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Class Business. Homework Liability Bonds. Derivatives. A derivative is a financial instrument whose price depends on the price of another underlying asset. Major derivative contracts are: Futures and forward contracts, Call and put options, Swaps. Historical Background. Before 1973

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Class business

Class Business

  • Homework

    • Liability

    • Bonds


Derivatives

Derivatives

  • A derivative is a financial instrument whose price depends on the price of another underlying asset.

  • Major derivative contracts are:

    • Futures and forward contracts,

    • Call and put options,

    • Swaps.


Historical background

Historical Background

  • Before 1973

    • Could not trade derivatives on any exchange

  • Today

    • Billions of dollars in contracts are traded

  • Why?

    • Fisher Black, arbitrage pricing

    • 1973 Black and Scholes published their model


Review

Review

  • A call option is a contract with two sides:

    • Long Side: pays for the right to buy an asset for a certain price at a certain time in the future.

    • Short Side: receives premium for agreeing to submit to demands of Long Side.

  • A put option is a contract with two sides:

    • Long Side: pays for the right to sell an asset for a certain price at a certain time in the future.

    • Short Side: receives premium for agreeing to submit to demands of Long Side


Option terminology

Option Terminology

  • Call – option with the ‘right’ to buy

  • Put – option with the ‘right’ to sell

  • Buy the option – Long, buy

  • Sell the option – Short, sell, write

  • Key Elements

    • Exercise or Strike Price (X) – price of future trade

    • Premium or Price (C, P) – what long position pays

    • Maturity or Expiration (T)


Option contracts

Option Contracts

  • European option: can only be exercised on the expiration date.

  • American option: can be exercised on any day prior to and including the expiration date.

  • Options Clearing Corporation:

    • Guarantees contract performance

    • Members (brokers) post margins with the OCC

    • Brokers require investor clients to post margins

    • OCC is “middle man” for exercising options


Option quotes on ibm

Option Quotes on IBM

Note: Each contract is for 100 shares

95.72


Open interest

Open Interest

D: Short

A: Long

F: Short

E: Long

Clearing House

B: Short

C: Long

G: Short


Different types of options

Different Types of Options

  • Stock Options

  • Index Options

  • Futures Options

  • Foreign Currency Options

  • Interest Rate Options


Profit profiles for long calls

Profit Profiles for Long Calls

Payoff

Long Call

ST – X –C

0

X

Spot Price (ST)

C


Profit profiles for short calls

Profit Profiles for Short Calls

Payoff

Spot Price (ST)

C

X

0

ST – X –C

Short Call


Call options zero sum game

Call Options - Zero Sum Game

Payoff

Long Call

0

X

Spot Price (ST)

Short Call


Profit profiles for long puts

Profit Profiles for Long Puts

Payoffs

X – ST–P

0

Spot Price (ST)

X

P

Long Put


Profit profiles for short puts

Profit Profiles for Short Puts

Payoffs

Short Put

P

X

0

Spot Price (ST)

P – (X – ST)


Put options zero sum game

Put Options - Zero Sum Game

Payoffs

Short Put

0

Spot Price (ST)

X

Long Put


Market and exercise price relationships

Market and Exercise Price Relationships

In the Money - exercise of the option would be profitable

Call: market price>exercise price (St > X)

Put: exercise price>market price (St < X)

Out of the Money - exercise of the option would not be profitable

Call: market price<exercise price (St < X)

Put: exercise price<market price(St > X)

At the Money - exercise price and asset price are equal (St = X)


Bull spread using calls

Bull Spread Using Calls

Profit

ST

X1

  • X2

Positon: Long 1 call at X1

Short 1 call at X2


Straddle combination

Straddle Combination

Profit

Position: Long 1 call at X

Long 1 put at X

X

ST


Option strategies involving stock

Option Strategies involving stock

Protective Put

Long Stock

Long Put

Profit

X

ST

) All you are doing is buying calls


Option strategies involving stock1

Option Strategies involving stock

Covered Call

Long Stock

Short Call

Profit

ST

X

) All you are doing is writing puts


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