Chapter 22

1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementEighth Editionby Frank K. Reilly & Keith C. Brown Chapter 22

2. Chapter 22Option Contracts Questions to be answered: • How are options traded on exchanges and in OTC markets? • How are options for stock, stock indexes, foreign currency, and futures contracts quoted in the financial press? • How can investors use option contracts to hedge an existing risk exposure?

3. Chapter 22Option Contracts • What are the three steps in establishing the fundamental “no arbitrage” value of an option contract? • What is the binomial (or two-state) option pricing model and in what ways is it an extension of the basic valuation approach? • What is the Black-Scholes option pricing model and how does it extend the binomial valuation approach?

4. Chapter 22Option Contracts • What is the relationship between the Black-Scholes and the put-call parity valuation models? • How does the payment of a dividend by the underlying asset impact the value of an option? • How can models for valuing stock options be adapted to other underlying assets, such as stock indexes, foreign currency, or futures contracts?

5. Chapter 22Option Contracts • How do American- and European-style options differ from one another? • What is implied volatility and what is its role in the contract valuation process?

6. Chapter 22Option Contracts • How do investors use options with the underlying security or in combination with one another to create payoff structures tailored to a particular need or view of future market conditions? • What differentiates a spread from a straddle, a strangle, or a range forward?

7. Derivatives • Forwards • fix the price or rate of an underlying asset • Options • allow holders to decide at a later date whether such fixing is in their best interest

8. Option Market Conventions • Option contracts have been traded for centuries • Customized options traded on OTC market • In April 1973, standardized options began trading on the Chicago Board Option Exchange • Options Clearing Corporation (OCC) acts as guarantor of each CBOE -traded options

9. Price Quotations for Exchange-Traded Options • Equity options • CBOE, AMEX, PHLX, PSE • typical contract for 100 shares • require secondary transaction if exercised • time premium affects pricing

10. Price Quotations for Exchange-Traded Options • Stock index options • only settle in cash • Foreign currency options • allow sale or purchase of a set amount of non-USD currency at a fixed exchange rate • quotes in USD • Options on futures contracts • Give the right, but not the obligation, to enter into a futures contract on an underlying security or commodity at a later date at a predetermined price

11. The Fundamentals of Option Valuation • Risk reduction tools when used as a hedge • Forecasting the volatility of future asset prices • direction and magnitude • Hedge ratio is based on the range of possible option outcomes related to the range of possible stock outcomes • Risk-free hedge buys one share of stock and sells call options to neutralize risk • Hedge portfolio should grow at the risk-free rate

12. The Binomial Option Pricing Model • Two-state option pricing model • up movement or down movement • forecast stock price changes from one subperiod to the next • up change • down change • number of subperiods

13. The Binomial Option Pricing Model

14. The Black-Scholes Valuation Model • Continuous changes rather than discrete • Geometric Brownian motion • volatility factor, s

15. The Black-Scholes Valuation Model Value is a function of five variables: 1. Current security price 2. Exercise price 3. Time to expiration 4. Risk-free rate 5. Security price volatility C = f(S, X, T, RFR, s)

16. Estimating Volatility • Mean and standard deviation of a series of price relatives

17. Problems With Black-Scholes Valuation • Stock prices do not change continuously • Arbitrageable differences between option values and prices (due to brokerage fees, bid-ask spreads, and inflexible position sizes) • Risk-free rate and volatility levels do not remain constant until the expiration date

18. Empirical studies showed that the Black-Scholes model overvalued out-of-the-money call options and undervalued in-the-money contracts Any violation of the assumptions upon which the Black-Scholes model is based could lead to a misevaluation of the option contract Problems With Black-Scholes Valuation

19. Option Valuation: Extensions and Advanced Topics • Valuing European-style put options • Valuing options on dividend-bearing securities • Valuing American-style options • Stock index options • Foreign currency options • Futures options

20. Options are a leveraged alternative to making a direct investment in the asset on which the contract is based Put options could be used in conjunction with an existing portfolio to limit the portfolio’s loss potential Option Trading Strategies

21. Option Trading Strategies • Protective put options • Covered call options • Straddles, strips, and straps • Strangle • Chooser options • Spreads • Range forwards

22. http://www.cboe.com/ http://www.optionmax.com http://www.finance.wat.ch/cbt/options http://www.coveredcall.com The InternetInvestments Online

23. End of Chapter 22 • Option Contracts

24. Future topicsChapter 23 • Swap Contracts, Convertible Securities, and Other Embedded Derivatives