Chapter 18 Derivatives and Risk Management

Options A right to buy or sell stock –at a specified price (exercise price or "strike" price) –within a specified time period The price of an option is called the "premium.”

Options to Buy Stock Call –Option to buy created by investors Warrants –Option to buy created by a corporation

Option to Sell Stock Put –Option to sell stock at a specified price within a specified time period

The Intrinsic Value of an Option Depends on the value of the underlying stock Is derived from the underlying stock –hence the name "derivatives”

The Intrinsic Value of an Option to Buy Stock The difference between –the price of the stock and –the strike (exercise) price

In, Out, & At the Money Options An "in" the money call option: price of the stock exceeds the exercise price (positive intrinsic value) An "out" of the money call option: exercise price exceeds the price of the stock An "at" the money call option: exercise price equals the price of the stock

The Intrinsic Value of an Option

An option cannot sell for less than its intrinsic value An option sells for its intrinsic value on the expiration date

Options & Leverage Options are purchased for their potential leverage Percentage return on option may exceed the percentage return on the underlying stock

The Time Premium of an Option Price of the option minus its intrinsic value Prior to expiration, an option sells for a time premium At expiration there is no time premium

The Time Premium of an Option

Chicago Board Options Exchange The first secondary market in options Option prices are reported in the financial press The "open interest:” number of contracts in existence

Profits & Losses to Buyers of Calls Maximum potential loss is the cost of the option Unlimited possible profits

Profits & Losses to Buyers of Calls

Profits, Buying Stock & Calls Calls –limited loss Stock –large possible loss Unlimited profit potential to either long position

Profits, Buying Stock & Calls

Writing Options Options are created ("written") by investors who either –own the underlying stock: “covered” option writing –do not own the underlying stock: “naked” option writing

Covered Call To write a covered call: buy the stock and sell the option Combines a long in the stock and a short in the option Covered call takes advantage of the disappearing time premium Profit is limited

Profit / Loss Profit/loss profile for covered call writing

Naked Call To write a naked call, sell the call The maximum possible profit is the sale price Since the writer does not own the stock, unlimited risk of loss if the price of the stock rises

Naked Call

Profit / Loss Compared When the buyer profits, the naked writer sustains a loss When the naked writer profits, the buyer sustains a loss The profit/loss on buying a call or writing a naked call are mirror images

Profit / Loss Compared

Puts An option to sell stock –at a specified price –within a specified time period Buy a put in anticipation of the stock's price declining Sell a put in anticipation of the stock's price remaining stable or rising

Put’s Intrinsic Value A put's intrinsic value rises as the price of the stock declines

Profit / Loss: Buying a Put Profit/loss profile for buying a put

Profit / Loss: Writing a Put Profit/loss profile for writing a put

Profit / Loss Once again the profit/loss profiles from buying a put and writing a put are mirror images

Profit / Loss

Stock Index Options Put and call options based on –an index of stock prices –instead of a specific stock Avoid the risk of selecting individual securities Capture movements in the market as a whole

Stock Index Call Buying a stock index call –a long position in the market –anticipates a market increase Selling a stock index call –a short position against the market –anticipates a market decline

Stock Index Put Buying a put is made in anticipation of a market decline Both buying a stock index put or selling an index call is made in anticipation of lower stock prices

Futures A formal agreement (contract) for –the delivery (seller) or –receipt (buyer) of a commodity Participants in futures markets are either –speculators –hedgers

Futures Contracts Contracts establish a futures price The current (spot) price may be –Lower –Higher than the futures price

Positions Speculators buy or sell contracts in anticipation of price changes The long position anticipates price increases The short position anticipates price decreases

Open Interest Number of contracts in existence

Closing a Futures Contract Close a position in a futures by entering into the opposite position A contract to sell "offsets" a contract to buy A contract to buy "offsets" a contract to sell

Futures and Leverage Futures offer large profits and losses The source of the leverage: the small margin requirement The margin requirement is a small percentage of the value of the contract

Margin Margin: a good faith deposit required of both –the long position and –the short position

Marking to the Market Futures positions are "marked to the market" daily Funds are transferred between accounts

Maintenance Margin A second margin requirement If funds in the account fall below the maintenance margin requirement, the investor receives a "margin call” Failure to meet the margin call results in the position being closed

Hedgers Buy and sell contracts to offset existing positions Are growers and other users of commodities Wish to reduce the risk of loss from price fluctuations

Hedgers Pass the risk of loss to the speculators Take the opposite positions of the speculators Forego the possibility of a large return to obtain future price certainty

Financial and Currency Futures Financial futures –contracts for the future delivery of a financial asset Currency futures –contracts for the future delivery of a currency

Stock Index Futures Based on an index of stock prices Speculators buy and sell stock index futures in anticipation of changes in stock prices Portfolio managers use stock index futures to hedge against movements in stock prices

Risk Management and Currency Futures Contracts Establishes a future price Manages exchange rate risk

Hedging Strategies If receiving a future payment, enter contract to sell the currency If making a future payment, enter contract to buy the currency