125220_16(T9): Derivatives - Options

  1. Option
    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)
  2. 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)
  3. Options can be either...
    • Exercisable at any time up to maturity (American) –cost?
    • Exercisable only at maturity (European)
  4. Buyer of a call makes profits when...
    when price of underlying physical price > strike price
  5. Buyer of put makes profits when...
    when price of underlying physical price < strike price
  6. 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.
  7. Obtain a pay-off for the call option - Pay-off for Spark Call option
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  8. Pay-off or profit and loss profile diagram:
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    • Strike price = $4
    • Break-even is the exercise price +cost of premium = $4.5
  9. Value of long call V
    Value of long call V = max(S – X, 0) - P
  10. 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
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  11. Example 2: Option terminology - Pay-off or profit and loss profile diagram
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  12. Put Options
    An put option gives the right to sell
  13. Writer
    • 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
  14. Naked call option
    A call option writer does not hold the underlying asset/shares
  15. Local Options Market- part of ASX
    • Options on Futures
    • Share Options
    • Warrants
  16. 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
  17. NZ Options on futures available for:
    • 90 day Bank Bills
    • NZSE 15 index
    • 3- and 10-year Government Bonds
  18. Local Options Market- part of ASX - 2. Share options
    • Traded on NZX
    • Based on shares of specified listed companies
  19. Local Options Market - part of ASX - 3. Warrants
    • Is a type of option
    • Contractual right but not obligation to buy or sell underlying asset
  20. 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
  21. 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
  22. Pricing of an option depends on the - "Market price of underlying asset relative to strike price"
    If prices expected ↑ ⇒ demand for options
  23. Pricing of an option depends on the - "Time to expiration of option"
    Longer the time, the higher the chance of profit
  24. Pricing of an option depends on the - "Volatility of underlying commodity price"
    More volatile, the greater chance option increases in value
  25. 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
  26. Intrinsic value
    Market price of underlying asset relative to option exercise price
  27. Intrinsic value of Call Option
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  28. Intrinsic value of Put Option
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  29. Example of hedging with an option - $60,000 in shares
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  30. Example of hedging with an option - 3 months later, shares worth $56,000
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  31. Example of hedging with an option - "Shares now worth $64,000"
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  32. Options versus Futures - "Futures"
    Buyers and sellers of futures contracts gain & lose symmetrically, & without limit (margin required)
  33. Options versus Futures - "Options"
    • Buyers loss limited to premium paid (no margin)
    • Sellers (writers) loss unlimited (margin required)
  34. A direct swap
    A swap when the two parties deal with each other to manage their risk exposure
  35. An intermediated swap
    One where one of the parties is a bank. Most swaps are intermediated
  36. Basis swap
    Swap where floating for floating interest payments are swapped
  37. 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
  38. Advantages of Currency Swaps - "Allows firms to..."
    • Obtain a lower cost of funds
    • Hedge their foreign exchange risk
  39. 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
  40. Swap dealers
    • 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
  41. Swap dealers
    • "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
  42. 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
  43. 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
Author
jordan_hs
ID
328101
Card Set
125220_16(T9): Derivatives - Options
Description
options
Updated