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18 Chapter model

# 18 Chapter model - 1 2 3 4 5 6 7 8 9 A B 18 Chapter model C...

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18 Chapter model 3/22/2010 7:08 2/22/2006 Chapter 18. Derivatives and Risk Management This spreadsheet model focuses on option pricing and analysis. FOR A CALL, AT EXPIRATION The option is: The investor makes (or loses): If S > K Exercised If S < K Allowed to expire Loses the cost of the call. If S = K Loses the cost of the call. FOR A PUT, AT EXPIRATION The option is: The investor makes (or loses): If S < K Exercised If S > K Allowed to expire Loses the cost of the put. If S = K Loses the cost of the put. OPTIONS (Section 18.4) A call option allows an investor to buy shares of a stock at a specified price by/on a future date. The writer of the call option is said to hold a short position on the option, while the buyer is said to hold a long position. The predetermined price for which the stock may be purchased is called the strike, or exercise, price. A put option allows you to buy the right to sell a stock at a specified price within some future period. If you happened to believe that the price of a stock was ready to fall, a put option would allow you the opportunity to turn a profit from that decline. In the case of both call and put options, the profit or loss made on an option transaction is determined by the value of the underlying asset, the strike price of the option, and the price of the option. The difference between S and K, minus the cost of the call. Worth the same whether exercised or expired. The difference between K and S, minus the cost of the put. Worth the same whether exercised or expired. A B C D E F G H I 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

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EXAMPLE At expiration, what is the profit/loss on each option? ABC DEF GHI Price of the option \$8.90 \$4.65 \$1.20 Value of stock (P or S) \$95.50 \$36.25 \$63.75 Strike price (K) \$80.00 \$40.00 \$65.00 Gain on the option \$15.50 \$3.75 \$0.00 Price of the option \$8.90 \$4.65 \$1.20 Profit/loss \$6.60 (\$0.90) (\$1.20) LOOKING AT INTRINSIC AND MARKET VALUE OF AN OPTION Suppose you decided to begin investing in options. You chose to purchase a call option on ABC, Inc. with a strike of \$80 for \$8.90. You buy a put option on DEF Industries with a strike of \$40 for \$4.65. Finally, you buy a call on GHI Technologies with a strike of \$65 for \$1.20. At expiration, ABC, DEF, and GHI have stock prices of \$95.50, \$36.25, and \$63.75, respectively. These options were purchased on the same day and expired on the same day. What is the profit/loss for each option's position? What is the profit/loss of the investment portfolio. We have established that at expiration a call option's value is simply the current price of the stock minus the strike price. However, at any point prior to maturity, it is quite difficult to determine the value of an option. Now, we must account for factors such as time to maturity and volatility. In other words, there is a time value factor that is beyond simple subtraction. Consider the case of Space Technology, Inc. (STI) whose common stock is currently trading at \$21. We will look at an option on STI's stock (with a strike of \$20), and look at the option's value in different states of the world. We calculate the intrinsic value of the option by simply
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