Financial Economics Lecture 15
Today Op8ons Op8ons contracts Puts Calls Stock Index Op8ons Interest Rate Op8ons Uses of Op8ons (Important Reading: Pilbeam, Ch 14, Readings on Site)
Defini8on Op8ons give the holder the right but not the obliga8on to purchase/sell an underlying security at a predetermined price. HUGE market
Huge markets Instruments 1990 1995 2000 2005 2008 Interest Rate 52.0 225.5 107.6 430.8 617.7 Currency 18.9 23.3 7.1 19.4 59.8 Equity Index 119.1 187.3 481.4 3139.8 4174.1 All Markets 190.0 436.1 596.1 3590.0 4851.6
Terminology Writer: sells the call/put op8on Holder: buyer of call/put op8on Call op8on: holder has right, not obliga8on to buy underlying asset Put op8on: holder has right, not obliga8on to sell underlying asset Exercise price: price at sale (strike price) Op8on premium: fee from holder- >writer.
Posi8on Buying a call? You re long call Selling a call? You re short call Buying a put? You re long put Selling a put? You re short put
Profit/Loss on Call Op8on Price of BP Shares on Expira<on date Holder Profit/Loss on Long Call 540-180 +180 550-80 80 558 0 0 560 +20-20 580 +220-220 600 +420-420 Writer Profit/Loss on Short Call
Call Op8on Contract EXAMPLE (Pilbeam, p 351-354) Asset is 1000 shares in BP, 525p now. A buys call op8on with strike of 540 for April 2010 for op8on premium of 18p per share ( 180) Max A can lose is 180, max op8on writer can profit is 180. If P(BP) goes down, A doesn t buy, why? If P(BP) goes up, A does buy, as he can sell them at a profit on the spot market.
Profit/Loss of Call Profit/Loss Long Call 180 0-180 558 Share Price On Expira8on Short Call
Put Op8on Example Again, BP shares, P(BP)=0.540, 1000 shares. Write put contract for + 1 month. Premium=0.38*1000=380. If in one month 502 < P(BP) < 540, holder exercises, but makes loss. Why? If P(BP) < 502, holder makes profit. EG P(BP) = 400 in 1 month, makes 140p- 38p=102 profit per share, he trousers 1020.
Put Op8on profit/loss Price of BP shares at expira<on Holder Profit/Loss on Long Put 400 +1020-1020 450 +520-520 480 +220-220 500 +20 +20 502 0 0 520-180 +180 540-380 +380 600-380 +380 Write Profit/Loss on short put
Ques8ons? Summary Op8on Definiton Calls Puts Profit/Loss dependent on premium/transac8ons
Stock Index Op8ons Stock market op8on: take a posi8on on the movement (up/down) of a stock market index. P(FTSE 100 index op8ons)= 10*FTSE 100 cash index. EG: Buy call December 2010 with index @ 4900 for 235 points (premium), holder has right btw now and 3 rd Dec (expira8on) to buy index @ level of 4900
Example Cost of Dec strike @ 4900=235*10=2350. Possible Values of FTSE 100 in Dec Holders Profit/Loss on Long Call 4900-2350 +2350 5100-350 +350 5135 0 0 5200 +650-650 5300 +1650-1650 Writer s Profit/Loss on short call Call Op8on Premium: 2350, Strike Price: 4900, Expira8on Dec 2009, Value: 10 per index point
Other Op8on types Interest Rate Op8ons: write op8ons based on +/- movements (8cks) in debt instruments Currency Op8ons: right, not obliga8on, to buy/sell amounts of a currency at a given exchange rate. American op8on: can exercise op8on right up to maturity date
Uses of Op8ons 1 Hedging equity risk How? Say you run a pension fund. You think a stock market index you re invested in will tank in a month. You buy put op8ons on the index to make sure you don t need to buy more shares later. If the stock market falls by some amount, you exercise right to sell, make profit from put, use that to realise the cash for the pension fund.
Uses of Op8ons 2 Hedging interest rate movement risk How? Say you need to have 20m from bank loans in 6 month s 8me to meet obliga8ons. Interest rates at 5% now. If they go up, you re losing money as cost of capital has increased Write put op8on on a bond index. If interest rates go up, bond prices fall. You sell bonds at predetermined price, capital gain compensates for higher interest rate payments
Uses of Op8ons 3 Risk adverse forex movements How? Your UK company wants to borrow 20m at a fixed 7%, requires US dollar interest & principle repayments Actual amounts dependent on ex.rate. Report profits in sterling. If sterling depreciates wrt UsD, disaster. Buy dollar calls: if sterling depreciates, all good.
Uses of Op8ons 4 Specula8on How? You ve 1000 to invest. Price ABC shares today at 2, you think will increase in value in 6 months to 3. Premium on 6 month call: 2.20. Could just buy 500 shares at 2. Or, invest 1000 in right to buy 10,000 shares at 2.20 (buy 10 calls for 1000 shares each) If P goes to 3, buy shares at 22,000, sell at 30,000, make 8k- 1k premium=7,000. Risk way up. If P goes to 2.10, just buy @ spot, then profit will be 50, but if you buy op8ons, then lose en8re 1000.
Currency Op8ons vs Forwards for Hedging US company want to order 1m worth of goods from Germany Euro/dollar market very vola8le. Expect euro to appreciate, need to be protected from this movement, but also want to profit from it if possible. Spot: 1.50/1 1 year forward: 1.45/1, 1 year Call: 1.45/1 for 8 US cents per euro. Next: different costs for forwards vs. currency op8on
In Class: Here are op8ons for ABC company per share, currently priced at 311. Assume 1000 shares Strike Price September Call Premium 300 61 44 330 48 60 September Put Premium You expect share price to rise to 400. What specula8ve strategies are there? Profits/Losses? You own 1000 shares of ABC, expect price to fall to 200. Can you hedge the risk of this away?
Op8on Strategies Straddle Buy both a call and a put at same strike price & expira8on Strangle Buy a call and a put on same security with different exercise prices. Strap Two calls, one put, same expira8on, different exercise prices Strip 1 call, 2 puts. And many, many more. See Pilbeam, p.367
Summary Stop! Write down 2 things you remember from today Summary: 1. Op8on Definiton 2. Calls/Puts 3. Reasons/Situa8ons where calls/puts are useful 4. Op8on strategies Next Time: Pricing Op8ons. See Pilbeam Cht 15.