Chapter 17

1. Chapter 17 Options and other Derivatives: Introduction

2. Chapter Summary • Objective: This chapter is an introduction to the option markets. • Options’ investment characteristics • Option strategies • Put-Call parity relationship • Option-like securities and exotic options

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

4. 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

5. 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

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

7. Summary Reminder • Objective: This chapter is an introduction to the option markets. • Options’ investment characteristics • Option strategies • Put-Call parity relationship • Option-like securities and exotic options

8. 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

9. 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

10. Payoff Call Holder 0 Call Writer Stock Price Payoff Profiles for Calls

11. 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

12. 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

13. Payoffs Put Writer 0 Put Holder Stock Price Payoff Profiles for Puts

14. Equity, Options & Leveraged Equity - Text Example Investment Strategy Investment Equity only Buy stock @ 50 200 shares $10,000 Options only Buy calls @ 5 2000 options $10,000 Leveraged Buy calls @ 5 200 options $1,000 equity Buy T-bills @ 3% $9,000 Yield

15. Equity, Options & Leveraged Equity - Payoffs Alcan Stock Price $45 $55 $65 All Stock $9,000 $11,000 $13,000 All Options $0 $10,000 $30,000 Lev Equity $9,270 $10,270 $12,270

16. Equity, Options & Leveraged Equity - Returns Alcan Stock Price $45 $55 $65 All Stock -10.0% 10.0% 30% All Options -100% 0% 200% Lev Equity -7.3% -2.7% 27.7%

17. Summary Reminder • Objective: This chapter is an introduction to the option markets. • Options’ investment characteristics • Option strategies • Put-Call parity relationship • Option-like securities and exotic options

18. 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

19. Profit Stock Protective Put Portfolio ST - P Protective Put Profit

20. 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)

21. Profit Stock Covered Call Portfolio ST -P Covered Call Profit

22. 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

23. Summary Reminder • Objective: This chapter is an introduction to the option markets. • Options’ investment characteristics • Option strategies • Put-Call parity relationship • Option-like securities and exotic options

24. 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 - X ST - X

25. Payoff Long Call Combined = Leveraged Equity Stock Price Short Put Payoff of Long Call & Short Put

26. 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

27. 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

28. Put-Call Parity Arbitrage Immediate Cashflow 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

29. Summary Reminder • Objective: This chapter is an introduction to the option markets. • Options’ investment characteristics • Option strategies • Put-Call parity relationship • Option-like securities and exotic options

30. Option-like Securities • Callable Bonds • Convertible Securities • Warrants • Collateralized Loans

31. Exotic Options • Asian Options • Barrier Options • Lookback Options • Currency Translated Options • Binary Options