Intermediate Investments F3031 Derivatives You and your bookie! A simple example of a derivative Derivatives Gone Wild! –Barings Bank –Metallgesellschaft –Orange County California

Intermediate Investments F3032 Derivatives A derivative is any security whose price is determined by or ‘derived from’ the prices of other securities. They are also sometimes called contingent claims, because their payoffs are contingent on the prices of other securities The first type of Derivative we will discuss are options –Calls –Puts

Intermediate Investments F3033 Options in the WSJ Some options trade OTC Most trade on organized exchanges Stock options are normally for 100 shares of stock Markets are ‘thin’ This can effect the ‘look’ of comparative prices American options – exercise any time before the maturity date European Options – may only be exercised on the maturity date

Intermediate Investments F3034 Call Options Gives the holder the right to buy an asset at a specific price called the exercise price or the strike price The holder is not required to exercise the option The holder would exercise the option only if the market price were higher than the strike price If the option is not exercised, it simply expires at the expiration date The purchase price of the option is called the option premium Profit to Buyer – Stock price – exercise price – option premium

Intermediate Investments F3035 Call Options (cont) Net Profit to writer of option – If not exercised, it is the option premium Net Profit to writer of option – If exercised, it is the exercise price – stock price + option premium Difference between payoff and profit –The call holder cannot have a negative payoff. Loss is limited to the option premium When the stock hits the strike (exercise) price, the value of the call increases dollar for dollar with the increase in price Option is “in the money” when there is a positive payoff Buying a call option is considered ‘bullish’. Why? Writing a call is considered ‘bearish’. Why?

Intermediate Investments F3036 Example of a Call Option Consider the following –Exercise price = $80.00 –Option premium = $5.00 What is the payoff and profit to the buyer of the option if the stock price is: –$78.00 –$82.00 –$88.00 What is the profit to the writer of the option at the same prices?

Intermediate Investments F3037 Put Options Gives the holder the right to sell an asset at a specific price called the exercise price or strike price You do not have to own the asset to sell it (short selling) The holder of the Put profits when the stock price falls below the strike price Once the stock drops to the exercise or strike price, the value of the put increases dollar for dollar with continued drops in the stock price Option is “in the money” when there is a positive payoff Buying a Put is considered ‘bearish’. Why? Selling a Put is considered ‘bullish’. Why?

Intermediate Investments F3038 Example of a Put Option Consider the following –Exercise price = $80.00 –Option premium = $4.75 What is the payoff and profit to the buyer of the option if the stock price is: –$82.00 –$78.00 –$72.00 What is the profit to the writer of the option at the same prices?

Intermediate Investments F3039 Option Strategies Protective Puts – Covered Calls – Long Straddle – Spreads –