1. Chapter 27 OPTIONS MARKETS

2. Options Contracts zthe right (not obligation) to buy/sell a specified amount of a specific underlying asset at a specified price either on or before a specified date zparties: buyer, writer (seller) zbuyer pays option price (or premium) for right zbuyer pays exercise (or strike) price on exercise zexpiration date or maturity date

3. Options Terminology zcall(buy underlying) & put (sell) options zAmerican (exercise up to maturity date) or European (exercise on maturity date) options z(buyer’s) maximum loss = (seller’s) maximum profit = option price yno margin needed for buyer yseller often asked to post option price as margin zexchange-traded or OTC options: former CFTC or SEC regulated, standardised clearinghouse, lower costs

4. Differences Between Options and Futures Contracts zfutures contract yboth parties obliged to transact ysymmetric risk/return zOptions contract yonly the writer obliged to transact ybuyer has a limited, known maximum loss yasymmetric risk/return zpick instrument to match risk type

5. Risk/Return Characteristics of Call Options ze.g. buying a (European) call = `long a call’: ylike taking a long position in the underlying asset with a fixed, maximum loss ybuyer gains if the price of the underlying asset rises yseller gains if the price of the underlying asset falls or is unchanged zleverage: buy multiple at option price; borrow to exercise if price moves in the right direction z(forthcoming diagrams assume no discounting)

6. Buyer’s profits if long a call profit price at expiration 45° strike price - option price

7. Risk/Return Characteristics of Put Options ze.g. buying a (European) put = `long a put’: ylike taking a short position in the underlying asset with a fixed, maximum loss ybuyer gains if the price of the underlying asset falls yseller gains if the price of the underlying asset rises or is unchanged

8. Buyer’s profits if long a put profit price at expiration 45° strike price - option price

9. Economic Role of the Options Market zhedging with futures: ylocking in price eliminates price risk ybut can’t gain from favourable price movements zhedging with options: ybounds price risk on one side ymay benefit from favourable price movements zhow to hedge with calls: yif you plan to buy an underlying asset in the future (e.g. wheat, $US, etc.) then price rises are a threat ybuying a calls hedges against these while keeping ability to gain from price fall in the underlying asset yvice versa with hedges

10. U.S. Options Markets zstock options: ycalls allowed 1973, puts 1977 ystandardised (like futures) zstock index options yallowed since 1983 ycash settlement zinterest rate options ye.g. debt (‘options on physical’) yoften OTC z FLEX options ycustomised but exchange traded (response to OTCs) z exotic options (OTC) ylimited exercise (set of dates) yalternative/either-or: can buy/sell one of X or Y at p x or p y youtperformance: strike value = price(portfolio B) – price(portfolio A)

11. Futures Options zbuys the right to acquire a position in a futures contract: ya long position in the case of a call option. ya short position in the case of a put option. zfutures options more popular than options on physicals in the fixed-income (debt/interest) market: yinstitutional: no interest payments to settle yfutures market more liquid than underlying (so also ‘better’ prices)