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Capital Markets

Capital Markets. Spring Semester 2010 Lahore School of Economics. Salaar farooq – Assistant Professor. Derivatives & Risk Mgmt: OPTIONS. Lecture. Derivatives & Risk Mgmt Ch 19 & 20 Learning Objectives. Options Contracts? Options Payoffs & Types? Option Strategies? Options pricing?

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Capital Markets

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  1. Capital Markets Spring Semester 2010 Lahore School of Economics Salaar farooq– Assistant Professor

  2. Derivatives & Risk Mgmt:OPTIONS Lecture

  3. Derivatives & Risk MgmtCh 19 & 20Learning Objectives • Options Contracts? • Options Payoffs & Types? • Option Strategies? • Options pricing? • Futures Contracts? • Futures payoffs & types? • Futures strategies? • Futures pricing?

  4. Derivative What is it?….

  5. Derivative What is it?…. • Securities whose prices are determined by OR derived from some underlying asset • Also called contingent claims (since payoffs are contingent on other assets) Options & Futures are both Derivatives

  6. Derivative Purpose…. Powerful tools for… ?

  7. Derivative Purpose…. Powerful tools for… • Hedging (shifting risk) • Speculation

  8. Derivative Options Contract…. A contract which gives the rightbut not the obligation to buy/sell an asset for a specified price on or before a specified expiration date

  9. Derivative - Options Terminology…. • Exercise or Strike price • Expiration date • American option • European option

  10. Derivative - Options Terminology…. • Exercise or Strike price The price at which the asset may be bought/sold or exercised • Expiration date The date the option expires • American option The option may be exercised on or before expiration • European option The option may be exercised ONLY at expiration

  11. Derivative - Options More Terminology…. • In the money • Out of the money • At the money • Payoff profile • Option premium

  12. Derivative - Options More Terminology…. • In the money When exercising the option results in a profit • Out of the money When exercising results in a loss • At the money When exercising results in Break-even (without premium)- ATM & BE are different • Payoff profile Shows the P/L of the option at different asset prices • Option premium Price paid to own the option

  13. Derivative Options Contract…. 2 Basic types • Call Option • Put Option

  14. Derivative Options Contract…. 2 Basic types • Call Option An option to BUY a share of stock at a specified price within a specific period • Put Option An option to SELL a share of stock at a specified price within a specified period

  15. Derivative Options Contract…. How they work? • Long Call Option Suppose you think BBC stock will rise in the next four months. The stock trades at $100 now. You don’t want to buy the stock outright but instead would like to have the option to purchase if the stock does go above $100. Option price is $3. You would buy a CALL with a strike price of $100 expiring in 4 mths by paying $3 for it. If the Px goes up, lets say to $110, you would exercise the call!... contd

  16. Derivative Options Contract…. How they work? • Long Call Option This means, You would be able to BUY the stock at $100 when the market price is at $110. And then be able to sell it at the MKT Px with profit.

  17. Derivative Options Contract…. Developing a payoff profile? • Long Call Option Suppose a stock sells for Rs 200. It has an offered CALL option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 150 b) 200 c) 205 d) 210 e) 220

  18. Derivative Options Contract…. Developing a payoff profile? • Long Call Option Suppose a stock sells for Rs 200. It has an offered CALL option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 150 (loss of 10) b) 200 (loss of 10) c) 205 (loss of 5) d) 210 (BE) e) 220 (profit of 10)

  19. Derivative Options Contract…. NOTICE… • Option Buyer has LIMITED downside & UNLIMITED Upside • Option Writer has the opposite Payoff • Risk/Return will be discussed a bit later • Writer takes on all the risk!!

  20. Derivative Options Contract…. Margin Requirements… • Buyer is not subject to margin reqmt. • Writer has to put up the option premium as margin & can get margin calls on MTM

  21. Derivative - Options More Terminology…. • Writer The seller of an option is called the “WRITER” • Covered Option When an option is written (sold) against actual stock held in portfolio • Naked Option When an option is written (sold) without any actual stock held in portfolio

  22. Derivative Options Contract…. Where are Options traded?… • Can trade both Exchanges & OTC • Advantages of Exchange traded options?

  23. Derivative Options Contract…. Where are Options traded?… • Can trade both Exchanges & OTC • Advantages of Exchange traded options: • Strike price & Expiration standardized • More liquid • Transaction costs are lower

  24. Options Contract…. Risk & Return Characteristics of Options…. • 4 Basic Option positions • Buying a Call • Selling a Call • Buying a PUT • Selling a PUT Assumption: European option (held till expiration)

  25. Options Contract…. CALL Options…. • Buying a CALL (Exercise or NOT?) • Actual Px below strike? • Px equal to strike • Px between strike & option premium • Px equal to strike+premium • Px more than strike+premium

  26. Options Contract…. CALL Options…. • Buying a CALL • Actual Px below strike? NO • Px equal to strike - NO • Px between strike & option premium - YES • Px equal to strike+premium - YES • Px more than strike+premium - YES

  27. Buying a MSFT Call Option for $1.2 with strike 25 (Bullish)

  28. Options Contract…. Call Options…. • Writing a CALL (Short Call position) – Selling a Call • Actual Px below strike? • Px equal to strike • Px between strike & option premium • Px equal to strike+premium • Px more than strike+premium

  29. Options Contract…. Call Options…. • Writing a CALL (Short Call position) – Selling a Call • Actual Px below strike? Premium profit • Px equal to strike? Premium profit • Px between strike & option premium? Reduced profit • Px equal to strike+premium? BE • Px more than strike+premium? LOSS Unlimited

  30. Payoff for the Writer of MSFT strike 25, premium $1.2 (Bearish) Short Call Position

  31. Derivative PUT Contract…. How they work? • Long PUT Option Suppose you think BBC stock will DROP in the next four months. The stock trades at $100 now. You don’t want to sell short the stock outright but instead would like to have the option to SELL if the stock does go below $100. Option price is $3. You would buy a PUT with a strike price of $100 expiring in 4 mths by paying $3 for it. If the Px drops, lets say to $90, you would exercise the call!... contd

  32. Derivative PUT Contract…. How they work? • Long PUT Option This means, You would be able to SELL the stock at $100 when the market price is at $90. And then be able to BUY it at the MKT Px with profit.

  33. Derivative PUT Contract…. Developing a payoff profile? • Long PUT Option Suppose a stock sells for Rs 200. It has an offered PUT option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 210 b) 200 c) 195 d) 190 e) 180

  34. Derivative PUT Contract…. Developing a payoff profile? • Long PUT Option Suppose a stock sells for Rs 200. It has an offered PUT option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 210 (Loss of 10) b) 200 (Loss of 10) c) 195 (Loss of 5) d) 190 (Break Even) e) 180 (Profit of 10)

  35. Options Contract…. PUT Options…. • Buying a PUT Option (Long Put position) • Actual Px below strike? YES • Px equal to strike - NO • Px between strike & option premium - YES • Px equal to strike-premium = YES • Px less than strike-premium = YES

  36. Long Put (Bearish) Buying a PUT

  37. Short Put (Bullish) Selling a PUT

  38. Options Contract…. Some combinations…. • Following are some combinations used by investors to create custom pay-off profiles

  39. Buying a MSFT Call Option for $1.2 with strike 25 (Bullish) Long Call

  40. Payoff for the Writer of MSFT strike 25, premium $1.2 (Bearish) Short Call

  41. Long Put (Bearish)

  42. Short Put (Bullish)

  43. Options Contract…. Pricing of Options…. • 6 Main Factors of Option pricing • Current Px of Underlying asset • Strike Price • Time of Expiration • Expected volatility over option life • Short term Risk-Free interest rate over option life • Anticipated C/F’s on underlying asset

  44. Options Contract…. Pricing of Options…. • Basic Components of Option Price • Intrinsic Value • Time Premium

  45. Options Contract…. Pricing of Options…. • Basic Components of Option Price • Intrinsic Value Economic value of the option if exercised immediately. If no positive value results, than intrinsic is zero. 2. Time Premium Amount by which the option price exceeds its intrinsic value

  46. Options Contract…. Price Components of Options…. • Basic Components of Option Price • Intrinsic Value Difference b/w the current price of asset & strike price, IF positive. Example: • If strike px = 100, asset px is 105, then intrinsic value = ? • If strike px = 100, asset px is 95, then intrinsic value = ?

  47. Options Contract…. Price Components of Options…. • Basic Components of Option Price • Intrinsic Value Difference b/w the current price of asset & strike price, IF positive. Example: • If strike px = 100, asset px is 105, then intrinsic value = 105-100=5 • If strike px = 100, asset px is 95, then intrinsic value = 0

  48. Derivative - Options More Terminology…. • In the money When strike price of Call is ? asset px. (profitable), intrinsic value >0 • Out of the money When strike price of Call is ? asset px (NOT profitable), intrinsic value = 0 • At the money When strike px of call is ? asset (NOT profitable), intrinsic value = 0

  49. Derivative - Options Intrinsic Value relationships…. • In the money When strike price of Call is below asset px. (profitable), intrinsic value >0 • Out of the money When strike price of Call is above asset px (NOT profitable), intrinsic value = 0 • At the money When strike px of call is same as asset (NOT profitable), intrinsic value = 0

  50. Options Contract…. Price Components of Options…. • Basic Components of Option Price • Time Premium Amount by which the Option price EXCEEDS its intrinsic value (due to time) Example: • If strike px = 100, asset px is 105, option px = 9- Time premium = ? • If strike px = 100, asset px is 90, option px = 9 – Time premium = ?

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