L12_options - FINANCE 431 INVESTMENTS Lecture 12: Option...

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Unformatted text preview: FINANCE 431 INVESTMENTS Lecture 12: Option Markets FIN 431: Investments 2 Options An option is a contract between two parties, lets call them the writer and the owner . The key feature of an option is that the owner chooses whether the contract is exercised . Example: Department Store gives customer the option to return merchandise for exchange or store credit. Owner of a convertible bond has the option to convert it into stock. FIN 431: Investments 3 Options The owner of a Call Option has the option to buy an underlying asset for a specified price. The writer has the obligation to sell if the option is exercised. The owner of a Put option has the option to sell an underlying asset for a specified price. The writer has the obligation to buy if the option is exercised. Like a future, an exchange-traded option: Has two parties, a buyer and a seller Sets a price today for a transaction later Called the Exercise Price or Strike Price Has an expiration date Clearinghouse acts as intermediary FIN 431: Investments 4 Options Unlike a future, an option Is exercised at the discretion of one party (owner). Requires the buyer (owner) to pay a premium to the writer at the time the contract is initiated. European-style options can be exercised only on the day they expire. American-style options can be exercised any time prior to expiration. FIN 431: Investments 5 Options Call Options Example: April 55 Microsoft Call Underlying Asset: 100 Shares Microsoft Expiration Date: Third Friday in April Strike Price: 55 American-Style The owner of this option can buy 100 shares of Microsoft for 55/share anytime prior to expiration. On December 28 Microsoft was trading for about 45.25 The premium for the April 55 call was about 3.25 per share. FIN 431: Investments 6 Options Call Options You buy 10 April 55 Microsoft calls Initial Investment = ($3.25/share) X (100 shares/contract) X (10 contracts) = $3,250 FIN 431: Investments 7 Options Call Options On the third Friday of April: If MSFT = 54 You have the right to buy for 55. But you can buy on the market for 54 The options expire Out of the Money Do not exercise. Loss = $3,250 If MSFT = 60 You have the right to buy for 55 The options expire In the Money Exercise: Buy 1,000 shares at 55. You can sell them at 60 Profit = (60-55)*1,000 3,250 = $1,750 If MSFT = 56 You have the right to buy for 55 Exercise: Buy 1,000 shares at 55. You can sell them at 56 Exercise: Loss = 1,000-3,250 = -$2,250 If you do not exercise: Loss = -$3,250 FIN 431: Investments 8 Options Call Options Payoff Function The payoff of a call option is equal to: max(0,S-X) S = Price of stock at the time the option expires X = Strike Price MSFT Example : Payoff = max(0,S-55) FIN 431: Investments 9 Options Call Options S - X S > X S < X Payoff Table S - 55 S > 55 S < 55 FIN 431: Investments 10 Options Call Options S Payoff 55 Payoff Diagram FIN 431: Investments 11 Options Call Options...
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This note was uploaded on 04/09/2012 for the course FIN 431 taught by Professor Sun during the Spring '12 term at Old Dominion.

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L12_options - FINANCE 431 INVESTMENTS Lecture 12: Option...

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