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Class Business

This insightful guide covers the history, terminology, and types of derivative contracts. Learn about options and their intricacies, including European and American options. Discover key elements and profit profiles for various option strategies.

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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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