OPTION MARKETS AND CONTRACTS

Transcription

1 NP = Notional Principal RFR = Risk Free Rate 2013, Study Session # 17, Reading # 63 OPTION MARKETS AND CONTRACTS S = Stock Price (Current) X = Strike Price/Exercise Price 1 63.a Option Contract A contract which gives the owner a right, not obligation, to enter into a transaction Involving an asset At a predetermined future date At a predetermined future price Predetermined future price = exercise/strike price. Predetermined future date = exercise date. Long: buyer of an option. Short: Seller of an option. Option Premium: upfront cost paid by the long to the short. Call Price: option premium for call option. Put Price: option premium for put option. Listed Stock Option Contract: Normally for 100 shares per contract. Option price is not exercise/strike price. If option is in value the holder may exercise or sell the option in the secondary market. Buyer/Seller Option Positions Option buyer has the right not the obligation. Option seller has the obligation if buyer exercises the option. Long Call: Buyer of a call option with right to buy an underlying asset at some future date with predetermined price. Short Call: Seller of a call option with obligation to deliver the asset to the call option holder. Long Put: Buyer of a put option with the right to sell an underlying asset at some future date with predetermined price. Short Put: The seller of a put option with an obligation to buy the asset from the put option holder. 63.b European and American Options American Options: Can be exercised during the contract life or at expiration. European Options: Can be exercised only at contract expiration. At contract expiration both European and American options with same asset, and strike price have same values. Identical Options Options with same: Maturity Underlying Asset Strike Price Expiration Before expiration American options may have value equal to or greater than European options due to their exercise flexibility.

2 2 63.c Moneyness of an Option In the money: If immediate exercise results in positive payoff. Out of the money: If immediate exercise results in negative payoff. At the Money: Exercise results in no payoff. Call Option Put Option In the money: S X > 0 Option holder would buy at X (from seller) and sell in the market at S. Out of the money: S X < 0 At the money: S = X In the money: X S > 0 Option holder would buy at S from market and sell to the option seller at X. Out of the money: X S < 0 At the money: S = X 63.d Options Exchange-Traded Options Over the Counter Options Regulated. Standardized. Liquid. Backed by clearinghouse. Expiration date usually of a few months. LEAPS: Long term Equity Anticipatory Securities equity op ons with expiry > than 1 year. Largely unregulated. Custom options. Counterparty risk involved. Facilitated by dealers. Primarily institutional investors involved. Active market on: Currencies Swaps Equities 63.e Types of Options Financial Options Equity Options Options based on: Stock Indices Treasury Bonds Interest rates Currencies Strike Price can be: YTM Index Level Exchange Rate LIBOR based options payoffs difference b/w LIBOR at expiration and strike rate. Call Options Gives the holder the right to enter into a futures contract at a later date. The strike price is already determined. The option writer has the obligation to take short position. Options on Future Put Options Gives the holder the right to take short position at future date. Futures Price = Strike Price (if option exercised) Writer of the option has obligation to take long position. Commodity Options Gives the holder a right to buy or sell fixed quantity of some physical asset at strike price. Bond Options Usually on treasury bonds due to active trading. Both deliverable & settled in cash. Based on bond price & specific value (face). Long on call will benefit if interest rates. Long on put will benefit if interest rates. Index Options Cash settled. Payoff = (present index level index mentioned in contract) x multiplier. If Payoff > 0 short call pays long call.

3 3 63.f Interest rate Options Exercise price (rate) Interest rate. Underlying asset Reference rate, such as LIBOR. Cash settled. Payoffs are based upon notional amount and spread b/w Strike rate & reference rate {(LIBOR Reference rate) x NP}. Mostly European Options. Long call receives payoff if LIBOR > Strike rate. Short put makes payment if LIBOR < Strike rate. Long interest rate call + Short interest rate put = same payoff as FRA. 63.g Interest Rate Cap Series of interest rate call options with expiry matching the reset dates on floating-rate loans. Cap protects borrower (of loan) if interest rate. Place a maximum upper limit on interest rate payments. Cap: Series of interest rate call options. Strike rate = cap rate. Pays when floating rate (reference) > cap rate. Each option in cap is called caplet. Payoff = (Reference rate Cap rate) x NP. For hedger: Notional Amount = loan amount. Interest Rate Floor Series of interest rate put options with expiry matching reset dates on floating loans. Floor protects floating rate lender from in interest. Place a minimum limit on interest rate payments. Floor: Series of interest rate puts. Strike rate = floor rate. Pays when floating rate (reference) < floor rate. Each option in floor is called floorlet. Payoff = (Floor rate Reference rate) x NP. Interest Rate Collar Composed of a long cap & short floor. A loan borrower (floating rate) can create a collar by buying a cap and selling a floor. If reference rate > cap loan borrower receives the difference. If reference rate < floor loan borrower pays the difference. Effectively the loan borrower only pays a rate b/w the collar.

4 4 63.h Payoff: Stock Option At expiration call owner receives an amount by which asset price exceeds strike price or zero otherwise. At expiration put owner receives amount by which asset price is below strike price or zero otherwise. Bonds are quoted in terms of YTM. T. Bills are quoted in terms of discount yields. Indices in terms of index points. Currencies used to translate asset value into domestic currency. Payoff: Interest Rate Option Payoff payment is made not at option expiration but at term of reference rate. Payoff is calculated by multiplying NP with difference of LIBOR & Strike rate. 63.i Option s Intrinsic Value Amount by which the option is in-the-money. The amount will be received if option is exercised. At the money op on has zero intrinsic value (both call/put). For call options Intrinsic Value, C = max [0, S X]. For put options Intrinsic Value, P = max [0, X S]. Option writer has either zero payoff or negative amount by which the option is in the money. Time value of an Option Amount by which option premium exceeds intrinsic value. Option Value = Intrinsic Value + Time Value Also called speculative value. During life of an option, its value at expiration can be > current intrinsic value. At expiration, time value of an option is zero. 63.j Option Value Limits European Call 0 c 0 S 0 European Put 0 p t X / (1+RFR) T American Call 0 C 0 S 0 American Put 0 P t X

5 5 63.k Lower & Upper bound for Options Option Minimum Value Maximum Value European Call c t max [0, S 0 X / (1 + RFR) T ] S 0 European Put p t max [0, X / (1+RFR) T S 0] X / (1+RFR) T-t American Call C t max [0, S 0 X / (1 + RFR) T ] S 0 American Put P t max [0, X S 0] X 63.l Option Price, Exercise Price & Time to expiration Call prices are inversely related to exercise price. Put price are directly related to exercise price. Usually longer time to expiration, op on value. Far out-of-the-money option extra time may have no effect. For European Puts, longer time to expiration may op on s value, when deep in-the-money. If volatility ( ), discount rate ( ), longer term put can be > (<) in value relative to short term put. 63.m Put Call Parity Fiduciary call: Call Option with strike price X & risk-free-zero coupon bond that pays X at expiration. Protective Put: Share of stock & put at strike price X. Fiduciary call and Protective Put have same payoff at expiration. Put Call parity for European Options: c + X/ (1+RFR) T = S + p. Synthetic positions can be created using put call parity. c = S + p - X/ (1+RFR) T p = c S + X/ (1+RFR) T S = c p + X/ (1+RFR) T X/ (1+RFR) T = S + p c 63. n If underlying asset has positive cash flow Put call parity: c + X/ (1+RFR) T = (S PVCF) + p. The maxima and minima relations are also adjusted for present value of expected cash flows. 63.o Vola lity of underlying asset or values of both call & put options. Options that depends on interest rates or bond values. RFR call values. RFR put values.