FINM3405L4 - Objectives Obj i Lecture 4 Understand basic...

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Lecture 4 ption Contracts Option Contracts Objectives ± Understand basic calls and puts (both long and short positions) nderstand decision rules and payoff functions ± Understand decision rules and payoff functions ± Be aware of upper and lower bounds on option prices, as well as the put-call parity relationship ± Know how to capture arbitrage profit if option prices violates any of these bounds e comfortable using Black choles formula ± Be comfortable using Black-Scholes formula ± Be able to utilise options to hedge risks, as well as for speculative purposes ± Start to understand how basic call and put options can be combined into trading strategies Types of Options ± Call option : the holder has the right to buy the underlying asset at the exercise/strike price within a specified period ± Put option : the holder has the right to sell the underlying asset at the exercise/strike price within a specified period Flexibility ± In each case, the holder has the right to trade, but is not obligated to do so. ± There are clear advantages to this flexibility ± thus, options must be bought (you pay the option premium/price/value) pp p ) – nb: this is a major difference between options and futures/forwards. Wrt the latter, there is no cost to enter (ignoring margin deposits)
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Exercise Features ± European options (both calls and puts) can only be exercised on the expiry date ± American options can be exercised at any time up to and including the expiry date (Long) Call Option ± Assume that it is March and we purchase a ept $10 ABC call option Sept $10 ABC call option ± The call option premium is $1.28 ± at expiry: ABC is $12 ( in-the-money ) – exercise right to buy at $10 and make $2 ± at expiry: ABC is $9 ( out-of-the-money ) – don’t exercise; let option lapse ± Decision rule: exercise if S T > X Payoff Diagram: Long Call Payoff Long Call Option gp Payoff = max[0, S T - X ] Stock Price X 0 Profit Diagram: Long Call Profit Stock Price X 0 Option Premium
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(Long) Put Option ± Assume that it is March and we purchase ept $10 ABC put option Sept $10 ABC put option ± The put option premium is $0.53 ± at expiry: ABC is $12 ( out-of-the-money ) – don’t exercise; let it lapse ± at expiry: ABC is $9 ( in-the-money ) – exercise right to sell and make $1 ± Decision rule: exercise if S T < X Payoff Diagram: Long Put Payoff Long Put Option Payoff = max[0, X - S T ] X Stock Price X 0 Profit Diagram: Long Put Profit Stock Price X 0 Option Premium Liquidating and Closing Out ±
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This note was uploaded on 08/27/2009 for the course FINM 3405 taught by Professor Philipgray during the Three '09 term at Queensland.

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FINM3405L4 - Objectives Obj i Lecture 4 Understand basic...

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