1. 3.1 Options Lecture 3

2. 3.2 Long Call on IBM Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months 30 20 10 0 -5 708090100 110120130 Profit ($) Terminal stock price ($)

3. 3.3 Short Call on IBM Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months -30 -20 -10 0 5 708090100 110120130 Profit ($) Terminal stock price ($)

4. 3.4 Long Put on Exxon Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths 30 20 10 0 -7 706050408090100 Profit ($) Terminal stock price ($)

5. 3.5 Short Put on Exxon Profit from writing an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths -30 -20 -10 7 0 70 605040 8090100 Profit ($) Terminal stock price ($)

6. 3.6 Payoffs from Options X = Strike price, S T = Price of asset at maturity Payoff STST STST X X STST STST X X

7. 3.7 Terminology Moneyness : –At-the-money option –In-the-money option –Out-of-the-money option Expiration date Strike price European or American Call or Put (option class)

8. 3.8 Types of Options Exchange-traded options –Stocks –Foreign Currency –Stock Indices –Futures Warrants Convertible bonds swapoptions....

9. 3.9 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

10. 3.10 Warrants (continued) Warrants are traded in the same way as stocks When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued

11. 3.11 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

12. 3.12 Executive Stock Options continued They become vested after a period ot time They cannot be sold They often last for as long as 10 or 15 years

13. 3.13 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

14. 3.14 Convertible Bonds (continued) 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

15. 3.15 Exchangeable Bonds An exchangeable bond is a sort of convertible bond that provides the conversion into the shares of a company different from the issuer Usually, the underlying stock is the equity of a strategic partnership There can be adverse signalling problem which are reduced with “best of” structures

16. 3.16 Trading Strategies Involving Options

17. 3.17 Three Alternative Strategies Take a position in the option & the underlying Take a position in 2 or more options of the same type (A spread) Combination: Take a position in a mixture of calls & puts (A combination)

18. 3.18 Positions in an Option & the Underlying Profit STST X STST X STST X STST X (a) (b) (c)(d) cap on long strategy floor on long strategy floor on short strategy cap on short strategy

19. 3.19 basket of options spread type: basket of options of the same type (call or put) –bull spread –bearish spread –butterfly spread combination type: basket of options of different types –straddles

20. 3.20 Bull Spread Using Calls X1X1 X2X2 Profit STST initial cash outflow

21. 3.21 Bull Spread Using Puts X1X1 X2X2 Profit STST initial cash outflow

22. 3.22 Bear Spread Using Calls X1X1 X2X2 Profi t STST initial cash inflow

23. 3.23 Bear Spread Using Puts X1X1 X2X2 Profit STST initial cash inflow

24. 3.24 Butterfly Spread Using Calls X1X1 X3X3 Profit STST X2X2 buy 2 calls and sell 2 calls

25. 3.25 Butterfly Spread Using Puts X1X1 X3X3 Profit STST X2X2

26. 3.26 A Straddle Combination Profit STST X bottom straddle

27. 3.27 A 2nd Straddle Combination top straddle X1X1 Profit STST

28. 3.28 A Strangle Combination X1X1 X2X2 Profit STST

29. 3.29 A Top Vertical Combination X1X1 X2X2 Profit STST