F303 Intermediate Investments

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F303 Intermediate Investments

• Class 17
• Derivative Instruments
• Andrey Ukhov
• Kelley School of Business
• Indiana University

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Outline of This Subject

• Definitions and uses of derivative instruments.
• Option trading.
• Option contracts.
• Calls and Puts.
• Payoffs from Calls and Puts.

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Derivative Instruments

• A relatively recent, but extremely important
  class of financial assets is derivative
  securities.
• These are securities whose are determined by, or
  derived from the prices of other securities.
• These assets are also called contingent claims
  because their payoffs are contingent on other
  securities.
• These assets are powerful tools for both hedging
  and speculation.

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Example of Derivatives

• Call Option
• Put Options
• Swaps
• Futures
• Forwards
• Option contracts are traded now on several
  exchanges. They are written on common stock,
  stock indexes, foreign exchange, precious metals,
  interest rate futures

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Option Contracts

• When you own an option you have a right to do
  something.
• Call Option
• This is a right (but not an obligation) to buy an
  asset at a pre-arranged price (the exercise
  price or strike price) on or until a
  pre-arranged date (the maturity)
• Put Option
• This is a right (but not an obligation) to sell
  an asset at a pre-arranged price (the exercise
  price or strike price) on or until a
  pre-arranged date (the maturity).

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Call Options

• Example A March call option on IBM stock with an
  exercise price of 120 entitles its owner to
  purchase IBM stock for a price of 120 at any
  time up to an including date in March.
• Pay 120 and receive a share of IBM stock
• The holder of the call is not required to
  exercise the option.
• It will pay to exercise the call only if the
  market value of the asset to be purchased exceeds
  the exercise price.

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Call Options

• The purchase price of the option is called the
  premium. It is the compensation the purchaser of
  the call must pay for the right to exercise the
  option if exercise becomes profitable.
• For every owner of an option there is a seller of
  an option.
• Sellers of the call option, who are said to write
  calls, receive premium income now as payment
  against the possibility they will be required at
  some later date to deliver the asset in return
  for an exercise price lower than the market value
  of the asset.

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Call Options An Example

• Consider a March 2002 maturity call option on a
  share of IBM stock with an exercise price of 220
  per share. The call sells for 10 in January
  2002.
• Until the calls expiration date, the purchaser
  of the calls is entitled to buy shares of IBM for
  220.
• Let us say that on 1 February 2002, IBM shares
  sell for 219 less than the exercise price of
  220. In this case, it does not make sense to
  exercise the call option to buy at 220.

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Call Options An Example

• If IBM stock remains below 220 by the expiration
  date, then the call will be left to expire
  worthless.
• If, on the other hand, IBM is selling above 220,
  then the call holder will find it optimal to
  exercise. Let us say that on expiration, IBM
  shares trade at 225. Then, the proceeds from
  exercise are given by
• Stock price Exercise price 225 - 220 5

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Values of Options at ExpiryBuying a Call
Payoff
Buy Call Option Payoff MAX0, S-X
45 degrees
Stock Price
X
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Values of Options at ExpiryWriting a Call
Payoff
Sell Call Option Payoff - MAX0, S-X
or MINX-S, 0
X
Stock Price
45 degrees
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Values of Options at ExpiryBuying a Put
Payoff
Buy Put Option Payoff MAX0, X-S
Stock Price
X
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Values of Options at ExpiryWriting a Put
Payoff
Sell Put Option Payoff - MAX0, X-S
or MINS-X,0
X
Stock Price
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In-the MoneyOut-of-the-Money

• An option is described as in the money when its
  exercise would produce profits for its holder.
• An option is out of the money when exercise will
  be unprofitable.
• A call option is in the money when the exercise
  price is below the assets value because purchase
  at the exercise price would be profitable.
• A call option is out of the money when the
  exercise price exceeds the asset value. In this
  case, no one would exercise the right to purchase
  for the strike price an asset worth less than the
  price.

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Payoff ExampleWhat are the payoffs to the buyer
of a call option and a put option if the exercise
price is 60?
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Key Points to Remember

• Definition and uses of derivatives
• Different types of derivatives
• Calls and Puts
• Payoffs of Calls and Puts
• In-the-money and out-of-the-money options