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Maf 630 Chapter 8

The document discusses options derivatives, including the key elements of options contracts. It defines call and put options, and outlines the differences between options and futures. Options provide the right but not obligation to buy or sell an asset, and are used for investment and risk management purposes. The two main methods for pricing options are the binomial and Black-Scholes models. Key factors that influence option prices include the underlying asset price, exercise price, time to maturity, interest rates, and asset volatility.

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80 views4 pages

Maf 630 Chapter 8

The document discusses options derivatives, including the key elements of options contracts. It defines call and put options, and outlines the differences between options and futures. Options provide the right but not obligation to buy or sell an asset, and are used for investment and risk management purposes. The two main methods for pricing options are the binomial and Black-Scholes models. Key factors that influence option prices include the underlying asset price, exercise price, time to maturity, interest rates, and asset volatility.

Uploaded by

Pablo Ekskoba
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER 8: OPTIONS DERIVATIVES

Options is a contract between two parties in which the buyer of the option (here we call the
option buyer) has the right but not obliged, to buy or sell a certain asset at a certain price
before/on a certain date from the seller of the option (here we call the option seller).
The option buyer who buys the option has the right but not obliged to exercise the option
unless he wishes to.
As for the option seller, he is obliged to perform according to the terms of the contract once
the option buyer exercises the option
TYPES OF OPTIONS
1. Call Option
Right to buy an asset at a specified exercise price on or before the exercise date
2. Put Option
Right to sell an asset at a specified exercise price on or before the exercise date

Call option
Put option

Buyer
Right to buy asset
Right to sell asset

Seller
Obligation to sell asset
Obligation to buy asset

DIFFERENCES BETWEEN OPTIONS AND FUTURES


Give right to buy or sell NOT obligation
Protected from unfavourable market movements
Only one party is obliged to transact
ADVANTAGES OF OPTIONS
Buyers of options have limited risk because they will not lose more than option price or
premium.
Exchange-traded (ET) options provide flexibility to trade freely in the open market which
improves the liquidity of the options traded in the exchange, allowing prices to be more
accurately priced.
USES OF OPTIONS
Investment in options provides leveraging
Options can be used extensively in risk management, i.e., hedging
Enhance revenue of portfolio by selling call options
Options use for financial engineering via strategies
Managing information asymmetry -attach put options at the IPO
KEY ELEMENTS OF OPTIONS
1. Types of Options
Call option gives the buyer the right (but not the obligation) to buy.
Put option gives the buyer the right (but not the obligation) to sell.
2. Underlying Asset e.g. share of a company, an index, foreign currencies, gold etc.

3. Strike Price or Exercise Price the agreed price at which the underlying asset is transacted if
the option is exercised.
Call Option; IV = Market Price Exercise Price
Put Option; IV = Exercise Price Market Price
4. Expiry Date maturity date i.e. the last day on which an option can be exercised.
5. Option Style
American style can be exercised at any time by the option buyer from the date he
acquires the option up to the date the option expired.
European style can be exercised only on the expiry date by the option buyer.
6. Option Classes and Series
Class of options refers to either puts or calls on the same underlying shares
regardless of the exercised price or the expiry date. E.g. XYZ call options.
Series of options refers to all options of the same type (i.e. puts or calls) and class
with the same exercised price and the expiry date. E.g. XYZ December RM6 call
options.
7. Premium Cost or price of an option. The price that the option buyer pays to the option
seller.
Intrinsic Value (IV) profit that can be obtained on an immediate exercise of the
option (only when the option is in-the money). It has zero IV if the option is either
at-the-money or out-of-the-money
Time Value (TV) Even if the option has zero IV, it will still have some value because
the option is yet to expire. TV is the value that arises from the probability that an
option will become profitable before its expiry date. TV is always positive before
maturity. The longer the time to expiry, the higher the TV. TV reduces when the
option approaches maturity. At maturity, TV = zero
OPTION STRATEGIES
Long call bullish strategy
Long put bearish strategy
Short call opposite of long call convinced that the market is not going up
Short put opposite of long put convinced that the market is not going down
PAY-OFF DIAGRAMS
BEP = Exercise Price + Premium
Profit/Loss = Market Price BEP
OR
Profit/Loss = IV Premium

Long Position (buy)

Short position (sell)


2

Long Call (right to buy)

Short Call (obligation to sell)

Long Put (right to sell)

Short Put (obligation to buy)

SYNTHETIC STRATEGIES
Make combinations of long and short options that exactly replicate the pay-off of the
underlying cash position. It also suggests that there are at least two ways of constructing
every risk profile.

OPTION PRICING
1. The Binomial Options Pricing Model
The value of option is the present value of the possible pay-offs to the option at
maturity.
Use discrete time model
Single period version
Two period version
Three period version
As the time interval is shortened, the value of options tends to be higher and gets
closer to true value.
Criticism tiresome computation
2. The Black-Scholes Option Pricing Model
The models great strength is simplicity of calculation compared to Binomial model.
Key assumptions:
Efficient market with frictionless trading
No transaction costs
Option has European style exercise
3

Underlying shares pay no dividend during maturity of option


Underlying share returns are log-normally distributed
Risk-free interest rate remains unchanged over the option maturity
Underlying share volatility is constant over option maturity

Ct = S.N(d1) Kert .N(d2)


d1 = ln(S/K) + [r + (2/2)] T
T
d2 = d1 T
where
Ct = Theoretical call value at time t
S = Spot price of underlying asset
K = Exercise price of call option
T = Time to expiration (as a % of year)
r = Risk-free interest rate
ert = Exponential function of risk free interest rate (r) and time to expiration (t)
N(.) = Standard normal cumulative distribution function in d
= Volatility of underlying asset as measured by standard deviation
ln (S/K) = Natural logarithm of (S/K)
DETERMINANTS OF OPTIONS PRICES
1. Value of the underlying asset
positive to call and negative to put
2. Exercise price
negative to call and positive to put
3. Maturity of the option
positive to call and ambiguous for put
4. The interest rate
positive to call and negative to put (because the higher the interest rate, the lower is
the PV of the exercise price)
5. Volatility of the underlying asset
positive to both call and put (because higher possibility to make profits)

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