Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-1 Chapter 17

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-2 Chapter Summary  Objective: This chapter is an introduction to the option markets. Options’ investment characteristics Option strategies Put-Call parity relationship Option-like securities and exotic options

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-3  Buy - Long  Sell - Short  Call  Put  Key Elements Exercise or Strike Price Premium or Price Maturity or Expiration Option Terminology

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-4  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-5  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-6  Stock Options  Index Options  Futures Options  Foreign Currency Options  Interest Rate Options Different Types of Options

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-7 Summary Reminder  Objective: This chapter is an introduction to the option markets. Options’ investment characteristics Option strategies Put-Call parity relationship Option-like securities and exotic options

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-8 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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 17-9 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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Payoff Profiles for Calls Payoff Stock Price 0 Call Writer Call Holder

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Payoffs to Put Holder 0if ST > X (X - ST) if ST < X Profit to Put Holder Payoff - Premium Payoffs and Profits at Expiration - Puts

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Payoffs to Put Writer 0if ST > X -(X - ST)if ST < X Profits to Put Writer Payoff + Premium Payoffs and Profits at Expiration - Puts

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Payoff Profiles for Puts 0 Payoffs Stock Price Put Writer Put Holder

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide InvestmentStrategyInvestment Equity onlyBuy shares$10,000 Options onlyBuy options$10,000 LeveragedBuy 5200 options $1,000 equityBuy 3% $9,000 Yield Equity, Options & Leveraged Equity - Text Example

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Alcan Stock Price $45$55$65 All Stock$9,000$11,000$13,000 All Options$0$10,000$30,000 Lev Equity $9,270$10,270$12,270 Equity, Options & Leveraged Equity - Payoffs

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Alcan Stock Price $45$55$65 All Stock-10.0%10.0% 30% All Options-100% 0% 200% Lev Equity -7.3%-2.7%27.7% Equity, Options & Leveraged Equity - Returns

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: This chapter is an introduction to the option markets. Options’ investment characteristics Option strategies Put-Call parity relationship Option-like securities and exotic options

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Protective Put Profit STST Profit - P Stock Protective Put Portfolio

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 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)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Covered Call Profit STST Profit -P Stock Covered Call Portfolio

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: This chapter is an introduction to the option markets. Options’ investment characteristics Option strategies Put-Call parity relationship Option-like securities and exotic options

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Long Call Short Put Payoff Stock Price Combined = Leveraged Equity Payoff of Long Call & Short Put

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: This chapter is an introduction to the option markets. Options’ investment characteristics Option strategies Put-Call parity relationship Option-like securities and exotic options

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Option-like Securities  Callable Bonds  Convertible Securities  Warrants  Collateralized Loans

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Exotic Options  Asian Options  Barrier Options  Lookback Options  Currency Translated Options  Binary Options