FINS1612 Chapter 20: Viney8e_IRM_ch20

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Financial Institutions, Instruments and Markets

8th edition

Instructor's Resource Manual

Christopher Viney and Peter Phillips

Chapter 20

Options

Learning objective 1: Understand the structure and operation of option contracts, and describe

the types and component parts of option contracts available in the global markets

• An option contract gives the option buyer the right, but not the obligation, to buy or sell a

specified asset at a predetermined price (the exercise price) at a specified date.

• A call option gives the option buyer the right to buy an asset, while a put option gives the buyer

of the option the right to sell an asset.

• A European-type option can only be exercised on the specified contract date, while an American-

type option can be exercised at any time up to the expiry date.

• Because the buyer of an option contract has the right but not the obligation to conduct a

transaction, the writer (seller) of an option will charge the buyer a premium.

• The premium is paid by the option buyer, to the option writer, at the start of the contract.

• The buyer of an option has no obligation to exercise the option. Therefore, an option allows a

risk manager to protect the downside of a risk exposure while at the same time leaving open the

opportunity to gain from any positive price movements.

Learning objective 2: Explain the profit and loss payoff profiles of call option and put option

contracts and consider the requirements of covered option contracts

• Profit and loss payoff profiles show the potential gains and losses that are available to both the

writer and the buyer of an option contract.

• The writer of an option receives the premium at the start of the option contract.

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• The writer of a call option retains the full premium so long as the current market price remains

below the exercise price. If the market price goes above the exercise price, the writer begins to

lose the premium. If the market price rises above the exercise price plus the premium (the break-

even price), the writer is in a loss position.

• With a put option the writer retains the full premium so long as the current market price remains

above the exercise price. If the market price goes below the exercise price, the writer begins to

lose the premium. If the market price falls below the exercise price less the premium (the break-

even price), the writer is in a loss position.

• A covered option is an option where the writer provides a guarantee that the writer can complete

the contract if the option is exercised. For example, an option is covered if the writer is holding

sufficient of the underlying asset, or is able to borrow the underlying asset before settlement

date. Exchange-traded options are covered options.

Learning objective 3: Describe the structure and organisation of the international and Australian

options markets, including examples of the types of option contracts available

• Exchange-traded options are standardised contracts where the clearing house places itself

between the option buyer and the option seller through the process of novation.

• Over-the-counter options may be non-standardised contracts negotiated between the buyer and

the seller (the seller usually being a commercial or investment bank).

• An enormous range of option contracts is available on exchanges around the world; each

exchange tends to specialise in options on certain asset classes.

• Exchange-traded option contracts available in the Australian market on ASX Trade and ASX

Trade 24 include options on futures contracts, share options on specified shares and share market

indices, low-exercise-price options over shares listed on the ASX (high premium, low exercise

price) and warrants.

• An over-the-counter interest rate option may be a cap, a floor or a combination called a collar.

Learning objective 4: Identify and explain important factors that affect the price of an option

contract, including intrinsic value, time value, price volatility and interest rates

• A range of variables affects the premium paid to buy an option.

• The intrinsic value, being the relationship between the market price of the underlying asset and

the option exercise price, is a key variable.

• The price of an option increases with the time to the expiration of the contract. Purely on the

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basis of probability, there is a greater chance that the option may be exercised if the option has a

long life.

• Similarly, the more volatile the price of the underlying asset, the greater is the value of the

option, since there is an increased probability that the price of the asset may attain a level at

which it will be profitable to exercise the option.

• Interest rates are another variable that affects the value of an option. Unlike the other variables,

the relationship between interest rates and the value of the option differs between call and put

options. In the case of a call option there is a positive relationship, while with a put option the

relationship is negative.

Learning objective 5: Develop options strategies that are appropriate to hedge price risk,

including single-option strategies and combined-option strategies, and discuss the advantages and

disadvantages of option contracts for the management of risk

• There is a vast range of options strategies that may be adopted by hedgers and speculators.

• The simplest are single-option strategies, including a long-asset and short-call strategy, and a

short-asset and long-call strategy.

• More complex strategies involve the simultaneous purchase and/or sale of two or more option

types. Strategies include a vertical bull spread, a call bull spread, a vertical bear spread, a put

bear spread, a long straddle, a long strangle, a short straddle and a short strangle.

• A barrier option may be a knock-out option that extinguishes if a specified nominated physical

market price is reached, or a knock-in option that is activated if a specified market price is

reached.

• An option contract allows a hedger to cover the downside of a risk exposure, but still take

advantage of any possible upside in price movements.

• In order to obtain this flexibility, the buyer of an option contract must pay a premium to the

writer of the contract.

• Option contracts are particularly useful in volatile markets, but the premiums will be higher.

• Complex option-based risk management strategies are available; however, a risk manager must

fully understand the risks being managed, the risk management products being used and the

implications of any new risks a strategy may create.

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Document Summary

Therefore, an option allows a risk manager to protect the downside of a risk exposure while at the same time leaving open the opportunity to gain from any positive price movements. 1: the writer of a call option retains the full premium so long as the current market price remains below the exercise price. If the market price goes above the exercise price, the writer begins to lose the premium. If the market price goes below the exercise price, the writer begins to lose the premium. For example, an option is covered if the writer is holding sufficient of the underlying asset, or is able to borrow the underlying asset before settlement date. Interest rates are another variable that affects the value of an option. Unlike the other variables, the relationship between interest rates and the value of the option differs between call and put options.

Related Questions

I. Fill in the blank using a number of terms listed below (@1 point). Annuity due, Asset Mgmt ratio, Call, Comparisons, Comparative ratio analysis, Corporation, Covered, Current Ratio, DSO, Du Pont Equation , Equal, Future performance, Greater, Higher, In-the-money, Less, Liquidity, Lower, Option, Ordinary Annuity, Out-of-the-money, Percentage, Perpetuity, Put, PV, Quick, Reduced, TIE, TATO, Trend Analysis, Writer 11. The payment or receipt of equal amounts, at the end of a series of equal periods, for a specified amount of time is called a(n) _______________. 12. When a loan is amortized over a five year term, the amount of interest paid is ________________ each year. 13. You have just won a $5 million lottery to be received in twenty annual equal payments of $250,000. What will happen to the present value of your winnings if the interest rate increases? It will be worth _________________. 14. The more frequent the compounding the _________________ the effective interest rate. 15. More frequent compounding results in _______________ future values and _______________ present values than less frequent compounding at the same nominal interest rate. 16. A(n) _______________ is a financial instrument that agrees to pay an equal amount of money per period into the indefinite future (i.e. forever). 17. A(n) _________________ is a contract which gives its holder the right to buy(or sell) an asset at some predetermined price within a specified period of time. 18. The seller of an option is called the option __________________. 19. An investor who writes call options against stock held in his or her portfolio is said to be selling _______________ options. 20. When the exercise price exceeds the current stock price, a call option is said to be _____________________; however, when the exercise price is less than the current price of the underlying stock, a call option is _________________. 21. An option which gives you the right to sell a stock at a specified price within some future period is called a(n) ______________ option.

The current price of a particular stock is $80. Each week the stock price goes up 15% or down 10% with some probability. a.) Find probabilities that the stock goes up or down which give that the expected return from investing in this stock is $0. These probabilities are called the ârisk neutralâ probabilities. b.) An American call option is a contract giving the buyer of the contract the right, but not the obligation to buy the stock at a future date (called the expiration date) from the seller for a predetermined price (called the strike price). Suppose you are interested in buying a call option which expires in three weeks with a strike price of $110. If the stock price is above $110 at the end of three weeks, then you can buy the stock for a lower price than it is worth, and you effectively earn the difference between the stock price and the strike price. If the stock price is below $110, the option expires worthless. What would a fair price for this option be (that is, how much is the expected earnings from this contract) if the probabilities that the stock goes up or down are given by your answer to part (a)? c.) Rather than using the probabilities in part (a), if banks offer an interest rate on cash holdings, it is common practice in financial modeling to find ârisk neutralâ probabilities so that the expected return on the stock is the same as the interest rate. Find these probabilities if the current interest rate is 5% per week. d.) What is the expected earnings from an American call option which expires in three weeks with a strike price of $110 under the probabilities from part (c)? (Note that the âpresent valueâ of $1 in three weeks is $1/(1.05)3= 0.86 since if we invest 86 cents at the interest rate, it will be worth $1 in three weeks). What is the present value of the American call option?

Problem 2

The writer of a regular exchange-listed put-option on a stock:

Has the right to buy 100 shares of the underlying stock at the market price.

Has the right to sell 100 shares of the underlying stock at the exercise price.

Has the obligation to buy 100 shares of the underlying stock at the exercise price.

Has the obligation to sell 100 shares of the underlying stock at the exercise price.

Has the obligation to buy 100 shares of the underlying stock at the market price.

please really need some help with these questions

Problem 3

Suppose an investor have a put option. What will happen if the stock price on the exercise date is below the exercise price?

A. The seller will need to deliver stock to the owner of the option. B. The seller will be obliged to buy stock from the owner of the option. C. The owner will not exercise his option.
D. The option will extend for nine more months.
E. None of the above options.

Problem 5

Suppose an investor sells one share of stock and buys a call option on the stock. What will be the value of her investment on the final exercise date if the stock price is above the exercise price? (Ignore transaction costs.)

A. The value of two shares of stock.
B. The value of one share of stock plus the exercise price. C. The exercise price.
D. The value of one share of stock minus the exercise price.

E. None of the above options.

Problem 9

All else equal, as the underlying stock price decreases:

A. The put price increases.
B. The put price decreases.
C. The call price increases.
D. There is no effect on put price.
E. The put price can either increase, decrease, or remain the same.

Problem 10

All else equal, as the underlying stock volatility decreases:

A. The put price increases.
B. The put price decreases.
C. The call price increases.
D. There is no effect on put price.
E. The put price can either increase, decrease, or remain the same.

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FINS1612 Chapter 20: Viney8e_IRM_ch20

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