Week 6

options markets: INTRODUCTION

Chapter Overview

This chapter describes characteristics of options, terminology used in the options’ markets, payoffs and profits to option owners and writers, and the put call parity relationship. Also discussed are securities with embedded options such as callable bonds, warrants, and collateralized loans. The chapter concludes with a brief survey of some exotic options.

Learning Objectives

After studying this chapter, the student should be able to calculate potential profits resulting from various option trading strategies and to formulate portfolio management strategies to modify the risk-return attributes of the portfolio. The student should also understand the put-call parity relationship, and be able to identify the embedded options in various assets and to determine how these option characteristics affect the prices of these assets.

Presentation of Material

20.1 The Option Contract

This first section presents basic terminology used with options. Discussion of this terminology assists in presentation of pricing and put-call parity relationships that are covered later in the chapter. The market and exercise price relationships are presented here.

Students should be familiar with the difference between American and European options. An American option can be exercised at any time prior to expiration or maturity. A European option can only be exercised on the expiration or maturity date. Most options that are traded in this country are American options. Foreign currency options stock index options that trade on the Chicago Board Options Exchange are exceptions.

Options are available on a variety of financial assets. Options are available on derivative instruments such as futures contracts. Index options are very popular instruments used in hedging. Most of the pricing and payoff examples that are built in the text are stock options.

20.2 Values of Options at Expiration

Section 20.2 presents payoffs and profits for call owners (Figure 20.2) and call writers (Figure 20.3). The call writer has unlimited loss potential if the stock price rises. The profit graphs are based on the value of the option at expiration. This section also presents the payoffs and profits for put owners (Figure 20.4) and put writers. The profit for a put writer is limited to premium of the option.

The text develops an example using options, stock and leveraged equity to demonstrate the use of options. The example shows that options can be used to control risk as well as to leverage returns. The example presents an important point that is often overlooked in discussion of options. Though the loss for an owner of an option is limited to the premium for the option— that is also 100% of the investment!

20.3 Option Strategies

A protective put involves the purchase of stock and the purchase of puts on an equivalent number of shares. The strategy reduces upside potential if the stock price rises by the cost of the put but it limits the loss if the stock declines in price occur. It provides limited downside protection but profit potential is limited if the stock price rises since the option will be exercised. Figure 20.6 and Figure 20.8 display payoff position and profit for a protective put and a covered call. As the graphs show, covered calls have limited upside potential and a higher return than stock ownership when stock price declines.

Section 20.3 then presents a description of each of the basic option strategies. A straddle will result in profits if the stock price increases or decreases enough to overcome the premiums for the options. Spreads involve combinations of call options or put options with differing exercise prices or times to expiration. Spreads with the same maturity but different exercise prices are referred to as vertical or money spreads. Spreads on instruments with different maturity dates are referred to as horizontal or time spreads.

20.4 The Put Call Parity Relationship

The development of the put-call parity theorem is presented here. Since the payoffs for the positions are equivalent to leveraged equity, prices of the alternative investments must be equal. If the prices for the equivalent strategies are different, arbitrage will be possible. Investors will trade on the arbitrage opportunities until prices move back to equilibrium levels.

20.5 Option-like Securities

Section 20.5 presents a partial list of securities that have embedded options. Class discussion of option-like securities typically leads to additional uses for the options pricing models. The discussion of collateralized loans presented in the text also makes for good class discussion.

20.6 Financial Engineering

An example of a financially engineered product illustrates the concept in this section. The product allows investment in index products yet behaves like a call option.

20.7 Exotic Options

One of the more innovative developments in the option market is the economic derivatives market. These products give investors a good sense of the market’s assessment on economic variables. A partial list of exotic options is presented here. These exotic options offer the possibility of better risk management by investors.

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