FRM Notes 2011 Unit IID Option Contracting

FRM Notes 2011 Unit IID Option Contracting - Version...

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Version: January 3, 2011 FIN 7400: Financial Risk Management II. TOOLS AND APPLICATIONS OF MARKET RISK MANAGEMENT D. Option Contracting Characteristics of Option Contracting An option is a contract between two parties in which one party, the buyer, has the right to buy or sell an asset or other derivative at a fixed price for a definite period of time. The buyer pays the other party, the seller or writer, the option price or premium. The right to buy is referred to as a call and the right to sell is referred to as a put. The fixed price is called the exercise price. If the option can be exercised at any time up to expiration, it is called an American option. If the option can be exercised only at expiration, it is called a European option. The buyer is said to be “long” the option and the seller is said to be “short.” Options are available on many types of assets, as well as other derivatives like other options and futures. Most of this introductory material will focus on options on stocks, because they are the easiest to understand. Options trade in two types of markets: the exchange listed market (options on stocks, stock indices, a few bonds, and currencies) and the over-the-counter market (options on any underlyings can be created here). Examine the Wall Street Journal or the web sites of the option exchanges (Chicago Board Options Exchange, American Stock Exchange, International Securities Exchange, Philadelphia Stock Exchange, Pacific Stock Exchange) to see how option prices are reported. These are for exchange-listed options, which are standardized. Current price quotes can be obtained from the exchange web sites or the Options Clearing Corporation site, http://www.optionseducation.org/quotes/default.jsp Most people hear more about options that trade on exchanges. Global exchange-listed options volume in 2009 was about 9.5 billion contracts, though it is difficult to gauge how much this represents because the sizes vary quite a lot across contracts and exchanges. The OTC options market is quite large. The BIS reported that as of June, 2010 currency options had notional principal of about $11.2 trillion and market value of about $411 billion, and interest rate options had notional principal of about $48.1 trillion and market value of about $1.5 trillion. In addition the BIS reports equity options notional principal of about $4.5 trillion and notional principal of $518 billion. Our initial goal in understanding options is to learn how option prices are determined. We first look at how the payoffs of options are determined. Option Payoffs Unit IID Notes Page 1 of 51 D. M. Chance, LSU
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Version: January 3, 2011 FIN 7400: Financial Risk Management An option’s payoff is its value at expiration . In other words, what is the option worth to the holder when it expires? How much does the holder of the option receive or the seller of the option pay out when the option expires. We first require some notation: X = exercise price of the option S T = price of the underlying asset at time T (expiration) C T =
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FRM Notes 2011 Unit IID Option Contracting - Version...

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