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ECON 372 Study Guide - Final Guide: Put Option, Call Option, Futures Contract


Department
Economics
Course Code
ECON 372
Professor
Usman Hannan
Study Guide
Final

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1
ECON 372 Notes
Chapter 1: Introduction
Derivative- An instrument whose value depends on the values of other more basic
underlying variables; Ex. Futures Contracts, Forward Contracts, Swaps, Options
Primary Market Secondary Market
(1) Futures/Forward Contracts Where contracts are traded
(2) Options
Uses for Derivatives:
To hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one
portfolio and buying another
Spot Contract- An agreement to buy or sell an asset immediately (or within a very
short period of time)
Spot Price- For immediate, or almost immediate, delivery price
Futures Contract- (formerly To-Arrive Contract) An agreement to buy or sell an
asset at a certain time in the future for a certain price via the Futures Exchange
Market (ex. CBOT, CME, etc.); entering the contract is free, but contract terms are
standardized by the exchange market it is on
Buyer = Long Futures Position committed to buy the asset
Seller = Short Futures Position
Futures Price- The price at which you agree to buy or sell a particular futures
contract; determined by law of supply and demand
Open-Outcry System- Traders physically meet on the floor of the exchange: “Trading Pit”
Electronic Trading- Replaces the open-outcry system; Traders enter their required
trades at a keyboard and a computer being used to match buyers and sellers
Over-The-Counter (OTC) Market- Trades over the telephone often between traders
at a financial institution and other traders at other financial institutions or a corporate
treasurer or a fund manager typically more trades via OTC than exchange market
Forward Contract- An agreement to buy or sell an asset at a certain time in the
future for a certain price OTC; Private agreements between two financial institutions
or a financial institution and a client; employs both spot and forward traders
Example: Calling someone up to buy/sell a contract in the future
Exchange Market
Over-the-Counter (OTC) Market
- Standardized contracts
- More tailored to investor needs
- Almost no credit risk
- Maybe some credit risk involved
Now (May 5, 2010)
Future (Aug, 5, 2010)
- Make contract to determine the future
- Buyer of 100 ounces of gold and seller of 100
ounces of gold are matched on the exchange
market (futures contract) or
OTC (forwards contract)
- Reduces risk from uncertain futures prices
- Matched at the exchange market (futures
contract) or matched over the counter
(forwards contract)
- The respective parties entering the contract are
bound to buy or sell the goods at the decided
price at the decided time

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Spot Traders- Trading an asset for almost immediate delivery
Forward Traders- Trading an asset for delivery at a future time
Options Contract- The right to buy or sell an asset (traded at exchanges OR over-
the-counter); Gives the holder the right to do something; the holder dos NOT have to
exercise this right
Two basic types:
1. Call Option- Holder has the right to buy a certain asset by or at a certain time
(maturity date) for a certain price (strike/exercise price)
- The holder has a choice as to whether to buy the asset
- Exercises option to buy if price rises above strike price (less cost)
2. Put Option- Holder has the right to sell a certain asset by or at a certain time
(maturity date) for a certain price (strike/exercise price)
- Exercises option to sell if price falls below strike price (make profit)
Buyer = Long Position
Seller = Short Position
Writing the Option = Selling an Option
American Option- Can be exercised at any time during its life (when the contract is
made up to the maturity date) * in the U.S., 1 options contract is to buy/sell 100 shares
European Option- Is exercised only at the maturity date
Strike Price- (Exercise Price) The price at which the asset may be bought/sold in an
options contract
Option Premium- An upfront price paid by the investor of an option contract needed
for the trade; determined by supply and demand
Properties of Options:
The price of a Call Option decreases as the strike price increases
The price of a Put Option increases as the strike price increases
Both Call and Put Options tend to become more valuable as time to maturity increases
Call Option Example: Prices of Options, September 12, 2006 Stock Price = $19.56
Price for an Option to buy ONE Share
Calls
Puts
Strike Price
Oct 2006
Apr 2007
Oct 2006
Jan 2007
Apr 2007
$15.00
4.650
5.150
0.025
0.150
0.275
$17.50
2.300
3.150
0.125
0.475
0.725
$20.00
0.575
1.650
0.875
1.375
1.700
$22.50
0.075
0.725
2.950
3.100
3.300
$25.00
0.025
0.275
5.450
5.450
5.450
Investor buys 1 April 2007 Call Option with Strike Price = $20.00
Price for an Option to buy ONE share = $1.650
In the US, an options contract buys/sells 100 shares
Investor must arrange $165 ($1.65x100) option premium to be remitted to the exchange through the broker
BUYER Cost for the right to buy 100 shares @ $20/each = $165
SELLER Receives $165 and agrees to sell 100 shares @ $20/each if the investor exercises the option
If price does not rise above $20, investor does NOT exercise option and loses $165
If price rises above the strike price to $30, then investor exercises option and makes a gain of (saves) $835
Cost @ $30: $30 x 100 = $3,000
Cost @ $20: $20 x 100 = $2,000 + $165 Option Premium = $2,165
Amount Saved = $3,000 - $2,165 = $835

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3
Put Option Example: Prices of Options, September 12, 2006 Stock Price = $19.56
Price for an Option to buy ONE Share
Calls
Puts
Strike Price
Oct 2006
Apr 2007
Oct 2006
Jan 2007
Apr 2007
$15.00
4.650
5.150
0.025
0.150
0.275
$17.50
2.300
3.150
0.125
0.475
0.725
$20.00
0.575
1.650
0.875
1.375
1.700
$22.50
0.075
0.725
2.950
3.100
3.300
$25.00
0.025
0.275
5.450
5.450
5.450
Investor buys 1 April 2007 Put Option with Strike Price = $17.50
Option Premium (Cost to buy Put Option @ $17.50/share) = $0.725 x 100 = $72.50
Investor obtains the right to sell 100 shares for $17.50/share prior to April 2007
If price does not fall below $17.50, the option is NOT exercised and loses of $72.50
If price falls below the strike price to $15, the option is exercised and makes a net profit of $177.50
Cost @ $15.00/share: $15.00x100 + $72.50 Option Premium = $1572.50
Sold @ $17.50/share: $17.50x100 = $1750.00
Net Profit = $1750.00 1572.50 = $177.50
Call Option Calculations:
Now
Future
Spot Market
Spot Price:
x1 /share
x1’ /share
Options Market
Strike Price:
x2 /share
x2’ /share
Profit - if x1 > x2, option contract is exercised
Gain = (x1x2) * 100 Option Premium
- if x1 < x2, option contract is not exercised, Loss = Option Premium
Profit
option premium x1=x2 Price
Put Option Calculations:
Profit - if x2 > x1, 1 option contract; Net Profit = (x2x1) * 100 Option Premium
- if x2 < x1, option contract is not exercised; loss = Option Premium
Profit
option premium x1=x2 Price
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