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CHAPTER 20

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

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CHAPTER 20

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  1. CHAPTER 20 Options Markets: Introduction

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

  3. 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 Market and Exercise Price Relationships

  4. Figure 20.1 Stock Options on IBM

  5. 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 American vs. European Options

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

  7. 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 Payoffs and Profits at Expiration - Calls

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

  9. Figure 20.2 Payoff and Profit to Call Option at Expiration

  10. Figure 20.3 Payoff and Profit to Call Writers at Expiration

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

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

  13. Figure 20.4 Payoff and Profit to Put Option at Expiration

  14. Equity, Options, & Bills Investment Strategy Investment Equity only Buy stock @ 100 100 shares $10,000 Options only Buy calls @ 10 1000 options $10,000 Calls plus bills Buy calls @ 10 100 options $1,000 Buy T-bills @ 3% $9,000 Yield

  15. Payoffs IBM Stock Price $95 $105 $115 All Stock $9,500 $10,500 $11,500 All Options $0 $5,000 $15,000 Calls plus bills $9,270 $9,770 $10,770

  16. Rates of Return IBM Stock Price $95 $105 $115 All Stock -5.0% 5.0% 15% All Options -100% -50% 50% Calls plus bills -7.3% -2.3% 7.7%

  17. Figure 20.5 Rate of Return to Three Strategies

  18. Table 20.1 Value of Protective Put Portfolio at Option Expiration

  19. Figure 20.6 Value of a Protective Put Position at Option Expiration

  20. Figure 20.7 Protective Put versus Stock Investment (at-the-money option)

  21. Table 20.2 Value of a Covered Call Position at Expiration

  22. Figure 20.8 Value of a Covered Call Position at Expiration

  23. 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 Option Strategies

  24. Table 20.3 Value of a Straddle Position at Option Expiration

  25. Figure 20.9 Value of a Straddle at Expiration

  26. Table 20.4 Value of a Bullish Spread Position at Expiration

  27. Figure 20.10 Value of a Bullish Spread Position at Expiration

  28. Buy one call and write one put Payoff ST< X ST > X Call owned 0 ST – X Put written -(X – ST) 0 Total payoff ST – X ST – X Since the payoff on (call + put) options is equal to leveraged equity, their prices must be equal: C – P = S0 – X/(1 + rf)T Put Call Parity Derivation

  29. If the prices are not equal arbitrage will be possible or C – P = S0 – X/(1 + rf)T Put Call Parity

  30. Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 5% Maturity = 1 yr X = 105 C – P = S0 – X/(1 + rf)T 17 – 5 > 110 – 105/(1 + 0.05) Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative Put Call Parity - Disequilibrium Example

  31. Table 20.5 Arbitrage Strategy

  32. Optionlike Securities Callable Bonds Convertible Securities Warrants Collateralized Loans

  33. Figure 20.11 Values of Callable Bonds Compared with Straight Bonds

  34. Figure 20.12 Value of a Convertible Bond as a Function of Stock Price

  35. Exotic Options Asian Options C = Max[mean S – X, 0] Look-back Options C = Max [Smax – X, 0] Digital Options C = $100 if ST> X 0 if ST < X

  36. Barrier Options Down-and-Out Barrier Options C = Max[ST – X, 0] if St> B 0 if St < B Down-and-In Barrier Options C = Max[ST – X, 0] if St < B 0 if St> B

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