Options I

Options I - Econ 174 FINANCIAL RISK MANAGEMENT LECTURE...

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Econ 174 – FINANCIAL RISK MANAGEMENT LECTURE NOTES Foster, UCSD October 16, 2011 A. The Mechanics of Options Markets 1. Option Contracts: a) An option is the right to buy or sell some underlying asset up to a specified date for a specified price. 1) The right does not have to be exercised; it is not an obligation to the buyer/holder of the option. (It IS an obligation or promise on the part of the seller/writer of the option.) 2) T = is the specified date, the “expiration date” or “maturity date.” 3) K = the specified price of underlying asset, the “strike” or “exercise” price per unit. 4) P or C = the price per unit of purchasing the put or call option itself, the “premium.” 5) Five principal assets underlying option contracts: Stock options (on common stock in about 2,200 U.S. corporations) Foreign currency options Options on futures contracts Interest rate options on T-bonds, CDs, etc. b) Types of options. 1) Call option – the right to buy the asset. 2) Put option – the right to sell the asset. 3) European-style option (calls or puts) – holder may exercise only at maturity. 4) American-style option (calls or puts) – holder may exercise any time up to maturity. c) Option positions. 1) The buyers of calls and puts are said to hold “long positions.” 2) The sellers (or “writers) of calls and puts are said to hold “short positions.” 3) Brokers, exchanges, OTC dealers, Option Clearing Corporation -- match option buyers with option writers, and maintain neutral positions. d) Payoffs and profits per unit of asset on naked option positions. [Fig. 1] 1) Profit = (payoff) − premium to European call option buyer/holder. π call = (S T − K) − c if S T > K and option is exercised π call = −c if S T K and option expires 2) Profit = (payoff) − premium to European put option buyer/holder. π put = (K − S T ) − p if S T < K and option is exercised Stock Option Notation (for 0 t T) S 0 , S t , S T Spot (stock market) price of stock ($/share) K Strike (exercise) price ($/share) P t , C t American put/call option premium ($/share) p t , c t European put/call option premium ($/share) T Expiration date or time to maturity (yrs)
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Ec 174 OPTIONS I p. 2 of 19 π put = −p if S T ≥ K and option expires 3) Profit to option writer/seller is mirror image of profit to option buyer/holder.
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Ec 174 OPTIONS I p. 3 of 19 e) Other sources of (call) options. 1) Executive stock options – as an incentive to promote effective management, a firm might issue call options on its own stock to its executives. If management responds appropriately, the firm’s stock price S t goes up and managers exercise their options at a profit. 2)
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This note was uploaded on 10/16/2011 for the course ECON 174 taught by Professor Foster,c during the Fall '08 term at UCSD.

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Options I - Econ 174 FINANCIAL RISK MANAGEMENT LECTURE...

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