FNCE90011 Derivative Securities
Option Payoff and Profit Diagrams
Appendix: Market Structure
Hull (8th edition) Chapters 1, 4.2, 5.2, 9, 11
Hull (7th edition) Chapters 1, 4.2, 5.2, 9, 11
Hull (6th edition) Chapters 1, 4.2, 5.2, 8, 10
Copyright © John C. Handley 2012.
1. BASIC CONCEPTS
What is a derivative ?
A derivative is an asset/security whose value is completely determined by the values of one or more other ("underlying" or "state") variables. In many cases the underlying variable is the price of a traded asset such as … stocks / shares
bonds / interest rates
And sometimes the underlying variable appears to be a bit “crazy” … such as in the case of weather derivatives
The derivatives market is the market where derivative securities are traded The four “big” classes of derivatives are:
(i) forwards and futures
(ii) options (iii) swaps (iv) credit derivatives
Users Of Derivatives
already has an exposure to future movements in the price of the underlying asset and is interested in reducing risk
eg: you own a share and you think the stock price will fall but you do not want to sell the share … what can you do ?
wishes to take a position in the market i.e. to take on risk with a view to making a profit. Either he is betting that the asset price will go up or that it will go down
eg: you think the stock price will increase but you do not want to buy the share … what can you do ?
arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets
This means that derivatives may be used to increase risk or to decrease risk 4
A contractual agreement which gives one party the right but not the obligation to exchange a specified asset, with the other party, at a specified price at a specified date
For simplicity, we will initially focus on options on stocks Long and Short Option Positions
The person who buys the option is said to have taken a long option position (on the asset) or is “long option”
The person who sells the option is said to have taken a short option position (on the asset) or is “short option”.
The option is created at the time the contract is entered into … the price paid at this time is called the premium.
Who Decides Whether the Option is Exercised ?
The decision whether to exercise the option or not rests with the long … the short must comply with the decision of the long.
There are two types of options:
A call option gives the long option investor ... the right but not the obligation to buy the stock from the short option investor at the time of exercise
A put option gives the long option investor ... the right but not the obligation to sell the stock to the short option investor at the time of exercise
When Can The Option Be Exercised ?
The last date that the option can be exercised is the expiry or maturity date ... if not exercised at maturity, then all contractual rights and obligations cease. Options may be classified as either European, American or Bermudan Enter Contract
The maturity date of an option contract is fixed … as time passes, we get closer to the maturity date and so the time to maturity (or life of the option) decreases
... see appendix
1. CALL OPTION
On entering the contract ( at time 0)
At Maturity ( at time T)
The exercise condition
2. PUT OPTION
On entering the contract (at time 0)
At Maturity (at time T)
The exercise condition
2. OPTION PAYOFF AND PROFIT DIAGRAMS
Four types of options positions:
(i) Long call
(ii) Long put
(iii) Short call
(iv) Short put
Interesting questions include:
why enter into...
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