Time Value of Money

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FINA 4339 Options Futures Section
Number 00443 Time Location 230-400 p.m. MW,
110-MH Instructor Dr. Pricha
Sethapakdi Phone [phone] Office 230F Melcher
Hall Office Hours 400-500 p.m. T, Th, and by
appointment. Internet http//www.cba.uh.edu/pri
cha Text and References Chance, Don M., An
Introduction to Derivatives, 4th
Ed. (Required) The Wall Street
Journal. (Recommended)
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Grading Policy Exam I, II, III 25 each Final
Exam 25 (Conditionally Optional) The final
exam is optional only if you complete all three
mid-term exams with an average of C or better.
Students who miss one or more mid-term exams or
have below C average must take the final exam.
No makeup exam will be given. Students may be
excused from an exam only if legitimate reasons
are given to the instructor prior to the exam. In
such cases, the comprehensive final exam will
substitute for the missed exam(s). Important
Dates Sep 21 Last day to drop the course
without a grade Nov 6 Last day to drop
the course with a W
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FINA 4339

• Class 1

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THE STRUCTURE OF OPTIONS MARKET
Call Options
An American call option gives its holder (buyer)
the right to buy the underlying asset at a
specific price, i.e. the exercise price, on or
before a specific future point in time, i.e. the
expiration date,
A call option is normally written at an exercise
price above the spot price at that point in time
and the option is said to be out-of-the-money.
However, the buyer will have to pay a price,
called the premium, for the option. The premium
is paid on the opportunity for the future spot
price to rise above the exercise price, i.e. the
option will be in-the-money, and the holder can
benefit form the price difference.
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THE STRUCTURE OF OPTIONS MARKET
Put Options
An American put option gives its holder (buyer)
the right to sell the underlying asset at a
specific price, i.e. the exercise price, on or
before a specific future point in time, i.e. the
expiration date,
A put option is normally written at an exercise
price below the spot price at that point in time
and the option is said to be out-of-the-money.
However, the buyer will have to pay a price,
called the premium, for the option. The premium
is paid on the opportunity for the future spot
price to fall below the exercise price, i.e. the
option will be in-the-money, and the holder can
benefit form the price difference.
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THE STRUCTURE OF OPTIONS MARKET
Options Market Development Before 1973 From
early 1900 options were traded only
over-the-counter through dealers who try to match
buyers and sellers. There were some problem
related to this market structure 1. Options
contracts were not standardized and could only be
exercised at expiration. 2. Writer could
default on the contract. The only guaranty was
from the dealer who might not remain in business
when the option expired. 3. Transaction costs
were high.
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THE STRUCTURE OF OPTIONS MARKET
Options Market Development After April 26, 1973
The Chicago Board Options Exchange (CBOE) was
established. This allowed options trading to be
centralized and contracts to be standardized. A
clearing house was establish to guarantee to
investors that the contracts would be fulfilled.
This resulted in lower transaction costs and
higher liquidity.
The stock market crash of 1987 discouraged many
individual investors from the market. Trading
remains strong among institutional investors and
more customized contracts which meet specific
investment goals were created and traded in the
OTC market today.
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THE STRUCTURE OF OPTIONS MARKET
The Over-the-Counter (OTC) Options Market
Despite some of the problems with the OTC
markets as mentioned earlier, option trading in
these markets remain strong today due to the
following reasons 1. The contracts can be
tailored to the specific needs of the buyers and
sellers. 2. Confidentiality of the
transaction. Large orders can be carried out in
private arrangements with little or no effect on
the market prices. 3. The OTC markets are
mainly unregurated. This allow the flexibilty for
the two parties to arrive at a mutual agreement
with no costly constraints nor bureaucratic red
tape.
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THE STRUCTURE OF OPTIONS MARKET
The Organized Exchange Market
The CBOE was established to organize options
trading by using standardized contracts and rules
and regulation to maintain an orderly trading
system. These allow the development of a
secondary market for the contracts and therefore
an improved liquidity in the market. CBOE
achieved the above opjectives by setting the
following specification
Listing Requirements Options were initially
limited to stocks of firms and multiple listing
were not allowed. In November 1990, the SEC
granted multiple listing to all new options. A
move towards more relaxed listing requirement has
been in place for the recent years to make
exchange options trading more competitive and
better serve the investment public.
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THE STRUCTURE OF OPTIONS MARKET
The Organized Exchange Market Contract Size
A standard exchange contract consists of 100
individual contracts. An adjustment to subsequent
stock split or stock dividend applies to the
contract size in the same way as the underlying
common shares. The exercise price is then divided
by the adjustment factor and rounded to the
nearest eighth dollar. However, any split which
results in an even multiple of 100 would earn the
holder of the option additional contract
determined by the multiple.
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THE STRUCTURE OF OPTIONS MARKET
The Organized Exchange Market Exercise Prices
For stock options, exercise prices are in 2.50
intervals if the stock price is less than 25, 5
intervals if the stock price is between 25 and
200, and 10 intervals if the stock price is
above 200.
Expiration Dates The expiration cycles are 1.
January, April, July, and October 2. February,
May, August, and November 3. March, June,
September, and December. The cycles are named
according the the first month of the cycle.