Options and

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Chapter 17
Options and other Derivatives Introduction
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Chapter Summary

• Objective This chapter is an introduction to the
  option markets.
• Options investment characteristics
• Option strategies
• Put-Call parity relationship
• Option-like securities and exotic options

3
Option Terminology

• Buy - Long
• Sell - Short
• Call
• Put
• Key Elements
• Exercise or Strike Price
• Premium or Price
• Maturity or Expiration

4
Market and Exercise Price Relationships

• In the Money - exercise of the option would be
  profitable
• Call market price gt exercise price
• Put exercise price gt market price
• Out of the Money - exercise of the option would
  not be profitable
• Call market price lt exercise price
• Put exercise price lt market price
• At the Money - exercise price and asset price are
  equal

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American vs. European Options

• 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

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Different Types of Options

• Stock Options
• Index Options
• Futures Options
• Foreign Currency Options
• Interest Rate Options

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Summary Reminder

• Objective This chapter is an introduction to the
  option markets.
• Options investment characteristics
• Option strategies
• Put-Call parity relationship
• Option-like securities and exotic options

8
Payoffs and Profits on Options at Expiration -
Calls

• Notation
• Stock Price ST Exercise Price X
• Payoff to Call Holder
• (ST - X) if ST gtX
• 0 if ST lt X
• Profit to Call Holder
• Payoff - Purchase Price

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Payoffs and Profits on Options at Expiration -
Calls

• Payoff to Call Writer
• - (ST - X) if ST gtX
• 0 if ST lt X
• Profit to Call Writer
• Payoff Premium

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Payoff Profiles for Calls
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Payoffs and Profits at Expiration - Puts

• Payoffs to Put Holder
• 0 if ST gt X
• (X - ST) if ST lt X
• Profit to Put Holder
• Payoff - Premium

12
Payoffs and Profits at Expiration - Puts

• Payoffs to Put Writer
• 0 if ST gt X
• -(X - ST) if ST lt X
• Profits to Put Writer
• Payoff Premium

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Payoff Profiles for Puts
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Equity, Options Leveraged Equity - Text Example
Investment Strategy Investment Equity only Buy
stock _at_ 50 200 shares 10,000 Options only Buy
calls _at_ 5 2000 options 10,000 Leveraged Buy
calls _at_ 5 200 options 1,000 equity Buy T-bills
_at_ 3 9,000 Yield
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Equity, Options Leveraged Equity - Payoffs
Alcan Stock Price 45 55 65 All
Stock 9,000 11,000 13,000 All
Options 0 10,000 30,000 Lev Equity
9,270 10,270 12,270
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Equity, Options Leveraged Equity - Returns
Alcan Stock Price 45 55 65 All
Stock -10.0 10.0 30 All Options -100
0 200 Lev Equity -7.3 -2.7 27.
7
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Summary Reminder

• Objective This chapter is an introduction to the
  option markets.
• Options investment characteristics
• Option strategies
• Put-Call parity relationship
• Option-like securities and exotic options

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Protective Put

• Use - limit loss
• Position - long the stock and long the put
• Payoff ST lt X ST gt X
• Stock ST ST
• Put X - ST 0

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Protective Put Profit
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Covered Call

• Use - Some downside protection at the
• expense of giving up gain potential
• Position - Own the stock and write a call
• Payoff ST lt X ST gt X
• Stock ST ST
• Call 0 - ( ST - X)

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Covered Call Profit
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Option Strategies

• 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

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Summary Reminder

• Objective This chapter is an introduction to the
  option markets.
• Options investment characteristics
• Option strategies
• Put-Call parity relationship
• Option-like securities and exotic options

24
Put-Call Parity Relationship
ST lt X ST gt X Payoff for Call Owned
0 ST - X Payoff for Put Written -( X - ST)
0 Total Payoff ST - X ST - X
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Payoff of Long Call Short Put
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Arbitrage Put Call Parity

• Since the payoff on a combination of a long call
  and a short put are equivalent to leveraged
  equity, the prices must be equal.
• C - P S0 - X / (1 rf)T
• If the prices are not equal arbitrage will be
  possible

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Put Call Parity - Disequilibrium Example

• Stock Price 110 Call Price 17
• Put Price 5 Risk Free 10.25
• Maturity .5 yr X 105
• C - P gt S0 - X / (1 rf)T
• 17- 5 gt 110 - (105/1.05)
• 12 gt 10
• Since the leveraged equity is less expensive,
  acquire the low cost alternative and sell the
  high cost alternative

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Put-Call Parity Arbitrage
Immediate Cashflow in Six Months Position Cas
hflow STlt105 STgt 105 Buy Stock -110 ST
ST Borrow X/(1r)T 100 100 -105 -105 Sell
Call 17 0 -(ST-105) Buy Put
-5 105-ST 0 Total 2 0 0
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Summary Reminder

• Objective This chapter is an introduction to the
  option markets.
• Options investment characteristics
• Option strategies
• Put-Call parity relationship
• Option-like securities and exotic options

30
Option-like Securities

• Callable Bonds
• Convertible Securities
• Warrants
• Collateralized Loans

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Exotic Options

• Asian Options
• Barrier Options
• Lookback Options
• Currency Translated Options
• Binary Options