1. CHAPTER 2 & 20 Asset Classes and Financial Instruments & Options Markets

2. Topics Interest-Bearing Securities –Money-market securities, –Long-term fixed income securities Equities –Common stocks, –Preferred stocks Derivatives –Futures, Options 2

3. Classifying Securities Basic TypeSubtypeSegment Interest-bearing securities Money market securities Money market (Short-term, liquid, low risk) Fixed-income securities Capital market (Long-term, less liquid, high risk) Equities Preferred stocks Common stocks Derivatives Futures Options 3

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5. INTEREST-BEARING SECURITIES 5

6. Interest-Bearing Assets Pay interest, as the name suggests. The value of these assets depends, at least for the most part, on interest rates. They all begin life as a loan of some sort, so they are all debt obligations of some issuers. Relatively low risk and often large denominations 6

7. Interest-Bearing Assets Money market instruments are short-term debt obligations of large corporations and governments. –These securities promise to make one future payment. –When they are issued, their lives are less than one year. –Relatively more liquid than longer-term fixed-income securities. Fixed-income securities are longer-term debt obligations of corporations or governments. –These securities promise to make fixed payments according to a pre-set schedule. –When they are issued, their lives exceed one year. –Less liquid. 7

8. The Money Market Major Components Subsector of the fixed-income market: Securities are short-term, liquid, low risk, and often have large denominations. 8

9. The Money Market Money Market Securities Treasury bills: Short-term debt of U.S. government Certificates of Deposit: Time deposit with a bank, –CDs are treated as bank deposits by the Federal Deposit Insurance Corporation, so they are currently insured for up to $250,000 in the event of a bank insolvency Commercial Paper: Short-term, unsecured debt of a company Bankers’ Acceptances: An order to a bank by a bank’s customer to pay a sum of money on a future date 9

10. The Money Market Money Market Securities Eurodollars: dollar-denominated time deposits in banks outside the U.S. Repos and Reverses: Short-term loan backed by government securities. Fed Funds: Very short-term loans between banks. Broker’s calls: Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. –The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it. –The rate paid on such loans is usually about 1% higher than the rate on short-term T-bills. 10

11. The Money Market T-Bills Treasury bills: Short-term debt of U.S. government with a maturity of less than one year. –Investors buy T-Bills at a discount from the stated maturity value –As maturity, the holder received the stated face value. –T-bills are highly liquid; sold at low transaction cost and with not much price risk. –The income earned on T-bills is exempt from all state and local taxes 11

12. Example: T-Bill T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). Let's say you buy a 13-week T-bill priced at $9,800. –Essentially, the U.S. government writes you an IOU for $10,000 that it agrees to pay back in three months. –You will not receive regular payments as you would with a coupon bond, for example. –Instead, the appreciation - and, therefore, the value to you - comes from the difference between the discounted value you originally paid and the amount you receive back ($10,000). –In this case, the T-bill pays a 2.04% interest rate ($200/$9,800 = 2.04%) over a three-month period. 12

13. Major Foreign Holders of U.S. Treasury Securities 13

14. http://www.usdebtclock.org/ 14

15. U.S. National Debt 15

16. The Money Market Yields on Money Market Instruments Except for Treasury bills, money market securities are not free of default risk Both the premium on bank CDs and the TED spread have often become greater during periods of financial crisis During the credit crisis of 2008, the federal government offered insurance to money market mutual funds after some funds experienced losses 16

17. Recent History: Yield Spreads 17

18. Interest rates : Market data from WSJ 18

19. The Bond Market Called as the fixed-income securities –Treasury Notes (up to 10 years) and Bonds (10 years +) commonly trade in denominations of $1,000. Both notes and bonds make semiannual interest payments called coupon payments Par Value - $1,000 Interest paid semiannually Quotes – percentage of par –Inflation-Protected Treasury Bonds or TIPS (Treasury Inflation-Protected Securities) 19

20. T-Bonds, Notes Quote, WSJ 20

21. The Bond Market –Federal Agency Debt Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac –International Bonds A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. A Yankee bond is a dollar-denominated bond sold in the United States by a non-U.S. issuer. Similarly, Samurai bonds are yen-denominated bonds sold in Japan by non-Japanese issuers. 21

22. The Bond Market Municipal Bonds (“munis”) –issued by state and local governments –their interest income is exempt from federal income taxation –Also, could be exempt from state and local governments in the issuing state –Types General obligation bonds: Backed by taxing power of issuer Revenue bonds: backed by project’s revenues or by the municipal agency operating the project. 22

23. The Bond Market Municipal Bond Yields To choose between taxable and tax-exempt bonds, compare after-tax returns on each bond. Let t equal the investor’s marginal tax bracket Let r equal the before-tax return on the taxable bond and r m denote the municipal bond rate. If r (1 - t ) > r m then the taxable bond gives a higher return; otherwise, the municipal bond is preferred. 23

24. The Bond Market Tax-Exempt Yield Table The equivalent taxable yield is simply the tax-free rate, r m, divided by (1-t ). 24

25. The Bond Market Corporate Bonds Issued by private firms Semi-annual interest payments Subject to larger default risk than government securities Options in corporate bonds –Callable –Convertible 25

26. Quote Example: Corporate Bonds Price quotations from www.wsj.com—the online version of The Wall Street Journal (some columns are self-explanatory):www.wsj.com You will receive 6.875% of the bond’s face value each year in 2 semi-annual payments. The price (per $100 face) of the bond when it last traded. The Yield to Maturity (YTM) of the bond. 3-26

27. The Bond Market Mortgage-Backed Securities Proportional ownership of a mortgage pool or a specified obligation secured by a pool One of the largest fixed income market Produced by securitizing mortgages –Mortgage-backed securities are called pass-throughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors. Most mortgage-backed securities were issued by Fannie Mae and Freddie Mac. 27

28. The Bond Market, VI Mortgage-Backed Securities Traditionally, pass-throughs were comprised of conforming mortgages, which met standards of credit worthiness. Eventually, “Private-label” issuers securitized large amounts of subprime mortgages, made to financially weak borrowers. Finally, Fannie and Freddie were allowed and even encouraged to buy subprime mortgage pools. September, 2008: Fannie and Freddie got taken over by the federal government. 28

29. Mortgage-Backed Securities Outstanding

30. EQUITY SECURITIES 30

31. Equity Securities Preferred stock: Perpetuity –Fixed dividends –Priority over common –Tax treatment Common stock: Ownership –Residual claim –Limited liability American Depository Receipts 31

32. Preferred Stocks The dividend is usually fixed and must be paid before any dividends for the common shareholders. In the event of a liquidation, preferred shares have a particular face value. Some preferred stocks are cumulative, meaning that any and all skipped dividends must be paid in full before common stockholders are paid. Most preferred stocks are issued by large companies, particularly banks and public utilities. –Example: Citigroup preferred stock (Do a Google search for it). 32

33. Preferred Stock Preferred stock resembles a fixed-income security. In this sense, it is a hybrid security. However, the main difference is that preferred stock is NOT a debt obligation. Also, for accounting and tax purposes, preferred stock is treated as equity. Potential gains/losses: –Dividends are “promised.” However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed. –The stock value may rise or fall depending on the prospects for the company and market-wide circumstances. 33

34. Common Stocks Represents ownership in a corporation. An owner receives a pro rated share of whatever is left over after all obligations have been met in the event of a liquidation. Also, shareholders retain voting rights. May or may not pay dividends at the discretion of a company's board of directors, which is elected by the shareholders. Tech stocks usually do not pay dividends, while utilities stocks pay a decent amount of dividends. Dividends can grow over time. There may be capital gains or losses. 34

35. Common Stock Price Quotes at http://finance.yahoo.comhttp://finance.yahoo.com First, enter symbol. Resulting Screen 35

36. STOCK MARKET INDEXES 36

37. Stock Market Indexes Price-Weighted Index For a price-weighted index, higher priced stocks receive higher weights. –This means stock splits cause issues. –But, stock splits can be addressed by adjusting the index divisor. The best-known, oldest, most widely followed barometer of day-to-day stock market activity is the Dow Jones Industrial Average (DJIA), or “Dow” for short. –The DJIA is a price-weighted index of the stock prices of 30 large companies representative of American industry like MMM, KO, IBM, PG, AXP, MCD, WMT, MSFT, GE, … –Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample) –Note: As of March 8, 2008, the DJIA divisor was a nice “round” 0.122834016! –Computed since 1896 37

38. Stock Market Indexes, III Value-Weighted Index For a value-weighted index (i.e., the S&P 500), companies with larger market values have higher weights. –Comprised of 500 stocks from major industry sectors –More broad-based and representative of overall market than DJIA –True index calculated from 1941–1943 base period closing market values 38

39. Other Indexes NYSE Composite Index –Includes all stocks listed in NYSE AMEX Composite Index –Includes all stocks listed on the NYSE Amex Nasdaq Composite Index –Includes all stocks traded on the Nasdaq stock market –Often used to track technology companies’ behavior Value Line Composite Index –Includes all stocks tracked by Value Line –Uses equal weighting to eliminate the bias of stocks with large total market values Wilshire 5000 Index –Includes 5,000 stocks traded on the major exchanges Russell 1000 Index –Includes 1,000 largest companies Russell 2000 Index –Includes 2,000 small companies Europe/Australia/Far East (EAFE MSCI) –Tracks stocks trade on foreign exchanges 39

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42. Price-Weighted Index DJIA t = ∑ (P it /D adj ) – P it = Closing price of stocks i on day t – D adj = Adjusted divisor It looks simple to construct but stock splits complicates the process. 42

43. Price-Weighted Average Portfolio: Initial value $25 + $100 = $125 Final value $30 + $ 90 = $120 Percentage change in portfolio value = -5/125 = -.04 = -4% Index: Initial index value (25+100)/2 = 62.5 Final index value (30 + 90)/2 = 60 Percentage change in index -2.5/62.5 = -.04 = -4% 43

44. Example I: DJIA-Effect of Stock Split Assume the index price-weighted index consists of three stocks, A, B, and C. This example illustrates how the index and the new divisor are computed before and after a 3-for-1 stock split for Stock A. StockPrice Before Split Price After Split A 30 10 B 20 20 C 10 10 Index 60 / 3 = 20 40 / X = 20 Divisor3 X=2 44

45. Example II: Changing the Divisor What would have happened to the divisor if Home Depot shares were selling at $65.72 per share? 45

46. Example III: DJIA-Effect of Stock Split The example demonstrates the impact of differently priced shares on a price-weighted index. It shows that higher priced stock will affect the index more (Case A) than lower priced stock (Case B). Period T Case A (T+1) Case B (T+1) A 100 110 100 B 50 50 50 C 30 30 33 Sum 180 190 183 Divisor 3 3 3 Average 60 63.3 61 Percentage Change 5.5% 1.7% 46

47. Criticism of the DJIA Limited to 30 non-randomly selected blue-chip stocks Does not represent a vast majority of stocks The divisor needs to be adjusted every time one of the companies in the index has a stock split Introduces a downward bias by reducing weighting of fastest growing companies whose stock splits Because the index is price weighted, a high-priced stock carries more weight than a low-priced stock. A high-growth stock will have higher prices and because such stocks tend to split, they will consistently lose weight within the index. 47

48. Dow 30 48

49. Value-Weighted Series Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding X Current Market Price Assign an beginning index value (10, 100, 1000, or something else) and new market values are compared to the base index Automatic adjustment for splits Weighting depends on market value 49

50. Value-Weighted Series Index t = index value on day t P t = ending prices for stocks on day t Q t = number of outstanding shares on day t P h = ending price for stocks on base day Q h = number of outstanding shares on base day 50

51. Example : How Does the Value-Weighted Index Change? (107,892 / 104,241 )*1,000 = 1,035.02 51

52. The Day 3 Index Can be Calculated in Two Ways: 52

53. DERIVATIVES - FUTURES 53

54. Derivative Markets Primary asset: Security originally sold by a business or government to raise money. Derivative asset: A financial asset that is derived from an existing traded asset, rather than issued by a business or government to raise capital. –More generally, any financial asset that is not a primary asset. –Options and futures provide payoffs that depend on the values of other assets such as commodity prices, bond and stock prices, or market index values. –A derivative is a security that gets its value from the values of another asset. –Warning! Derivative assets are highly complicated securities and their pricings and trading process are quite technical. 54

55. Futures Contract An agreement made today regarding the terms of a trade that will take place later. Calls for delivery of an asset (or in some cases, its cash value) at maturity date for an agreed-upon price set today, called the futures price, to be paid at contract maturity. –Long (or, short) position: Take (or, make) delivery at maturity –For example, you are a jeweler and will need many ounces of gold in six months. You strike a deal today with a seller in which you promise to pay, say, $400 per ounce in six months for the 100 ounces of gold, no matter what actual price in six months will prevail. 55

56. Futures Contracts Examples: Financial futures (i.e., S&P 500, T- bonds, foreign currencies, and others); Commodity futures (i.e., wheat, crude oil, cattle, and others), weather ??? Potential gains/losses: –At maturity, you gain if your contracted price is better than the market price of the underlying asset, and vice versa. –If you sell your contract before its maturity, you may gain or lose depending on the market price for the contract. –Note that enormous gains and losses are possible. 56

57. Futures Contracts Price Quotes for Interest Rate Futures Source: Markets Data Center at www.wsj.com. www.wsj.com 57

58. Futures Contracts Price Quotes (cont’d) The first column tells us the delivery date for the bonds specified by the contract. The settle is a price reflecting the trades at the end of the day. Suppose you buy one September contract at the settle price. What you have done is agree to buy T-bonds with a total par value of $100,000 in September at a price of 110-02 per $100 of par value, where the “02” represents 2/32. It represents a price of $110,062.50 per $100,000 face value. No money changes hands today between a buyer and seller. Upon maturity, your T-bonds will be delivered. Or, you can close out the contract before the maturity date by taking the opposite date, thereby canceling your current position. More details will be presented in more advanced classes. 58

59. Futures Contracts Price Quotes (cont’d) 59

60. Futures Price Quotes Online Soybeans Futures 60 1066’2 = $10.66 2/8 *5000 bushels = 10.6625*5000=$53,312.5

61. Mexican Peso Futures, US$/Peso (CME) MaturityOpenHighLowSettleChangeHighLow Open Interest Mar.10953.10988.10930.10958---.11000.0977034,481 June.10790.10795.10778.10773---.10800.097303,405 Sept.10615.10610.10573---.10615.099301,418 All contracts are for 500,000 new Mexican pesos. “Open,” “High” and “Low” all refer to the price on the day. “Settle” is the closing price on the day and “Change” indicates the change in the settle price from the previous day. “High” and “Low” to the right of Change indicates the highest and lowest prices for this specific contact during its trading history. “Open Interest” refers to the number of contracts outstanding for a particular delivery month—it’s a good proxy for demand for a contract. Notice that open interest is greatest in the nearby contract. In general, open interest typically decreases with term to maturity of most futures contracts. The holder of a March long position is committing himself to pay $.10958 per euro for peso 500,000—a $54,790 position. As there are 34,481 such contracts outstanding, this represents a notational principal of over $1.8 billion! 61

62. DERIVATIVES - OPTIONS 62

63. Option Basics A stock option is a derivative security, because the value of the option is “derived” from the value of the underlying common stock. Derivatives are contingent claims because their payoffs depend on the value of other securities. An option is a contract which gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time. There are two basic financial option types. –Call options are options to buy the underlying asset. When exercising a call option, you “call in” the asset. –Put options are options to sell the underlying asset. When exercising a put, you “put” the asset to someone. 63

64. Option Contracts A call option gives the owner the right, but not the obligation, to buy something, while a put option gives the owner the right, but not the obligation, to sell something. The “something” can be an asset, a commodity, or an index. –Stock Options –Index Options –Futures Options –Foreign Currency Options –Interest Rate Options The price you pay today to buy an option is called the option premium. The specified price at which the underlying asset can be bought or sold is called the strike price, or exercise price. 64

65. The Option Contract A call option gives its holder the right to buy an asset: –At the exercise or strike price –On or before the expiration date –Exercise the option to buy the underlying asset if market value > strike. A put option gives its holder the right to sell an asset: –At the exercise or strike price –On or before the expiration date –Exercise the option to sell the underlying asset if market value < strike. 65

66. Option Basics Option contracts are legal agreements between two parties—the buyer of the option, and the seller of the option. The minimum terms stipulated by stock option contracts are: –The identity of the underlying stock. –The strike price, or exercise price. –The option contract size. –The option expiration date, or option maturity. –The option exercise style (American or European). –The delivery, or settlement, procedure. Stock options trade at organized options exchanges, such as the CBOE, as well as over-the-counter (OTC) options markets. Listed option contracts are standardized to facilitate trading and price reporting. –Listed stock options give the option holder the right to buy or sell 100 shares of stock. 66

67. Option Vocabulary Exercise (or strike) price: The price stated in the option contract at which the security can be bought or sold. Option price (premium): The market price of the option contract. Expiration date: The date the option matures. Exercise value (option payoff): The value of a call or put option if it were exercised today –EV of Call = Max (S T ─ X, 0) –EV of Put = Max (X ─ S T, 0) 67

68. Option “Moneyness” “In-the-money” option: An option that would yield a positive payoff if exercised “Out-of-the-money” option: An option that would NOT yield a positive payoff if exercised Use the relationship between S (the stock price) and X (the strike price): Note for a given strike price, only the call or only the put can be “in-the- money.” In-the-MoneyOut-of-the-MoneyAt-the-Money Call OptionS > XS < XS = X Put OptionS < XS > XS = X 68

69. Option Writing The act of selling an option is referred to as option writing. The seller of an option contract is called the writer. If holder exercises the option, the option writer must make (call) or take (put) delivery of the underlying asset. –The writer of a call option contract is obligated to sell the underlying asset to the call option holder. –The writer of a put option contract is obligated to buy the underlying asset from the put option holder. The purchase price of the option is called the premium. Because option writing obligates the option writer, the option writer receives the price (premium income) of the option today from the option buyer. 69

70. The Options Clearing Corporation The Options Clearing Corporation (OCC) is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. The OCC issues and clears all option contracts trading on U.S. exchanges. Note that the exchanges and the OCC are all subject to regulation by the Securities and Exchange Commission (SEC). Visit the OCC at: www.optionsclearing.com.www.optionsclearing.com 70

71. American vs. European Options 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 In the U.S., most options are American style, except for currency and stock index options. Exercise style is not linked to where the option trades. European- style and American-style options trade in the U.S., as well as on other option exchanges throughout the world. Very Important: Option holders also have the right to sell their option at any time. That is, they do not have to exercise the option if they no longer want it. 71

72. Option Price Quotes A list of available option contracts and their prices for a particular security is known as an option chain. Option chains are available online through many sources, including the CBOE (http://quote.cboe.com) and Yahoo! Finance (http://finance.yahoo.com).http://quote.cboe.comhttp://finance.yahoo.com Stock option ticker symbols include: –Letters to identify the underlying stock. –A letter to identify the expiration month as well as whether the option is a call or a put. (A through L for calls; M through X for puts). –A letter to identify the strike price (a bit more complicated—see Yahoo for tables to explain this letter.) 72

73. Listed Option Quotes at Yahoo! Finance 73

74. Comparison Option Right, but not obligation, to buy or sell; option is exercised only when it is profitable Options must be purchased The premium is the price of the option itself. Futures Contract Obliged to make or take delivery. Long position must buy at the futures price, short position must sell at futures price Futures contracts are entered into without cost 74

75. OPTIONS - EXAMPLES 75

76. Example: Call Option You buy the call option contract that will allow you to buy from an option seller 100 shares of IBM for $50 per share at any time during the next three months. The call option is traded at $1 for each share of underlying stock. Exercise (or strike) price = $50 Option Price = $1 Expiration: Three months Suppose the price of IBM share rises to $55. You can exercise your option to buy IBM share at an exercise price ($50). Thus, the exercise value is $5 ($55 - $50). 76

77. Example: Call Option Suppose an IBM share will rise to $55, stay at $50 or fall to $40 per share in three months. Call price = $1 IBM spot price $50 per share IBM spot price = $55 Exercise value = $5 Profit = $4 Now3 months IBM spot price = $50 Exercise value = $0 Profit = -$1 IBM spot price = $40 Exercise value = $0 Profit = -$1 77

78. How do we make profits (or lose money) from option trading? From the previous example, assuming that the option is in-the-money at expiration, you can buy IBM share at $50 from an option seller and sell them at current market price ($55). You just made net profit of $4 profit (=55-50-1). Thus, the call option buyer is betting on price appreciation of the underlying assets, while the put option buyer is betting on price depreciation of the underlying assets. From the previous example, suppose IBM shares never rises above $50. Then your option expires worthless, so you lose an entire option price ($1). 78

79. Call Option Profits -20 1009080706001020304050 -40 20 0 -60 40 60 Stock price ($) Option profit ($) Buy a call Exercise price = $50 79

80. Example: Put Option You buy the put option contract that will allow you to sell from an option seller 100 shares of IBM for $50 per share at any time during the next three months. The put option is traded at $3 for each share of underlying stock. Exercise (or strike) price = $50 Option Price = $3 Expiration: Three months Suppose the price of IBM share falls to $40. You can exercise your option to sell IBM share at an above-market exercise price ($50). Thus, the exercise value is $5 ($55 - $50). 80

81. Example: Put Option Suppose an IBM share will rise to $55, stay at $50 or fall to $40 per share in three months. Put price = $3 Now3 months IBM spot price $50 per share IBM spot price = $55 Exercise value = $0 Profit = -$3 IBM spot price = $50 Exercise value = $0 Profit = -$3 IBM spot price = $40 Exercise value = $10 Profit = $7 81

82. Put Option Profits -20 1009080706001020304050 -40 20 0 -60 40 60 Stock price ($) Option profit ($) Buy a put 82

83. Option Payoffs versus Option Profits Option investment strategies involve initial and terminal cash flows. –Initial cash flow: option price (often called the option premium). –Terminal cash flow: the value of an option at expiration (often called the option payoff). The terminal cash flow can be realized by the option holder by exercising the option. Option Profits = Terminal cash flow − Initial cash flow 83

84. Payoff and Profit Expiration 84

85. Option Payoffs and Profits 85

86. Example: Profit and Loss on a Call A January 2010 call on IBM with an exercise price of $130 was selling on December 2, 2009, for $2.18. The option expires on the third Friday of the month, or January 15, 2010. If IBM remains below $130, the call will expire worthless. –Option payoff= 0, –Profit = -$2.18 per share Suppose IBM sells for $132 on the expiration date. –Option payoff = stock price-exercise price = $132- $130= $2 –Profit = Final value – Original investment = $2.00 - $2.18 = -$0.18 –Option will be exercised to offset loss of premium. –Call will not be strictly profitable unless IBM’s price exceeds $132.18 (strike + premium) by expiration. 86

87. Example: Profit and Loss on a Put Consider a January 2010 put on IBM with an exercise price of $130, selling on December 2, 2009, for $4.79. Option holder can sell a share of IBM for $130 at any time until January 15. If IBM goes above $130, the put is worthless. –Option payoff= 0, –Profit = -$4.79 per share Suppose IBM’s price at expiration is $123. –Value at expiration = exercise price – stock price = $130 - $123 = $7 –Investor’s profit: $7.00 - $4.79 = $2.21 –Holding period return = 46.1% over 44 days! 87

88. Payoffs and Profits at Expiration - Calls 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 Payoff to Call Writer = - (S T – X) if S T >X = 0 if S T < X Profit to Call Writer = Payoff + Premium 88

89. Payoffs and Profits at Expiration - Puts Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X Profit to Put Holder Payoff – Premium Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X Profits to Put Writer Payoff + Premium 89

90. WHY OPTIONS? 90

91. Why Options? A basic question asked by investors is: “Why buy stock options instead of shares in the underlying stock?” To answer this question, we compare the possible outcomes from these two investment strategies: –Buy the underlying stock. –Buy options on the underlying stock. 91

92. Buying the Underlying Stock versus Buying a Call Option Suppose IBM is selling for $90 per share and call options with a strike price of $90 are $5 per share. Investment for 100 shares: –IBM Shares: $9,000 –One listed call option contract: $500 Suppose further that the option expires in three months. Finally, let’s say that in three months, the price of IBM shares will either be: $100, $80, or $90. 92

93. Buying the Underlying Stock versus Buying a Call Option, Cont. Let’s calculate the dollar and percentage returns given each of the prices for IBM stock: 93 Buy 100 IBM Shares ($9000 Investment): Buy One Call Option ($500 Investment): Dollar Profit: Percentage Return: Dollar Profit: Percentage Return: Case 1: $100$1,00011.11%$500100% Case 2: $80-$1,000-11.11%-$500-100% Case 3: $90$00%-$500-100%

94. Options vs. Stocks Whether one strategy is preferred over another is a matter for each individual investor to decide. –That is, in some instances investing in the underlying stock will be better. In other instances, investing in the option will be better. –Each investor must weight the risk and return trade-off offered by the strategies. It is important to see that call options offer an alternative means of formulating investment strategies. –For 100 shares, the dollar loss potential with call options is lower. –For 100 shares, the dollar gain potential with call options is lower. –The positive percentage return with call options is higher. –The negative percentage return with call options is lower. 94

95. Option versus Stock Investments Another Example Could a call option strategy be preferable to a direct stock purchase? Suppose you think a stock, currently selling for $100, will appreciate. A 6-month call costs $10 (contract size is 100 shares). You have $10,000 to invest. 95

96. Option versus Stock Investments Strategy A: Invest entirely in stock. Buy 100 shares, each selling for $100. Strategy B: Invest entirely in at-the-money call options. Buy 10 call contracts, each selling for $10. (This would require $10,000 =(10*100*$10) Strategy C: Purchase 1 call contract for $1,000. Invest your remaining $9,000 in 6-month T-bills, to earn 3% interest. The bills will be worth $9,270 at expiration. 96

97. InvestmentStrategyInvestment Equity onlyBuy stock @ 100100 shares$10,000 Options onlyBuy calls @ 101000 options$10,000 LeveragedBuy calls @ 10100 options $1,000 equityBuy T-bills @ 3% $9,000 Yield Option versus Stock Investment 97

98. Strategy Payoffs 98

99. Rate of Return to Three Strategies 99

100. Strategy Conclusions The previous slides shows that the all-option portfolio, B, responds more than proportionately to changes in stock value; it is levered. Portfolio C, T-bills plus calls, shows the insurance value of options. –C ‘s T-bill position cannot be worth less than $9270. –Some return potential is sacrificed to limit downside risk. 100

101. Investing in Stocks versus Options Stocks: Suppose you have $10,000 for investments. Macron Technology is selling at $50 per share. Number of shares bought = $10,000 / $50 = 200 If Macron is selling for $55 per share 3 months later, gain = ($55  200) - $10,000 = $1,000 If Macron is selling for $45 per share 3 months later, gain = ($45  200) - $10,000 = -$1,000 101

102. Investing in Stocks versus Options Options: A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4. A call contract costs $4  100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25  100 = 2500 shares) If Macron is selling for $55 per share 3 months later, gain = {($55 – $50)  2500} - $10,000 = $2,500 If Macron is selling for $45 per share 3 months later, gain = ($0  2500) – $10,000 = -$10,000 102

103. MANAGING RISK WITH OPTIONS 103

104. Using Options to Manage Risk Protective put - Strategy of buying put options to protect against falling values. Protective puts provide “insurance” for the value of an asset or a stream of cash inflows. 104

105. Using Options to Manage Risk Protective call - Strategy of buying call options to protect against rising prices. Protective calls provide a way to “lock-in” the value of a liability or a stream of cash outflows. 105

106. Covered Calls Purchase stock and write calls against it. Call writer gives up any stock value above X in return for the initial premium. If you planned to sell the stock when the price rises above X anyway, the call imposes “sell discipline.” 106

107. Exercises 107

108. Exercises (cont’d) Suppose you want to buy the right to BUY 100 shares of IBM with a $140 anytime between now and July (i.e., the Option 4 from the table). Evaluate your potential gains and losses at option expiration for stock prices of $120, $140, and $160. Stock pricegain/loss ($)gains/loss (%) $120-175-100% $140 -175-100% $160 18251043% 108

109. Exercises (cont’d) Given information in question 5, conduct the same analysis for IBM 140 July PUT options. StockGain/Loss ($)Gain/Loss (%) $1201725627% $140-275-100% $160 -275-100% 109