CHAPTER 8 OPTIONS DERIVATIVES

Learning Objectives Describe what is an option and difference from futures Describe the difference between ETO and OTC options Explain the uses of options Explain the differences between call option and put option Explain the terms in-the-money, at-the-money and out-of-money Describe the differences between American Style Option and European Style Option Explain the terms class of option, series of options and premium Describe the contract specification of call and put of OKLI Sketch the pay-off diagram of the basic strategies, straddles, strangles and spreads Explain the difference between Binomial Options Pricing Model and The Black-Scholes Option Pricing Model Explain the determinants of option prices

Chapter Outline Introduction to Options ET Options vs OTC Options Uses of Options The Key Elements of an Option KLCI Options Pay-off Diagrams Options Strategies Option Pricing

What is an Option? Options is a contract between two parties in which the buyer of the option (here we call the option buyer) has the right but not obliged, to buy or sell a certain asset at a certain price before/on a certain date from the seller of the option (here we call the option seller). The option buyer who buys the option has the right but not obliged to exercise the option unless he wishes to. As for the option seller, he is obliged to perform according to the terms of the contract once the option buyer exercises the option.

Option Terminology Call Option Right to buy an asset at a specified exercise price on or before the exercise date. Put Option Right to sell an asset at a specified exercise price on or before the exercise date.

Option Obligations

Differences between Option and Futures Compare to futures, the buyer of the option has a choice of not to complete the deal and would only deal if the price is favourable to him. The option buyer hence is being protected from unfavourable market movements. Therefore, the risk of loss is carried by the option seller.

Primary Advantages of Options Buyers of options have limited risk because they will not lose more than option price or premium. ET options provide flexibility to trade freely in the open market. The flexibility improves the liquidity of the options traded in the exchange, allowing prices to be more accurately priced.

ETO and OTC Options Exchange Traded Options (ETO) are options that originate and traded on a formal exchange. Equity options are the most commonly traded on an exchange. Over The Counter (OTC) options are not traded through a formal exchange. Instead the buyers and sellers arrange deals through telephone or face to face meetings.

Uses of Options Investment in options provides leveraging Options can be used extensively in risk management, i.e., hedging Enhance revenue of portfolio by selling call options Options use for financial engineering via strategies Managing information asymmetry -attach put options at the IPO

Egs of options traded in Bursa Malaysia and Singapore Stock Exchange Kuala Lumpur Composite Index Options (OKLI) Singapore Equity Index Options SGX MSCI Singapore (SiMSCI) Options SGX MSCI Taiwan Index Options (European Style) SGX Nikkei 225 Index Options Interest Rate Options SGX 10-Year Mini Japanese Government Bond Options SGX Eurodollar Options SGX Euroyen LIBOR Options SGX Euroyen TIBOR Options

The Key Elements of an Option Types of Options Call option – gives the buyer the right (but not the obligation) to buy. Put option – gives the buyer the right (but not the obligation) to sell. Underlying Asset – e.g. share of a company, an index, foreign currencies, gold etc. Strike Price or Exercise Price – the agreed price at which the underlying asset is transacted if the option is exercised. Expiry Date – maturity date i.e. the last day on which an option can be exercised. Option Style American style – can be exercised at any time by the option buyer from the date he acquires the option up to the date the option expired. European style – can be exercised only on the expiry date by the option buyer.

The Key Elements of an Option Option Classes and Series Class of options refers to either puts or calls on the same underlying shares regardless of the exercised price or the expiry date. E.g. XYZ call options. Series of options refers to all options of the same type (i.e. puts or calls) and class with the same exercised price and the expiry date. E.g. XYZ December RM6 call options.

The Key Elements of an Option Premium – Cost or price of an option. The price that the option buyer pays to the option seller. Intrinsic Value (IV) – profit that can be obtained on an immediate exercise of the option.

Time Value (TV) – Even if the option has zero IV, it will still have some value because the option is yet to expire. TV is the value that arises from the probability that an option will become profitable before its expiry date. TV is always positive before maturity. The longer the time to expiry, the higher the TV. TV reduces when the option approaches maturity. At maturity, TV = zero Residual value of an option’s premium above its intrinsic value. Declines overtime as options approached expiry.

Suppose you bought ABC September RM9 call option for RM0. 50 Suppose you bought ABC September RM9 call option for RM0.50. The ABC stock is currently traded at RM15. Give the following details for this option: Type of option Call – contract that give the right to buy Underlying asset ABC stock Strike price RM9 Expiry date Sept Premium 50 sen IV RM6 IF ABC is selling for RM7, IV = 0 TV = RM0.50

Suppose you bought ABC September RM9 put option for RM0. 50 Suppose you bought ABC September RM9 put option for RM0.50. The ABC stock is currently traded at RM15. Give the following details for this option: Type of option Put – the right to sell Underlying asset ABC stock Strike price RM9 Expiry date Sept Premium RM0.50 IV TV = RM0.50 IF ABC is selling for RM7, IV = RM2 (9-7)

In-the-Money/At-the-Money/Out-of-the-Money In-the-Money – if it has intrinsic value. Option is in-the-money if it has intrinsic value, or can be exercised. E.g. call option is in-the-money if: Strike price < market price Put option is in-the-money if: Strike price > market price At-the-Money- Strike price of the option is the same with price of underlying asset. If Strike price = Market price Out-of-the-Money – Option is out of-the-money if it has no intrinsic value, or cannot be exercised Call option – If strike price > market price Put option – If strike price < market price

Activity 2 Options Strike price KLCI call 1140 KLCI put 1150 ABC call RM5 ABC put RM7 State which option is in-, at- or out-of the money if the price of ABC stock is RM5, and the current index level is 1175. Options KLCI call In-the-money KLCI put Out-of-the-money ABC call At-the-money ABC put In-the money

KLCI Options Is an equity-based option Entails the right or the obligation to buy or sell an underlying asset which includes a basket of shares i.e., 30 Malaysian companies listed in Bursa Malaysia.