Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 1 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter 19 Options Markets Website:

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 2 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Learning Objectives Understand how call and put options are used and how they are priced Examine the instruments traded on the Australian options market Understand how options can be used for either risk management or for speculative purposes

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 3 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 4 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.1 Introduction Options differ from futures because they provide asymmetric cover against price movements Options limit the effects of adverse price movements without reducing profits from favourable price movements Options involve a premium to be paid by the buyer to the seller (writer)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 5 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 6 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.2 The Nature of Options An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a predetermined price (exercise or strike price), on or before a specified date (expiration date) An option will only be exercised if it is in the buyer’s best interest

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 7 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.2 The Nature of Options (cont.) Types of options – Call options  Give the option buyer the right to buy the commodity or instrument at the exercise price – Put options  Give the buyer the right to sell the commodity or instrument at the exercise price Options can be exercised either – Only on expiration date (European) – Any time up to expiration date (American)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 8 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.2 The Nature of Options (cont.) Premium is the price paid by an option buyer to the writer (seller) of the option ‘Cap’—an options contract that places an upper limit on an interest rate ‘Floor’—an options contract that places a lower limit on an interest rate ‘Collar’—a combination of cap and floor options limiting upper and lower rates

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 9 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 10 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses Call option profit and loss profiles – Example: a call option for shares in a listed company at a strike price of $12, and a premium of $1.50  Figure 19.1 indicates the profit and loss profiles of a call option for (a) the buyer or holder (long call) and (b) the seller or writer (short call)  The critical break points of the market price of the share at expiration date are $13.50  If S > X (i.e. > $12), option is ‘in-the-money’

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 11 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 12 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 13 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.) The value of the option to the buyer or holder (long call party) is V = max(S - X, 0) - P(19.1) The value of the option to the writer (or short call party) is V = P - max(S - X, 0)(19.2)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 14 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.) Put option profit and loss profiles – Example: a put option for shares in a listed company at a strike price of $12, and premium of $1.50  Figure 19.2 indicates the profit and loss profiles of a put option for (a) the buyer or holder (long put) and (b) the writer or seller (short put)  The critical break points of the market price of the share at expiration date are $12  Buyer exercises option if S < X (i.e. < $12)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 15 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 16 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 17 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.) The value of the option to the buyer or holder (long put party) is V = max(X -S, 0) - P(19.3) The value of the option to the writer (or short put party) is V = P - max(X - S, 0)(19.4)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 18 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.) Covered and uncovered options – Unlike futures, the risk of loss for a buyer of an option contract is limited to the premium – However, sellers (writers) of options have potentially unlimited risk and may be subject to margin requirements unless they write a covered option  I.e. the writer of an option holds the underlying asset or provides a financial guarantee

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 19 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.3 Profits and Losses (cont.) Covered and uncovered options (cont.) – The writer of a call option has written a covered option if either  The writer owns sufficient of the underlying asset to satisfy the option contract if exercised, or  The writer is also the holder of a call option on the same asset, but with a lower exercise price – The writer of a put option has written a covered option if  The writer is also the holder of a put option on the same asset, but with a higher exercise price

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 20 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 21 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market Option markets are categorised as – Over-the-counter – Exchange-traded  These are recorded through a clearing house  Clearing house acts as counter-party to buyer and seller, thus creating two options contracts through the process of ‘novation’  The clearing house allows buyers and sellers to close out (i.e. reverse) their contracts

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 22 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) International options markets – An exchange in a particular country will usually specialise in option contracts that are directly related to physical or futures market products also traded in that particular country – Trading on international exchanges varies  The largest exchanges, CBOT and CME, retain the open outcry trading on the floor involving 4000 to 5000 people – International links between exchanges allow 24-hour trading

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 23 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options markets – Types of options traded  Options on futures contracts  Share options  Low exercise price options (LEPOs)  Warrants  Over-the-counter markets

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 24 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Options on futures contracts  Traded on the Sydney Futures Exchange (SFE)  Buyer of options contract has the right to buy (call) or sell (put) a futures contract  Options on futures available for 90-day bank-accepted bills S&P/ASX All Ordinaries share price index 3- and 10-year Commonwealth Treasury bonds Overnight options on the above Treasury bond and share price options

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 25 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Share options  Traded on the ASX  Based on ordinary shares of specified listed companies  Usually three or more options contracts for each company, each having identical expiration dates, but different exercise prices  The options clearing house maintains a system of deposits, maintenance margins and a share scrip depository

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 26 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Low exercise price options (LEPOs)  Traded on the ASX since 1995  A highly leveraged option on individual stocks, with an exercise price between 1 and 10 cents, and a premium that is similar to the price of the underlying stock  Exercisable only at expiration date (i.e. European)  Available over a range of high-liquidity stocks listed on the ASX

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 27 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Warrants  A type of option (i.e. contractual right but not obligation to buy or sell an underlying asset)  Warrants may be either Equity warrants i.e. attached to debt issues – Option to convert debt to ordinary shares of the issuing company Financial products to manage risk – Issued by financial institutions – Traded on ASX via SEATS – American or European

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 28 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Warrants (cont.)  Other types of warrants include Fractional warrants – Cover only a part of a listed share – May require two fractional warrants to be exercised to buy a share Fully covered warrants – Underlying shares lodged in trust by issuer as guarantee

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 29 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Warrants (cont.)  Other types of Warrants include (cont.) Index warrants – Issued on a share price index (e.g. S&P/ASX All Ordinaries index, S&P 500 index Basket warrants Capped warrants Instalment warrants Capital plus warrants Endowment warrants

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 30 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.4 Organisation of the Market (cont.) The Australian options market (cont.) – Over-the-counter markets  Used to trade options not traded on the exchanges  Allows flexibility in terms of Amount Term Interest rate or price

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 31 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 32 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.5 Pricing an Option Option price or premium is determined by four key factors – Intrinsic value – Time value – Price volatility – Interest rates

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 33 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.5 Pricing an Option (cont.) Intrinsic value – The market price of the underlying asset relative to the exercise price – The greater the intrinsic value, the greater the premium – Options with positive intrinsic value are called ‘in-the-money’ options i.e. the buyer is able to exercise contract at a profit

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 34 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.5 Pricing an Option (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 35 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.5 Pricing an Option (cont.) Time value of an option – The longer the time to expiry, the greater the possibility that the option will be able to be exercised for a profit (i.e. in-the-money) – If the spot price moves adversely, the loss is limited to the premium

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 36 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.5 Pricing an Option (cont.) Price volatility – The greater the volatility of the spot price, the greater the chance of exercising the option for a profit, or a loss – But the option will only be exercised if the price moves favourably – The greater the spot price volatility, the greater the option premium

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 37 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.5 Pricing an Option (cont.) Interest rate levels – Interest rates have opposite impacts on put and call options  Positive relationship between interest rates and the price of a call Present value of deferred payment if exercised versus lower present value of profit if exercised  Negative relationship between interest rates and the price of a put Opportunity cost of holding asset Lower present value of the profit if exercised

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 38 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 39 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies Single-option strategies – Example: long asset (i.e. bought) and bearish (negative) about future asset price  Strategy Limit downside risk by writing a call option Figure 19.4 and Table 19.6 in the textbook illustrate the profit profile of this strategy

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 40 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 41 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 42 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Single-option strategies (cont.) – Example: short asset (i.e. sold) and bullish (positive) about future asset price  Strategy Buy a call in the underlying asset (i.e. take a long call position) Figure 19.5 and Table 19.7 in the textbook illustrate the profit profile of this strategy

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 43 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies – Example: very bullish about future price of the asset  Strategy: ‘vertical bull spread’—contracts with same expiration dates, different exercise prices Write (sell) a put option and earn a premium – To benefit from fall in spot price Hold (buy) a call option with exercise price greater than written put Effect: Offsets high premium associated with call Figure 19.6 in textbook illustrates the profit profile

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 44 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.)

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 45 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – Example: quite bullish, but with some risk of a price fall  Strategy Hold (buy) a call option – To benefit from fall in spot price Write (sell) a call option with a higher exercise price than the long call This ‘call bull spread’ limits the potential loss Figure 19.7 in textbook illustrates the profit profile

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 46 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – Example: very bearish about the future price of the asset  Strategy Hold (buy) put option – To benefit from fall in spot price Write (sell) a call option with a higher exercise price than the long put This ‘vertical bear spread’ limits the potential gain but exposes the writer to unlimited losses Figure 19.8 in textbook illustrates the profit profile

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 47 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – Example: quite bearish, but with some risk of a price rise  Strategy Hold (buy) put option – To benefit from fall in spot price Write (sell) a put option with a lower exercise price than the long put This ‘put bear spread’ limits the potential loss if the price rises Figure 19.9 in textbook illustrates the profit profile

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 48 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – Example: expectation of increased price volatility, with no trend  Strategy Hold (buy) a put option Hold (buy) a call option with common exercise price ‘Long straddle’ provides positive pay-off for both large upward and downward price movements If prices remain unchanged, individual makes loss equal to sum of premiums Figure in textbook illustrates the profit profile

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 49 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – Example: expectation of increased volatility, without trend, with stagnation  Strategy Hold (buy) call option with out-of-the-money exercise price Hold (buy) put option with out-of-the-money exercise price With ‘long strangle’ loss is decreased if price remains unchanged, compared to ‘long straddle’ Figure in textbook illustrates the profit profile

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 50 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – Example: expectation of asset price stability  Strategy Take opposite position to long straddle and long strangle Strategy I: Short straddle – Sell call and put with same exercise price Strategy II: Short strangle – Sell call and put, both out-of-the-money Figure in textbook illustrates the profit profiles

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 51 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.6 Option Risk Management Strategies (cont.) Combined-options strategies (cont.) – More complex strategies  Short butterfly  Short condor  Call ratio backspread  Put ratio backspread

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 52 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 53 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.7 Conclusion: Options Versus Futures Revisited The potential gains and losses to buyers and sellers of futures contracts are different from that of options – Options provide one-sided price protection that is not available through futures – The option buyer limits losses and allows profits to accumulate  However, the premium may be quite high

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 54 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 19.1Introduction 19.2The Nature of Options 19.3Profits and Losses 19.4Organisation of the Market 19.5Pricing an Option 19.6 Option Risk Management Strategies 19.7 Conclusion: Options Versus Futures Revisited 19.8 Summary

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 55 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.8 Summary The holder of an option (long party) has the right to buy (call) or sell (put) the commodity at a specified exercise price The writer (seller) is the short party ASX and SFE trade standardised options, unlike over-the-counter market

Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 56 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 19.8 Summary (cont.) The premium paid to buy an option is affected by its intrinsic value, time value, price volatility, and interest rates A broad array of option strategies may be adopted by hedgers and speculators