Chapter 4

Chapter 4 - Notes 4 Finance 5108 An option gives the holder...

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Notes 4 Finance 5108 An option gives the holder the right (not the obligation) to buy/sell something (called the underlying asset) at a fixed price (called the strike price or exercise price) for a given period of time (time to expiration). To obtain this right the buyer pays to the seller (writer) compensation known as a premium. In every initial transaction, there is the buyer and seller of the option and all option gains or losses are a transfer of wealth between these two individuals. When the holder of the option makes money, the seller (writer) loses that amount of money. - The right to buy the underlying security is referred to as a call option. -The right to sell is called a put option. (Always 100 shares of stock) European: at expiry only American: any time before or at expiry The premium paid for an option has two components. The first component is called intrinsic value. This is the value of the option if it were exercised. For a call option this would be the current market price minus the strike price. The only caveat is that the intrinsic value can never be less that zero. For a put option, the intrinsic value is the Strike price minus the market price. Formulas for the intrinsic value are the following Intrinsic value of a call = Max(Market Price- strike price, 0) Intrinsic value of a put = Max(Strike Price -market price,0) The total premium of an option includes the intrinsic value and time value. Premium = Intrinsic value + time value Time premium = total premium - intrinsic value Say that we look in the paper and see that a 45 (strike price) Jan call option on ATT is trading for a premium or price of \$6 and that the current market price of price of ATT is \$48 per share. In this case the intrinsic value is \$3 (\$48- \$45) per share. Therefore the time value on the option is \$6-\$3 or \$3 per share. What if the market price is \$44 per share and the price of the option is still \$6. Then the intrinsic value is 0 and the whole of the premium is time value. It should be noted that the intrinsic value cannot be negative. The smallest time value can be is 0 per share. A profit profile on the next page shows what the intrinsic value of a call/put option at expiration for different market prices. The following graph shows the profit for both the seller (writer) and holder (buyer) of a call at expiration for a call

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with a strike price of 105 sold for a premium of \$5. From this graph it can be seen that the maximum loss of the buyer is the premium paid for the option. The break even for the buyer ( and seller) of the option is when the price of the market price is equal to the strike plus the premium paid for the option. In this case this would
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This note was uploaded on 11/23/2009 for the course FIN 5180 taught by Professor Rader during the Fall '09 term at Temple.

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Chapter 4 - Notes 4 Finance 5108 An option gives the holder...

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