Chapter 15 - options markets Flashcards
call option
The right to buy an asset at a specified exercise price on or before a specified expiration date
exercise/strike price
Price set for calling (buying) an asset or putting (selling) an asset
premium
Purchase price of an option
seller of call options
- writes calls
- Receive premium income now as payment against the possibility they will be required at some later date to deliver the asset in return for an exercise price less than the market value of the asset
- If call expires, profit = premium
- If call is exercised, profit = premium - (value of stock to deliver - exercise price paid for those shares)
- If that difference is larger than the initial premium, the writer incurs a loss
put option
The right to sell an asset at a specified exercise price on or before a specified expiration date
In the money (ITM)
- An option where exercise would generate a positive cash flow
- ITM call: strike < MP
- ITM put: strike > put
Out of the money (OTM)
- An option that, if exercised, would produce a negative cash flow
- Out-of-the-money options are therefore never exercised
- OTM call: strike > MP
- OTM put: strike < MP
At the money (ATM)
An option where the exercise price equals the asset price
largest options market
International Securities Exchange
LEAPS
Long-term Equity AnticiPation Securities
American options
- Can be exercised on or before its expiration
-Generally more valuable than identical European options because of the more leeway
European option
Can be exercised only at expiration
Options Clearing Corporation (OCC)
- Clearinghouse for options, jointly owned by the exchanges on which options are traded
- Mediary
- Because OCC guarantees contract performance, it requires option writers to post margin
- OTM options require less margin because expected payouts are lower
Index options
- A call/put based on a stock market index (E.x. S&P 500)
- Does not require the writer actually “deliver/purchase the index” upon exercise
- a cash settlement procedure is used
- Payoff = exercise price - value of index
futures options
- Holders have the right to buy/sell a specified futures contract, futures price is the expiration
- Call holder receives current futures price - exercise price
foreign currency options
- Right to buy/sell a specified quantity of foreign currency for a specified number of $
- Quoted in cents or fractions of a cent per unit of foreign currency
currency options
payoff depend on the difference between the exercise price and the exchange rate at expiration
currency futures option
payoff depends on the difference between the exercise price and the exchange rate futures price
interest rate options
- Treasury notes/bonds/bills and gov bonds of other major economies
- Treasury note/bond rates, federal funds rate, LIBOR, and British and euro-denominated yields
Payoff to call holder at expiration =
- (ST - X) if ST > X
- 0 if ST <= X
- Net profit = payoff - initial price of call
Payoff to call writer at expiration =
- -(ST - X) if ST > X)
- 0 if ST <= X
Payoff to put holder at expiration =
- 0 if ST >= X
- (X - ST) if ST < X
- Net profit = payoff - initial price of put
Payoff to put writer at expiration =
- 0 if ST >= X
- -(ST - X) if ST < X
writing puts naked
- writing a put without an offsetting short position in the stock
- Exposes the writer to losses if the market falls
bullish options
- Purchasing calls
- Writing puts
bearish options
- Purchasing puts
- Writing calls
risk management using options
Strategies to limit the risk of a portfolio
protective put
- An asset combined with a put option that guarantees minimum proceeds equal to the put’s exercise price
- Cost of protection is that, if the stock price increases, your profit is reduced by the cost of the put
covered call
- Writing a call on an asset together with buying the asset
- “Covered” because the potential obligation to deliver the stock can be satisfied using the stock held in the portfolio
straddle
- A combination of a call and a put, each with the same exercise price and expiration date
- Worst-case is no movement in the stock price
strip
two puts and one call on a security with the same exercise price and expiration date
strap
two calls and one put on a security with the same exercise and expiration date
spread
A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration
money spread
purchase of one option and the sale of another with a different exercise price
time spread
sale and purchase of options with differing expiration dates
collar
An options strategy that brackets the value of a portfolio between two bounds
callable bond
- Entitling the issuer to buy the bonds back form the bondholders at a specified call price
- Conveys a “call option” to the issuer, where the exercise price is the call price
- “Premium” to the bondholder (“writer”) is higher coupon rate
convertible securities
- Convey options to the holder of the security rather than to the issuing firm
- Gives its holder the right to exchange each bond or share of Pstock for a fixed number of shares of Cstock, regardless of the MP of the securities at the time
warrants
- An option issued by the firm to purchase shares of the firm’s stock
- Requires the firm to issue a new share of stock to satisfy its obligation
- Provides CF to the firm when the warrant holder pays the exercise price
- Generally protected against stock splits and dividends in that the number of warrants and the exercise price is adjusted to offset the effects of the split
fully diluted EPS
EPS figures under the assumption that all convertible securities and warrants are exercised
nonrecourse loan
gives the lender no recourse beyond the right to the collateral
Asian options
- have payoffs that depend on the average price of the underlying asset during some portion of the life of the option
- may be of interest to firms that wish to hedge a profit stream that depends on the average price of a commodity over some time period
Currency-translated options
- Have asset or exercise prices denominated in a foreign currency
- The amount of currency that will be translated into dollars depends on the performance of the foreign investment
Quanto option
allows an investor to fix in advance the exchange rate at which in investment in a foreign currency can be converted back into dollars
digital options
Have fixed payoffs that depend on whether a condition is satisfied by the price of the underlying asset
