chapter 23 - BMM Chapter 23 Options Derivatives Derive...

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1BMM Chapter 23: OptionsDerivativesDerive their value from another assetOptionsFuturesWarrantsConvertiblesSwaps…
2Source: Greenwich AssociatesReasons Institutions use Equity DerivativesDerivatives and RiskOften characterized as “Risky” securitiesProvide additional leverageHence, beta of options higher than beta of underlying securitiesUncovered, speculative positions can cause large lossesNick Leeson and BaringsLeverage can help when hedging a large underlying position
3Hedging with options: ExampleFarmer sows corn; harvest in nine monthsAlternative 1: sell at the corn price in nine monthsAlternative 2: use derivatives to hedgeBuy put options and choose the exercise priceSets a floor on the minimum price for the cropSell corn futuresEstablishes the sale priceOptions on Financial AssetsExecutive Stock Options– Long term call options given to executives as part of their compensation package. Warrants- Right to buy shares from a company at a stipulated price before a set date.Convertible Bond- Bond that the holder may exchange for a specific number of shares.Callable Bond- Bond that may be repurchased by the issuer before maturity at specified call price.
4Option termsBuy - Long Sell - ShortCall—the right to buy an asset at a specified exercise price on or before the exercise date.Put—the right to sell an asset at a specified exercise price on or before the exercise date.

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