1. Salaar - Finance Capital Markets Spring Semester 2010 Lahore School of Economics Salaar farooq – Assistant Professor

2. Salaar - Finance Lecture Derivatives & Risk Mgmt: OPTIONS

3. Salaar - Finance Derivatives & Risk Mgmt Ch 19 & 20 Learning Objectives Options Contracts? Options Payoffs & Types? Option Strategies? Options pricing? Futures Contracts? Futures payoffs & types? Futures strategies? Futures pricing?

4. Salaar - Finance Derivative What is it?….

5. Salaar - Finance Derivative What is it?…. Securities whose prices are determined by OR derived from some underlying asset Also called contingent claims (since payoffs are contingent on other assets) Options & Futures are both Derivatives

6. Salaar - Finance Derivative Purpose…. Powerful tools for… ?

7. Salaar - Finance Derivative Purpose…. Powerful tools for… Hedging (shifting risk) Speculation

8. Salaar - Finance Derivative Options Contract…. A contract which gives the right but not the obligation to buy/sell an asset for a specified price on or before a specified expiration date

9. Salaar - Finance Derivative - Options Terminology…. Exercise or Strike price Expiration date American option European option

10. Salaar - Finance Derivative - Options Terminology…. Exercise or Strike price The price at which the asset may be bought/sold or exercised Expiration date The date the option expires American option The option may be exercised on or before expiration European option The option may be exercised ONLY at expiration

11. Salaar - Finance Derivative - Options More Terminology…. In the money Out of the money At the money Payoff profile Option premium

12. Salaar - Finance Derivative - Options More Terminology…. In the money When exercising the option results in a profit Out of the money When exercising results in a loss At the money When exercising results in Break-even (without premium)- ATM & BE are different Payoff profile Shows the P/L of the option at different asset prices Option premium Price paid to own the option

13. Salaar - Finance Derivative Options Contract…. 2 Basic types Call Option Put Option

14. Salaar - Finance Derivative Options Contract…. 2 Basic types Call Option An option to BUY a share of stock at a specified price within a specific period Put Option An option to SELL a share of stock at a specified price within a specified period

15. Salaar - Finance Derivative Options Contract…. How they work? Long Call Option Suppose you think BBC stock will rise in the next four months. The stock trades at $100 now. You don’t want to buy the stock outright but instead would like to have the option to purchase if the stock does go above $100. Option price is $3. You would buy a CALL with a strike price of $100 expiring in 4 mths by paying $3 for it. If the Px goes up, lets say to $110, you would exercise the call!... contd

16. Salaar - Finance Derivative Options Contract…. How they work? Long Call Option This means, You would be able to BUY the stock at $100 when the market price is at $110. And then be able to sell it at the MKT Px with profit.

17. Salaar - Finance Derivative Options Contract…. Developing a payoff profile? Long Call Option Suppose a stock sells for Rs 200. It has an offered CALL option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 150 b) 200 c) 205 d) 210 e) 220

18. Salaar - Finance Derivative Options Contract…. Developing a payoff profile? Long Call Option Suppose a stock sells for Rs 200. It has an offered CALL option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 150 (loss of 10) b) 200 (loss of 10) c) 205 (loss of 5) d) 210 (BE) e) 220 (profit of 10)

19. Salaar - Finance Derivative Options Contract…. NOTICE… Option Buyer has LIMITED downside & UNLIMITED Upside Option Writer has the opposite Payoff Risk/Return will be discussed a bit later Writer takes on all the risk!!

20. Salaar - Finance Derivative Options Contract…. Margin Requirements… Buyer is not subject to margin reqmt. Writer has to put up the option premium as margin & can get margin calls on MTM

21. Salaar - Finance Derivative - Options More Terminology…. Writer The seller of an option is called the “WRITER” Covered Option When an option is written (sold) against actual stock held in portfolio Naked Option When an option is written (sold) without any actual stock held in portfolio

22. Salaar - Finance Derivative Options Contract…. Where are Options traded?… Can trade both Exchanges & OTC Advantages of Exchange traded options?

23. Salaar - Finance Derivative Options Contract…. Where are Options traded?… Can trade both Exchanges & OTC Advantages of Exchange traded options: 1.Strike price & Expiration standardized 2.More liquid 3.Transaction costs are lower

24. Salaar - Finance Options Contract…. Risk & Return Characteristics of Options…. 4 Basic Option positions 1.Buying a Call 2.Selling a Call 3.Buying a PUT 4.Selling a PUT Assumption: European option (held till expiration)

25. Salaar - Finance Options Contract…. CALL Options…. Buying a CALL (Exercise or NOT?) 1.Actual Px below strike? 2.Px equal to strike 3.Px between strike & option premium 4.Px equal to strike+premium 5.Px more than strike+premium

26. Salaar - Finance Options Contract…. CALL Options…. Buying a CALL 1.Actual Px below strike? NO 2.Px equal to strike - NO 3.Px between strike & option premium - YES 4.Px equal to strike+premium - YES 5.Px more than strike+premium - YES

27. Salaar - Finance Buying a MSFT Call Option for $1.2 with strike 25 (Bullish)

28. Salaar - Finance Options Contract…. Call Options…. Writing a CALL (Short Call position) – Selling a Call 1.Actual Px below strike? 2.Px equal to strike 3.Px between strike & option premium 4.Px equal to strike+premium 5.Px more than strike+premium

29. Salaar - Finance Options Contract…. Call Options…. Writing a CALL (Short Call position) – Selling a Call 1.Actual Px below strike? Premium profit 2.Px equal to strike? Premium profit 3.Px between strike & option premium? Reduced profit 4.Px equal to strike+premium? BE 5.Px more than strike+premium? LOSS Unlimited

30. Salaar - Finance Payoff for the Writer of MSFT strike 25, premium $1.2 (Bearish) Short Call Position

31. Salaar - Finance Derivative PUT Contract…. How they work? Long PUT Option Suppose you think BBC stock will DROP in the next four months. The stock trades at $100 now. You don’t want to sell short the stock outright but instead would like to have the option to SELL if the stock does go below $100. Option price is $3. You would buy a PUT with a strike price of $100 expiring in 4 mths by paying $3 for it. If the Px drops, lets say to $90, you would exercise the call!... contd

32. Salaar - Finance Derivative PUT Contract…. How they work? Long PUT Option This means, You would be able to SELL the stock at $100 when the market price is at $90. And then be able to BUY it at the MKT Px with profit.

33. Salaar - Finance Derivative PUT Contract…. Developing a payoff profile? Long PUT Option Suppose a stock sells for Rs 200. It has an offered PUT option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 210 b) 200 c) 195 d) 190 e) 180

34. Salaar - Finance Derivative PUT Contract…. Developing a payoff profile? Long PUT Option Suppose a stock sells for Rs 200. It has an offered PUT option for Rs 10 with a strike price of Rs 200. What would be the payoff profile at the following stock prices a) 210 (Loss of 10) b) 200 (Loss of 10) c) 195 (Loss of 5) d) 190 (Break Even) e) 180 (Profit of 10)

35. Salaar - Finance Options Contract…. PUT Options…. Buying a PUT Option (Long Put position) 1.Actual Px below strike? YES 2.Px equal to strike - NO 3.Px between strike & option premium - YES 4.Px equal to strike-premium = YES 5.Px less than strike-premium = YES

36. Salaar - Finance Long Put (Bearish) Buying a PUT

37. Salaar - Finance Short Put (Bullish) Selling a PUT

38. Salaar - Finance Options Contract…. Some combinations…. Following are some combinations used by investors to create custom pay-off profiles

39. Salaar - Finance Buying a MSFT Call Option for $1.2 with strike 25 (Bullish) Long Call

40. Salaar - Finance Payoff for the Writer of MSFT strike 25, premium $1.2 (Bearish) Short Call

41. Salaar - Finance Long Put (Bearish)

42. Salaar - Finance Short Put (Bullish)

43. Salaar - Finance Options Contract…. Pricing of Options…. 6 Main Factors of Option pricing 1.Current Px of Underlying asset 2.Strike Price 3.Time of Expiration 4.Expected volatility over option life 5.Short term Risk-Free interest rate over option life 6.Anticipated C/F’s on underlying asset

44. Salaar - Finance Options Contract…. Pricing of Options…. Basic Components of Option Price 1.Intrinsic Value 2.Time Premium

45. Salaar - Finance Options Contract…. Pricing of Options…. Basic Components of Option Price 1.Intrinsic Value Economic value of the option if exercised immediately. If no positive value results, than intrinsic is zero. 2.Time Premium Amount by which the option price exceeds its intrinsic value

46. Salaar - Finance Options Contract…. Price Components of Options…. Basic Components of Option Price 1.Intrinsic Value Difference b/w the current price of asset & strike price, IF positive. Example: a)If strike px = 100, asset px is 105, then intrinsic value = ? b)If strike px = 100, asset px is 95, then intrinsic value = ?

47. Salaar - Finance Options Contract…. Price Components of Options…. Basic Components of Option Price 1.Intrinsic Value Difference b/w the current price of asset & strike price, IF positive. Example: a)If strike px = 100, asset px is 105, then intrinsic value = 105-100=5 b)If strike px = 100, asset px is 95, then intrinsic value = 0

48. Salaar - Finance Derivative - Options More Terminology…. In the money When strike price of Call is ? asset px. (profitable), intrinsic value >0 Out of the money When strike price of Call is ? asset px (NOT profitable), intrinsic value = 0 At the money When strike px of call is ? asset (NOT profitable), intrinsic value = 0

49. Salaar - Finance Derivative - Options Intrinsic Value relationships…. In the money When strike price of Call is below asset px. (profitable), intrinsic value >0 Out of the money When strike price of Call is above asset px (NOT profitable), intrinsic value = 0 At the money When strike px of call is same as asset (NOT profitable), intrinsic value = 0

50. Salaar - Finance Options Contract…. Price Components of Options…. Basic Components of Option Price 1.Time Premium Amount by which the Option price EXCEEDS its intrinsic value (due to time) Example: a)If strike px = 100, asset px is 105, option px = 9- Time premium = ? b)If strike px = 100, asset px is 90, option px = 9 – Time premium = ?

51. Salaar - Finance Options Contract…. Price Components of Options…. Basic Components of Option Price 1.Time Premium Amount by which the Option price EXCEEDS its intrinsic value (due to time) Example: a)If strike px = 100, asset px is 105, option px = 9- Time premium = 9-5 = 4 b)If strike px = 100, asset px is 90, option px = 9 – Time premium = 9-0 = 9

52. Salaar - Finance Options Contract…. Pricing of Options…. 6 Main Factors of Option pricing (Breakdown) 1.Current Px of Underlying asset 2.Strike Price 3.Time of Expiration 4.Expected volatility over option life 5.Short term Risk-Free interest rate over option life 6.Anticipated C/F’s on underlying asset

53. Salaar - Finance Options Contract…. Pricing of Options…. 1.Current Px of Underlying asset Option px changes as price of underlying changes. Call px increases w/increase in asset px (for same strike) Put px decreases w/increase in asset px

54. Salaar - Finance Options Contract…. Pricing of Options…. 2.Strike Px The lower the strike px, the higher the px of a call The higher the strike px, the higher the px of put

55. Salaar - Finance Options Contract…. Pricing of Options…. 3.Time to expiration An option is a wasting asset & has no value after expiration! The longer the time, greater the price (time premium) NOTE: probability of a favorable px move decreases with less time

56. Salaar - Finance Options Contract…. Pricing of Options…. 4.Expected Px Volatility of Asset over option life Volatility is measured by standard deviation The more the Vols, (greater the probability of favorable px move), …Greater the option px NOTE: Beta (systematic risk) is not used. Total vols. is relevant

57. Salaar - Finance Options Contract…. Pricing of Options…. 5.Short term risk-free rate (over option life) Greater the Rf, greater the call option px NOTE: Buying an option frees up cash for investor from buying the underlying. This can then be invested at the Rf! So… greater Rf, more attractive the Option, greater the option px in case of Put… option px will be lower, since selling directly provides invest able funds

58. Salaar - Finance Options Contract…. Pricing of Options…. 6.Anticipated C/F’s from asset (over option life) C/F from asset makes the asset more attractive & Decreases the call option px & Increase the put option px NOTE: Option holders don’t have interim C/F rights

59. Salaar - Finance Summary…. Pricing of Options…. 6 Main Factors of Option pricing 1.Current Px of Underlying asset – increases CALL 2.Strike Price – Lower the strike, higher the CALL 3.Time of Expiration – Longer the time, higher the px 4.Expected volatility over option life – higher vols, higher px 5.Short term Risk-Free rate – Higher Rf, Higher Call px,-lower Put px 6.C/F’s on underlying asset – Higher C/F’s, lower call px

60. Salaar - Finance Pricing of Options…. 6 Main Factors of Option pricing (if increased) Call PxPut Px 1.Current Px of asset –increases decrease 2.Strike Price – ?? 3.Time of Expiration – 4.Expected volatility – 5.ST Risk-Free rate – 6.C/F’s on asset –

61. Salaar - Finance Pricing of Options…. 6 Main Factors of Option pricing (if increased) Call PxPut Px 1.Current Px of asset –increases decrease 2.Strike Price – decreaseincrease 3.Time of Expiration –?? 4.Expected volatility – 5.ST Risk-Free rate – 6.C/F’s on asset –

62. Salaar - Finance Pricing of Options…. 6 Main Factors of Option pricing (if increased) Call PxPut Px 1.Current Px of asset –increases decrease 2.Strike Price – decreaseincrease 3.Time of Expiration –increaseincrease 4.Expected volatility – ?? 5.ST Risk-Free rate – 6.C/F’s on asset –

63. Salaar - Finance Pricing of Options…. 6 Main Factors of Option pricing (if increased) Call PxPut Px 1.Current Px of asset –increases decrease 2.Strike Price – decreaseincrease 3.Time of Expiration –increaseincrease 4.Expected volatility – increaseincrease 5.ST Risk-Free rate – ?? 6.C/F’s on asset –

64. Salaar - Finance Pricing of Options…. 6 Main Factors of Option pricing (if increased) Call PxPut Px 1.Current Px of asset –increases decrease 2.Strike Price – decreaseincrease 3.Time of Expiration –increaseincrease 4.Expected volatility – increaseincrease 5.ST Risk-Free rate – increasedecrease 6.C/F’s on asset – ??

65. Salaar - Finance Pricing of Options…. 6 Main Factors of Option pricing (if increased) Call PxPut Px 1.Current Px of asset –increases decrease 2.Strike Price – decreaseincrease 3.Time of Expiration –increaseincrease 4.Expected volatility – increaseincrease 5.ST Risk-Free rate – increasedecrease 6.C/F’s on asset – decreaseincrease

66. Salaar - Finance Options Contract…. Real Quote Example…. This is what a real quote would look like!

67. Salaar - Finance Johnson & Johnson Options quotes Specs

68. Salaar - Finance Starbucks options

69. Salaar - Finance Options Contract…. Economic Role of Option Markets…. Hedging Investor owns Asset A selling for $100. investor expects to sell in one mth but is concerned px might drop. What should he/she do?

70. Salaar - Finance Options Contract…. Economic Role of Option Markets…. Hedging with PUT Investor owns Asset A selling for $100. investor expects to sell in one mth but is concerned px might drop. Buy Put Option premium for a $100 strike is $2 Guarantees a min px to sell of 98 (100-2), & offers unlimited upside THIS IS A HEDGE AGAINST A PRICE DROP!

71. Salaar - Finance Options Contract…. Economic Role of Option Markets…. Hedging Investor will receive $100 in 1 mth & wants to buy Asset A currently selling for $100. investor expects to BUY in one mth but is concerned px might rise. What should he/she do?

72. Salaar - Finance Options Contract…. Economic Role of Option Markets…. Hedging with Call Suppose an Investor will receive $100 in 1 mth & wants to buy Asset A currently selling for $100 now. investor expects to BUY in one mth but is concerned px might rise. Buy Call option price of $2 with strike $100 Guarantees a Max px to Buy of 102 (100+2), & offers unlimited upside THIS IS A HEDGE AGAINST A PRICE RISE!

73. Salaar - Finance Options Ch 11 Learning Summary Options Contracts: Right but not obligation… Options Types: Calls & Puts Option Strategies: Combinations & payoffs Options pricing: Intrinsic Value & Time premium The 6 factors: Asset Px, Strike, Time, Vols, Rf, C/F’s

74. Salaar - Finance Finished: Options Next: Futures