FIN401- Ch. 15 Class notes

FIN401- Ch. 15 Class notes - FIN 401 Principles of...

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Unformatted text preview: FIN 401 Principles of Investments and Security Markets Chapter 15: Options Markets 2 Derivative Instruments Derivatives are securities whose prices are determined by, or derived from the prices of other securities. These assets are also called contingent claims because their payoffs are contingent on other securities. These assets are powerful tools for both hedging and speculation. 3 Example of Derivatives Call Option; Put Options; Swaps; contractual exchange of cash flows Futures; Forwards; Option contracts are traded now on several exchanges. They are written on common stock, stock indexes, foreign exchange, precious metals, interest rate futures 4 Option Contracts When you own an option you have a right(not the obligation) to do something. If you dont want to take advantage of an option it has a value of 0. Never will be negative in value Call Option This is a right (but not an obligation) to buy an asset at a pre-arranged price (the exercise price or strike price) on or until a pre-arranged date (the maturity); Put Option This is a right (but not an obligation) to sell an asset at a pre-arranged price (the exercise price or strike price) on or until a pre-arranged date (the maturity). 5 Call Options The purchase price of the option is called the premium . It is the compensation the purchaser of the call must pay for the right to exercise the option if exercise becomes profitable. For every owner of an option there is a seller of an option. Sellers of the call option, who are said to write 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. 6 Call Options: An Example 1)Consider a December 2010 maturity call option on a share of IBM stock with an exercise price of $150 per share. The call sells for $10 in October 2010. 2)Until the calls expiration date, the purchaser of the call is entitled to buy shares of IBM for $150. 3)Let us say that on October 1, 2010, IBM shares sell for $149 less than the exercise price of $150. In this case, it does not make sense to exercise the call option to buy at $150 because if you buy it at $150 and current is $149 you would take a loss * In this scenario if you wanted IBM stock you would go to the market and pay $149 for the stock 7 Call Options: An Example If IBM stock remains below $150 by the expiration date, then the call will be left to expire worthless. If, on the other hand, IBM is selling above $150, then the call holder will find it optimal to exercise. Let us say that on expiration, IBM shares trade at $155. Then, the proceeds from exercise are given by: Stock price Exercise price = $155 - $150 = $5 Values of Options at Expiration Buying a Call Stock Price Payoff X Buy Call Option Payoff: MAX[0, S-X] 45 degrees S = current stock price X = option exercise price If stock price is below exercise the value of the option is 0 If premium is $10 then stock price must be $10 greater to start seeing profits 9...
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This note was uploaded on 11/15/2011 for the course FIN 401 taught by Professor Staff during the Spring '08 term at Miami University.

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FIN401- Ch. 15 Class notes - FIN 401 Principles of...

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