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GHPLecture 4

1) Options provide the right but not the obligation to buy or sell an underlying asset, while futures contracts require the fulfillment of the contract. Options require upfront payment of a premium while futures can be entered into at no cost. 2) There are two main types of options: calls provide the right to buy and puts provide the right to sell. Options can either be European, exercisable only at expiration, or American, exercisable at any time. 3) The value of options is influenced by factors like the current price of the underlying, strike price, time to expiration, volatility, interest rates, and dividends. In general, option value increases with current price, volatility, and

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44 views

GHPLecture 4

1) Options provide the right but not the obligation to buy or sell an underlying asset, while futures contracts require the fulfillment of the contract. Options require upfront payment of a premium while futures can be entered into at no cost. 2) There are two main types of options: calls provide the right to buy and puts provide the right to sell. Options can either be European, exercisable only at expiration, or American, exercisable at any time. 3) The value of options is influenced by factors like the current price of the underlying, strike price, time to expiration, volatility, interest rates, and dividends. In general, option value increases with current price, volatility, and

Uploaded by

Sagar Amin
Copyright
© Attribution Non-Commercial (BY-NC)
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Download as PPT, PDF, TXT or read online on Scribd
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Introduction to Derivatives

Lecture 4

Options vs. Futures

Option holder has the right to do something while in a Futures contract certain action has to be performed. Option holder may not exercise his right. Futures contract can be entered at no cost while Option buyer has to pay some money up-front.

Types of Options

A call is an option to buy. A put is an option to sell. A European option can be exercised only at the end of its life. An American option can be exercised at any time.

Call & Put Options

A holder of call option expects stock price to become higher than strike price. A holder of put option expects stock price to become lower than strike price.

Option Positions

Long Position: One who has bought the option. Short Position: One who has sold (or written) the option. Different combinations are possible:

Long call Long put Short call Short put

Long Call on eBay

Profit from buying one eBay European call option: option price = $ 5, strike price = $100, option life = 2 months
30 Profit ($) 20

10
70 0 -5 80 90 100

Terminal stock price ($) 110 120 130

Short Call on eBay

Profit from writing one eBay European call option: option price = $5, strike price = $100
Profit ($)

5 0
-10 -20

110 120 130


70 80 90 100 Terminal stock price ($)

-30

Long Put on IBM

Profit from buying an Oracle European put option: option price = $7, strike price = $70
30 Profit ($) 20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100

Short Put on IBM

Profit from writing an IBM European put option: option price = $7, strike price = $70
Profit ($)
7 Terminal stock price ($) 70 80 90 100

0
-10 -20

40

50

60

-30

Payoffs from Options


Payoff Payoff X
X Payoff X ST Payoff X ST ST ST

Payoffs from OptionsExample

An investor buys a call with strike price of Rs. 100 and sells a put with same strike price. What is his net position?

Payoffs from OptionsExample

Its like buying a forward contract with delivery price of Rs. 100.
Profit

Stock Price Rs. 100

Assets Underlying Exchange-Traded Options


Stocks Foreign Currency Stock Indices Futures

Specification of Exchange-Traded Options


Expiration date Strike price European or American Option class: All options of same type (calls or puts).

Specification of Exchange-Traded Options

Moneyness :

At-the-money option: Would give the holder a zero cash flow if the option is exercised immediately. In-the-money option: Would give the holder a positive cash flow if the option is exercised immediately. Out-of-the-money option: Would give the holder a negative cash flow if the option is exercised immediately.

Intrinsic Value: Is defined as maximum of zero & value the option will have if it is exercised immediately. Time Value.

Example

On October 25, 2006, companys stock price closed at Rs. 28. The following option prices were quoted. Compute intrinsic and time value of these options.

Strike Expir Price ation

Call Price

Put Price

25
30 35

Nov
Jan Nov

3.90
2.55 0.25

0.60
4.10 7.50

Example
Strike Call Call Call Put Put Put 25 30 35 25 30 35 Expiration Nov Jan Nov Nov Jan Nov Intrinsic Value 3 0 0 0 2 7 Time Value 0.90 2.55 0.25 0.60 2.10 0.50

Example

How does the strike price and the time to expiration affect the call and put option prices? Call options are decreasing in price as the strike price increases. Put options are increasing in price as the strike price increases. Both are increasing in price as the time to maturity increases.

Dividends & Stock Splits

Suppose you own N options with a strike price of K : No adjustments are made to the option terms for cash dividends. When there is an n-for-m stock split:

the strike price is reduced to mK/n. the no. of options is increased to nN/m.

Stock dividends are handled in a manner similar to stock splits.

Market Makers

Most exchanges use market makers to facilitate options trading. A market maker quotes both bid and ask prices when requested. The market maker does not know whether the individual requesting the quotes wants to buy or sell.

Margins

Purchase of calls & puts on margin is not allowed. Why? Margins are required when options are sold.

Notation

c : European call option price p : European put option price S0 : Stock price today K : Strike price T : Life of option : Volatility of stock price

C : American Call option price P : American Put option price ST :Stock price at option maturity D : Present value of dividends during options life r : Risk-free rate for maturity T with cont comp

Effect of Variables on Option Pricing

Current stock price:

Calls becomes more valuable as stock price increases. Why? What is effect on value of puts?

Strike Price:

Calls becomes less valuable as strike price increases. Puts become more valuable as strike price increases.

Effect of Variables on Option Pricing

Time to expiration:

Calls and puts both become more valuable as time to expiration increases. Why? What is effect of dividends?

Volatility:

Volatility is a measure of uncertainty about future stock price movements. Calls and puts both become more valuable as volatility increases. Why? Because there is downside protection.

Effect of Variables on Option Pricing

Risk-free Rate:

As interest rates increase the expected growth rate of stock price tend to increase. But PV of future cash flows reduces. In case of Calls first effect tends to increase the price and second one reduces it. The first effect dominates and value of calls tends to increase with increase in risk-free rate. In case of Puts both effects tend to decrease the value. Why?

Effect of Variables on Option Pricing

Dividends:

Value of calls decreases. Why? Value of puts increases. Why?

Effect of Variables on Option Pricing


Variable S0 K T r D c

+ ? + +

+ ? + +

+ + + +

+ + + +

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