McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Options Markets: Introduction Chapter 20

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Buy - Long Sell - Short Call Put Key Elements -Exercise or Strike Price -Premium or Price -Maturity or Expiration Option Terminology

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved In the Money - exercise of the option would be profitable. Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable. Call: market price>exercise price Put: exercise price>market price At the Money - exercise price and asset price are equal. Market and Exercise Price Relationships

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved American - the option can be exercised at any time before expiration or maturity. European - the option can only be exercised on the expiration or maturity date. American vs European Options

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options Different Types of Options

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Notation Stock Price = S T Exercise Price = X Payoff to Call Holder ( S T - X) if S T >X 0if S T < X Profit to Call Holder Payoff - Purchase Price Payoffs and Profits on Options at Expiration - Calls

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff + Premium Payoffs and Profits on Options at Expiration - Calls

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Profit Profiles for Calls Profit Stock Price 0 Call Writer Call Holder

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X Profit to Put Holder Payoff - Premium Payoffs and Profits at Expiration - Puts

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X Profits to Put Writer Payoff + Premium Payoffs and Profits at Expiration - Puts

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Profit Profiles for Puts 0 Profits Stock Price Put Writer Put Holder

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved InvestmentStrategyInvestment Equity onlyBuy shares$10,000 Options onlyBuy options$10,000 LeveragedBuy options $1,000 equityBuy 2% $9,000 Yield Equity, Options & Leveraged Equity - Text Example

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved IBM Stock Price $95$105$115 All Stock$9,500$10,500$11,500 All Options$0 $5,000$15,000 Lev Equity $9,270 $9,770$10,770 Equity, Options & Leveraged Equity - Payoffs

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved IBM Stock Price $95$105$115 All Stock-5.0%5.0% 15% All Options-100% -50% 50% Lev Equity -7.3%-2.3% 7.7% Equity, Options & Leveraged Equity - Rates of Return

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Protective Put Use - limit loss Position - long the stock and long the put PayoffS T X Stock S T S T Put X - S T 0

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Protective Put Profit STST Profit -P Stock Protective Put Portfolio

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Covered Call Use - Some downside protection at the expense of giving up gain potential. Position - Own the stock and write a call. PayoffS T X Stock S T S T Call 0 - ( S T - X)

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Covered Call Profit STST Profit -P Stock Covered Call Portfolio

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Straddle (Same Exercise Price) Long Call and Long Put Spreads - A combination of two or more call options or put options on the same asset with differing exercise prices or times to expiration. Vertical or money spread: Same maturity Different exercise price Horizontal or time spread: Different maturity dates Option Strategies

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved S T X Payoff for Call Owned 0S T - X Payoff for Put Written-( X -ST) 0 Total Payoff S T - X S T - X Put-Call Parity Relationship

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Long Call Short Put Payoff Stock Price Combined = Leveraged Equity Payoff of Long Call & Short Put

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. C - P = S 0 - X / (1 + r f ) T If the prices are not equal arbitrage will be possible. Arbitrage & Put Call Parity

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% Maturity =.5 yr X = 105 C - P > S 0 - X / (1 + r f ) T > (105/1.05) 12 > 10 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative. Put Call Parity - Disequilibrium Example

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Put-Call Parity Arbitrage ImmediateCashflow in Six Months PositionCashflowS T 105 Buy Stock-110 S T S T Borrow X/(1+r) T = Sell Call+17 0-(S T -105) Buy Put S T 0 Total 2 0 0

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Optionlike Securities Callable Bonds Convertible Securities Warrants Collateralized Loans

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Exotic Options Asian Options Barrier Options Lookback Options Currency Translated Options Binary Options

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Chapter 20 Weblinks This site contains online option education material. It has extensive programs to learn about the use of options, options pricing, and option markets. This site has extensive links to many other sites. It contains sections on education, exchanges, research, quotes, as well as extensive sources related to futures markets.

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Chapter 20 Weblinks The Options Industry Council site contains extensive educational material including access to the freely available Options Toolbox. The toolbox is an excellent source that allows you to simulate different options positions and examine the pricing on options. Links to numerous options and other derivative websites. Links to numerous options and other derivative websites.

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Chapter 20 Weblinks Exchange sites:

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Home Assignment Required: problems 1, 2, 7 (3 rd ed). problems 2, 3, 7 (5 th ed). visit the recommended web sites closely follow financial news!