Lecture 8 - Lecture 8 Option Valuation Speculating with...

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Lecture 8 Option Valuation
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Speculating with Options Suppose the price of Merck is $50 and the following option prices are observed: $50 1-month call $3.00 $60 1-month call $0.50 $50 3-month call $5.00 $60 3-month call $2.00 You believe that two months from now there is a good chance Merck will announce a cure for gingivitus. How might you speculate on this information?
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Speculating with Options Profit functions of three strategies with the same initial cost
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Speculating with Options Options are sometimes called highly levered positions, because their extreme sensitivity to the underlying price is somewhat similar to a levered portfolio: o Borrow $450. o Buy 10 shares of Merck for $50 each. o Initial cash outflow is still $50.
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The Determinants of Option Value At maturity, the value of an option depends only on the stock price and exercise price. Prior to maturity, a number of other variables also influence the option price. Variable Value of Call Option Stock Price Exercise Price Volatility Time to Maturity Interest Rate Dividend Yield + - + + + -
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Intuition As the stock price increases, the expected value of (Stock Price – Exercise Price) and hence the expected payoff increases. As the exercise price increases, the expected value of (Stock Price – Exercise Price) and hence the expected payoff decreases. As volatility increases, the expected option payoff goes up: -- Extremely good stock outcomes can improve the option payoff without limit but extremely poor outcome cannot worsen the payoff below zero. Longer
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This note was uploaded on 02/06/2012 for the course MGMT 411 taught by Professor Clarke during the Spring '09 term at Purdue University-West Lafayette.

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Lecture 8 - Lecture 8 Option Valuation Speculating with...

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