Version 1192001 Lecture Options Markets 1 Topics Uses

Version 11/9/2001 Lecture Options Markets 1

Topics Uses of Options Call Options Put Options Financial Engineering Copyright K. Cuthbertson, D. Nitzsche. 2

READING Investments: Spot and Derivative Markets, K. Cuthbertson and D. Nitzsche CHAPTER 21: Options Markets Copyright K. Cuthbertson, D. Nitzsche. 3

Uses of Options 4

Uses of Options An Option gives you the right (but not the obligation) to buy (or sell) ‘something’ at some time in the future, at a (strike) price agreed today. For this privilege you pay the option (price) premium today. One way they differ from futures is If the deal is favourable to you then you will ‘take delivery’ BUT if you do not want to go through with the deal (because it is not advantageous to you), then you can simply do nothing and ‘walk away’. Copyright K. Cuthbertson, D. Nitzsche. 5

Uses of Options ‘Something’in the options contract can be Shares of AT&T Stock index (S&P 500) T-bond Currencies Gold/Silver (index) Interest rates Copyright K. Cuthbertson, D. Nitzsche. 6

Uses of Options Speculation - provide leverage- only pay small option premium and ‘downside’ losses are limited Insurance - can limit ‘downside’ outcome but allows most of the ‘upside potential’ Delta Hedging - ensures that the value of your portfolio is unchanged (over say 1 -week) - I. e. no ‘upside’ or ‘downside’ Arbitrage - ensures there are no (v. few) miss-priced options (‘too advanced’ for this course) Copyright K. Cuthbertson, D. Nitzsche. 7

Uses of Options When options are combined with other options or other assets (e. g. stocks) then this is known as financial engineering “European Option” only be exercised at maturity “American Option” can be exercised at any time (eg. before maturity). BUT you can sell/buy any existing option to another person at any time (I. e. prior to expiration/maturity) If you buy and later sell the option then ‘delivery’ (of the share) TO YOU is cancelled (by the Clearing House, CBOT) Copyright K. Cuthbertson, D. Nitzsche. 8

Call Options 9

Buy European Call Option Buy ( “long”) European Call Option You have the choice of buying the underlying asset (stock) at a future date, at a (strike) price which is fixed today ~for this privilege you pay the ( call ) option premium price (today) OR Acquire the right, but not an obligation, to purchase the (underlying) asset at a specified future date(expiration expiry maturity date) for a certain price ( strike exercise price) and in an amount ( contract size) which is fixed in advance. Copyright K. Cuthbertson, D. Nitzsche. 10

Figure 1 Buy One European Call Option (‘Underlying’ asset = stock) Strike Price, K = 80 Profit +1 $5 0 K=80 Call Premium $3 83 88 ST Speculator: Buys call if thinks S will rise in the future (above K=80) Hedger: Pension fund wants to buy stock in the future and fears a rise in S. Locks in a MAX price of K. Copyright K. Cuthbertson, D. Nitzsche. 11

Profit from Call at Expiry Each call option contract is for delivery of 100 shares (but call premium is based on ‘one share’) If ST > K 88 > 80 Exercise the option (“in-the-money”) Gross profit = ST - K = 88 - 80 = $8 Net profit = ST - K - C = $8 - $3 = $5 That is net profit = $500 per contract (and ‘upside’ is unlimited) If ST < K Do not exercise the option (out-of-the-money) Loss = C (100) = $300 Speculators loss is limited to $300 per contract (ie. e ‘insurance’) Copyright K. Cuthbertson, D. Nitzsche. 12

Summary: Payoff from Call at Expiry SPECULATION Because you only pay about $3 to ‘gamble’ on the future stock price, which will have a current value of around $80, then options provide ‘leverage’ for a speculator. The ‘downside’ is also limited to the call premium paid. Copyright K. Cuthbertson, D. Nitzsche. 13

Summary: Payoff from Call at Expiry HEDGER: Obtains INSURANCE. If the stock price at maturity (T) is high (e. g. ST = 88) then the pension fund ‘exercises the option’ at the CBOT and pays only K=80 for the stock. BUT if the stock price is low (e. g. ST = 60) then the pension fund ‘walks away’ from the option contract (ie. does not exercise at K=80) and simply buys the stock in the spot market (e. g. NYSE) at 60. Pension fund has ‘insured’ that the max. price it will pay is K=80 but it can take advantage of lower stock prices should these arise. For this ‘flexibility’ the pension fund pays the call premium of $3 (today). Copyright K. Cuthbertson, D. Nitzsche. 14

Write(Sell) European Call Option Sell ( = write ) European Call Option Acquire an obligation to sell the (underlying) asset to the buyer if the buyer decides to exercise the option (and you are still holding a written call). The writer of the option must deliver if ‘the long’ decides to excercise the option at expiry Paradoxically the writer of an option, does not have an ‘option/choice’ AT MATURITY, ( but before maturity the writer has the ‘option’ to close out her position, with another trader) Copyright K. Cuthbertson, D. Nitzsche. 15

Figure 2 Sell( Write) a European Call Option Strike Price, K = 80 0 $3 Call Premium K=80 83 88 -1 ST -$5 Writer: Has to pay an initial margin (e. g. 50% of current value of stocks, underlying the contract + the option premium) Copyright K. Cuthbertson, D. Nitzsche. 16

Put Options 17

European Put Option Buy ( Long) European Put Option Have the choice of selling the underlying asset (stock) at a future date, at a (strike) price which is fixed today For this privilege you pay the ( put ) option premium price OR Acquire the right, but not an obligation, TO SELL the (underlying) asset at a specified future date(expiration expiry maturity date) for a certain price ( strike exercise price) and in an amount ( contract size) which is fixed in advance. Copyright K. Cuthbertson, D. Nitzsche. 18

Buy a Put = Trial Separation BUCKSIDE 19

Exercise the Put = DIVORCE BUCKSIDE ( Fin ) 20

Figure 3 Buy (Long) : European Put Profit Strike Price K= $ 70 -1 +3 0 Put Premium 65 2 68 K=70 0 ST Speculator: Buys put if thinks S will FALL in the future Hedger: Pension fund ALREADY HOLDS STOCKS and in the future, fears a FALL in S. Locks in a MIN PRICE of K, at which to sell the shares. But if S does not fall blow K=70 , then ‘walks away’ and sells shares in the spot market (e. g. NYSE) Copyright K. Cuthbertson, D. Nitzsche. 21

Figure 4 Sell( Write): European Put Profit +1 0 +2 0 Put Premium -3 65 68 K=70 ST Strike price K= $ 70 Stock price at expiry, ST = 65 22

Summary INSURANCE BUYING, Calls and Puts allow you to ‘lock in’ a (strike) ‘price’ in the future, by paying the option premium today. This ‘price’ can be for a company stock, stock-index, Tbond, currency or an interest rate (e. g. to ‘insure’ the maximum cost of borrowing on a existing loan). You may also choose to NOT EXERCISE the option, if it is better to do the deal in the ‘spot market’. SPECULATION (‘LEVERAGE’) Bull market - buy a call Bear market - buy a put Copyright K. Cuthbertson, D. Nitzsche. 23

Financial Engineering Copyright K. Cuthbertson, D. Nitzsche. 24

Financial Engineering: Synthetic Call Option -1 0 Long Put plus +1 +1 +1 0 Long Stock equals Long Call Basis of Put-Call Parity: P + S = C + Cash [= K/(1+r)] Use: Pension Fund hedging its stock holding when it fears a fall in stock prices (over the next 6 months) and wishes to temporarily establish a “floor value (=K) but also benefit from any stock price rises. (see ‘Long Put’ above) Copyright K. Cuthbertson, D. Nitzsche. 25

Financial Engineering: Leeson’s Short Straddle Short (=sell) Call 0 Profit -1 0 +1 plus Short(=sell) Put equals +1 0 -1 K Short Straddle You are initially credited with the call and put premia C + P (at t=0) but if at expiry if there is either a large fall or a large rise in S (relative to the strike price K ) then you will make a loss (eg. Leeson’s short straddle : Kobe Earthquake which led to a fall in S = “Nikkei-225” and large losses).

END OF SLIDES Copyright K. Cuthbertson, D. Nitzsche. 27

TAKE A BREAK 28