1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Chapter 20 Options Markets: Introduction 20-1

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Buy - Long Sell - Short Call Put Key Elements –Exercise or Strike Price –Premium or Price –Maturity or Expiration Option Terminology 20-2

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 20-3

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 20-4

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Stock Options Index Options Futures Options Foreign Currency Options Interest Rate Options Different Types of Options 20-5

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 at Expiration – Calls 20-6

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Payoff to Call Writer –- (ST - X) if ST >X 0if ST < X Profit to Call Writer –Payoff + Premium Payoffs and Profits at Expiration - Calls 20-7

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Profit Profiles for Calls Profit Stock Price 0 Call Writer Call Holder 20-8

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Payoffs to Put Holder: 0if ST > X (X - ST) if ST < X Profit to Put Holder –Payoff – Premium Payoffs and Profits at Expiration – Puts 20-9

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Payoffs to Put Writer” 0if ST > X -(X - ST)if ST < X Profits to Put Writer –Payoff + Premium Payoffs and Profits at Expiration - Puts 20-10

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Profit Profiles for Puts 0 Profits Stock Price Put Writer Put Holder 20-11

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh InvestmentStrategyInvestment Equity onlyBuy stock @ 100300 shares$10,000 Options onlyBuy calls @ 101000 options$10,000 LeveragedBuy calls @ 10100 options $1,000 equityBuy T-bills @ 2% $9,000 Yield Equity, Options and Leveraged Equity 20-12

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh IBM Stock Price $95$105$115 All Stock$9,500$10,500$11,500 All Options$0$5,000$15,000 Lev Equity $9,270 $9,770$10,770 Equity, Options Leveraged Equity – Payoffs 20-13

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh IBM Stock Price $95$105$115 All Stock-5.0%5.0% 15% All Options-100% -50% 50% Lev Equity -7.3%-2.3% 7.7% Rates of Return 20-14

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 20-15

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Protective Put Profit STST Profit -P Stock Protective Put Portfolio 20-16

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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) 20-17

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Covered Call Profit STST Profit -P Stock Covered Call Portfolio 20-18

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 20-19

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 20-20

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Long Call Short Put Payoff Stock Price Combined = Leveraged Equity Payoff of Long Call and Short Put 20-21

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 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 and Put Call Parity 20-22

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Stock Price = 110Call Price = 17 Put Price = 5Risk Free = 10.25% Maturity =.5 yrX = 105 C - P > S 0 - X / (1 + r f ) T 17- 5 > 110 - (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 20-23

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Put-Call Parity Arbitrage ImmediateCashflow in Six Months PositionCashflowS T 105 Buy Stock-110 S T S T Borrow X/(1+r) T = 100+100-105-105 Sell Call+17 0-(S T -105) Buy Put -5105-S T 0 Total 2 0 0 20-24

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Option vs. Stock investments Options may be viewed as a substitute for buying or selling stocks: Buying calls: Bullish strategy Writing calls: Bearish strategy Buying puts: Bearish strategy Buying call or put, premium has to be paid 20-25

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Option-like Securities Callable Bonds Convertible Securities Warrants Collateralised Loans 20-26

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Financial Engineering Creation of portfolio with specified payoff patterns Used by institutional investors Example Liquid-yield option note (LYON) ‘A zero-coupon convertible callable and puttable bond.’ 20-27

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Exotic Options Asian Options Barrier Options Lookback Options Currency Translated Options Binary Options 20-28

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Summary Call Option: Right to buy Put Option: Right to sell American style option: flexibility in exercise European style option: Exercise on expiry Underlying of options: -Stocks, Stock Indices -Foreign currencies, Fixed income securities and future contracts 20-29

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh Summary Options strategies: -Covered calls, protective puts -Straddles, spreads and collars Put-call parity Option characteristics and securities Options on OTC markets 20-30