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Chapter 20

Chapter 20. Options Markets: Introduction. Option Terminology. Buy - Long Sell - Short Call Put Key Elements Exercise or Strike Price Premium or Price Maturity or Expiration. Market and Exercise Price Relationships. In the Money - exercise of the option would be profitable

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Chapter 20

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  1. Chapter 20 Options Markets:Introduction 20-1

  2. Option Terminology • Buy - Long • Sell - Short • Call • Put • Key Elements • Exercise or Strike Price • Premium or Price • Maturity or Expiration 20-2

  3. Market and Exercise Price Relationships In the Money - exercise of the option would be profitable Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable Call: market price>exercise price Put: exercise price>market price At the Money - exercise price and asset price are equal 20-3

  4. 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 20-4

  5. Different Types of Options • Stock Options • Index Options • Futures Options • Foreign Currency Options • Interest Rate Options 20-5

  6. Payoffs and Profits on Options at Expiration - Calls Notation Stock Price = ST Exercise Price = X Payoff to Call Holder (ST - X) if ST >X 0 if ST < X Profit to Call Holder Payoff - Purchase Price 20-6

  7. Payoffs and Profits on Options at Expiration - Calls Payoff to Call Writer - (ST - X) if ST >X 0 if ST < X Profit to Call Writer Payoff + Premium 20-7

  8. Payoff Call Holder 0 Call Writer Stock Price Payoff Profiles for Calls 20-8

  9. Payoffs and Profits at Expiration - Puts Payoffs to Put Holder 0 if ST> X (X - ST) if ST < X Profit to Put Holder Payoff - Premium 20-9

  10. Payoffs and Profits at Expiration - Puts Payoffs to Put Writer 0 if ST > X -(X - ST) if ST < X Profits to Put Writer Payoff + Premium 20-10

  11. Payoffs Put Writer 0 Put Holder Stock Price Payoff Profiles for Puts 20-11

  12. Equity, Options & Leveraged Equity - Text Example Investment Strategy Investment Equity only Buy stock @ 100 300 shares $10,000 Options only Buy calls @ 10 1000 options $10,000 Leveraged Buy calls @ 10 100 options $1,000 equity Buy T-bills @ 2% $9,000 Yield 20-12

  13. Equity, Options & Leveraged Equity - Payoffs IBM Stock Price $95 $105 $115 All Stock $9,500 $10,500 $11,500 All Options $0 $5,000 $15,000 Lev Equity $9,270 $9,770 $10,770 20-13

  14. Equity, Options & Leveraged Equity - Rates of Return IBM Stock Price $95 $105 $115 All Stock -5.0% 5.0% 15% All Options -100% -50% 50% Lev Equity -7.3% -2.3% 7.7% 20-14

  15. Protective Put Use - limit loss Position - long the stock and long the put Payoff ST< X ST > X Stock ST ST Put X - ST 0 20-15

  16. Protective Put Profit Profit Stock Protective Put Portfolio ST -P 20-16

  17. Covered Call Use - Some downside protection at the expense of giving up gain potential Position - Own the stock and write a call Payoff ST< X ST > X Stock ST ST Call 0 - ( ST - X) 20-17

  18. Profit Stock Covered Call Portfolio ST -P Covered Call Profit 20-18

  19. Option Strategies Straddle (Same Exercise Price) Long Call and Long Put Spreads - A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration Vertical or money spread Same maturity Different exercise price Horizontal or time spread Different maturity dates 20-19

  20. Put-Call Parity Relationship ST< X ST > X Payoff for Call Owned 0 ST - X Payoff for Put Written -( X -ST) 0 Total Payoff ST - XST - X 20-20

  21. Payoff Long Call Combined = Leveraged Equity Stock Price Short Put Payoff of Long Call & Short Put 20-21

  22. Arbitrage & Put Call Parity Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. C - P = S0 - X / (1 + rf)T If the prices are not equal arbitrage will be possible 20-22

  23. Put Call Parity - Disequilibrium Example Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% Maturity = .5 yr X = 105 C - P > S0 - X / (1 + rf)T 17- 5 > 110 - (105/1.05) 12 > 10 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative 20-23

  24. Put-Call Parity Arbitrage ImmediateCashflow in Six Months Position Cashflow ST<105 ST> 105 Buy Stock -110 ST ST Borrow X/(1+r)T = 100 +100 -105 -105 Sell Call +17 0 -(ST-105) Buy Put -5 105-ST 0 Total 2 0 0 20-24

  25. Optionlike Securities • Callable Bonds • Convertible Securities • Warrants • Collateralized Loans 20-25

  26. Exotic Options • Asian Options • Barrier Options • Lookback Options • Currency Translated Options • Binary Options 20-26

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