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.
Inthemoney
is when the price of the underlying exceeds the strike price.
7.
Outofthemoney
is when the price of the underlying is less than the strike price.
8.
Atthemoney
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
This preview has intentionally blurred sections. Sign up to view the full version.
View Full DocumentThe 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
This is the end of the preview.
Sign up
to
access the rest of the document.
 Spring '09
 Halstead
 Derivatives, Options, Strike price, Citigroup

Click to edit the document details