salaar - finance capital markets spring semester 2010 lahore school of economics salaar farooq –...

Salaar - Finance

Capital MarketsCapital Markets

Spring Semester 2010Spring Semester 2010

Lahore School of EconomicsLahore School of Economics

Salaar farooq – Assistant Professor

Salaar - Finance

Lecture

Derivatives & Risk Mgmt:Derivatives & Risk Mgmt:

OPTIONSOPTIONS

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Derivatives & Risk MgmtCh 19 & 20

Learning Objectives

Options Contracts?

Options Payoffs & Types?

Option Strategies?

Options pricing?

Futures Contracts?

Futures payoffs & types?

Futures strategies?

Futures pricing?

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DerivativeWhat is it?….

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DerivativeWhat is it?….

Securities whose prices are determined by OR derived from some underlying asset

Also called contingent claims

(since payoffs are contingent on other assets)

Options & Futures are both Derivatives

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DerivativePurpose….

Powerful tools for… ?

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DerivativePurpose….

Powerful tools for…

Hedging (shifting risk)

Speculation

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DerivativeOptions Contract….

A contract which gives the right but not the

obligation to buy/sell an asset for a specified price

on or before a specified expiration date

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Derivative - OptionsTerminology….

Exercise or Strike price

Expiration date

American option

European option

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Derivative - OptionsTerminology….

Exercise or Strike price

The price at which the asset may be bought/sold or exercised

Expiration date

The date the option expires

American option

The option may be exercised on or before expiration

European option

The option may be exercised ONLY at expiration

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Derivative - OptionsMore Terminology….

In the money

Out of the money

At the money

Payoff profile

Option premium

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Derivative - OptionsMore Terminology….

In the money

When exercising the option results in a profit

Out of the money

When exercising results in a loss

At the money

When exercising results in Break-even (without premium)- ATM & BE are different

Payoff profile

Shows the P/L of the option at different asset prices

Option premium

Price paid to own the option

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DerivativeOptions Contract….

2 Basic types

Call Option

Put Option

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DerivativeOptions Contract….

2 Basic types

Call Option

An option to BUY a share of stock at a specified price within a specific period

Put Option

An option to SELL a share of stock at a specified price within a specified period

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DerivativeOptions Contract….

How they work?

Long Call Option

Suppose you think BBC stock will rise in the next four months.

The stock trades at $100 now. You don’t want to buy the stock outright but instead would like to have the option to purchase if the stock does go above $100. Option price is $3.

You would buy a CALL with a strike price of $100 expiring in 4 mths by paying $3 for it.

If the Px goes up, lets say to $110, you would exercise the call!... contd

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DerivativeOptions Contract….

How they work?

Long Call Option

This means,

You would be able to BUY the stock at $100 when the market price is at $110.

And then be able to sell it at the MKT Px with profit.

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DerivativeOptions Contract….

Developing a payoff profile?

Long Call Option

Suppose a stock sells for Rs 200.

It has an offered CALL option for Rs 10 with a strike price of Rs 200.

What would be the payoff profile at the following stock prices

a) 150

b) 200

c) 205

d) 210

e) 220

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DerivativeOptions Contract….

Developing a payoff profile?

Long Call Option

Suppose a stock sells for Rs 200.

It has an offered CALL option for Rs 10 with a strike price of Rs 200.

What would be the payoff profile at the following stock prices

a) 150 (loss of 10)

b) 200 (loss of 10)

c) 205 (loss of 5)

d) 210 (BE)

e) 220 (profit of 10)

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DerivativeOptions Contract….

NOTICE…

Option Buyer has LIMITED downside & UNLIMITED Upside

Option Writer has the opposite Payoff

Risk/Return will be discussed a bit later

Writer takes on all the risk!!

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DerivativeOptions Contract….

Margin Requirements…

Buyer is not subject to margin reqmt.

Writer has to put up the option premium as margin & can get margin calls on MTM

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Derivative - OptionsMore Terminology….

Writer

The seller of an option is called the “WRITER”

Covered Option

When an option is written (sold) against actual stock held in portfolio

Naked Option

When an option is written (sold) without any actual stock held in portfolio

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DerivativeOptions Contract….

Where are Options traded?…

Can trade both Exchanges & OTC

Advantages of Exchange traded options?

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DerivativeOptions Contract….

Where are Options traded?…

Can trade both Exchanges & OTC

Advantages of Exchange traded options:

1. Strike price & Expiration standardized

2. More liquid

3. Transaction costs are lower

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Options Contract….Risk & Return Characteristics of Options….

4 Basic Option positions

1. Buying a Call

2. Selling a Call

3. Buying a PUT

4. Selling a PUT

Assumption: European option (held till expiration)

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Options Contract….CALL Options….

Buying a CALL (Exercise or NOT?)

1. Actual Px below strike?

2. Px equal to strike

3. Px between strike & option premium

4. Px equal to strike+premium

5. Px more than strike+premium

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Options Contract….CALL Options….

Buying a CALL

1. Actual Px below strike? NO

2. Px equal to strike - NO

3. Px between strike & option premium - YES

4. Px equal to strike+premium - YES

5. Px more than strike+premium - YES

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Buying a MSFT Call Option for $1.2 with strike 25 (Bullish)

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Options Contract….Call Options….

Writing a CALL (Short Call position) – Selling a Call

1. Actual Px below strike?

2. Px equal to strike

3. Px between strike & option premium

4. Px equal to strike+premium

5. Px more than strike+premium

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Options Contract….Call Options….

Writing a CALL (Short Call position) – Selling a Call

1. Actual Px below strike? Premium profit

2. Px equal to strike? Premium profit

3. Px between strike & option premium? Reduced profit

4. Px equal to strike+premium? BE

5. Px more than strike+premium? LOSS Unlimited

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Payoff for the Writer of MSFT strike 25, premium $1.2 (Bearish)Short Call Position

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DerivativePUT Contract….

How they work?

Long PUT Option

Suppose you think BBC stock will DROP in the next four months.

The stock trades at $100 now. You don’t want to sell short the stock outright but instead would like to have the option to SELL if the stock does go below $100. Option price is $3.

You would buy a PUT with a strike price of $100 expiring in 4 mths by paying $3 for it.

If the Px drops, lets say to $90, you would exercise the call!... contd

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DerivativePUT Contract….

How they work?

Long PUT Option

This means,

You would be able to SELL the stock at $100 when the market price is at $90.

And then be able to BUY it at the MKT Px with profit.

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DerivativePUT Contract….

Developing a payoff profile?

Long PUT Option

Suppose a stock sells for Rs 200.

It has an offered PUT option for Rs 10 with a strike price of Rs 200.

What would be the payoff profile at the following stock prices

a) 210

b) 200

c) 195

d) 190

e) 180

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DerivativePUT Contract….

Developing a payoff profile?

Long PUT Option

Suppose a stock sells for Rs 200.

It has an offered PUT option for Rs 10 with a strike price of Rs 200.

What would be the payoff profile at the following stock prices

a) 210 (Loss of 10)

b) 200 (Loss of 10)

c) 195 (Loss of 5)

d) 190 (Break Even)

e) 180 (Profit of 10)

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Options Contract….PUT Options….

Buying a PUT Option (Long Put position)

1. Actual Px below strike? YES

2. Px equal to strike - NO

3. Px between strike & option premium - YES

4. Px equal to strike-premium = YES

5. Px less than strike-premium = YES

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Long Put (Bearish)Buying a PUT

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Short Put (Bullish)Selling a PUT

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Options Contract….Some combinations….

Following are some combinations used by investors to create custom pay-off profiles

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Buying a MSFT Call Option for $1.2 with strike 25 (Bullish)Long Call

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Payoff for the Writer of MSFT strike 25, premium $1.2 (Bearish)Short Call

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Long Put (Bearish)

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Short Put (Bullish)

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Options Contract….Pricing of Options….

6 Main Factors of Option pricing

1. Current Px of Underlying asset

2. Strike Price

3. Time of Expiration

4. Expected volatility over option life

5. Short term Risk-Free interest rate over option life

6. Anticipated C/F’s on underlying asset

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Options Contract….Pricing of Options….

Basic Components of Option Price

1. Intrinsic Value

2. Time Premium

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Options Contract….Pricing of Options….

Basic Components of Option Price

1. Intrinsic Value

Economic value of the option if exercised immediately.

If no positive value results, than intrinsic is zero.

2. Time Premium

Amount by which the option price exceeds its intrinsic value

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Options Contract…. Price Components of Options….

Basic Components of Option Price

1. Intrinsic Value

Difference b/w the current price of asset & strike price, IF positive.

Example:

a) If strike px = 100, asset px is 105, then intrinsic value = ?

b) If strike px = 100, asset px is 95, then intrinsic value = ?

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Options Contract….Price Components of Options….

Basic Components of Option Price

1. Intrinsic Value

Difference b/w the current price of asset & strike price, IF positive.

Example:

a) If strike px = 100, asset px is 105, then intrinsic value = 105-100=5

b) If strike px = 100, asset px is 95, then intrinsic value = 0

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Derivative - OptionsMore Terminology….

In the money

When strike price of Call is ? asset px. (profitable), intrinsic value >0

Out of the money

When strike price of Call is ? asset px (NOT profitable), intrinsic value = 0

At the money

When strike px of call is ? asset (NOT profitable), intrinsic value = 0

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Derivative - OptionsIntrinsic Value relationships….

In the money

When strike price of Call is below asset px. (profitable), intrinsic value >0

Out of the money

When strike price of Call is above asset px (NOT profitable), intrinsic value = 0

At the money

When strike px of call is same as asset (NOT profitable), intrinsic value = 0

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Options Contract….Price Components of Options….

Basic Components of Option Price

1. Time Premium

Amount by which the Option price EXCEEDS its intrinsic value (due to time)

Example:

a) If strike px = 100, asset px is 105, option px = 9- Time premium = ?

b) If strike px = 100, asset px is 90, option px = 9 – Time premium = ?

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Options Contract….Price Components of Options….

Basic Components of Option Price

1. Time Premium

Amount by which the Option price EXCEEDS its intrinsic value (due to time)

Example:

a) If strike px = 100, asset px is 105, option px = 9- Time premium = 9-5 = 4

b) If strike px = 100, asset px is 90, option px = 9 – Time premium = 9-0 = 9

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Options Contract….Pricing of Options….

6 Main Factors of Option pricing (Breakdown)

1. Current Px of Underlying asset

2. Strike Price

3. Time of Expiration

4. Expected volatility over option life

5. Short term Risk-Free interest rate over option life

6. Anticipated C/F’s on underlying asset

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Options Contract….Pricing of Options….

1. Current Px of Underlying asset

Option px changes as price of underlying changes.

Call px increases w/increase in asset px (for same strike)

Put px decreases w/increase in asset px

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Options Contract….Pricing of Options….

2. Strike Px

The lower the strike px, the higher the px of a call

The higher the strike px, the higher the px of put

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Options Contract….Pricing of Options….

3. Time to expiration

An option is a wasting asset & has no value after expiration!

The longer the time, greater the price (time premium)

NOTE: probability of a favorable px move decreases with less time

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Options Contract….Pricing of Options….

4. Expected Px Volatility of Asset over option life

Volatility is measured by standard deviation

The more the Vols, (greater the probability of favorable px move),

…Greater the option px

NOTE: Beta (systematic risk) is not used. Total vols. is relevant

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Options Contract….Pricing of Options….

5. Short term risk-free rate (over option life)

Greater the Rf, greater the call option px

NOTE:

Buying an option frees up cash for investor from buying the underlying.

This can then be invested at the Rf!

So… greater Rf, more attractive the Option, greater the option px

in case of Put…

option px will be lower, since selling directly provides invest able funds

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Options Contract….Pricing of Options….

6. Anticipated C/F’s from asset (over option life)

C/F from asset makes the asset more attractive &

Decreases the call option px

&

Increase the put option px

NOTE: Option holders don’t have interim C/F rights

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Summary….Pricing of Options….

6 Main Factors of Option pricing

1. Current Px of Underlying asset – increases CALL

2. Strike Price – Lower the strike, higher the CALL

3. Time of Expiration – Longer the time, higher the px

4. Expected volatility over option life – higher vols, higher px

5. Short term Risk-Free rate – Higher Rf, Higher Call px,-lower Put px

6. C/F’s on underlying asset – Higher C/F’s, lower call px

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Pricing of Options….

6 Main Factors of Option pricing (if increased)

Call Px Put Px

1. Current Px of asset – increases decrease

2. Strike Price – ??

3. Time of Expiration –

4. Expected volatility –

5. ST Risk-Free rate –

6. C/F’s on asset –

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Pricing of Options….

6 Main Factors of Option pricing (if increased)

Call Px Put Px

1. Current Px of asset – increases decrease

2. Strike Price – decrease increase

3. Time of Expiration – ??

4. Expected volatility –

5. ST Risk-Free rate –

6. C/F’s on asset –

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Pricing of Options….

6 Main Factors of Option pricing (if increased)

Call Px Put Px

1. Current Px of asset – increases decrease

2. Strike Price – decrease increase

3. Time of Expiration – increase increase

4. Expected volatility – ??

5. ST Risk-Free rate –

6. C/F’s on asset –

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Pricing of Options….

6 Main Factors of Option pricing (if increased)

Call Px Put Px

1. Current Px of asset – increases decrease

2. Strike Price – decrease increase

3. Time of Expiration – increase increase

4. Expected volatility – increase increase

5. ST Risk-Free rate – ??

6. C/F’s on asset –

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Pricing of Options….

6 Main Factors of Option pricing (if increased)

Call Px Put Px

1. Current Px of asset – increases decrease

2. Strike Price – decrease increase

3. Time of Expiration – increase increase

4. Expected volatility – increase increase

5. ST Risk-Free rate – increase decrease

6. C/F’s on asset – ??

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Pricing of Options….

6 Main Factors of Option pricing (if increased)

Call Px Put Px

1. Current Px of asset – increases decrease

2. Strike Price – decrease increase

3. Time of Expiration – increase increase

4. Expected volatility – increase increase

5. ST Risk-Free rate – increase decrease

6. C/F’s on asset – decrease increase

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Options Contract….Real Quote Example….

This is what a real quote would look like!

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Johnson & Johnson Options quotes

Specs

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Starbucks options

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Options Contract….Economic Role of Option Markets….

Hedging

Investor owns Asset A selling for $100.

investor expects to sell in one mth but is concerned px might drop.

What should he/she do?

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Options Contract….Economic Role of Option Markets….

Hedging with PUT

Investor owns Asset A selling for $100.

investor expects to sell in one mth but is concerned px might drop.

Buy Put Option premium for a $100 strike is $2

Guarantees a min px to sell of 98 (100-2), & offers unlimited upside

THIS IS A HEDGE AGAINST A PRICE DROP!

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Options Contract….Economic Role of Option Markets….

Hedging

Investor will receive $100 in 1 mth & wants to buy Asset A currently selling for $100.

investor expects to BUY in one mth but is concerned px might rise.

What should he/she do?

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Options Contract….Economic Role of Option Markets….

Hedging with Call

Suppose an Investor will receive $100 in 1 mth & wants to buy Asset A currently selling for $100 now.

investor expects to BUY in one mth but is concerned px might rise.

Buy Call option price of $2 with strike $100

Guarantees a Max px to Buy of 102 (100+2), & offers unlimited upside

THIS IS A HEDGE AGAINST A PRICE RISE!

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Options Ch 11Learning Summary

Options Contracts: Right but not obligation…

Options Types: Calls & Puts

Option Strategies: Combinations & payoffs

Options pricing: Intrinsic Value & Time premium

The 6 factors: Asset Px, Strike, Time, Vols, Rf, C/F’s

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Finished: Options

Next: Futures