Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 1 Chapter 16 Options Markets

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 2 Option Terminology Buy Sell Call Put Key Elements

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 3 Market and Exercise Price Relationships In the Money - exercise of the option would be profitable Call: Put: Out of the Money - exercise of the option would not be profitable Call: Put: At the Money -

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 4 American vs European Options American - European -

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 5 Different Types of Options Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 6 Payoffs and Profits on Options at Expiration - Calls Notation Stock Price = S T Exercise Price = X Payoff to Call Holder ( S T - X) 0 Profit to Call Holder

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 7 Payoffs and Profits on Options at Expiration - Calls Payoff to Call Writer - ( S T - X) 0 Profit to Call Writer

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 8 Profit Stock Price 0 Call Writer Call Holder Profit Profiles for Calls

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 9 Payoffs and Profits at Expiration - Puts Payoffs to Put Holder 0 (X - S T ) Profit to Put Holder

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 10 Payoffs and Profits at Expiration - Puts Payoffs to Put Writer 0 -(X - S T ) Profits to Put Writer

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 11 Profit Profiles for Puts 0 Profits Stock Price Put Writer Put Holder

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 12 Equity, Options & Leveraged Equity - Text Example InvestmentStrategyInvestment Equity only $8,000 Options only $8,000 Leveraged $1,000 equity $7,000

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 13 Equity, Options & Leveraged Equity - Payoffs Microsoft Stock Price $75$80$100 All Stock$ All Options$$$ Lev Equity $ $ $

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 14 Equity, Options & Leveraged Equity - Rates of Return Microsoft Stock Price $75 $80$100 $75 $80$100 All Stock-6.25% 0% 25% All Options-100% -100%100% Lev Equity % %14.25%

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 15 Put-Call Parity Relationship S T X Payoff for Call Owned Payoff for Put Written Total Payoff

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 16 Payoff of Long Call & Short Put Long Call Short Put Payoff Stock Price Combined = Leveraged Equity

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 17 Arbitrage & Put Call Parity Since the payoff on a combination of a long call and a short put are equivalent to leveraged equity, the prices must be equal. If the prices are not equal arbitrage will be possible

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 18 Put Call Parity - Disequilibrium Example Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 10.25% Maturity =.5 yr X = 105

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 19 Put-Call Parity Arbitrage ImmediateCashflow in Six Months PositionCashflowS T 105 Buy Stock Borrow X/(1+r) T = 100 Sell Call Buy Put Total

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 20 Option Strategies Protective Put Covered Call Straddle (Same Exercise Price)

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 21 Option Strategies Spreads - Vertical or money spread Horizontal or time spread

Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 22 Exotic Options Asian Options Barrier Options Lookback Options Currency-Translated Options Binary Options