Topic 4 - Options and Corporate Finance: Basic Concepts Flashcards
What does an option contract gives the holder the right to do?
gives the holder the right, but not the obligation, to buy or sell a given quantity of an underlying asset on (or before) a given date, at a price agreed upon today
whats the difference between European versus American options?
- European options can be exercised only at expiry
- American options can be exercised at any time up to
expiry
What does the difference in EU vs US options mean for their value?
an American option can never be worth less than a European option that is otherwise the same - because early exercise could be a valuable opportunity
What does a call option do?
A Call option gives the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future, at a price agreed upon today
What does a put option do?
A Put option gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at a price agreed upon today
When is a call in/out of the money?
- In-the-Money if S0 > E
- Out-of-the-money if S0
When is a put in/out of the money?
- In-the-Money if S0 E
what are the Components of Option Value? (2)
intrinsic and time value
What is intrinsic value?
The difference between the exercise price of the option and the spot price of the underlying asset.
What is the time value of an option?
The difference between the option premium (i.e., price) and the intrinsic value of the option
what is the formula for intrinsic value of call and put option?
C = S -E P = E -S
what is the formula for time value for both call and puts?
Time value = C - Intrinsic value
who bares more risk the call/put holder or the call/put seller?
The holder does not bear risk – if the stock price goes down/up the option is allowed to expire unexercised
When is a US put/call option equal to a EU put/call option, with the same characteristics?
at expiry as there is no more time value
What is a Protective Put strategy?
Buy stock and buy put to protect against price decrease
What is a covered call strategy?
Buy stock, sell call to reduce the cost of buying stock
What is a long straddle and what is a short straddle?
Long: buy call and buy put
Short: Sell call and sell put
Only makes money if the price moves in one or the other direction by the sum of the cost of both the call and the put.
What is the put call party?
If the value of one option is known, the other can be determined without resorting to direct valuation
if they have the same exercise price and term to expiry.
If a put is under priced what should you do to make an arbitrage profit?
buy put
exercise put (sell stock)
buy stock
If a call is under priced what should you do to make an arbitrage profit?
buy call
exercise call (buy stock)
sell stock
what are five things that can impact on the value of an american put option?
- The price of the underlying asset (decrease put)
- The strike price of the option.
- The time to expiration of the option.
- The volatility of the underlying asset.
- The interest rate (decrease put)
