12 - Derivatives Markets 3

12 - Derivatives Markets 3 - Lecture 12 TOPIC 6 Derivatives...

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11/6/2008 1 © HB, 2008 Lecture 12 TOPIC 6 Derivatives Markets 3 (Options Strategies) Lecture 10 notes Lecture 10 Physical Market 90 days from now Buy a 90-day $1m T-note At the current yield of 7% pa The holder can make profit or loss with a futures contract, but consider the combined situation (both futures contract and bank bill)! © HB, 2008 Change to 7% © HB, 2008 Quick Overview Option buyer : purchases the contract, paying the contract premium and obtaining a right . Right to buy an asset = Call option Right to sell an asset = Put option Has limited risk of loss and unlimited profit potential Option writer : sells the contract, keeping the contract premium but taking on an obligation. Obligation to sell an asset = Call option Obligation to buy an asset = Put option Has unlimited risk of loss and limited profit potential
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11/6/2008 2 © HB, 2008 Buying calls and selling puts allows the investor to gain if the price of the underlying asset rises . Selling calls and buying puts allows the investor to gain if the price of the underlying asset falls . Long Call Short Put Short Call Long Put © HB, 2008 Option Pricing Theoretical price of an option The price of an option is called the premium . » The price of an option is derived from arbitrage arguments . » We will only consider the factors that determine the price of an option and not the pricing models in this course. Basic components of the option price » 1. Intrinsic value » 2. Time value » 3. Other factors: Price volatility of underlying asset Interest rate levels © HB, 2008 Intrinsic value of an option Intrinsic value – the option’s economic value, at any time , if it is exercised immediately. » Based on the market price of the underlying asset relative to the option exercise price . For a call option : Intrinsic value = Current share price – Strike price = S 0 – X, if S 0 > X = 0, if S 0 X
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11/6/2008 3 © HB, 2008 Intrinsic value Intrinsic value is the option’s economic value, at any time, if it is exercised immediately. Market price of the underlying asset relative to the option exercise price.
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12 - Derivatives Markets 3 - Lecture 12 TOPIC 6 Derivatives...

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