1. CHAPTER 20 Investments Options Markets: Introduction Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

2. 20- 2 Cover image  Buy - Long  Sell - Short  Call  Put  Key Elements –Exercise or Strike Price –Premium or Price –Maturity or Expiration Option Terminology

3. 20- 3 Cover image 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

4. 20- 4 Cover image 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

5. 20- 5 Cover image  Stock Options  Index Options  Futures Options  Foreign Currency Options  Interest Rate Options Different Types of Options

6. 20- 6 Cover image Figure 20.1 Stock Options on IBM

7. 20- 7 Cover image Figure 20.2 Index Options

8. 20- 8 Cover image 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

9. 20- 9 Cover image Payoff to Call Writer - ( S T - X) if S T >X 0if S T < X Profit to Call Writer Payoff + Premium Payoffs and Profits at Expiration - Calls

10. 20- 10 Cover image Figure 20.3 Payoff and Profit to Call Option at Expiration

11. 20- 11 Cover image Figure 20.4 Payoff and Profit to Call Writers at Expiration

12. 20- 12 Cover image Payoffs to Put Holder 0if S T > X (X - S T ) if S T < X Profit to Put Holder Payoff - Premium Payoffs and Profits at Expiration - Puts

13. 20- 13 Cover image Payoffs to Put Writer 0if S T > X -(X - S T )if S T < X Profits to Put Writer Payoff + Premium Payoffs and Profits at Expiration - Puts

14. 20- 14 Cover image Figure 20.5 Payoff and Profit to Put Option at Expiration

15. 20- 15 Cover image InvestmentStrategyInvestment Equity onlyBuy stock @ 100100 shares$10,000 Options onlyBuy calls @ 101000 options$10,000 LeveragedBuy calls @ 10100 options $1,000 equityBuy T-bills @ 3% $9,000 Yield Equity, Options & Leveraged Equity

16. 20- 16 Cover image 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

17. 20- 17 Cover image 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

18. 20- 18 Cover image Figure 20.6 Rate of Return to Three Strategies

19. 20- 19 Cover image Table 20.1 Value of a Protective Put Position at Option Expiration

20. 20- 20 Cover image Figure 20.7 Value of a Protective Put Position at Option Expiration

21. 20- 21 Cover image Figure 20.8 Protective Put versus Stock Investment (at-the-money option)

22. 20- 22 Cover image Table 20.2 Value of a Covered Call Position at Expiration

23. 20- 23 Cover image Figure 20.9 Value of a Covered Call Position at Expiration

24. 20- 24 Cover image 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

25. 20- 25 Cover image Table 20.3 Value of a Straddle at Option Expiration

26. 20- 26 Cover image Figure 20.10 Value of a Straddle at Expiration

27. 20- 27 Cover image Table 20.4 Value of a Bullish Spread Position at Expiration

28. 20- 28 Cover image Figure 20.11 Value of a Bullish Spread Position at Expiration

29. 20- 29 Cover image C + X / (1 + r f ) T = S 0 + P If the prices are not equal arbitrage will be possible. Put Call Parity

30. 20- 30 Cover image Stock Price = 110 Call Price = 17 Put Price = 5 Risk Free = 5% Maturity = 1 yr X = 105 C + X / (1 + r f ) T > S 0 + P 117 > 115 Since the leveraged equity is less expensive, acquire the low cost alternative and sell the high cost alternative. Put Call Parity - Disequilibrium Example

31. 20- 31 Cover image Table 20.5 Arbitrage Strategy

32. 20- 32 Cover image Optionlike Securities  Callable Bonds  Convertible Securities  Warrants  Collateralized Loans

33. 20- 33 Cover image Figure 20.12 Values of Callable Bonds Compared with Straight Bonds

34. 20- 34 Cover image Figure 20.13 Value of a Convertible Bond as a Function of Stock Price

35. 20- 35 Cover image Figure 20.14 Collateralized Loan

36. 20- 36 Cover image Figure 20.15 Return on Indexed Linked CD

37. 20- 37 Cover image Table 20.6 Prices of Digital Options on Initial Jobless Claims

38. 20- 38 Cover image Figure 20.16 Implied Probability of Jobless Claims Derived from Traded Digital Options

39. 20- 39 Cover image Exotic Options  Asian Options  Barrier Options  Lookback Options  Currency Translated Options  Digital Options