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Unformatted text preview: Money Markets and Finance Lecture 10 Arbitrage: Options Contracts 1. Lecture Overview In today’s lecture we will discuss another type of derivative called an option contract . An option contract is regarded as a type of derivative as it derives its value from the asset underlying the contract. Today’s lecture will focus on discussing: – What option contracts are; – The characteristics of option contracts; – How option contracts are similar to and differ from forward and futures contracts; and, – How option contracts can be used to “hedge” risks faced by a firm. We will further consider the use of options in risk management in Lecture 11. 2. What is an Option Contract? An option is a contract that gives the buyer the right , but not the obligation to buy or sell an asset at a predetermined price ( exercise price ) to the seller of the option: – In other words, the buyer ( holder or person in the long position) has a right to exercise (or to enforce the contract), but the seller ( writer or person in the short position) must comply with the buyer’s decision; and, – Options represent a claim on an underlying asset and therefore, like futures and forward contracts, are a type of derivative security. 2. What is an Option Contract? An option contract normally specifies: – Whether the option gives the buyer a right to buy the underlying asset ( a call option ) at the exercise price or a right to sell the underlying asset ( a put option ) at the exercise price; – The exercise or strike price, X (ie the price at which the asset may be bought / sold by the option holder); – The maturity or expiration date , which is the terminating date of the option. The time to expiry is denoted T ; and, – The specific asset underlying the option contract. 2. What is an Option Contract? An option contract also normally specifies: – The amount of the asset that may be bought or sold under the option contract; and, – Whether the option is American (can be exercised at any time before or on expiry) or European (can only be exercised at expiry) in nature. 3. Call Options A call option has the following features: – It gives the holder or the person in the long position the right but not the obligation to buy the asset underlying the contract; – The writer of the option or the person in the short position is obliged to sell the asset if the holder exercises their right to buy it under the option contract; and, – If the option can only be exercised by the holder at expiry, it is known as a European call option . If the option can be exercised by the holder at any time before expiry or at expiry, it is known as an American call option . 4. Put Options A put option has the following features: – It gives the holder or the person in the long position the right but not the obligation to sell the asset underlying the contract; – The writer of the option or the person in the short position is obliged to buy the asset if the holder exercises their right to...
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This note was uploaded on 10/13/2011 for the course FINM 1001 taught by Professor Miss during the Three '10 term at Australian National University.
- Three '10