CHAPTER 20 Investments Options Markets: Introduction Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

20- 2 Cover image  Buy - Long  Sell - Short  Call  Put  Key Elements –Exercise or Strike Price –Premium or Price –Maturity or Expiration Option Terminology

20- 3 Cover image 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

20- 4 Cover image 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

20- 5 Cover image  Stock Options  Index Options  Futures Options  Foreign Currency Options  Interest Rate Options Different Types of Options

20- 6 Cover image Figure 20.1 Stock Options on IBM

20- 7 Cover image Figure 20.2 Index Options

20- 8 Cover image 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 at Expiration - Calls

20- 9 Cover image Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff + Premium Payoffs and Profits at Expiration - Calls

Cover image Figure 20.3 Payoff and Profit to Call Option at Expiration

Cover image Figure 20.4 Payoff and Profit to Call Writers at Expiration

Cover image 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

Cover image 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

Cover image Figure 20.5 Payoff and Profit to Put Option at Expiration

Cover image InvestmentStrategyInvestment Equity onlyBuy shares$10,000 Options onlyBuy options$10,000 LeveragedBuy options $1,000 equityBuy 3% $9,000 Yield Equity, Options & Leveraged Equity

Cover image 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

Cover image 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% Rates of Return

Cover image Figure 20.6 Rate of Return to Three Strategies

Cover image Table 20.1 Value of a Protective Put Position at Option Expiration

Cover image Figure 20.7 Value of a Protective Put Position at Option Expiration

Cover image Figure 20.8 Protective Put versus Stock Investment (at-the-money option)

Cover image Table 20.2 Value of a Covered Call Position at Expiration

Cover image Figure 20.9 Value of a Covered Call Position at Expiration

Cover image 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

Cover image Table 20.3 Value of a Straddle at Option Expiration

Cover image Figure Value of a Straddle at Expiration

Cover image Table 20.4 Value of a Bullish Spread Position at Expiration

Cover image Figure Value of a Bullish Spread Position at Expiration

Cover image C + X / (1 + r f ) T = S 0 + P If the prices are not equal arbitrage will be possible. Put Call Parity

Cover image Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 5% Maturity = 1 yr X = 105 C + X / (1 + r f ) T > S 0 + P 117 > 115 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative. Put Call Parity - Disequilibrium Example

Cover image Table 20.5 Arbitrage Strategy

Cover image Optionlike Securities  Callable Bonds  Convertible Securities  Warrants  Collateralized Loans

Cover image Figure Values of Callable Bonds Compared with Straight Bonds

Cover image Figure Value of a Convertible Bond as a Function of Stock Price

Cover image Figure Collateralized Loan

Cover image Figure Return on Indexed Linked CD

Cover image Table 20.6 Prices of Digital Options on Initial Jobless Claims

Cover image Figure Implied Probability of Jobless Claims Derived from Traded Digital Options

Cover image Exotic Options  Asian Options  Barrier Options  Lookback Options  Currency Translated Options  Digital Options