Wulin Suo 1 MGT 821/ECON 873 Financial Derivatives Options: General Properties

Wulin Suo 2 Options Assets Underlying Exchange-Traded Options  Stocks, Foreign Currency, Stock Indices, Futures Specification of Exchange-Traded Options  Expiration date  Strike price  European or American  Call or Put (option class)

Wulin Suo 3 Terminology Moneyness :  At-the-money option  In-the-money option  Out-of-the-money option Option chain Option class  Same type: call or put Option series  A particular contract that’s traded Intrinsic value Time value

Wulin Suo 4 Dividends & Stock Splits Suppose you own N options with a strike price of X :  No adjustments are made to the option terms for cash dividends  When there is an n-for-m stock split, the strike price is reduced to mX/n the no. of options is increased to nN/m  Stock dividends are handled in a manner similar to stock splits

Wulin Suo 5 Warrants Warrants are options that are issued (or written) by acorporation or a financial institution The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire

Wulin Suo 6 Warrants Warrants are traded in the same way as stocks The issuer settles up with the holder when a warrant is exercised When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued

Wulin Suo 7 Executive Stock Options Option issued by a company to executives When the option is exercised the company issues more stock Usually at-the-money when issued They become vested after a period of time They cannot be sold They often last for as long as 10 or 15 years

Wulin Suo 8 Convertible Bonds Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

Wulin Suo 9 Convertible Bonds Very often a convertible is callable The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose Very often a convertible is callable The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

Wulin Suo 10 Options embedded in Other Financial Products E.g.:  equity linked GIC  Extendible GIC  Mortgage rate caps

Wulin Suo 11 Properties of Stock Option Prices Effects of market variables cpCP Variable S0S0 X T  r D ++ – + ?? – + – – –– + – + – +

Wulin Suo 12 Bound for European Options: No Dividends Call Put Put-Call Parity

Wulin Suo 13 Early Exercise Usually there is some chance that an American option will be exercised early  An exception is an American call on a non- dividend paying stock  This should never be exercised early Why?  What if the stock pays dividends? Puts?

Wulin Suo 14 The Impact of Dividends on Lower Bounds to Option Prices Call Put

Wulin Suo 15 Extensions of Put-Call Parity American options; D = 0 S 0 - X < C - P < S 0 - Xe -rT European options; D > 0 c + D + Xe -rT = p + S 0 American options; D > 0 S 0 - D - X < C - P < S 0 - Xe -rT