Financial Risk Management of Insurance Enterprises Options 1

What is an Option Contract? Options provide the right, but not the obligation, to buy or sell an asset at a fixed price Call option is right to buy Put option is right to sell Key distinction between forwards, futures and swaps and options is performance Only option sellers (writers) are required to perform under the contract (if exercised) After paying the premium, option owner has no duties under the contract 2

Some Terminology The exercise or strike price is the agreed on fixed price at which the option holder can buy or sell the underlying asset Exercising the option means to force the seller to perform Make option writer sell if a call, or force writer to buy if a put Expiration date is the date at which the option ceases to exist 3

More Terminology American options allow holder to exercise at any point until expiration European option only allows holder to exercise on the expiration date The premium is the amount paid for an option 4

A Simple Example Suppose PCLife owns a European call option on IBM stock with an exercise price of $100 and an expiration date of 3 months If in 3 months, the price of IBM stock is $120, PCLife exercises the option PCLife’s gain is $20 If at the expiration date the price of IBM is $95, PCLife lets the option expire unexercised If the price of IBM in one month is $3,000, PCLife will not exercise (Why not?) 5

Option Valuation Basics Two components of option value Intrinsic value Time value Intrinsic value is based on the difference between the exercise price and the current asset value (from the owner’s point of view) For calls, max(S-X,0) X= exercise price For puts, max(X-S,0) S=current asset value Time value reflects the possibility that the intrinsic value may increase over time Longer time to maturity, the higher the time value 6

In-the-Moneyness If the intrinsic value is greater than zero, the option is called “in-the-money” It is better to exercise than to let expire If the asset value is near the exercise price, it is called “near-the-money” or “at-the-money” If the exercise price is unfavorable to the option owner, it is “out-of-the-money” 7

Basic Option Value: Calls At maturity If X>S, option expires worthless If S>X, option value is S-X Read call options left to right Only affects payoffs to the right of X 8

Basic Option Value: Calls (p.2) Of course, for the option writer, the payoff at maturity is the mirror image of the call option owner 9

Basic Option Values: Puts At maturity If S>X, option expires worthless If X>S, option value is X-S Read put options right to left Only affects payoffs to the left of X 10

Combining Options and Underlying Securities Call options, put options and positions in the underlying securities can be combined to generate specific payoff patterns

Payoff Diagram Example Name two options strategies used to get the following payoff 11

Payoff Diagram Example Reading with calls (left to right) Buy one call with X=10 Sell two calls with X=30 Buy one call with X=50 Reading with puts (right to left) Buy one put with X=50 Sell two puts with X=30 Buy one put with X=10 12

Determinants of Call Value Value must be positive Increasing maturity increases value Increasing exercise price, decreases value American call value must be at least the value of European call Value must be at least intrinsic value For non-dividend paying stock, value exceeds S-PV(X) Can be seen by assuming European style call 13

Determinants of Call Value (p.2) As interest rates increase, call value increases This is true even if there are dividends As the volatility of the price of the underlying asset increases, the probability that the option ends up in-the-money increases 14

Put-Call Parity Consider two portfolios One European call option plus cash of PV(X) One share of stock plus a European put Note that at maturity, these portfolios are equivalent regardless of value of S Since the options are European, these portfolios always have the same value If not, there is an arbitrage opportunity (Why?) 15

Fisher Black and Myron Scholes Developed a model to value European options on stock Assumptions No dividends No taxes or transaction costs One constant interest rate for borrowing or lending Unlimited short selling allowed Continuous markets Distribution of terminal stock returns is lognormal Based on arbitrage portfolio containing stock and call options Required continuous rebalancing

Black-Scholes Option Pricing Model C = Price of a call option S = Current price of the asset X = Exercise price r = Risk free interest rate t = Time to expiration of the option  = Volatility of the stock price N = Normal distribution function

Using the Black-Scholes Model Only variables required Underlying stock price Exercise price Time to expiration Volatility of stock price Risk-free interest rate

Example Calculate the value of a call option with Stock price = $18 Exercise price = $20 Time to expiration = 1 year Standard deviation of stock returns = .20 Risk-free rate = 5%

Answer

Use of Options Options give users the ability to hedge downside risk but still allow them to keep upside potential This is done by combining the underlying asset with the option strategies Net position puts a floor on asset values or a ceiling on expenses 16

Hedging Commodity Price Risk with Options P/C insurer pays part of its claims for replacing copper plumbing Instead of locking in a fixed price using futures or swaps, the insurer wants to get a lower price if copper prices drop Insurer can buy call options to protect against increasing copper prices If copper prices increase, gain in option offsets higher copper price 17

Hedging Copper Prices 18

Additional Uses of Options Interest rate risk Currency risk Equity risk Market risk Individual securities Catastrophe risk

Next Lecture Combining the building blocks with each other to create new risk management products Combining the building blocks with debt or equity to create hybrid securities