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FIN730 > Module 4.2 > Flashcards

Module 4.2 Flashcards

1
Q

Background on Options (1 of 5)

A

Call Option: Right to buy underlying financial instrument at exercise price (or strike price) within a specified period of time.

In the money when market price > exercise price At the money when market price = exercise price

Out of the money when market price < exercise price

Put Option: Right to sell underlying financial instrument at exercise price (or strike price) within a specified period of time.

In the money when market price < exercise price At the money when market price = exercise price

Out of the money when market price > exercise price

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2
Q

Comparison of Options and Futures

A

To obtain an option, a premium must be paid in addition to the price of the financial instrument. The owner of an option can choose to let the option expire on the expiration date without exercising it

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3
Q

Markets Used to Trade Options

A

The Chicago Board Options Exchange (CBOE), created in 1973, is the most important exchange for trading options. Options are also traded at the CME Group. As the popularity of stock options increased, various stock exchanges began to list options. Listing Requirements — One key requirement is a minimum trading volume of the underlying stock. Role of the Options Clearing Corporation — Serves as a guarantor on option contracts traded in the United States. Regulation of Options Trading — SEC and others.

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4
Q

How Option Trades Are Executed

A

Computer technology allows investors to have trades executed electronically. Market-makers can execute stock option transactions for customers. Types of Orders An investor can use either a market order or a limit order for an option transaction. Online Trading — Option contracts can also be purchased or sold online.

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5
Q

Stock Option Quotations (Exhibit 14.1) Institutional Use of Options

A

Although options positions are sometimes taken by financial institutions for speculative purposes, they are more commonly used for hedging. (Exhibit 14.2)

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6
Q

Viperon Company Stock Option Quotations

A
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7
Q

Institutional Use of Options Markets

A
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8
Q

Determinants of Call Option Premiums

A

§Influence of the Market Price — The higher the existing market price of the underlying financial instrument relative to the exercise price, the higher the call option premium, other things being equal. (Exhibit 14.3)

§Influence of the Stock’s Volatility — The greater the volatility of the underlying stock, the higher the call option premium, other things being equal.

§Influence of the Call Option’s Time to Maturity — The longer the call option’s time to maturity, the higher the call option premium, other things being equal. (Exhibit 14.4)

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9
Q

Relationship between Exercise Price and Call Option Premium on KSR Stock

A
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10
Q

Relationship between Time to Maturity and Call Option Premium on KSR Stock

A
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11
Q

Determinants of Put Option Premiums

A

§Influence of the Market Price — The higher the existing market price of the underlying stock relative to the exercise price, the lower the put option premium, other things being equal. (Exhibit 14.5)

§Influence of the Stock’s Volatility — The greater the volatility of the underlying stock, the higher the put option premium, other things being equal.

§Influence of the Put Option’s Time to Maturity — The longer the time to maturity, the higher the put option premium, other things being equal (Exhibit 14.6)

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12
Q

Relationship between Exercise Price and Put Option Premium on KSR Stock

A
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13
Q

Relationship between Time to Maturity and Put Option Premium on KSR Stock

A
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14
Q

How Option Pricing Can Be Used to Derive a Stock’s Volatility

A

§Some investors assess a specific stock’s risk by using the option-pricing formula to estimate the stock’s anticipated volatility.

§By using the prevailing option premium and values for the other factors in the option-pricing formula, the implied volatility or implied standard deviation can be estimated.

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15
Q

Explaining Changes in Option Premiums

A

§Economic conditions and market conditions can cause abrupt changes in the stock price or in the anticipated volatility of the stock price over the time until option expirations, leading to changes in the stock option’s premium. (Exhibit 14.7)

§Indicators Monitored by Participants in the Options Market Traders of options tend to monitor economic indicators because economic conditions affect cash flows of firms and thus can affect expected stock valuations and stock option premiums.

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16
Q

Framework for Explaining Why a Stock Option’s Premium Changes over Time

A
17
Q

Speculating with Stock Options

A

Speculating with Call Options

§Call options can be used to speculate on the expectation of an increase in the price of the underlying stock.

§See Exhibits 14.8 – 14.11.

Speculating with Put Options

§Put options can be used to speculate on the expectation of a decrease in the price of the underlying stock.

§See Exhibits 14.12.

18
Q

Potential Gains or Losses on a Call Option: Exercise Price = $115, Premium = $4

A
19
Q

Potential Gains or Losses for Three Call Options (Buyer’s Perspective)

A
20
Q

Potential Returns on Three Different Call Options

A
21
Q

Potential Returns for Three Call Options (Buyer’s Perspective)

A
22
Q

Potential Gains or Losses on a Put Option: Exercise Price = $110, Premium = $2

A
23
Q

Excessive Risk from Speculation

A

§Firms should closely monitor the trading of derivative contracts by their employees to ensure that derivatives are being used within the firm’s guidelines.

§Firms should separate the reporting function from the trading function so that traders cannot conceal trading losses.

§When firms receive margin calls on derivative positions, they should recognize that there may be potential losses on their derivative instruments and should closely evaluate those positions.

24
Q

Hedging with Covered Call Options (Exhibit 14.13)

A

§Call options on a stock can be used to hedge a position in that stock.

§When the stock declines in value, the premium received from selling the call partially offsets the losses incurred on the stock.

§When the stock increases in value, the call will be exercised and the stock will be sold to the purchaser of the call option.

25
Q

Risk-Return Trade-off from Covered Call Writing

A
26
Q

Risk-Return Trade-off from Covered Call Writing Graph

A
27
Q

Hedging with Put Options

A

§Put options are used to hedge when portfolio managers are concerned about a temporary decline in a stock’s value.

§Hedging with LEAPs

§Long-term equity anticipations (LEAPs) are options that have longer terms to expiration, usually between two and three years from the initial listing date.

§These options are available for some large capitalization stocks, and they may be a more effective hedge over a longer term period than using options with shorter terms to expiration.

28
Q

Options on ETFs and Stock Indexes

A

§Options are also traded on exchange-traded funds (ETFs) and stock indexes.

§A stock index option provides the right to trade a specified stock index at a specified price by a specified expiration date.

§Call options on stock indexes allow the right to purchase the index, and put options on stock indexes allow the right to sell the index.

§Options on indexes have become popular for speculating on general movements in the stock market. (Exhibit 14.14)

29
Q

Sampling of ETFs and Indexes on Which Options Are Traded

A
30
Q

Hedging with Stock Index Options

A

Financial institutions and other firms commonly take positions in options on ETFs or indexes to hedge against market or sector conditions that would adversely affect their asset portfolio or cash flows.

§Hedging with Long-Term Stock Index Options — LEAPs are used by option market participants who want options with longer terms until expiration.

§Dynamic Asset Allocation with Stock Index Options

Dynamic asset allocation involves switching between risky and low-risk investment positions in response to changing expectations. Some portfolio managers use stock index options as a tool for dynamic asset allocation.

31
Q

Using Index Options to Measure the Market’s Risk

A

§A stock index’s implied volatility can be derived from information about options on that stock index.

§The same factors that affect the option premium on a stock affect the option premium on an index.

32
Q

Options on Futures Contracts

A

§In recent years, the concept of options has been applied to futures contracts to create options on futures contracts (sometimes referred to as “futures options”).

§An option on a particular futures contract gives its owner the right (but not an obligation) to purchase or sell that futures contract for a specified price within a specified period of time.

§Options are available on stock index futures.

§Options on indexes have become popular for speculating on general movements in the stock market.

Options are also available on interest rate futures, such as Treasury note futures or Treasury bond futures

33
Q

Speculating with Options on Futures

A

Speculators who anticipate a change in interest rates should also expect a change in bond prices.

§Speculation Based on an Expected Decline in Interest Rates If speculators expect a decline in interest rates, they may consider purchasing a call option on Treasury bond futures.

§Speculation Based on an Expected Increase in Interest Rates If speculators expect interest rates to increase, they can benefit from purchasing a put option on Treasury bond futures.

34
Q

Hedging with Options on Interest Rate Futures

A

Financial institutions commonly hedge their bond or mortgage portfolios with options on interest rate futures contracts
.(Exhibit 14.15)

Hedging with Options on Stock Index Futures

§Determining the Degree of the Hedge with Options on Stock Index Futures — A higher premium must be paid to purchase put options with a higher strike price.

§Selling Call Options to Cover the Cost of Put Options — Fees can be generated by selling call options to help cover the cost of purchasing put options.

35
Q

Results from Hedging with Put Options on Treasury Bond Futures

A
36
Q

Options as Executive Compensation

A

Limitations of Option Compensation

§Many option compensation programs do not account for general market conditions.

§Executives with substantial options may be tempted to manipulate the stock’s price upward in the short term, even though doing so adversely affects the stock price in the long term.

§Backdating Options — In the late 1990s and early 2000s, some firms allowed their CEOs to backdate options they had already been granted to an earlier period when the stock price was lower. In 2006, firms that allowed backdating terminated the practice.

37
Q

Limitations of Option Compensation Programs

A

§Stock options are not always effective at aligning executives’ incentives with actual firm performance.

§Executives with substantial options may be tempted to manipulate the stock’s price upward in the short term, even though doing so adversely affects the stock price in the long term.

Firms can prevent the wrongful use of options by requiring that executives hold them for several years before exercising them

38
Q

Globalization of Option Markets

A

Currency Options Contracts

§A currency call option provides the right to purchase a specified currency for a specified price within a specified period of time.

§Speculators purchase call options on currencies that they expect to strengthen against the dollar.

§A currency put option provides the right to sell a specified currency for a specified price within a specified period of time.

§Speculators purchase put options on currencies they expect to weaken against the dollar.

§For every buyer of a currency call or put option, there must be a seller (or writer).

FIN730 (17 decks)

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