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FIN 620-session 8 lecture

FIN 620-session 8 lecture - FIN 620 Long-Term Financial...

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FIN 620 Long-Term Financial Management Session 8  1. Lecture Notes/Comments 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. 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. There has been a great deal of innovation in the derivatives field over the years. In the options area, a number of interesting twists on the standard option contract provide interesting class discussion topics. Consider the growing credit derivatives sector, which had a substantial impact on the recent financial crisis. A couple of examples are “price/spread” options, which are triggered by changes in the spread between the value of
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emerging market debt and U.S. Treasuries and “default puts,” for which payment occurs upon the default of a third party. It is easy to become fascinated by the topics of hedging and speculation. Options provide an excellent opportunity to introduce the differences between these terms. Hedging occurs when you use options (or some other security) to offset a position you already have. For example, if you own 100 shares of GM stock and the price has risen nicely, you might want to hedge against a price decline by buying a put option contract. Speculators do not hold offsetting positions. Instead, they take a single (naked) position hoping the price will move in the direction they want. If you expect the price of GM to decline, you could buy put options and then profit if you are correct. If you are incorrect, then your loss is limited to the price that you paid for the options. Both investors bought put options, but for very different reasons. The first is
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FIN 620-session 8 lecture - FIN 620 Long-Term Financial...

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