Chapter 14 Options Markets

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Option Terminology Buy - Long Sell - Short Call Put Key Elements

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market and Exercise Price Relationships In the Money - Out of the Money - At the Money -

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. American vs European Options American - European -

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Different Types of Options Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Payoffs and Profits on Options at Expiration - Calls Notation Stock Price = S T Exercise Price = X Payoff to Call Holder Profit to Call Holder

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Payoffs and Profits on Options at Expiration - Calls Payoff to Call Writer Profit to Call Writer

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Stock Price 0 Call Writer Call Holder Profit Profiles for Calls

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Payoffs and Profits at Expiration - Puts Payoffs to Put Holder Profit to Put Holder

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Payoffs and Profits at Expiration - Puts Payoffs to Put Writer Profits to Put Writer

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Profiles for Puts 0 Profits Stock Price Put Writer Put Holder

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity, Options & Leveraged Equity - Text Example InvestmentStrategyInvestment Equity onlyBuy shares$8,000 Options onlyBuy options$8,000 LeveragedBuy options $1,000 equityBuy 2% $7,000 Yield

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity, Options & Leveraged Equity - Payoffs Microsoft Stock Price $75$80$100 All Stock$7,500$8,000$10,000 All Options$0$0$16,000 Lev Equity $7,140$7,140 $9,140

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Equity, Options & Leveraged Equity - Rates of Return Microsoft Stock Price $75 $80$100 $75 $80$100 All Stock-6.25% 0% 25% All Options-100% -100%100% Lev Equity % %14.25%

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Put-Call Parity Relationship S T X Payoff for Call Owned Payoff for Put Written Total Payoff

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Payoff of Long Call & Short Put Long Call Short Put Payoff Stock Price Combined = Leveraged Equity

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Arbitrage & Put Call Parity Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. If the prices are not equal arbitrage will be possible

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Put Call Parity - Disequilibrium Example Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% Maturity =.5 yr X = 105 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Put-Call Parity Arbitrage ImmediateCashflow in Six Months PositionCashflowS T 105 Buy Stock Borrow X/(1+r) T = 100 Sell Call Buy Put Total

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Option Strategies Protective Put Long Stock Long Put Covered Call Long Stock Short Call Straddle (Same Exercise Price) Long Call Long Put

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Option Strategies 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

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Exotic Options Asian Options Barrier Options Lookback Options Currency-Translated Options Binary Options