Topic 3

Options
Derivatives
Instruments

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Option Terminology

Option Terminology
1. What is a listed call option?
A contract giving the holder the right to buy
100 shares of stock at a preset price called
the exercise or strike price.

2. What is a listed Put option?

A contract giving the holder the right to sell 100
shares of stock at a preset price

Expirations of 1,2,3,6,& 9 months and

sometimes 1 year are normal contract periods.
Contracts expire on the Saturday following the
third Friday of the expiration month.
Contracts may be sold prior to maturity.

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Option Characteristics

Option Characteristics
The cost of an option is called the premium and
it is a small percentage of the cost of the
underlying asset.

If a call option holder wishes to purchase the

stock, he or she will exercise the option.
The option holder must pay the exercise price to
the option writer.

The option buyer pays the cost; the option writer

receives the cost at the time of sale of the option.

Exercise prices are adjusted for stock splits and

stock dividends, but NOT cash dividends.

The underlying company is not involved in the

option market.

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American vs. European Options

American:

European:

Options are a zero sum game.

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Option Terminology
3. Uses of options:

the option can be exercised at any date

after purchase.

a. To hedge changes in stock price.

b. Change your risk and return profile

the option can only be exercised

immediately before expiration

For example, buying a call is analogous to buying

stock on margin.

c. Short sale constraints can be avoided with

puts.
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Types of Options
4. Types of options

Values of Options at Expiration

Listed Options
OTC Options
Index Options
Options on Futures
Foreign Currency Options
Interest Rate Options
Exotic Options
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Option Terminology

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Profit

5. Symbols & Valuation

Ct = Price paid for a call option at time t. t = 0 is
today,
T = Immediately before the option's expiration.
Pt = Price paid for a put option at time t.
St = Stock price at time t.
X = Exercise or Strike Price
> X.
A call is in the money if St ____
A call is out of the money if St ____ X.
A put is in the money if St ____ X.
> X.
A put is out of the money if St ____

Call profit at expiration

B.E.: ST = X + C0

-$735

$100

$92.65

$0

$107.35

-C0 + ST X

-C0

Stock
PriceT

Ex = $100

>

Bullish or bearish?

IBM Jul 100 call option

Stock Price = $96.14
Exercise = $100
Call premium = $735
Contract Size 100 shares

>

High or low volatility strategy?

Both are at the money when?

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Writing a naked call

Profit

WRITING A NAKED CALL

Profit Table

Stock
PriceT

$0

ST < X

ST > X

+C0

+C0

+C0

CT

(ST X)

= Profit

+C0

+C0 ST + X

Breakeven

ST = X + C0

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Writing a naked call

Buying a put option

Profit

BUYING A PUT
Profit Table
P0

+C0

+C0 ST + X

$0

B.E.: ST = X + C0

Stock
PriceT

ST < X

ST > X

P0

P0

+PT

X ST

= Profit

X S T P0

P0

Breakeven

ST = X P0

Bullish or bearish?

High or low volatility strategy?
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Buying a put option

Profit
$8,834

$0

$100

$88.34

$111.66

P0

B.E.: ST = X P0

-$1,166

Ex = $100

Bullish or bearish?

Profit Table

ST < X

ST > X

+P0

+P0

+P0

PT

(X ST )

= Profit

ST X + P0

+P0

Breakeven

ST = X P0

Stock
Pricet
Put

Alternative Stock Strategy?

High or low volatility strategy?

Profit

Writing A Put

IBM Dec 100 put option

Stock price = $96.14
Exercise = $100
Put premium = $1,166
Contract Size 100 shares

Short
position
in IBM

X S T P0

Writing a put option

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Writing a put option

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Profit

$1,166
S T X + P0

$0

$88.34

$100

Long
Position
in
Xx IBM
= $100

- $8,834

Bullish or bearish?

$111.66

+P0

Stock
Pricet

$0

Stock
Pricet

IBM Jul 100 put option

Stock price = $96.14
Exercise = $100
Put premium = $1,166
Contract Size 100
shares

Alternative Stock Strategy?

High or low volatility strategy?

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Buy stocks and at the money puts:

Protective Put

Buy stocks and at the money puts:

Protective Put

Profit

Long
position
in IBM

All examples that include both stocks and

options assume usage of at the money
options.

Hedged
Position

Stock
Pricet

$0

Put

Hedged profit equals sum of profits of put and stock

at each stock price.
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Buy stocks and at the money puts:

Protective Put

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Writing Covered Calls

Profit

Long
position
in IBM

LONG STOCK, LONG PUT

Profit Table

ST < X

ST > X

ST S0

ST S0

ST S0

P0

P0

P0

+PT

X ST

= Profit

ST S0 + X ST P0
= X S0 P0

Breakeven

Bullish or bearish?

Covered Call

Written call
$0

ST S0 P0

ST = S0 - C0

S0

Stock
Pricet

ST = S0 + P0
Profit
Protective
Put

$0

High or low volatility strategy?

Stock
Pricet

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Bullish or bearish?
High or low volatility strategy?
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Writing Covered Calls

Optionlike Securities

WRITING COVERED CALLS

Profit Table

ST < X

ST > X

ST S0

ST S0

ST S0

+C0

+C0

+C0

CT

(ST X)

= Profit

ST S0 + C0

X S0 + C0

Breakeven

ST = S0 C0

1. Callable bonds
Issuing firm has the right to call in the bond
and pay call price.
When will the firm want to exercise its call
option?

Profit

Stock
Pricet

$0

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Optionlike Securities

Optionlike Securities

3. Warrants

2. Convertible Securities

Firm sometimes issue warrants with its

bonds. The warrants are similar to call
options, which is to purchase new stock at a
fixed price.

Security holder has the option to convert the

bond to a fixed number of shares of common
stock.
Bonds Conversion Value = Conversion Ratio x
Common Stock Price
If a bond is convertible to 20 shares of stock, stock
is priced at $60 per share. The bonds conversion
value = $1,200

Exercise of warrants (and convertibles) can

result in dilution of earnings per share

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Warrants

Warrants

There are two major kinds of warrants listed

on the Main Board in Hong Kong:

Equity warrants
Derivative warrants

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Warrants

Warrants
Normally, equity warrants may be issued
subject to the following requirements:

Equity warrants

Equity warrants are warrants carrying the right

to subscribe equity securities of an issuer
(listed or to be listed) which are newly issued
or granted on their own by that issuer or any of
its subsidiaries.

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The securities to be issued upon exercise of

the warrants and other existing subscription
rights, other than options granted under
employee share schemes, must not exceed
20% of the issued equity capital of the issuer
at the time of issue of the warrants;
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Warrants

Warrants

The warrants must expire not less than one

and not more than five years from the date of
issue and must not be convertible into further
rights to subscribe for securities which expire
over a period outside the limit.

Equity warrants may be listed only if the

underlying securities are listed on the
Exchange or on another recognised exchange.

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Warrants

Warrants

Derivative warrants

Derivative warrants are similar to equity

warrants but are issued by a party which is
independent of the issuer of the underlying
securities or its subsidiaries.

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The underlying assets of derivative warrants

may be assets other than equity securities.

Cash payment instead of the delivery of the

underlying assets may be involved upon
exercise of a derivative warrant.

But the issuer must specify at launch whether

the warrants will be settled in cash or physical
scrip upon exercise.

Basket warrants and warrants on foreign

stocks are to be settled wholly in cash.
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Warrants

Warrants

Derivative warrants are divided into 2 categories:

Non-collateralised warrants:
derivative warrants where the performance of
an issuers obligations is NOT secured by the
deposit of the underlying securities or assets
with an independent trustee.

Collateralised warrants:
derivative warrants where the performance of
an issuers obligations is secured by the
deposit of the securities or assets underlying
the derivative warrant with an independent
trustee who holds the securities or assets for
the benefit of the warrant holders.

Instead, the issuer usually adopts hedging

strategies to provide for its obligations during
the life of the warrants.
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Futures and Forwards

Forward - an agreement calling for a future
delivery of an asset at an agreed-upon price

Futures

Futures - similar to forward but has standardized

terms and is traded on an exchange.
Key difference in futures
Futures have secondary trading (liquidity)
Marked to market
Standardized contract terms such as delivery dates,
price units, contract size
Clearinghouse guarantees performance
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Key Terms for Futures Contracts

The Futures price: agreed-upon price paid at
maturity

Key Terms for Futures Contracts

Profits on long and short positions at maturity
Long = Futures price at maturity minus
original futures price

Long position: Agrees to purchase the

underlying asset at the stated futures price at
contract maturity

Short = Original futures price minus futures

price at maturity

Short position: Agrees to deliver the

underlying asset at the stated futures price at
contract maturity

At contract maturity T:
FT= ST F = Futures price, S = spot price
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Figure 17.2 Profits to Buyers and Sellers

of Futures and Options Contracts

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Types of Contracts
Agricultural commodities
Metals and minerals (including energy
contracts)
Financial futures
Interest rate futures
Stock index futures
Foreign currencies

Why does the payoff for the call option differ from the long futures
position?
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Table 17.1 Sample of Futures

Contracts

The Clearinghouse and Open Interest

Clearinghouse - acts as a party to all buyers and sellers.
A futures participant is obligated to make or take
delivery at contract maturity
Closing out positions
Reversing the trade
Take or make delivery
Most trades are reversed and do not involve actual
delivery

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Marking to Market and the Margin

Account

Open Interest
The number of contracts opened that have not been
offset with a reversing trade: measure of future
liquidity

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Margin Arrangements
Margin call occurs when the maintenance
margin is reached, broker will ask for
additional margin funds

Initial Margin: funds that must be deposited in a

margin account to provide capital to absorb
losses
Marking to Market: each day the profits or losses
are realized and reflected in the margin account.
Maintenance or variance margin: an established
value below which a traders margin may not fall.
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Marking to Market Example

More on futures contracts

On Monday morning you sell one T-bond futures

contract at 97-27 (97 27/32% of the $100,000 face
value). Futures contract price is thus $97,843.75
_________.
The initial margin requirement is $2,700 and the
maintenance margin requirement is $2,000.

Convergence of Price: As maturity approaches

the spot and futures price converge
Delivery: Specifications of when and where
delivery takes place and what can be delivered

$97,843.75

$2700.00

97-13

$97,406.25 -$437.50

$3137.50 +16.2% +0.45%

98-00

$98,000.00 $593.75

$2543.75

-5.8% -0.16%

$100,000.00 $2,000.00 $543.75

+$2156.25

-79.9% -2.2%

100-00

Margin call

Cash Settlement: Some contracts are settled in

cash rather than delivering the underlying assets

$2,700.00

Leverage multiplier = 79.9/2.2 36

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Trading Strategies

Futures Market Strategies

Speculation
Go short if you believe price will fall
Go long if you believe price will rise

Hedging
Long hedge: An endowment fund will purchase
stock in 3 months. The manager buys futures
now to protect against a rise in price.
Short hedge: A hedge fund has invested in long
term bonds and is worried that interest rates may
increase. Could sell futures to protect against a
fall in price.
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Additional Financial Futures

Contracts

Stock Index Futures

Available on both domestic and
international stocks

Foreign Currency
Forward contracts
Currency markets are the largest markets in the world,
Forward contracts are available from large banks,
Used extensively by firms to hedge foreign currency
transactions.

Several advantages over direct stock

purchase
lower transaction costs
easier to implement timing or allocation
strategies

Futures contracts are available for major

currencies at the CME, the LIFFE and others.
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Additional Financial Futures

Contracts

March, June, September and December delivery

contracts are available.

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Additional Financial Futures

Contracts

Interest Rate Futures

A short position in these contracts will

benefit if interest rates increase and may be
used to hedge a bond portfolio.

Major contracts include contracts on

Eurodollars, Treasury Bills, Treasury notes
and Treasury bonds.

A long position benefits if interest rates fall.

A bank that has short term loans funded by
longer term debt could hedge its funding risk
with a long position.

Contracts on some foreign interest rates

are also available.

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Additional Financial Futures

Contracts

Interest Rate Swap

Large component of derivatives market

Interest Rate Futures

Interest Rate Swaps

Hedging with futures will often require a cross

hedge.

One party agrees to pay the counterparty a

fixed rate of interest in exchange for paying a
variable rate of interest or vice versa,

A cross hedge is hedging a spot position with a

futures contract that has a different underlying
asset. For example, hedge a corporate bond
the firm owns by selling Treasury bond futures.

No principal is exchanged.

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Figure 17.8 Interest Rate Swap

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Currency Swaps
Currency Swaps
Two parties agree to swap principal and
interest payments at a fixed exchange rate
Firm may borrow money in whatever currency
has lowest interest rate and then swap
payments into the currency they prefer.

Company B wants fixed

Company A wants variable
rate financing to match
rate financing. They will pay 7.05%
their variable rate investments.
They will pay LIBOR + 5 basis
* Swap dealer agrees to
points

In 2007 there were $272 trillion notional

principal in interest rate swaps outstanding
and about $12.3 trillion principal in currency
swaps. (Source, BIS)

both deals, manages net risk

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