Ch 5: Options and Other Derivatives Flashcards
Options: In the money
when the strike price can be exercised at profit
options: at the money
when the strike price is the same as the current market price
Option: out of the money
when the strike price is at a loss at the time
European type options
Exercise at the End (only at Expiry)
American type options
Exercise Anytime prior to expiration
Intrinsic value of premium
Profit available to the option holder if it were immediately exercised (ie diff between the mkt value of the underlying instrument and the strike price)
Time Value of option
- Chance that the option will move into the money
- Decreases as the option approaches expiry (less likelihood that underlying instrument will move
- Premiums will increase in volatile markets as there is increased likelihood that an option will be exercised
Cap
- interest rate option transaction. Caps the level of interest rate on a floating rate borrowing
- cap = strip of consecutive options over BBSW sold as a package
- protects from rising rates, therefore equivalent to a call on the interest rate (if rates go up buyer receives payment)
- can also be considered a put on bank bills (right to sell BB at predetermined price)
++ call on rates vs put on securities: can be confusing, therefore use cap, floor etc
Floor
- protects buyer from a fall in interest rates (places a floor on interest rate received
Collar
- Borrower (investor) simultaneously purchases (sells) a cap and sells (purchases) a floor.
- ## usually structured as zero cost collar (premium of sold option offsets exactly the premium from the bought option
Swaption
- define
- payer swaption
- receiver swaption
- option over an interest rate swap
- payer swaption: buyer would pay fixed rate if exercised
- receiver swaption: buyer would receive fixed rate if exercised
Black Scholes assumptions (6)
- stock pays no dividends during options life
- European exercise terms are used - ie only exercise at expiry. (American options are more valuable)
- Markets are efficient
- Transaction costs and taxes are zero
- Interest rates remain constant and known (risk free rate)
- Returns are log normally distributed
Black Scholes in original form
- cannot ….
- Black Model accounts for this by…
- cannot be used for bonds or fixed interest securities because of pull to par problem (known value at maturity, therefore violates the random probability distribution of price
- uses forward price of bond, therefore assumes forward price at option maturity is log normally distributed (compare to Black Scholes where spot price is log normally distributed over life of option)
Binomial model
- tree of stock prices moving forward from present to expiration.
- at each step assume stock price moves up or down by an amount calculated using volatility and time to expiration
Monte Carlo option model
- method of estimating a value by the random generation of numbers and statistical principles (in particular, confidence intervals)