chap18 - 1 CHAPTER 18 Derivatives and Risk Management...

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CHAPTER 18 Derivatives and Risk Management 1
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2 Understand what are call and put options. Understand what are options contracts and how they can be used to reduce risk. Understand what factors impact an option’s value.
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Economic Benefits Provided by Options 3 Derivative securities are instruments that derive their  value from the value of other assets. Derivatives include options, futures, and swaps.   Options and other derivative securities have several  important economic functions: Help bring about a more efficient allocation of risk;  Save transactions costs…sometimes it is cheaper to trade a  derivative than the asset underlying it, and Permit investment strategies that would not otherwise be possible.
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Options and Option Terms 4 Call Option : allows holder to buy an underlying asset at a specified price. Put Option : allows holder to sell an underlying asset at a specified price. H The specified price is called the exercise or strike price , and the option must be exercised by its expiration date. H European options can only be exercised on the expiration date H American options can be exercised at any time prior and up to the expiration date.
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Options Vocabulary 5 Neither trade usually has any connection to the  underlying firm. Long position   The buyer of an option has a long  position, and has the right to exercise  the option. Short position   The seller (or writer) of an option has a  short position, and must fulfill the  contract if the buyer exercises. As compensation, the seller receives  the option premium. Can trade options on an exchange (such as CBOE)  or in the over-the-counter market.
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Other Option Terms 6 Option Price: the market price of the option (C for call, P for put) Exercise (or Intrinsic) Value: the minimum value of an option. H Call = Stock Price (S) – Exercise Price (X) H Put = Exercise Price (X) – Stock Price (S)
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7 In the money option: positive exercise value At the money option: zero exercise value Out of the money option: negative exercise value Option Time or Speculative Value: Option Premium – Option Exercise Value
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Some Option Price Quotes Stock Exercise Price June Sept June Sept MAD 50 45 7 11 1 2 MAD 50 50 3 8 2.75 7.88 MAD 50 55 1 3 6.88 10 Calls Expiration Month Puts Expiration Month 8
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Payoff Diagrams 9 Shows value of an option on the expiration date   Y-axis plots exercise value of option X-axis plots price of underlying asset   Use payoff 
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chap18 - 1 CHAPTER 18 Derivatives and Risk Management...

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