options_lec - Chapter 20 Options 202 Learning Objectives...

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20-2 Chapter 20 Options
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20-3 Learning Objectives Understand the structure and operation of option contracts and the types available Explain the profit and loss payoff profiles of call and put option contracts Describe the structure and organisation of international and Australian options markets Explain the factors affecting the price of options Develop options strategies for hedging price risk Discuss the advantages and disadvantages of option contracts in managing risk
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20-4 Chapter Organisation 20.1 The Nature of Options 20.2 Option Profit and Loss Payoff Profiles 20.3 Organisation of the Market 20.4 Factors Affecting an Option Contract Premium 20.5 Option Risk Management Strategies 20.6 Conclusion 20.7 Summary
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20-5 20.1 The Nature of Options Options differ from futures because they provide asymmetric cover against price movements Options limit the effects of adverse price movements without reducing profits from favourable price movements Options involve the payment of a premium by the buyer to the seller (writer) An option gives the buyer the right, but not the obligation , to buy or sell a specified commodity or financial instrument at a predetermined price (exercise or strike price), on or before a specified date (expiration date) An option will be exercised only if it is in the buyer’s best interests
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20-6 20.1 The Nature of Options (cont.) Types of options Call options Give the option buyer the right to buy the commodity or instrument at the exercise price When will you exercise your option? Put options Give the buyer the right to sell the commodity or instrument at the exercise price When will you exercise your option? Options can be exercised either: only on expiration date (European); or any time up to expiration date (American)
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20-7 20.1 The Nature of Options (cont.) Premium The price paid by an option buyer to the writer (seller) of the option Exercise price or strike price The price specified in an options contract at which the option buyer can buy or sell
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20-8 Chapter Organisation 20.1 The Nature of Options 20.2 Option Profit and Loss Payoff Profiles 20.3 Organisation of the Market 20.4 Factors Affecting an Option Contract Premium 20.5 Option Risk Management Strategies 20.6 Conclusion 20.7 Summary
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20-9 20.2 Option Profit and Loss Payoff Profiles (cont.) Call option profit and loss payoff profiles (cont.) The value of the option to the buyer or holder (long call party) is: V = max(S - X, 0) - P (20.1) The value of the option to the writer (short call party) is: V = P - max(S - X, 0) (20.2)
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20-10 20.2 Option Profit and Loss Payoff Profiles Call option profit and loss payoff profiles Example: a call option for shares in a listed company at a strike or exercise price ( X ) of $12, and a premium ( P ) of $1.50 The critical break points of the market price of the share ( S ) at expiration date are <$12, $12 to $13.50 and >$13.50 If S (market price of asset) > X (i.e. > $12) , option is ‘in the money’
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Option Profit and Loss Payoff Profiles Spot Price Value of long call V=max(S-X,0)-P Exercise long call?
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