Session8-Chapter22

Session8-Chapter22 - Session 8 RWJ Chapters 22 We now turn...

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Session 8 RWJ, Chapters 22 We now turn to the basic and most common variety of derivatives: call and put options. Like many other financial assets derivatives like options require a payment of money for purchase and have a future risky payoff. The distinctive feature of options is that their payoffs are based on prices of other financial assets. Options, like other derivatives, can also be very risky. In the second part of this session we will study warrants and convertible bonds. Warrants give the owners the right to purchase stock at a future date at a fixed price, and are similar to call options in some (but not all) respects. Convertible bonds may be converted to equity prior to maturity. We end the session by discussing why warrants and convertible bonds may be issued. Options An option is a contract that gives the owner the right, without the obligation, to buy or sell a specified asset on or before a specified date at a specified price. It follows that the payoff to an option can only be positive. The owner will purchase the option only if he or she can sell it for a higher price (which could be the market price). As the payoff may be positive, but never negative, an option has a positive price when purchased. Option Terminology 1. Exercising the option is using the option to buy or sell the underlying asset. 2. Strike or exercise price is the fixed price at which the underlying asset may be bought or sold. 3. Expiration date (Expiry) is the last day that the option can be exercised. 4. American option is an option that can be exercised any time up to and including the expiration date. 5. European option is an option that can only be exercised on the expiration date 6. In-the-money is when the price of the underlying exceeds the strike price. 7. Out-of-the-money is when the price of the underlying is less than the strike price. 8. At-the-money is when the price of the underlying is equal to the strike price. Call Options A Call option gives the owner the right, but not the obligation, to buy the underlying asset at a fixed price before the option expires
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The Value of a Call Option at Expiration S 1 = stock price at expiration S 0 = stock price today C 1 = value of call at expiration C 0 = call premium today E = exercise price If S 1 E, then C 1 = 0 If S 1 E, then C 1 = S 1 – E Payoff to Call = max(S T – E, 0) The profit from buying a call is equal to the intrinsic value (payoff) less the premium paid. Note that this subtraction of price from payoff ignores time value of money, and this sort of a calculation can only be justified if the time from purchase to exercise is small. Put Options A Put option gives the owner the right, but not the obligation, to sell the underlying asset at a fixed price before the option expires The Value of a Put Option at Expiration If S 1 ≥ E, then P 1 = 0 If S 1 ≥ E, then P 1 = E – S 1 Payoff to Put = max(E - S T , 0) The profit from buying a put is equal to the intrinsic value (payoff) less the
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Session8-Chapter22 - Session 8 RWJ Chapters 22 We now turn...

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