Lecture 15 Flashcards
Protective put =
Purchase of stock combined with put option that guarantees minimum proceeds which are equal to the put’s exercise price
Protective puts can be used as insurance against
Stock price declines
Protective puts lock in
Minimum portfolio value
Cost of insurance =
Put premium
Covered calls =
Purchase stock and write calls against it
Call is ‘covered’ because
Potential obligation to deliver stock is covered by the stock held in the portfolio
Call writer gives up any stock value…
Above exercise price in return for initial premium.
Covered calls forfeit
Potential capital gains should the stock price rise above the exercise price
Long straddle =
Buy call and put with same exercise price and maturity and bet on volatility
Straddle useful for investors
Who believe there will be large movements in stock price, but uncertain about direction of move
Worst-case scenario for straddle strategy
No movement in stock price > call and put expire worthless and investor loses outlay for purchase of both options
To make a profit in straddle
Change in stock price must exceed cost both options
Writer of straddle is betting
Stock price will not change much
Spreads =
Combination of two or more calls (or puts) on the same stock with differing exercise prices or times to maturity
Bullish spread =
Investor thinks one option is overpriced relative to another. Way to profit from stock price increases > pay-off either increases or is unaffected
Money spread =
Purchase one option and simultaneous sale of another with different exercise price
Time spread =
Refers to sale and purchase of options with differing expiration dates
Pay off =
Difference in value call held and value call written
Collars =
Options strategy that brackets the value of portfolios between two bonds
Collars limit downside risk by
Selling upside potential
Collars > net outlay for options is approx zero if
Fund put purchase by writing covered call
Collars are appropriate for investors who
Has a target wealth goal in mind but is unwilling to risk losses beyond a certain level
Put-call parity =
Simultaneously holding a short European put and long European call of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration, and a forward price equal to the option’s strike price
Pay off to put-call parity portfolio =
Identical to pay off in protective put strategy
Call plus bond portfolio must
Cost the same as the stock plus put portfolio
To exploit mispricing
Buy cheap portfolio and sell expensive portfolio
Put call parity can only exist
In European options, which must be exercised on expiration date (not American)
Callable bonds =
Bonds issued with call provisions, which give issuer the right to buy bonds back from bondholders in the future at a specified call price
Exercise price =
Repurchase price of bond
Convertible securities =
Gives holder the right to exchange a bond/ share of preferred stock for a fixed number of shares of common stock regardless of the market price of the securities at the time
Most convertible securities are issued ‘deep out of the money’:
Issuer sets a conversion ratio such that the conversion is not profitable unless there is a substantial increase in stock prices, or fall in bond prices
Warrants =
Call options issued by a firm (can be tailored to meet the needs of the firm)
Exercise of a warrant requires
A firm to issue a new share of stock
Warrants result in
Cash flow to firm when warrant holder pays the exercise price
Asian options =
Options with payoff that depends on the average price of underlying asset
Barrier options (down and out)
Payoff depends on some barriers eg barrier price
Lookback options
Payoff depends on a minimum/ maximum price of underlying asset
Currency translated options
Have assets/ exercise prices denominated in foreign currency
Digital options (binary)
Have fixed pay-offs that depend on whether the condition is satisfied by the price of the underlying assets
