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Chapter 20_Hand-out 14

Chapter 20_Hand-out 14 - CHAPTER 20 OPTIONS MARKETS...

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CHAPTER 20 OPTIONS MARKETS: INTRODUCTION 20.1 THE OPTION CONTRACT Derivative instruments, or simply derivatives , play a large and increasingly important role in financial markets. These are securities, whose prices are determined by, or “derive from”, the prices of other securities. These assets are also called contingent claims because their payoffs are contingent on the prices of other securities. Options and futures contracts are both derivative securities. Option contract are traded now on several exchanges. They are written on common stock, stock indexes, foreign exchange, agricultural commodities, precious metals, and interest rate futures. I addition, the OTC market also has enjoyed a tremendous resurgence in recent years as trading in custom-tailored options has exploded. Popular and potent tools in modifying portfolio characteristics, options have become essential tools a portfolio manager must understand. 1. Call and Put Options A call option gives its holder the right to purchase an asset for a specified price, called the exercise , or strike price , on or before some specified expiration date. For example, an April call option on IBM stock with exercise price $105 entitles its owner to purchase IBM stock for a price of $105 at any time up to and including the expiration date in April. The holder of the call is not required to exercise the option. The holder will choose to exercise only if the market value of the asset to be purchased exceeds the exercise price. When the market price does exceed the exercise price, the option holder may "call away" the asset for the exercise price. Otherwise, the option may be left unexercised. If it is not exercised before the expiration date of the contract, a call option simply expires and no longer has value. Therefore, if the market stock price is greater than the exercise price on the expiration date, the value of the call option equals the difference between the stock price and the exercise price; but if the stock price is less than the exercise price at expiration, the call will be worthless. The net profit on the call is the value of the option minus the price originally paid to purchase it. The purchase price of the option is called the premium . It represents the compensation the purchaser of the call must pay for the right to exercise the option if exercise becomes profitable. Sellers of call options, who are said to write 1
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calls, receive premium income now as payment against the possibility they will be required at some later date to deliver the asset in return for an exercise price lower than the market value of the asset. If the option is left to expire worthless because the exercise price remains above the market price of the asset, then the writer of the call clears a profit equal to the premium income derived from the sale of the option. But if the call is exercised, the profit to the option writer is the premium income derived when the option was initially sold minus the difference
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