Gives the buyer the right, but not the obligation to buy or sell ‘commodities’ at a specified price (exercise price or strike price), on or before a specified date (expiration date)
Type of options
- Call: gives the buyer the right to buy the ‘commodity’ at the exercise price (preset price- also called strike price)
- Put: gives the buyer the right to sell the ‘commodity’ at the exercise price (or strike price)
Options can be either...
- Exercisable at any time up to maturity (American) –cost?
- Exercisable only at maturity (European)
Buyer of a call makes profits when...
when price of underlying physical price > strike price
Buyer of put makes profits when...
when price of underlying physical price < strike price
Example 1 of a Call Option - Assume a speculator buys a 3-month call option on the NZ telecommunications Spark, currently trading in options markets. The call gives the right to buy a Spark share in 3 month’s time at a price of $4.00 (strike price). The premium (the price of option) = 50 cents - "If in 3 months, Spark is below $4.00 (e.g. $3.00)?" - "If in 3 months, Spark is above $4.00 (e.g. $4.80)?"
- If in 3 months, Spark is below $4.00 (e.g. $3.00), then call is not exercised & loss of 50 cents.
- If in 3 months, Spark is above $4.00 (e.g. $4.80), speculator will exercise call & buy share at $4 by exercising the option & sell in market for $4.80.
Obtain a pay-off for the call option - Pay-off for Spark Call option
Pay-off or profit and loss profile diagram:
- Strike price = $4
- Break-even is the exercise price +cost of premium = $4.5
Value of long call V
Value of long call V = max(S – X, 0) - P
Example 2: Option terminology - Consider a buyer of a call option on share with a strike price of $12, & a premium of $1.50
- Once the security price (S) rises above $13.50 (the strike price + premium) it becomes profitable to exercise the option
Example 2: Option terminology - Pay-off or profit and loss profile diagram
An put option gives the right to sell
- Option sellers for which they receive a premium from the buyer at the beginning
- This must compensate them for the risk if they are obliged to carry out the transaction if the option holder exercises
- Must sell underlying shares to holder of the call if they exercise option
Naked call option
A call option writer does not hold the underlying asset/shares
Local Options Market- part of ASX
- Options on Futures
- Share Options
Local Options Market- part of ASX - 1. Options on Futures
- Traded on SFE –NZFOE part
- Buyer of Options contract has the right to buy (call) or sell (put) a futures contract
NZ Options on futures available for:
- 90 day Bank Bills
- NZSE 15 index
- 3- and 10-year Government Bonds
Local Options Market- part of ASX - 2. Share options
- Traded on NZX
- Based on shares of specified listed companies
Local Options Market - part of ASX - 3. Warrants
- Is a type of option
- Contractual right but not obligation to buy or sell underlying asset
Warrants may be either
- Attached to debt issues (i.e. Equity Warrants)
- Option to be converted to ordinary shares of the issuing company (American or European)
- Financial Products to manage risk
- Issued by financial institutions
- May be traded on NZX
Pricing of an option depends on the...
- Market price of underlying asset relative to strike price
- Time to expiration of option
- Volatility of underlying commodity price
- Level of interest rates
- The strike or exercise price & for dividend paying stocks, dividends must be included
Pricing of an option depends on the - "Market price of underlying asset relative to strike price"
If prices expected ↑ ⇒ demand for options
Pricing of an option depends on the - "Time to expiration of option"
Longer the time, the higher the chance of profit
Pricing of an option depends on the - "Volatility of underlying commodity price"
More volatile, the greater chance option increases in value
Pricing of an option depends on the - "Level of interest rates"
- Interest rates have opposite effect on puts & calls
- Positive relationship between interest rates & the price of a call
- Negative relationship between interest rates & the price of a put
Market price of underlying asset relative to option exercise price
Intrinsic value of Call Option
Intrinsic value of Put Option
Example of hedging with an option - $60,000 in shares
Example of hedging with an option - 3 months later, shares worth $56,000
Example of hedging with an option - "Shares now worth $64,000"
Options versus Futures - "Futures"
Buyers and sellers of futures contracts gain & lose symmetrically, & without limit (margin required)
Options versus Futures - "Options"
- Buyers loss limited to premium paid (no margin)
- Sellers (writers) loss unlimited (margin required)
A direct swap
A swap when the two parties deal with each other to manage their risk exposure
An intermediated swap
One where one of the parties is a bank. Most swaps are intermediated
Swap where floating for floating interest payments are swapped
Interest Rate Swaps - "Main reasons for growth"
- Lower net cost of funds
- Restructuring of firms’ existing debt
- Means of managing risk
- Lock in profit margins
- Gain access to otherwise inaccessible markets
Advantages of Currency Swaps - "Allows firms to..."
- Obtain a lower cost of funds
- Hedge their foreign exchange risk
Hedging purposes of Currency Swaps
- Exporters could use a swap to convert a series of debt payments into the currency that they will be paid in to create a natural hedge.
- Banks can hedge their international debt borrowings
- Originally, FIs acted as brokers
- Have developed to act as counterparties (dealers) to both parties
- Commercial banks play major role because of their easy access to money & FX markets
- "Commercial banks play major role because of their easy access to money & FX markets"
- Dealer runs a “book” of swaps to kept record of swaps
- They try not to have any mismatches in the “book” with respect to S/T or L/T interest rate exposures, foreign exposures & floating-rate index exposures
- If mismatched, they will try to hedge exposure
- Because of risks & service offered, fee charged equal to 5 to 10 basis points (0.05 - 0.10%) of notional principal
Financial Contracts - Credit Default Swaps
- Contractual agreement transferring credit risk from one party to another
- Aim: To transfer credit risk from one party to another
Credit Default Swaps - "Two parties to CDS"
- Protection seller: agrees to compensate protection buyer if credit default event specified in contract occurs
- Protection buyer: who has bought some debt instrument or a loan provider & seeks to transfer credit risk to seller