ecg590i_lecture07

ecg590i_lecture07 - ECG590I Asset Pricing. Lecture 7:...

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ECG590I Asset Pricing. Lecture 7: Basics of options, including trading strategies 1 7 Basics of options, including trading strategies Option: The option of buying (call) or selling (put) an asset. European option: Can be exercised only at expiration. American option: Can be exercised anytime on or before expiration. In-the-money: (a) Call option - the asset price is greater than the strike price or (b) Put option: the asset price is less than the strike price. Out-of-the-money: Not in-the-money. John Seater, North Carolina State University, Fall 2007
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ECG590I Asset Pricing. Lecture 7: Basics of options, including trading strategies 2 7.1 Factors A/ecting Options Prices The list of factors: 1. Current stock price S 0 2. Strike price: K 3. Time to expiration: T 4. Volatility of stock price: 5. Risk-free interest rate: r 6. Dividends expected during life of option: D John Seater, North Carolina State University, Fall 2007
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ECG590I Asset Pricing. Lecture 7: Basics of options, including trading strategies 3 Signs of partial derivatives S 0 K T r D European call ( c ) + - ? + + - European put ( p ) - + ? + - + American call ( C ) + - + + + - American put ( P ) - + + + - + S 0 : the higher the spot price today, the higher the expected spot price at the expiration (or before). Payo/ on the call would be higher; payo/ on the put would be lower. K : a higher strike price lowers the payo/ for the call and increases the payo/ for the put. John Seater, North Carolina State University, Fall 2007
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ECG590I Asset Pricing. Lecture 7: Basics of options, including trading strategies 4 T : For American options, the longer the time to expiration, the longer the time for the asset price to move until it is in the money. For price to move, but longer wait to exercise. : the higher the volatility of the asset price, the higher the probability of having a big increase or decrease of the asset price of the life of the option. Only the good outcome matters for an option, which is why the sign is unambiguously positive. r : interest is a gain for holders of call options (they earn interest on their cash while the wait to exercise the option) and a loss for holders of put options. D : Holders of put options receive dividends as they wait to exercise the option, and holders of call options forego the dividends. John Seater, North Carolina State University, Fall 2007
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5 7.2 Upper and Lower Bound For both American ( C ) and European options ( c ), the option can never be worth more than the stock. Therefore C ± S 0 c ± S 0 Otherwise, arbitrageurs can make a riskless pro±t by selling the call and using the proceeds to buy the stock. John Seater, North Carolina State University, Fall 2007
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ecg590i_lecture07 - ECG590I Asset Pricing. Lecture 7:...

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