Options EZ - Introduction to Options Econ 422: Investment,...

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1 Introduction to Options Econ 422: Investment, Capital & Finance University of Washington Summer 2010 E. Zivot 20056 R.W. Parks/L.F. Davis 2004 August 18, 2010 Derivatives • A derivative is a security whose payoff or value depends on (is derived from) the value of another security, the ‘underlying’ security. • Derivatives are referred to as contingent claims, the claim is contingent on the underlying asset. Examples of derivatives E. Zivot 20056 R.W. Parks/L.F. Davis 2004 • Examples of derivatives: – Options – Forward Contracts – Futures –Swaps
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2 Financial & Non-Financial Option Examples Financial Examples: – Traded Options (CBOE, NYSE) – Convertible bond (embedded option within debt instrument) – Prepayment option on mortgage – Venture Capital follow-on investment option – Employee stock options E. Zivot 20056 R.W. Parks/L.F. Davis 2004 Non-Financial Examples: – Enrollment in this course— ‘right to attend lectures but not obligated’ Financial ‘Option’ Definitions • An option provides you the right, without obligation to buy or sell an asset at a pr obligation, to buy or sell an asset at a pre- specified price in the future. • An option is a derivative security in that its value is contingent upon the underlying asset. E. Zivot 20056 R.W. Parks/L.F. Davis 2004
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3 Financial ‘Option’ Definitions • ‘Plain vanilla’ options : Call Option : provides the holder/owner the right to buy anassetatapre-specified price in the future. an asset at a pre specified price in the future. Put Option : provides the holder/owner the right to sell an asset at a pre-specified price in the future. – ‘specific price’ = Strike Price – ‘asset’ referred to as ‘underlying’ E. Zivot 20056 R.W. Parks/L.F. Davis 2004 – ‘price’ of option = ‘value’ or ‘premium’ of option – ‘expiration’ date = ‘maturity’ Financial ‘Option’ Definitions Two types of exercise rights : European option : rights can only be invoked or ‘exercised’ on a specific date = expiration date American option : rights can be invoked or i d’ ti b f th E. Zivot 20056 R.W. Parks/L.F. Davis 2004 ‘exercised’ any time on or before the expiration date
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4 MSFT June 10 Call Options June 1 close price: 25.89 E. Zivot 20056 R.W. Parks/L.F. Davis 2004 MSFT June 10 Put Options June 1 close price: 25.89 E. Zivot 20056 R.W. Parks/L.F. Davis 2004
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5 Time T Payoff for Call Option on MSFT • Suppose you own a European Call option on MSFT MSFT • X = strike price = 25 • T = maturity date (eg. June 18, 2010) • S(T) = share price of MSFT stock at maturity • Assume MSFT does not pay dividends C(T) l f ll ti t t it • C(T) = value of call option at maturity E. Zivot 20056 R.W. Parks/L.F. Davis 2004 Time T Payoff for Call Option on MSFT • S(T) < X => Call option is worthless (out of the money) =>C(T) = 0 the money) > C(T) 0 • S(T) > X => Call option is exercised and has value S(T) – X (in the money) => C(T) = S(T) –X • General formula for payoff at maturity: C(T) = max{0, S(T) – X} E. Zivot 20056 R.W. Parks/L.F. Davis 2004
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6 Time T Payoff for Call Option Consider you own a European Call option on the stock of MSFT.
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This note was uploaded on 12/21/2011 for the course ECON 422 taught by Professor Staff during the Fall '08 term at University of Washington.

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Options EZ - Introduction to Options Econ 422: Investment,...

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