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McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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Options
The right but not the obligation…
This chapter explores various options and their payoff structure.
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Basic Options
Put OptionThe right to sell an asset at a specified exercise price on or
before the exercise date
Call OptionThe right to buy an asset at a specified exercise price on or
before the exercise date
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Option Obligations
Buyer Seller
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
Does the seller of a call option hope the price of the underlying security moves up or down?
Does the buyer of a put option hope the price of the underlying security moves up or down?
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Option ValueOption Value: The value of an option at expiration is a function of the stock price and the exercise price.
Call Option
Put Option
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Option Value: ExampleOption values given an exercise price of $720
00060$120ValuePut
1206000$0Value Call
840780720660$600PriceStock
What are the payoff limits for call option buyers? Sellers?
What are the payoff limits for put option buyers? Sellers?
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Call Option Value
Call option value (buyer) given a $720 exercise price.
Share Price
Cal
l opt
ion
valu
e
720 840
$120
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Call Option Profit
$20 call option (buyer) given a $720 exercise price
Share Price
Cal
l opt
ion
valu
e
720 840
$100
Profit (buyer): Current Price - Exercise Price - Cost of Call
Profit = ($840 $720) $20 $100
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Call Option ValueCall option payoff (seller) given a $720 exercise price.
Share Price
Cal
l opt
ion
$ pa
yoff
720 840
$-120
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Call Option Profit
$20 call option (seller) given a $720 exercise price:
Share Price
Cal
l opt
ion
$ pa
yoff
720 840
$-120
Profit (Seller): Exercise Price - Current Price + Cost of Call
$-100
Profit = $720 $840 $20 $100
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Call Option: Example
How much must the stock be worth at expiration in order for a call holder to break even if the exercise price is $50 and the call premium
was $4?
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Put Option ValuePut option value (buyer) given a $720 exercise price:
Share Price
Put
opt
ion
valu
e
600 720
$120
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Put Option Profit
$30 put option (buyer) given a $720 exercise price:
Share Price
Put
opt
ion
valu
e
600 720
$90
Profit (buyer): Exercise Price - Current Price - Cost of Put
Profit = $720 $600 $30 $90
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Put Option Value
Put option payoff (seller) given a $720 exercise price.
Share Price
Put
opt
ion
$ pa
yoff
600 720
-$120
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Put Option Profit
$30 put option (seller) given a $720 exercise price.
Share Price
Put
opt
ion
$ pa
yoff
600 720
-$90
Profit (Seller): Current Price - Exercise Price + Cost of Put
Profit = $600 $720 $30 $90
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Put Options: Example
What is your return on exercising a put option which was purchased for $10 with an exercise price of $85? The stock price at expiration is
$81.
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Option Hedging Strategy
Protective Put:
Share Price
Pos
itio
n V
alue Protective Put
Long Put
Long Stock
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Protective Put Value
Share Price
Pos
itio
n V
alue Protective Put
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Call Option Value: Upper and Lower Limits
Stock Price Upper Limit
Lower Limit
(Stock price - exercise price) or 0whichever is higher
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Call Option Value
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Call Option Value
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Black-Scholes Option Pricing Model
OptionC = Ps[N(d1)] - S[N(d2)]e-rt
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Options on Real Assets
Real Options - Options embedded in real assets
Option to ExpandOption to Abandon
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Options on Financial Assets
Executive Stock Options
Warrants
Convertible Bonds
Callable Bonds