CHAPTER 14 Options Markets

Chapter Objectives n Explain how stock options are used to speculate n Explain why stock option premiums vary n Explain how options are used by financial institutions to hedge their security portfolios

Stock Options n An option contract grants the buyer, who has paid a premium to the seller (writer), the right to buy or sell the underlying asset at a stated price within a specific period of time n The premium paid to the writer is the cost of the option n Buyer has the “option,” but not the obligation, to exercise the option

Background on Options n A call option buyer has right but not the obligation to buy the underlying asset at a set exercise or “strike” price for a specified period of time n A put option buyer has the right but not the obligation to sell the underlying asset at a set “strike” price for a specified period of time n Note components of an option: specific quantity of asset, price, and time period

Background on Options n Premium is the price the buyer of the put or call pays to buy an option contract n Seller or writer of the option contract l Receives the premium up front l Has an ongoing obligation to sell (call) or buy (put) if the buyer decides to exercise the option contract n Current market price of the underlying asset or financial instrument is called the spot price

Background on Options n Call options l “In-the-money” means the call option’s strike or exercise price is lower than the market price for the underlying financial instrument u The holder of the call can buy the stock at a price below the current market price u The call premium (price) of the option would also be higher by the “in-the-money” l At-the-money means the strike price equals the market price of the underlying asset

Background on Options n Put option l In-the-money means the put option’s strike or exercise price is higher than the market price for the underlying financial instrument l Put options give the investor an opportunity to make money from falling prices l Investor has locked in a sale price, making the price of the option (premium) higher as the stock price decreases l At-the-money means the strike price equals the market price of the underlying asset

Background on Options n Expiration is the date when the contract matures n American-style options contracts can be exercised any time up until they expire n European-style options can only be exercised just before their expiration n Option contracts guaranteed by a clearinghouse to make sure sellers or writers fulfill their obligations n Stock options specify 100 shares of stock

Stock Option Quotations n Options quotations available in the financial press and on the Internet l Typically more than one option contract for a company’s stock l Many contracts trade for the same stock but with different strike prices and expiration dates l Quotes indicate the volume, premium, strike price and maturity

Exhibit 14.1 McDonald’s Stock Option Quotations StrikeExp.Vol.CallVol.Put McDonald’s45Jun1804½602¾ 45Oct705¾1203¾ 50Jun36011/811/8 4051/851/8 50Oct903½406½

Speculating with Call Options n BUY A CALL: Speculator thinks a stock price will appreciate above a particular strike price n Buyer of call pays premium for the right but not the obligation to buy stock at the strike price n If the stock price appreciates above the strike price the option contract is in-the-money and buyer of the call would exercise or sell the option at a price including the “in-the-money” and a premium n If the stock price does not appreciate, buyer of the call does not exercise and losses are limited to the cost of the premium—buyer able to share in appreciation without large investment

Speculating with Call Options n If stock price rises above call’s strike price, buyer exercises and purchases shares at a price below their current market price n Breakeven occurs once stock price is high enough above strike to cover premium’s cost n Net gain or loss equals + Price received for selling stock (spot price) - Amount paid for the shares (call’s strike) - Amount of the premium

+ 0 - Breakeven = Strike + Premium Speculating with Call Options Call Buyer Strike PriceCall Writer

Speculating with Put Options n BUY A PUT: Speculator thinks a stock price will depreciate below a particular strike price n Buyer of put pays premium for the right but not the obligation to sell stock at the strike price n If the stock price depreciates below the strike price the option contract is in-the-money and buyer of the put would exercise n If the stock price does not depreciate, buyer of the put does not exercise and losses are limited to the cost of the premium

Speculating with Put Options n If stock price falls below strike, buyer of a put exercises and sells shares at a price above their current market price n Breakeven occurs once stock price is low enough below strike to cover premium’s cost n Net gain or loss equals +Price received for selling stock (strike price) - Amount paid for the shares (spot market) - Amount of the premium

+ 0 - Put Buyer Put Seller Breakeven = Strike - Premium Strike Price or At-The-Money Speculating with Put Options

Determinants of Call Option Premiums Market Price of the Underlying Asset Time to Maturity of the Option Contract Volatility of the Underlying Asset Value of Call Option Premium

Determinants of Call Option Premiums n The greater the current market price of the underlying asset compared to the exercise price, the higher the premium for a call option l As the market price of the underlying asset approaches or moves above the strike price, there is increased chance of continued price appreciation and increased gain from the option l Purchaser is willing to pay more for the option l “Under Water” option has less chance of being “in-the-money” and the premium is less

Determinants of Call Option Premiums n Greater volatility of the underlying financial asset means higher call option premiums l Volatile price means a higher chance price will go well above strike l That chance makes buyers willing to pay more n For a call, the longer the time to maturity, the higher the premium l Owner will have increased chance for the option to be “in-the-money” with more time available

Determinants of Put Option Premiums n The lower the current market price of the underlying asset compared to the exercise price, the higher the premium for a put option l Better chance of price depreciation well below strike price if the price of the underlying asset is already close to or below the exercise price l Stock price appreciation reduces premium as chance of “in-the-money” decreases n Volatility and maturity issues the same as for call options

Explaining Changes in Option Premiums n Indicators monitored by participants in the options market l Premiums influenced by price movements of the underlying stocks l Monitor economic indicators, industry-specific, and firm-specific conditions l Speculative options positions limit the downside risk (the cost of the premium) so options owners may view some indicators differently

Exhibit Stock Option Premium Changes Over Time International Economic Conditions U.S. Fiscal Policy U.S. Monetary Policy U.S. Economic Conditions U.S. Risk-Free Interest Rate Stock Market Conditions Market Risk Premium Required Return on the Stock Issuer’s Risk Premium Expected Cash Flows Generated by the Firm for Investors Issuer’s Industry Conditions Expected Volatility of Stock Prices over the Period Prior to Option Expiration Price of Firm’s Stock Option’s Exercise Price Stock Price Relative to Option’s Exercise Price Option’s Time until Expiration Stock Option’s Premium

Hedging with Stock Options n Investor hedge against possible adverse stock price movements n Downside price insurance for stock investor l Investor can sell/write a call or buy a put if concerned about a temporary decline in a stock price l Writer/seller gains premium income from “covered” option to offset possible stock losses in exchange for giving up possible upside profit l Buying a put trades premium for downside floor on stock portfolio

Using Options to Measure a Stock’s Risk n Standard deviation is used to measure risk for a stock n Stock option premiums commonly are used to derive the market’s anticipation of a stock’s standard deviation over the life of the option n Anticipated volatility of a stock is not observable but the stock option formula can be used to derive an estimate

Stock Index Options n Right to trade a specified stock index at a specified price by a specified expiration date n Options on several indexes l S&P 100 l Major Market Index l Value Line l National OTC index l NYSE composite

Stock Index Options n Hedging with stock index options l Pension funds and financial institutions that own large portfolios of stocks l Buy stock index puts to lock in gain or hedge downturns in the market l Select index option that matches portfolio n Hedging with long-term stock index futures l LEAPs or long-term equity anticipations l Expiration dates at least two years into the future, longer than normal options

Stock Index Options n Dynamic asset allocation with stock index options n As expectations change, switch between risky and low-risk investment positions l Anticipating stock price increases, portfolio managers purchase calls and increase their risk exposure l Hedge if unfavorable conditions expected l Sell calls to insure against market declines

Stock Index Options n Using index options to measure the market’s risk n Stock index’s implied volatility can be derived from options n Over time standard deviation sometimes abruptly changes l Review of historical events explain changes l Gulf War, stock market crashes, and global economic and financial crisis

Options on Futures Contracts n Options on futures allow the right but not the obligation to purchase or sell a particular futures contract for a specified price and for a specified period of time n Types of options on futures that are available l Stock index futures l Interest rate futures n Used for speculation and one-way hedging

Options on Futures Contracts n Speculating with options on futures if an interest rate decline is anticipated n Purchase a call option on Treasury bond futures n If expectations are correct, T-bond prices and futures contract increase as interest rate levels decrease n Exercise the option to purchase futures at the strike price which is lower than the value of the futures contract n Selling futures offsets futures position at a profit

Options on Futures Contracts n Speculating with options on futures n Advantages of using options on futures l Expectations are not always correct l If rates actually rise, speculator loses if in futures contracts, but just the premium if in options l Loss is reduced using the options on futures strategy as compared to a futures only speculative position l If rates rise, do not exercise option on futures

Options on Futures Contracts n Risks of speculating with options on futures n Example in 1995 of Barings PLC l U.K. investment bank l $1 billion in losses from derivative positions n Lessons l Monitor derivative trading closely l Separate reporting from trading so losses are not concealed l Recognize margin calls may signal problems

Hedging with Options on Futures n Used by financial institutions with long-term mortgages funded by short-term liabilities so the downside risk is from an interest rate increase l Can use a strategy to gain from futures options if rates actually increase, offsetting loss of interest margin in the business l Prepayment risk on loans is important if the institution loses its offsetting mortgage loans

Hedging with Options on Futures n A portfolio manager wishes to hedge the downside risk(one-way insurance) of a stock portfolio while allowing for the upside potential n Buy put options on futures to hedge a possible temporary decline in the market n Can choose among strike prices available and decide the degree of risk to hedge n Can sell call options to cover the cost of buying put options n Widespread institutional uses of options

Globalization of Options Markets n Global stock market drives need for global options market n Options exchanges exist in many countries n Currency options contracts l Options on foreign currencies l Speculate on changes in foreign exchange rates, the underlying asset l Hedge risks caused by firm’s transactions denominated in foreign currencies