AGEC 420, Lec 371 Agec 420 – April 24 Review Quiz #8 Markets Options Reminder: Assignments due # 7 (not 10): Data download and Chart, Fri. April 26 # 8: Regression, Fri. May 3

AGEC 420, Lec 372 Markets CBOT: CME:

AGEC 420, Lec 373 Options Call option: –right to buy the underlying futures contract –at the specified strike price Put option: –right to sell the futures at the strike price

AGEC 420, Lec 374 Hedging with Options Short hedger protects against a price decline by buying put options Long hedger protects against a price increase by buying call options

AGEC 420, Lec 375 Advantages (vs Futures) 1. Can benefit from a favorable price move 2. No margin calls – for the buyer. The most it can cost is the premium - i.e. the cost of buying the option.

AGEC 420, Lec 376 Selling options –Selling a put: involves an obligation to buy futures at the strike (if the option is exercised) –Selling a call: involves an obligation to sell futures at the strike

AGEC 420, Lec 377 Option Price (the Premium) Is determined by supply and demand Depends on –the strike price –time remaining until expiration price volatility

AGEC 420, Lec 378 Option Price (the Premium) Premium = Intrinsic Value + Time Value

AGEC 420, Lec 379 Intrinsic Value --> profit available from exercising the option Call Option has intrinsic value if futures > strike Put Option has intrinsic value if futures < strike So: Intrinsic value depends on the difference between strike and futures

AGEC 420, Lec 3710 “In”,“Out of”,“At” the money In-the-money Option has intrinsic value – can exercise at a profit Call is in the money if futures > strike Put is in the money if futures < strike

AGEC 420, Lec 3711 “In”,“Out of”,“At” the money At-the-money  futures = strike price Out-of-the-money  No intrinsic value: Call is out of the money if futures < strike Put is out of the money if futures > strike No profit available from exercising the option

AGEC 420, Lec 3712 Time value Depends on 1. Time remaining until the option expires The longer the time, the greater the value

AGEC 420, Lec 3713 Time value Depends on 2. Price volatility level The higher the volatility, the greater the value (greater chance of an out-of-the-money option moving into the money)

AGEC 420, Lec 3714 Time value Depends on 3. Interest rates The higher the interest rate, the lower the option value

AGEC 420, Lec 3715 Using an Option 1. Sell it (before it expires) 2. Exercise it –by taking the futures position at the strike price 3. Let it expire (if worthless) eg at expiration, the right to sell for $4.00 is worthless if futures price is above $4.00

AGEC 420, Lec 3716 Short Hedge - Futures Short Hedger –Wants protection from a price decline –Take a position in futures/options that will make $ if prices decline –In futures: sell (go short) If price fall – futures position makes $ If prices rise – futures position looses $ –Price is effectively locked-in (subject to basis risk)

AGEC 420, Lec 3717 Short hedge - Options Short Hedger –Wants protection from a price decline –Take a position in futures/options that will make $ if prices decline –In options: buy a put If price fall – put becomes more valuable - position makes $ If prices rise – put expires worthless –Price not locked-in (upside potential – at a cost)

AGEC 420, Lec 3718 Position diagrams