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Mechanics of Options Markets Chapter 8. OPTIONS ARE CONTRACTS Two parties: Seller and buyer A contract: Specifying the rights and obligations of the two parties. An underlying asset: a financial asset, a commodity or a security, that is the basis of the contract..

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Mechanics of Options Markets Chapter 8

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Mechanics of options markets chapter 8

Mechanics of Options MarketsChapter 8


Mechanics of options markets chapter 8

OPTIONS ARE CONTRACTS

Two parties:Seller and buyer

A contract:Specifying the rights and obligations of the two parties.

An underlying asset:

a financial asset, a commodity or a security, that is the basis of the contract.


Assets underlying exchange traded options p 190

Assets UnderlyingExchange-Traded Options(p. 190)

  • Stocks

  • Foreign Currency

  • Stock Indices

  • Futures

  • Options

  • Bonds


Mechanics of options markets chapter 8

OPTIONS BASICS

A contingent claim:

The option’s value is contingent upon the value of the underlying asset

Two Types of Options:

A Call:THE RIGHT TO BUY THE UNDERLYING ASSET

A Put:THE RIGHT TO SELL THE UNDERLYING ASSET


Mechanics of options markets chapter 8

CALL Buyer holderlong.

In exchange for making a payment of money, the call premium, the call buyer has

the right to BUY

a specified quantity of the underlying asset for the exercise (strike) price before the option’s expiration date.


Mechanics of options markets chapter 8

PUT Buyer holderlong.

In exchange for making a payment of money, the put premium, the put buyer has

the right to SELL

a specified quantity of the underlying asset for the exercise (strike) price before the option’s expiration date.


Mechanics of options markets chapter 8

Call Sellerwritershort.

In exchange for receiving the call’s premium, the

Call sellerhas the obligation

to SELL the underlying asset for the predetermined exercise (strike) price upon being served with an exercise notice during the life of the option, I.e., before the option expires.


Mechanics of options markets chapter 8

Put Sellerwritershort.

In exchange for receiving the put premium, the

Put sellerhas the obligation

to BUY the underlying asset for the predetermined exercise (strike) price upon being served with an exercise notice during the life of the option, I.e., before the option expires.


Mechanics of options markets chapter 8

  • The two main types of Options (PUTS and CALLS)

  • American Options

  • exercisable any time before expiration

  • European Options

  • exercisable only on expiration date


Mechanics of options markets chapter 8

OPTIONS NOTATIONS:

S –The underlying asset’s market price

K -The exercise (strike) price

t –The current date

T –The expiration date

T -t The time till expiration

c, p European call, put premiums

C, P American call, put premiums


Mechanics of options markets chapter 8

Options definitions using the above notation:

LONG CALL

On date t, the BUYER of a call option pays the call’s market price, ct, Ct, and holds the right to buy the underlying asset at the strike price, K, before the call expires on date T.

(or on T, if the call is European).

Thus => the call holder expects the price of the underlying asset, St, to increase during the life of the option contract.


Mechanics of options markets chapter 8

SHORT CALL

On date t, the SELLER of a call option receives ct, Ct, and must sell the underlying asset for K, if the option is exercised by its holder before the option expires on date T.

Thus => expects the price of the underlying asset, St, to remain below or at the exercise price, K, during the option’s life. This way the writer keeps the premium.


Mechanics of options markets chapter 8

LONG PUT

On date t, the BUYER of a put option pays pt, Pt, and holds the right to sell the underlying asset for K before the put expires on date T.

Thus => expects the market price of the underlying asset, St, to decrease during the life of the put.


Mechanics of options markets chapter 8

SHORT PUT

On date t, the SELLER of a put receives pt, Pt, and must buy the underlying asset for K if the put is exercised by its holder before the put expires on date T.

Thus => expects the market price of the underlying asset, St, to remain at or above K during the life of the put. This way the put writer keeps the premium.


Mechanics of options markets chapter 8

A numerical example: LONG CALL

C(S= $47.27share;K = $45/share;T-t = .5yrs)

Ct= $5.78/share

On date t, the BUYER of this call pays the call’s market price, $5.78/share, and holds the right to buy the underlying asset at the strike price, K = $45/share, before the call expires at T, half a year from now (at T, if the call is European).

Thus => the call holder expects the price of the underlying asset, St = $47.27/share, to increase during the life of the option contract.


Mechanics of options markets chapter 8

A numerical example: SHORT CALL

C( S=$47.27share;K =$45/share; T-t = .5yrs)

Ct= $5.78/share

On date t, the SELLER of this call receives $5.78/share and must sell the underlying asset for K = $45/share, if the option is exercised by its holder before the option expires at T, half a year from now.

Thus => hopes the price of the underlying asset, currently St = $47.27/share, remains below or at the exercise price, K = $45/share, during the option’s life of half a year and hence, keep the premium ct = $5.78/share


Mechanics of options markets chapter 8

A numerical example: LONG PUT

p(S= $47.27share;K = $45/share;T-t = .5yrs)

pt= $2.25/share

On date t, the BUYER of this put pays the market price of pt = $2.25/share and holds the right to sell the underlying asset for K = $45/share before the put expires half a year from now, at T.

Thus => expects the market price of the underlying asset, St= $47.27/share, to decrease during the half a year life span of the put.


Mechanics of options markets chapter 8

A numerical example: SHROT PUT

p(S =$47.27share;K = $45/share;T-t = .5yrs)

pt= $2.25/share

On date t, the SELLER of this put receives the market premium pt=$2.25/share and must buy the underlying asset for K = $45 if the put is exercised by its holder before the put expires half a year from now at T. Thus => expects the market price of the underlying asset, St = $47.27/share to remain at or above K = $45 during the life span of the put and to keep the premium, pt = $2.25/share.


Mechanics of options markets chapter 8

$

47.27K = 45

t = nowT = .5yrS


Mechanics of options markets chapter 8

  • More terminology

  • Premium =The option Market Price

  • Premium = [Intrinsic value + extrinsic value]

  • Intrinsic value:

    • CallsMax{0, St - K) ≥ 0

    • PutsMax{0, K - St) ≥ 0

  • Extrinsic value (time value):

  • Premium – Intrinsic value


  • Mechanics of options markets chapter 8

    At-the-money

    St = K

    In this case the intrinsic value for both calls and puts is zero:

    St - K = K - St = 0

    and the premium consists of the

    Extrinsic (time) value only.

    PREMIUM = 0 + extrinsic value


    Mechanics of options markets chapter 8

    In-the-money

    CallsPuts

    St > K St < K

    or:

    St – K > 0 K – St > 0

    The Intrinsic value of an option that is

    in-the money is positive.


    Mechanics of options markets chapter 8

    Out-of-the-money

    CallsPuts

    St < K St > K

    or

    St - K< 0 K – St < 0

    In this case the intrinsic value is zero and the premium consists of the extrinsic (time) value only.

    PREMIUM = 0 + extrinsic value


    Mechanics of options markets chapter 8

    The next table shows the market prices (premiums) of calls and puts on IBM

    On Friday NOV 30 2007 = t When IBM was trading at St = $105/share.

    Notice that there where options traded for several expiration dates and for a wide range of strike prices.

    Blanks mean that the option did not trade on NOV 30 2007

    OR

    did not exist.


    Mechanics of options markets chapter 8

    • Options Markets

    • OTC options:

    • Over the counter (OTC)

    • Meaning

    • Not on an organized exchange.

    • 2.Exchange traded options:

    • An organized exchange

    • Options clearing corporation (OCC)


    Mechanics of options markets chapter 8

    WHEN OPTIONS ARE TRADED ON

    THE OTC

    TRADERS BEAR

    Credit risk

    Operational risk

    Liquidity risk


    Mechanics of options markets chapter 8

    Credit Risk:

    Does the other party have the means to pay?

    Operational Risk:

    Will the other party deliver the commodity?

    Will the other party pay?


    Mechanics of options markets chapter 8

    Liquidity Risk.

    Liquidity = the speed (ease) with which investors can buy or sell securities (commodities) in the market. In case either party wishes to get out of its side of the contract, what are the obstacles?

    How to find another counterparty? It may not be easy to do that. Even if you find someone who is willing to take your side of the contract, the other party may not agree.


    Mechanics of options markets chapter 8

    THE Option Clearing Corporation (OCC)(p. 198)

    The exchanges understood that there will exist no efficient options markets without contracts standardization

    and an

    absolute guarantee

    to the options’ holders – that the market is default-free, so they have created the:

    OPTIONS CLEARING CORPORATION (OCC) The OCC is a nonprofit corporation


    Mechanics of options markets chapter 8

    THE OPTION CLEARING CORPORATION PLACE IN THE MARKET

    EXCHANGE CORPORATION

    OPTIONS CLEARING CORPORATION

    CLEARING

    MEMBERS

    NONCLEARING

    MEMEBRS

    OCC MEMBER

    CLIENTES

    BROKERS


    Mechanics of options markets chapter 8

    The OCC’s

    absolute guarantee

    The holders

    of calls and puts will

    always be able to exercise

    their options

    if they so wish to do!!!


    Mechanics of options markets chapter 8

    The absolute guarantee

    The OCC’s absolute guarantee provides traders with

    a default-free market.

    Thus, any investor who wishes to engage in options buying knows that there will be no operational default.


    Mechanics of options markets chapter 8

    The OCC

    Also,

    clears all options trading.

    Maintains the list of all

    long and short positions.

    Matches all long positions with short positions.

    Hence, the total sum of all options traders positions must be ZERO at all times.


    Mechanics of options markets chapter 8

    The OCC

    Maintains the accounting books of all trades.

    Charges fees to cover costs

    Assigns Exercise notices

    Given the OCC’s guarantee, the market is anonymous and traders only have to offset their positionsin order to come out of the market.

    The OCC has no control over the market prices. These are determined by trader’s supply and demand.


    Mechanics of options markets chapter 8

    The OCC

    The OCC’s absolute guarantee together with matching all short and long trading

    makes the market very liquid.

    1 – traders are not afraid to enter the market

    2 – traders can quit the market

    at any point in time by

    OFFSETTING their original position.


    Mechanics of options markets chapter 8

    • OFFSETTING POSITIONS

    • A trader with a LONG position who wishes to get out of the market MAY:

    • Exercise, or

    • open a SHORT position with equal number of the same options.

    • Example:Suppose

    • LONG 5, SEP, $85, IBM puts; p0 = $4/share

    • This position must be offset by

    • SHORT 5, SEP, $85, IBM puts; p1 = $3/share

    • Cash flows: -$2,000 + $1,500 = -$500.


    Mechanics of options markets chapter 8

    OFFSETTING POSITIONS

    A trader with a SHORT position who wishes to get out of the market MUST open a LONG position with equal number of the same options.

    Example:Suppose

    SHORT 25, JAN, $75, BA calls; c = $7/share This position must be offset by

    LONG 25, JAN, $75, BA calls; c = $5/share

    Cash flows: $17,500 - $12,500 = $5,000.


    Mechanics of options markets chapter 8

    THE OCC Standardization:

    Contract size:the number of units of the underlying asset covered in one option.

    Exersice prices:Mostly, increments of $2.5, $5.00 and $10.00.

    Exercise notice and assignment procedures

    Delivery sequence.


    Mechanics of options markets chapter 8

    • THE OCC Standardization:

    • Expiration dates:Saturday, immediately following the third Friday of the expiration month.

    • The basic expiration cycles:

    • [JANAPR JUL OCT]

    • [FEBMAY AUG NOV]

    • [MARJUN SEP DEC]


    A review of some financial economics principles

    A Review of Some Financial Economics Principles

    Arbitrage: A market situation whereby an investor can make a profit with:

    no equity and no risk.

    Efficiency: A market is said to be efficient if prices are such that there exist no arbitrage opportunities.

    Alternatively, a market is said to be inefficient if prices present arbitrage opportunities for investors in this market.


    Mechanics of options markets chapter 8

    Valuation: The current market value (price) of any project or investment is the net present value of all the future expected cash flows from the project.

    One-Price Law: Any two projects whose cash flows are equal in every possible state of the world have the same market value.

    Domination: Let two projects have equal cash flows in all possible states of the world but one. The project with the higher cash flow in that particular state of the world has a higher current market value and thus, is said to dominate the other project.


    Mechanics of options markets chapter 8

    The Holding Period Rate of Return (HPRR):

    Buy shares of a stock on date t and sell

    them later on date T. While holding the

    shares, the stock has paid a cash dividend in

    the amount of $D/share.

    The Holding Period Rate of Return HPRR is:


    Mechanics of options markets chapter 8

    Example:

    St = $50/share

    ST = $51.5/share

    DT-t = $1/share

    T = t + 73days.


    Mechanics of options markets chapter 8

    Risk-Free Asset: is a security of investment whose return carries no risk. Thus, the return on this security is known and guaranteed in advance.

    Risk-Free Borrowing And Landing: By purchasing the risk-free asset, investors lend their capital and by selling the risk-free asset, investors borrow capita at the risk-free rate.


    Mechanics of options markets chapter 8

    The One-Price Law:

    There exists only one risk-free rate in an efficient economy.

    Proof: By contradiction. Suppose two risk-free

    rates exist in a market and R > r. Since both are

    free of risk, ALL investors will try to borrow at r

    and invest the money borrowed in R, thus assuring

    themselves the difference. BUT, the excess demand

    For borrowing at r and excess supply of lending

    (investing) at R will change them. Supply = demand

    only when R = r.


    Compounded interest p 76

    Compounded Interest (p. 76)

    Any principal amount, P, invested at an

    annual interest rate, R, compounded

    annually, for n years would grow to:

    An = P(1 + R)n.

    If compounded Quarterly:

    An = P(1 +R/4)4n.


    Mechanics of options markets chapter 8

    In general:

    Invest P dollars in an account which pays an

    annual interest rate R with m compounding

    periods every year.

    The rate in every period is R/m.

    The number of compounding periods is nm.

    Thus, P grows to:

    An = P(1 +R/m)mn.


    Mechanics of options markets chapter 8

    An = P(1 +R/m)mn.

    Monthly compounding becomes:

    An = P(1 +R/12)12n

    and daily compounding yields:

    An = P(1 +R/365)365n.


    Mechanics of options markets chapter 8

    EXAMPLES:

    n =10 years;R =12%; P = $100

    1.Simple compounding, m = 1, yields:

    A10 = $100(1+ .12)10 = $310.5848

    2.Monthly compounding, m = 12, yields:

    A10 = $100(1 + .12/12)120 = $330.0387

    3.Daily compounding, m = 365, yields:

    A10 = $100(1 + .12/365)3,650 = $331.9462.


    Mechanics of options markets chapter 8

    Notations:

    The annual rate R will be stated as Rm in order

    to make clear how many times a year it is

    compounded.

    For the annual rate is 10% with quarterly

    compounding, the corresponding formula is:

    An = P(1 +.10/4)4n

    For the same annual rate with monthly

    compounding the corresponding formula is:

    An = P(1 +.10/12)12n


    Mechanics of options markets chapter 8

    DISCOUNTING

    The Present Value today, date t, of a future cash flow, FVT, on a future date T,

    is given by DISCOUNTING:


    Mechanics of options markets chapter 8

    DISCOUNTING: the general case:

    Let cji, j = 1,2,3,…m, be a sequence of m cash

    flows paid in year i, i = 1,2,3,…,n.

    Let Rm be the annual rate during these years.

    DISCOUNTING these cash flows yields the

    Present Value:


    Mechanics of options markets chapter 8

    CONTINUOUS COMPOUNDING

    In the early 1970s, banks came up with the

    following economic reasoning: Since the

    bank has depositors money all the time, this

    money should be working for the depositor

    all the time! This idea, of course, leads to the

    concept of continuous compounding.

    We want to apply this idea to the formula:


    Mechanics of options markets chapter 8

    CONTINUOUS COMPOUNDING

    This reasoning implies that in order to impose the concept of continuous time on the above compounding expression, we need to solve:

    This expression may be rewritten as:


    Mechanics of options markets chapter 8

    Recall that the number “e” is:

    Xe

    12

    1002.70481382

    10,0002.71814592

    1,000,0002.71828046

    In the limit 2.718281828…..


    Mechanics of options markets chapter 8

    Recall that in our example:

    n = 10 years.

    R = 12%

    P=$100.

    So, P = $100 invested at a 12% annual rate,

    continuously compounded for ten years will

    grow to:


    Mechanics of options markets chapter 8

    Continuous compounding yields the

    highest return:

    CompoundingmFactor

    Simple13.105848208

    Quarterly43.262037792

    Monthly123.300386895

    Daily3653.319462164

    Continuously ∞3.320116923


    Mechanics of options markets chapter 8

    Continuous Discounting (p. 77)

    This expression may be rewritten as:


    Mechanics of options markets chapter 8

    Continuous Discounting

    This expression may be rewritten as:


    Mechanics of options markets chapter 8

    Recall that in our example:

    P = $100; n = 10 years and R = 12%

    Thus, $100 invested at an annual rate of 12% , continuously compounded for ten years will grow to: $332.0117.

    Therefore, we can write the continuously discounted value of $320.0117:


    Mechanics of options markets chapter 8

    Equivalent Interest Rates (p.77)

    Rm = The annual rate with m compounding periods

    every year.


    Mechanics of options markets chapter 8

    Equivalent Interest Rates (p.77)

    rc =The annual rate with continuous compounding


    Mechanics of options markets chapter 8

    Equivalent Interest Rates (p.77)

    Rm = The annual rate with m

    compounding periods every year.

    rc = The annual rate with continuous compounding.

    Definition: Rm and rc are said to be equivalent

    if:


    Mechanics of options markets chapter 8

    Equivalent Interest Rates (p.77)


    Mechanics of options markets chapter 8

    Equivalent Interest Rates (p.77)

    The same method applies to any two rates with different periods of compounding. Thus, if we have Rm1 and another Rm2 then the relationship between the two rates is:


    Mechanics of options markets chapter 8

    Risk-free lending and borrowing

    Treasury bills: are zero-coupon bonds, or pure discount bonds, issued by the Treasury.

    A T-bill is a promissory paper which promises its holder the payment of the bond’s Face Value (Par- Value) on a specific future maturity date.

    The purchase of a T-bill is, therefore, an investment that pays no cash flow between the purchase date and the bill’s maturity. Hence, its current market price is the NPV of the bill’s Face Value:

    Pt = NPV{the T-bill Face-Value}

    We will only use continuous compounding


    Mechanics of options markets chapter 8

    Risk-free lending and borrowing

    Risk-Free Asset: is a security whose return is a known constant and it carries no risk.

    T-bills are risk-free LENDING assets.Investors lend money to the Government by purchasing T-bills (and other Treasury notes and bonds)

    We will assume thatinvestors also can borrow moneyat the risk-free rate. I.e., investors may write IOU notes, promising the risk-free rate to their buyers, thereby, raising capital at the risk-free rate.


    Mechanics of options markets chapter 8

    Risk-free lending and borrowing

    LENDING:

    By purchasing the risk-free asset,

    investors lend capital.

    BORROWING:

    By selling the risk-free asset, investors borrow capital.

    Both activities are at the

    risk-free rate.


    Mechanics of options markets chapter 8

    We are now ready to calculate the current value of a T-Bill.

    Pt = NPV{the T-bill Face-Value}.

    Thus:

    the current time, t, T-bill price, Pt , which pays FV upon its maturity on date T, is:

    Pt = [FV]e-r(T-t)

    r is the risk-free rate in the economy.


    Mechanics of options markets chapter 8

    EXAMPLE: Consider a T-bill that promises its holder FV = $1,000 when it matures in 276 days, with a risk-free yield of 5%:Inputs for the formula:

    FV = $1,000; r = .05; T-t= 276/365yrs

    Pt = [FV]e-r(T-t)

    Pt = [$1,000]e-(.05)276/365

    Pt = $962.90.


    Mechanics of options markets chapter 8

    EXAMPLE: Calculate the yield-to -maturity of a bond which sells for $965 and matures in 100 days, with FV = $1,000.

    Pt= $965; FV = $1,000; T-t= 100/365yrs.

    Solving for r:

    Pt = [FV]e-r(T-t)


    Mechanics of options markets chapter 8

    SHORT SELLING STOCKS (p. 97)

    An Investor may call a broker and ask to “sell a particular stock short.”

    This means that the investor does not own shares of the stock, but wishes to sell it anyway. The investor speculates that the stock’s share price will fall and money will be made upon buying the shares back at a

    lower price. Alas, the investor does not own shares of the stock. The broker will lend the investor shares from the broker’s or a client’s account and sell it

    in the investor’s name. The investor’s obligation is to hand over the shares some time in the future, or upon the broker’s request.


    Mechanics of options markets chapter 8

    SHORT SELLING STOCKS

    Other conditions:

    The proceeds from the short sale cannot be used by the short seller. Instead, they are deposited in an escrow account in the investor’s name until the investor makes

    good on the promise to bring the shares back. Moreover, the investor must deposit an additional amount of at least 50% of the short sale’s proceeds in the escrow account. This additional amount guarantees that there

    is enough capital to buy back the borrowed shares and hand them over back to the broker, in case the shares price increases.


    Mechanics of options markets chapter 8

    SHORT SELLING STOCKS

    There are more details associated with short selling stocks. For example, if the stock pays dividend, the short seller must pay the dividend to the broker. Moreover, the short seller does not gain interest on the amount deposited in the escrow account, etc.

    We will use stock short sales in many of strategies associated with options trading. In all of these strategies, we will assume that no cash flow occurs from the time the strategy is opened with the stock short sale until the time the strategy terminates and the stock is repurchased.


    Mechanics of options markets chapter 8

    SHORT SELLING STOCKS

    In terms of cash flows per share:

    St is the cash flow/share from selling the stock short thereby, opening a SHORT POSITION on date t.

    -ST is the cash flow from purchasing the stock back on date T (and delivering it to the lender thereby, closing the SHORT POSITION.)


    Mechanics of options markets chapter 8

    Options Risk-Return Tradeoffs at expiration

    PROFIT PROFILE OF A STRATEGY:

    A graph of the profit/loss as a function of all possible market prices of the underlying asset

    We will begin with profit profiles at the option’s expiration; I.e., an instant before the option expires.


    Mechanics of options markets chapter 8

    Options Risk-Return Tradeoffs at Expiration

    1.Only at expiration  T-t = 0

    • No time value! Only intrinsic value!

      The CALL at Expiration:

      is exercised if the CALL is

      in-the money:ST > K

      and the Cash flow/share = ST – K.

      expires worthless if the CALL is

      out-of-the money:ST K

      and the Cash flow/share = 0.

      Algebraically:

      Cash Flow/share = Max{0, ST – K}


    Mechanics of options markets chapter 8

    Options Risk-Return Tradeoffs at Expiration

    1.Only at expiration  T-t = 0

    • No time value! Only intrinsic value!

      The PUT at Expiration:

      is exercised if the PUT is

      in-the money:ST < K

      and the Cash flow/share = K - ST.

      expires worthless if the PUT is

      out-of-the money:ST> K

      and the Cash flow/share = 0.

      Algebraically:

      Cash Flow/share = Max{0, ST – K}


    Mechanics of options markets chapter 8

    • All parts of the strategy remain open till the option’s expiration.

      4.All parts of the strategy are closed out at option’s expiration.

      5.A Table Format

      The analysis of every strategy is done with a table of cash flows.

      Every row is one part (leg) of the strategy.

      Every row is analyzed separately.

      The cash flow of the entire strategy is the vertical sum of the rows.


    Mechanics of options markets chapter 8

    The algebraic expressions of cash flows per share: ICF(t)CF at Expiration(T)

    Long stock:-St + ST

    Short stock: St - ST

    Long call:-ct+Max{0, ST -K}

    Short call: ct - Max{0, ST -K}

    Long put:-pt +Max{0, K- ST}

    Short put: pt - Max{0, K - ST}

    The profit/loss per share is the cash flow at expiration plus the initial cash flow of the strategy, disregarding the time value ofmoney.


    Mechanics of options markets chapter 8

    The algebraic expressions of P/L per share at

    expiration:

    P/L per share at Expiration

    Long stock:-St + ST

    Short stock: St - ST

    Long call:-ct+ Max{0, ST -K}

    Short call: ct- Max{0, ST -K}

    Long put:-pt+ Max{0, K- ST}

    Short put: pt- Max{0, K - ST}


    Mechanics of options markets chapter 8

    6.A Graph of the profit/loss profile at expiration

    The P/L per share from the strategy as a function of all possible prices of the underlying asset at expiration.


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