topic05_note

topic05_note - EC372 Bond and Derivatives Markets Topic #5:...

Info iconThis preview shows pages 1–4. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: EC372 Bond and Derivatives Markets Topic #5: Options Markets I: fundamentals R. E. Bailey Department of Economics University of Essex Outline Contents 1 Call options and put options 1 2 Payoffs on options 3 3 Option-like assets 6 4 Upper and lower bounds for option prices 6 4.1 Lower bounds for European option premiums . . . . . . . . . . . . . . . . . . . . . 6 5 The put-call parity relationship 8 Reading: Economics of Financial Markets , chapter 18 1 Call options and put options Call options and put options Options provide a right but not an obligation to take an action Call option: the right but not the obligation to buy , on or before the expiry date, an underlying asset for the exercise price Put option: the right but not the obligation to sell , on or before the expiry date, an underlying asset for the exercise price Holders (buyers) and Writers (issuers) Holder owns the option: has long position (an asset) Writer has issued the option: has a short position (a liability) Two styles: American style: exercise at any time prior to expiry date European style: exercise at expiry date only Options can die, unexercised options are exercised only if it is profitable to do so 1 Call Option Holder : May buy asset for Exercise price from Writer. Writer : Must sell asset for Exercise price, at Holders discretion. Put Option Holder : May sell asset for Exercise price to Writer. Writer : Must buy asset for Exercise price, at Holders discretion. Option contracts and markets The option contract specifies: Underlying asset Expiry date, T Exercise (or, strike) price, X Whether the option is call or put Whether the option is American or European Exotic options: more complicated specification The market determines: Underlying asset price, S Option premium option price : c = European call; C = American call; p = European put; P = American put. Interest factor: R ( t, T ) ($1 invested at t becomes R ( t, T ) at T ) Time to expiry: = T- t , where t = today Trading in options Exchange traded options: standardized, anonymous, guaranteed by exchange authorities. Over The Counter (OTC) options: private agreements between named counter-parties. Margin deposits Option buyer pays the premium, no further obligation Option writer makes margin deposit collateral for contingent liability Termination of an option contract: 1. Option dies , unexercised at T 2. Holder exercises the option 3. Offsetting trade (holder sells or writer buys) 2 2 Payoffs on options Payoffs on options Assumption: frictionless markets European call option payoff at T : c T = max[ S T- X, 0] c T = S T- X , if S T X c T = 0 , if S T < X (option dies) European put option payoff at T : p T = max[ X- S T , 0] p T = X- S T , if S T X p T = 0 , if S T > X (option dies) American options: can be exercised at any time, hence premiums cannot be less than payoff...
View Full Document

This note was uploaded on 03/15/2012 for the course EC 372 taught by Professor R.e.bailey during the Spring '12 term at Uni. Essex.

Page1 / 10

topic05_note - EC372 Bond and Derivatives Markets Topic #5:...

This preview shows document pages 1 - 4. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online