ACC2022 Corporate Finance

Seminar 7
(Week 8)

Options and Contingent Claims I

Associate Professor SzeKee

Seminar 7 Outline:
• Derivatives as tools in risk
management
• The Basic of Options
• Understanding Option Contracts
• Option Payoffs at Expiration
– Long position
– Short position
• Reasons for trading options
• Combinations of Options
• Put-Call Parity

Text: Chapter 20, 21

Derivatives as tools in risk management
• Derivatives are financial contracts or instruments which derive
their value from an underlying asset: stocks, bonds, indexes,
commodities or currency.

– They are synthetic tools used in risk management

• Risk: uncertainty in the timing and magnitude of cash flows,

arising from assets or liabilities.

• Investors and capital issuers wish to manage risk for two main
reasons:

1. Match or adjust risk exposure closer to risk averseness.

2. Depending on future expectations of gain or loss, aim to

maximise the
Derivatives as tools in risk management

• Examples of derivatives:
– Forward contracts *Traded privately

– Futures contracts * Traded in the

market
– Swap contracts * interest rate swap
or forex swap
– Options contracts (Covered in this
module)

4
 The Basic of Options
What is an option?
• A contract that gives its owner (holder) the right (but not the
obligation) to purchase or sell an asset at a fixed price (exercise
price) at some future date

• Whether to exercise or not is the choice of the holder of the

option; options can be allowed to lapse

• If the holder chooses to exercising an Option, then it means

– The holder of an option enforces the agreement and buys or sells the
underlying asset at the agreed-upon price

• If the underlying assets are shares or

bonds etc, then it is call a
financial option

• If the underlying assets involve tangible assets (buildings,

facilities, land, machines) and physical actions (such as
 The Basic of Options - Terminology

• Calls: A Call option gives the holder the right (but not the
obligation) to buy a specified asset at a specified price (strike
or exercise price) any time up until a specified expiration
date (exercise date)

• Puts: A Put option gives the holder the right (but not the
obligation) to sell a specified asset at a specified price (strike
or exercise price) any time up until a specified expiration
date (exercise date)

• Exercise Price (Strike Price): Price at which the asset may

be
purchased in the case of calls, or sold in case of puts.

• Expiration date: Last date on which an option can be

exercised.
– American options – can be exercised up to (including)
expiration
– European options – can only be exercised at expiry.
Understanding Option Contracts

Parties involved in Option Contracts:

1. Option Holder: The owner of an option contract
goes long
– Strategies:
a) Buying a call: You have the right (not obligation) to buy
at pre- determined price
b) Buying a put: You have the right (not obligation) to sell
at pre- determined price

2. Option Writer: The seller of an option contract

goes short
– Strategies:
a) Writing a call: You are obligated to sell at pre-determined
price if
holder exercises
b) Writing a put: You are obligated to buy at pre-determined
price if holder exercises
Understanding Option Contracts

Call Put

Long (Holder/ Buyer) Right to buy the Right to sell the

asset at the pre- asset at the pre-
determined price determined price

Short (Writer/ Seller) Obligation to sell Obligation to buy

the asset at the the asset at the
pre- determined pre- determined
price price
 Understanding Option Contracts (con’t)
Option Quotations - Terminology
• At-the-money *Exercise price = current share price
– Describes an option whose exercise price is equal to the
current stock price
• In-the-money *If exercise = holder gains + NPV
– Describes an option whose value if immediately exercised
would be positive
• Deep In-the-money: Describes an option that is in-the-
money and for which the strike price and the stock price are
very far apart
• Out-of-the-money
– Describes an option whose value if immediately exercised
would be negative
• Deep Out-of-the-money: Describes an option that is out-of–
the-money and for which the strike price and the stock price
are very far apart
 Call Option Strategies
(Long Position)
Payoff of a Long Call Option with a Strike Price of $10 at Expiration

Value
(Payoff
)
Profit not
capped
for holder
Call Option Payoffs at Expiration

Long Position in an Option Contract

Call option is right to buy underlying share
• Holder will only exercise if the strike price is less than
the current market price of the share (ie, exercise when
K<S)
• The value of a call option at expiration is

C  max (S  K, 0)

Where S is the stock price at expiration, K is the exercise

price, C is the value of the call option, and max is the
maximum of the two quantities in the parentheses

This is also known as the intrinsic

value of the call option
 Put Option Strategies
(Long Position)
Payoff of a Long Put Option with a Strike
Price of $10 at Expiration

Capped
Profit
for holder
(who will sell
<$0)
 Put Option Payoffs at Expiration
Long Position in an Option Contract (con’t)
Put option is right to sell underlying share
• Holder will only exercise if the strike price is greater than
the current market price of the share (ie, exercise when
K>S)
• The value of a put option at expiration is

P  max (K  S, 0)
Where S is the stock price at expiration, K is the exercise
price, P is the value of the put option, and max is the
maximum of the two quantities in the parentheses
 Option Payoffs at Expiration
(Short Position)
Short Position in an Option Contract
An investor that sells an option has an obligation.
– This investor takes the opposite side of the contract to the
investor who bought the option. Thus the seller’s cash
flows are the negative of the buyer’s cash flows.

Writer Writer
(call) (put)
 Profits for holding an Option
Contract
Profits for holding an Option Contract

• Payoffs on a long position in an

option contract are never
negative.
– Recall, Max(S-K,0) or Max (K-S,
0)

• However, holder of an option

needs to pay a premium to be
given the
right (but not obligation) to buy or
sell.

• Therefore, profit (ie, payoffs less premium paid) from

purchasing an option and holding it to expiration could be
negative because the payout at expiration might be less than
 Profits for holding an Option
Contract (con’t)
CALL PUT

Option
Premiu
m
 Illustrations

Eg1: You have purchased a 3 mth call option which

gives you the right to purchase one XYZ Ltd share
for $100. The option premium is $5.

If at the end of 3 mths, XYZ Ltd shares are trading

@$80,
you will not exercise the option (out of the money).
– Cheaper to buy it from the open market
– Total cost = $

If at the end of 3 mths, the shares are trading

@$150, you will exercise the option (in the money).
– Cheaper to buy it by exercising the option
– Total cost = $
 Illustrations

Eg1: You have purchased a 3 mth call option which

gives you the right to purchase one XYZ Ltd share
for $100. The option premium is $5.
CALL

Option
Premium
$5
 Illustrations

Eg1: You have purchased a 3 mth call option which

gives you the right to purchase one XYZ Ltd share
for $100. The option premium is $5.

If at the end of 3 mths, XYZ Ltd shares are trading

@$80,
you will not exercise the option (out of the money).
– Cheaper to buy it from the open market
– Total cost = $

If at the end of 3 mths, the shares are trading

@$150, you will exercise the option (in the money).
– Cheaper to buy it by exercising the option
– Total cost = $
 Illustrations (con’t)

Eg2: You have purchased a 3 mth put option

which gives you the right to sell one XYZ Ltd share
for $100. The option premium is $5.

If at the end of 3 mths, the share are trading @$80,

you will exercise the option (in the money).
– Can sell higher by exercising the option
– Total net revenue = $

If at the end of 3 mths, the shares are trading

@$150, you will not exercise the option (out of the
money).
– Can sell higher in the open market
– Total net revenue = $
 Illustrations (con’t)
Eg2: You have purchased a 3 mth put option
which gives you the right to sell one XYZ Ltd share
for $100. The option premium is $5.

PUT
 Illustrations (con’t)

Eg2: You have purchased a 3 mth put option

which gives you the right to sell one XYZ Ltd share
for $100. The option premium is $5.

If at the end of 3 mths, the share are trading @$80,

you will exercise the option (in the money).
– Can sell higher by exercising the option
– Total net revenue = $

If at the end of 3 mths, the shares are trading

@$150, you will not exercise the option (out of the
money).
– Can sell higher in the open market
– Total net revenue = $
 Illustrations (con’t)
Eg3: You purchase the CSR call option, exercise price $2.25 for
$0.37 and fund the purchase with a bond with a yield of 6%.
Time to expiry is 42 days. Plot the profit of your position as a
function of the stock price at expiry.

Profit =
Reasons for trading options

1. Hedge * have the assets and is in the market

– To reduce risk by holding contracts or
securities whose payoffs are negatively
correlated with some risk exposure

2. Speculate *no assets just going for the profits

– When investors use contracts or securities
to place a bet on the direction in which
they believe the market is likely to move
 Combinations of Options
1. Straddle
• A portfolio that is long a call option and a put option on the
same stock with the same exercise date and strike price
• This strategy may be used if investors expect the stock to
be very volatile and move up or down a large amount, but
do not necessarily have a view on which direction the
stock will move.
Long
Put Long
Call
 Combinations of Options
1. Straddle
• Profit function:
• Alternatively, we can say: profit = payoff - c - p
ST <=K ST >K
Long call
Long put
Net P/L

Profit or Loss Payof

($) f

ST
K
Profi
t
 Combinations of Options (con’t)
2. Butterfly Spread
• A portfolio that is long two call options with differing strike prices,
and short two call options with a strike price equal to the average
strike price of the first two calls
• While a straddle strategy makes money when the stock and
strike prices are far apart, a butterfly spread makes money
when the stock and strike prices are close.
 Combinations of Options (con’t)
2. Butterfly Spread
• Profit Function:

• Alternatively, we can say: profit = payoff – c1 +

2c2 – c3

Profit or Loss
($)
Payof
f
K1 K2 ST
K3
Profit
 Combinations of Options (con’t)
3. Protection Insurance
• Protective Put
• Put options are generally not held as an
investment, but rather as insurance to hedge
other risk in a portfolio.
• A long position in a put held on a stock you
already own
• Portfolio Insurance
1. A protective put written on a portfolio rather than
a single stock. When the put does not itself
trade, it is synthetically created by constructing a
replicating portfolio
2. Portfolio insurance can also be achieved by
purchasing a bond and a call option
 Combinations of Options (con’t)
3. Protection Put (con’t)

stock

cal
l

bon
k k
d

pu
t
 Combinations of Options (con’t)
3. Protection Put (con’t)
• Profit function: Profit function: ST – S0 + Max(K-ST,
0) - p
ST <= K ST > K
Long stock
Long put
Net P/L

Profit or Loss
($) Lon Lon
g g
put stoc
k
K
ST
 Put-Call Parity
• Consider the two different ways to construct portfolio insurance
– Purchase the stock and a put
– Purchase a bond and a call
• Because both positions provide exactly the same payoff, the
Law of One Price requires that they must have the same price.
• Therefore,
S  P  PV(K) + C
– Where K is the strike price of the option, C is the call price, P is the put
price, and S is the stock price
• Rearranging the terms gives an expression for the price of a
European call option for a non-dividend-paying stock.
C  P  S  PV (K )
– This relationship between the value of the stock, the
bond, and call and put options is known as put-call parity.
 Put-Call Parity (con’t)
For a non-dividend paying stock, Put-Call Parity can also be
written as:
PV of (K)

C Intrinsic  K Time
S value dis(K
value
) P
– Where dis(K) is the amount of the discount from face value of the zero-coupon bond
K

Intrinsic Value: The amount by which an option is in-the-money,

or zero
if the option is out-of-the-money

Time Value: The difference between an option’s price and its

intrinsic value

For a dividend paying stock: The put-callparity relationship

for a
Intrinsic value
dividend-paying stock can be written as
Time value

C  S  K  dis(K )  P  PV (Div)
 Put-Call Parity Example
Assume:
– You wish to buy a one-year call option and put option on Dell
– The strike price for each Dell share is $25 (a year’s time);
current price
is $21.87
– The risk-free rate is 5.5%; The price of each call is $2.85
(premium of call)
– Using put-call parity, what should be the price of each put?
Solution:
Put-Call Parity states:
NOTE:
• If the stock pays a dividend, the payoff from a protective put
differs from the payoff from the bond plus call portfolio
• Put-call parity becomes C= P + S - PV(K) - PV(Div)