1. Class Business Homework – Liability Liability – Bonds Bonds

2. Derivatives A derivative is a financial instrument whose price depends on the price of another underlying asset. Major derivative contracts are: – Futures and forward contracts, – Call and put options, – Swaps.

3. Historical Background Before 1973 – Could not trade derivatives on any exchange Today – Billions of dollars in contracts are traded Why? – Fisher Black, arbitrage pricing – 1973 Black and Scholes published their model

4. Review A call option is a contract with two sides: – Long Side: pays for the right to buy an asset for a certain price at a certain time in the future. – Short Side: receives premium for agreeing to submit to demands of Long Side. A put option is a contract with two sides: – Long Side: pays for the right to sell an asset for a certain price at a certain time in the future. – Short Side: receives premium for agreeing to submit to demands of Long Side

5. Call – option with the ‘right’ to buy Put – option with the ‘right’ to sell Buy the option – Long, buy Sell the option – Short, sell, write Key Elements – Exercise or Strike Price (X) – price of future trade – Premium or Price (C, P) – what long position pays – Maturity or Expiration (T) Option Terminology

6. Option Contracts European option: can only be exercised on the expiration date. American option: can be exercised on any day prior to and including the expiration date. Options Clearing Corporation: – Guarantees contract performance – Members (brokers) post margins with the OCC – Brokers require investor clients to post margins – OCC is “middle man” for exercising options

7. Option Quotes on IBM CallsLast SellNetBidAskVolOIPutsLast SellNetBidAskVolOI Mar 90.00 (IBM CR-E) 6.80+0.906.506.70481397 Mar 90.00 (IBM OR-E) 0.10-0.050.050.15108325 Mar 95.00 (IBM CS-E) 2.30+0.102.202.308486551 Mar 95.00 (IBM OS-E) 0.70-0.150.700.8041916810 Mar 100.0 (IBM CT-E) 0.30--0.200.3015326748 Mar 100.0 (IBM OT-E) 3.50-0.303.703.9024410573 Mar 105.0 (IBM CA-E) 0.05--00.054012119 Mar 105.0 (IBM OA-E) 9.200.908.408.60202514 Apr 90.00 (IBM DS-E) 6.90-0.807.207.401110363 Apr 90.00 (IBM PS-E) 0.70--0.650.752023396 Apr 95.00 (IBM DS-E) 3.70+0.103.403.606918629 Apr 95.00 (IBM PS-E) 1.95-0.101.902.009214856 Apr 100.0 (IBM DT-E) 1.30+0.101.101.208625849 Apr 100.0 (IBM PT-E) 4.40-0.604.504.70215000 Apr 105.0 (IBM DA-E) 0.30+0.050.250.3011111770 Apr 105.0 (IBM PA-E) 8.80pc8.608.900717 Note: Each contract is for 100 shares 95.72

8. Open Interest Clearing House A: Long B: ShortC: Long D: Short E: LongF: Short G: Short

9. Different Types of Options Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options

10. Profit Profiles for Long Calls Payoff Spot Price (S T ) 0 Long Call X S T – X – C C

11. Profit Profiles for Short Calls Payoff Spot Price (S T ) 0 Short Call X S T – X – C C

12. Call Options - Zero Sum Game Payoff Spot Price (S T ) 0 Short Call Long Call X

13. Profit Profiles for Long Puts 0 Payoffs Spot Price (S T ) Long Put X P X – S T – P

14. Profit Profiles for Short Puts 0 Payoffs Spot Price (S T ) Short Put X P – (X – S T ) P

15. Put Options - Zero Sum Game 0 Payoffs Spot Price (S T ) Short Put Long Put X

16. In the Money - exercise of the option would be profitable Call: market price>exercise price (S t > X) Put: exercise price>market price (S t < X) Out of the Money - exercise of the option would not be profitable Call: market price<exercise price (S t < X) Put: exercise price X) At the Money - exercise price and asset price are equal (S t = X) Market and Exercise Price Relationships

17. Bull Spread Using Calls X1X1 X2X2 Profit STST Positon: Long 1 call at X 1 Short 1 call at X 2

18. Straddle Combination Position: Long 1 call at X Long 1 put at X Profit STST X

19. Option Strategies involving stock Protective Put Long Stock Long Put Profit STST X ) All you are doing is buying calls

20. Option Strategies involving stock Covered Call Long Stock Short Call Profit STST X ) All you are doing is writing puts