−C = K o In the money, if S−C > K o Out of money, if S−C < K

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Option Positions

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 13.1: Profit from Call Option  Given: o Buying 100 shares (one contract) o K = $625 o T = January 22,2016 o S = $ (September 11, 2014) o C = $45.60 o The initial investment = 100 × ($45.60) = $4,560  Find: Profit from exercising the European call option when the stock price is $700 at maturity

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 13.2: Profit from Put Option  Given: o Buying 100 shares (one contract) o K = $580 o T = January 22,2016 o S = $ (September 11, 2014) o C = $58.30 o The initial investment = 100 × ($58.30) = $5,830  Find: Profit from exercising the European put option when the stock price is $500 at maturity

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Buy Option Strategies: Three Ways to Buy Call Options Investor buys for Call Options (1,000 shares) on Stock Z Price: $55 Strike price: $60 Premium: $750 (a) Hold to Maturity and trade at strike price If stock rises to 65$5,000 − $750 = $4,250 If stock rises to 60$0 − $750 = $750 loss (b) Trade for profit before option expires If stock rises to 62$2,000 − $750 =$1,250 If stock rises to 60 1/2 $500 − $750 = $250 loss (c) Let the option expire If stock drops to 55$750 loss

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Sell Option Strategies: Two Ways to Sell Call Options (Writing Call Options) Investor owns 1,000 shares of Stock Z Price: $55/share Investor owns no share of Stock Z Write 10 covered calls Strike price: $60 Collect premium $750 (a) If stock rises to $57 No takes; option expires Keep the premium ($750 profit) (b) If stock rises to $60 Buy 10 calls to cancel obligations and prevent losing stocks. $750 (premium collected) − $750 (premium on offsetting calls) = Breakeven Write 10 naked calls Strike price: $60 Collect premium $750 (a) If stock rises to $57 No takes; option expires Keep the premium ($750 profit) (b) If stock rises to $65 Option is exercised. You must buy 1,000 shares to sell to meet call. $750 premium − $65,000 to buy + $60,000 = $4,250 net loss (You need to line up $64,250.)

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 13.3: Limiting Downside Risk  Given: o Option 1: Purchase 500 shares of GILD stock at $106 o Option 2: Purchase 5 GILD five-month $110 calls at $8 o Three possible scenarios for stock price at expiration o $118 < S T o $100 < S T < $118 o $100 > S T  Find: Profit or loss from three possible scenarios

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 13.4: How to Use a Protective Put as Insurance  Given: o Option 1: Buy QCOM at $76, without owning a put for protection. o Option 2: Buy QCOM at $76 and buy a QCOM six-month $75-put contract at $4.40.  Find: Compare two options for risk exposure.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution o Upside potential unlimited o Downside risk only $5.40

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How Option Premium Fluctuates o The greater the difference between the exercise price and the actual current price (exercise price > actual current price) of the item, the cheaper the premium, because there is less chance the option will be exercised. o The closer the expiration date of an out-of-the money option (where the market price is higher than the strike price), the cheaper the price is.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Duration of Exercise Date o The more time there is until expiration, the larger the premium, because the chance of reaching the strike price is greater and the carrying costs are more. o Call and put options move in opposition. Call options rise in value as the underlying market prices go up. Put options rise in value as market prices go down.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Option Premium = Option Price Option Premium = Intrinsic Value + Time Value What the position would be worth if exercised now Market’s assessment of future underlying value