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Class Business

Class Business. Homework Liability Bonds. Derivatives. A derivative is a financial instrument whose price depends on the price of another underlying asset. Major derivative contracts are: Futures and forward contracts, Call and put options, Swaps. Historical Background. Before 1973

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Class Business

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  1. Class Business • Homework • Liability • Bonds

  2. Derivatives • A derivative is a financial instrument whose price depends on the price of another underlying asset. • Major derivative contracts are: • Futures and forward contracts, • Call and put options, • Swaps.

  3. Historical Background • Before 1973 • Could not trade derivatives on any exchange • Today • Billions of dollars in contracts are traded • Why? • Fisher Black, arbitrage pricing • 1973 Black and Scholes published their model

  4. Review • A call option is a contract with two sides: • Long Side: pays for the right to buy an asset for a certain price at a certain time in the future. • Short Side: receives premium for agreeing to submit to demands of Long Side. • A put option is a contract with two sides: • Long Side: pays for the right to sell an asset for a certain price at a certain time in the future. • Short Side: receives premium for agreeing to submit to demands of Long Side

  5. Option Terminology • Call – option with the ‘right’ to buy • Put – option with the ‘right’ to sell • Buy the option – Long, buy • Sell the option – Short, sell, write • Key Elements • Exercise or Strike Price (X) – price of future trade • Premium or Price (C, P) – what long position pays • Maturity or Expiration (T)

  6. Option Contracts • European option: can only be exercised on the expiration date. • American option: can be exercised on any day prior to and including the expiration date. • Options Clearing Corporation: • Guarantees contract performance • Members (brokers) post margins with the OCC • Brokers require investor clients to post margins • OCC is “middle man” for exercising options

  7. Option Quotes on IBM Note: Each contract is for 100 shares 95.72

  8. Open Interest D: Short A: Long F: Short E: Long Clearing House B: Short C: Long G: Short

  9. Different Types of Options • Stock Options • Index Options • Futures Options • Foreign Currency Options • Interest Rate Options

  10. Profit Profiles for Long Calls Payoff Long Call ST – X –C 0 X Spot Price (ST) C

  11. Profit Profiles for Short Calls Payoff Spot Price (ST) C X 0 ST – X –C Short Call

  12. Call Options - Zero Sum Game Payoff Long Call 0 X Spot Price (ST) Short Call

  13. Profit Profiles for Long Puts Payoffs X – ST–P 0 Spot Price (ST) X P Long Put

  14. Profit Profiles for Short Puts Payoffs Short Put P X 0 Spot Price (ST) P – (X – ST)

  15. Put Options - Zero Sum Game Payoffs Short Put 0 Spot Price (ST) X Long Put

  16. Market and Exercise Price Relationships In the Money - exercise of the option would be profitable Call: market price>exercise price (St > X) Put: exercise price>market price (St < X) Out of the Money - exercise of the option would not be profitable Call: market price<exercise price (St < X) Put: exercise price<market price(St > X) At the Money - exercise price and asset price are equal (St = X)

  17. Bull Spread Using Calls Profit ST X1 • X2 Positon: Long 1 call at X1 Short 1 call at X2

  18. Straddle Combination Profit Position: Long 1 call at X Long 1 put at X X ST

  19. Option Strategies involving stock Protective Put Long Stock Long Put Profit X ST ) All you are doing is buying calls

  20. Option Strategies involving stock Covered Call Long Stock Short Call Profit ST X ) All you are doing is writing puts

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