Chapter 20 Flashcards
Derivatives Markets
A derivative is a security that gets its value from the values of another asset, such as commodity prices, bond and stock prices, or market index values
Options
Call: Right to buy underlying asset at the strike or exercise price
- Value of calls decreases as strike price increases
Put: Right to sell underlying asset at the strike or exercise price
-Value of puts increase with strike price
**Value of both calls and puts increases with time until expiration
Futures Contracts
An agreement made today regarding the delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity
Long position: Take delivery at maturity
Short position: Make delivery at maturity
Comparison: options vs Futures Contract
Options:
Right, but not obligation, to buy or sell; option is exercised only when it is profitable
Options must be purchased
The premium is the price of the option itself.
Futures Contract:
Obliged to make or take delivery; long position must buy at the futures price, short position must sell at futures price
Futures contracts are entered into without cost
Derivatives
are securities that get their value from the price of other securities.
Derivatives are contingent claims because their payoffs depend on the value of other securities
Option Types:
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
Option:
Contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset during a certain period of time or at the end of the period for a pre-specified price
Holder
Buyer of the contract (Long position)
Writer
Seller of the contract (Short position)
The Option Contract
The purchase price of the option is called the premium.
Sellers (or Writers) of options receive premium income.
If Holder (or Buyer) exercises the option, the option writer must make delivery (call) or take delivery (put) of the underlying asset
Market and Exercise Price Relationships
In the Money - exercise of the option would be profitable
Call: exercise price < market price
Put: exercise price > market price
Out of the Money - exercise of the option would not be profitable
Call: market price < exercise price.
Put: market price > exercise price.
At the Money - exercise price and asset price are equal
Payoffs and Profits at Expiration - Calls
Payoff to Call Holder (ST - X) if ST >X 0 if ST < X Profit to Call Holder Payoff - Purchase Price of Call
Payoffs and Profits at Expiration - Calls
Payoff to Call Writer
- (ST - X) if ST >X
0 if ST < X
Profit to Call Writer
Payoff + Premium
The Option Contract: Puts
A put option gives its holder the right (but not the obligation) to sell an asset:
At the exercise or strike price
On or before the expiration date
Exercise the option to sell the underlying asset if market value < strike.
Put Options
Pays the options price at time=0 and has the right to exercise the option at time=T (European option)
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
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
Protective Puts
Puts can be used as insurance against stock price declines.
Protective puts lock in a minimum portfolio value.
The cost of the insurance is the put premium.
Options can be used for risk management, not just for speculation.
Covered Calls
Purchase stock and write calls against it.
Call writer gives up any stock value above X in return for the initial premium.
If you planned to sell the stock when the price rises above X anyway, the call imposes “sell discipline.”
Straddle
Long straddle: Buy call and put with same exercise price and maturity.
The straddle is a bet on volatility.
To make a profit, the change in stock price must exceed the cost of both options.
You need a strong change in stock price in either direction.
The writer of a straddle is betting the stock price will not change much.
Spread
A spread is a combination of two or more calls (or two or more puts) on the same stock with differing exercise prices or times to maturity.
Some options are bought, whereas others are sold, or written.
A bullish spread is a way to profit from stock price increases
Put-Call Parity
The call-plus-bond portfolio (on left) must cost the same as the stock-plus-put portfolio (on right):
Put Call Parity - Disequilibrium Example
Stock Price = 110 Call Price = 17
Put Price = 5 Risk Free = 5%
Maturity = 1 yr Strike Price = 105
117 > 115
