Lecture 14 Flashcards
Derivatives =
Securities that get their value from the price of other securities
Derivatives are traded
On both organised exchanges, and over the counter
Call option
Gives its holder the right to buy an asset:
- At the exercise/ strike price
- On/before the expiration date
One will exercise the option to buy the underlying asset if
The market value exceeds the strike price (what you paid for it)
Is the holder required to exercise their option?
No
If the option remains unexercised before the expiration date per the contract
The option expires, and no longer has any value
Put options
Give the holder the right to sell an asset:
- At exercise/ strike price
- On/ before the expiration date
One will exercise the option to sell the underlying asset if
The market value falls below the strike price
Upon exercise of a put option
The investor’s broker will purchase the necessary shares at the market price, and deliver these to the option writer for the exercise price
Owner of the put profits
By the difference between the exercise price and the market price
Purchase price of the option =
Premium
Sellers (writers) of options receive
Premium income
If the holder exercises their option
The writer (seller) must make (call) or take (put) delivery of the underlying asset
In the money =
Exercise of an option would be profitable
In the money > call
Exercise price < market price
In the money > put
Exercise price > market price
Out of the money =
Exercise of the option would not be profitable
Out of the money > call
Market price < exercise price
Out of the money > call
Market price > exercise price
Exercise price =
Price per share at which the owner of a traded option is entitled to buy/ sell the underlying security
At the money =
Exercise price = asset price
American option
Can be exercised at any time before expiration or maturity
European option
Can only be exercised on expiration or maturity date
Over the counter advantage
Terms of the contract can be tailored to the needs of the traders
Over the counter disadvantage
The costs of establishing OTC contract are higher than exchange-traded
Exchange trading
Options contracts are standardised for each listed option
Call holder profit =
Pay off - Purchase price (premium)
Call writer profit =
Pay off + Premium
Put holder profit =
Pay off - Premium
Put writer profit =
Pay off + Premium
