FIN4504 Final Study Guide American European Option Characteristics American Options o Allows its holder to exercise the right to purchase if a call or sell if a put the underlying asset on or before the expiration date o More valuable than European options o Most traded options in the US are American style European Options o Allow for exercise of the option only on the expiration date Asian Call Option Characteristics Options with payoffs that depend on the average rather than final price of the underlying asset during at least some portion of the life of the option May interest firms that wish to hedge a profit stream that depends on the average price of a commodity over some period of time Lookback Option Characteristics Options that have payoffs that depend in part on the minimum or maximum price of the underlying asset during the life of the option Provides a form of perfect market timing providing the call holder with a payoff equal to the one that would accrue if the asset were purchased for X dollars and later sold at its highest price Exchange Traded Option Characteristics Options contracts traded on exchanges are standardized by allowable expiration dates and exercise prices for each listed option Each stock option contract provides for the right to buy sell 100 shares Standardization of the terms of listed option contracts means all market participants trade in a limited and uniform set of securities o Increases the depth of trading in any particular option lowers trading costs results in more competitive market Most options trading occurs on exchanges Put Call Option Characteristics Call Options o Gives its holder the right to purchase an asset for a specified price exercise price o The holder will choose to exercise only if the market value of the asset to be purchased exceeds the exercise price o If not exercised before the expiration date of the contract a call option expires and no longer has value exercise price o Value of the call option will equal the difference between the stock price and the o Payoff to call holder stock price exercise price if stock price exercise price Payoff 0 if stock price exercise price o The net profit on the call is the value of the option minus the price originally paid to purchase it o Worth less when the exercise price is higher o Purchasing call options is a bullish strategy Writing calls is bearish o Gives its holder the right to sell an asset for a specified exercise or strike price on or before some expiration date o Profits increase when the asset value falls o Payoff to put holder 0 if stock price exercise price Payoff exercise price stock price if stock price exercise price Put Options o Worth more when the exercise price is higher o Purchasing put options is a bearish strategy Selling puts is bullish In the money an option where exercise would be profitable Premium Purchase price of an option At the money an option where the exercise price and asset price are equal Out of the money an option where exercise would not be profitable Advantages Disadvantages of Exchange Traded Options Ease of trading provided by exchanges Liquid secondary market provided by exchanges Options traded on OTC markets offer the advantage that the terms of the contract are negotiable Intrinsic value value Time Value Impact to Option Value with Movement of Option Components o Stock price minus exercise price or the profit that could be attained by immediate exercise of an in the money call option o As the stock price gets larger the option value approaches the adjusted intrinsic The stock price minus the present value of the exercise price o Difference between an option s price and its intrinsic value o Most of an option time value typically is a type of volatility value As long as the option holder can choose not to exercise the payoff can t be worse than 0 o As the stock price increases it becomes more likely that the call option will be exercised The volatility value becomes minimal when exercises is assured Determinants of Option Value o Stock Price if increases Call Value increases minus the exercise price Put Value decreases o Exercise price if increases Call Decreases minus the exercise price Put Increases price minus the stock price o Volatility of stock price if increases Call Increases Call value increases because the payoff is equal to the stock price Put value decreases because the payoff is equal to the exercise price minus the stock price Call value decreases because the payoff is equal to the stock price Put value increases because the payoff is equal to the exercise The source of the extra value is the limited loss an option holder can suffer No matter how far below the exercise price the stock drops the option holder gets zero In the case of good performance the call option will expire in the money and it will be more profitable the higher the stock price No matter how high above the stock price goes the option holder gets zero If the stock drops the put will expire in the money and it will be more profitable the lower the stock price Put Increases o Time to expiration if increases Call Increases The more distant expiration dates there is more time for unpredictable future events to affect prices and the range of likely stock prices increases As time to expiration lengthens the PV of the exercise price falls Put Increases Uncertain volatility Like call options increasing the time to expiration increases the The PV of the exercise price falls negatively affects put options o Interest rate if increases Call Increases Put Decreases Higher interest rates reduce the PV of the exercise price Higher interest rates reduce the PV of the exercise price o Dividend rate of the stock if increases Call Decreases High dividend payout policy puts a drag on the growth rate of the stock price A higher dividend yield must imply a lower expected rate of capital gain Put Increases Higher dividend payout slows the growth rate of the stock The lower the stock price the higher the put option s payout OCC The Option Clearing Corporation The OCC is the clearinghouse for options trading Places itself between options traders Jointly owned by the exchanges on which stock options are traded o Becomes the buyer of the option from the writer and the writer of the option to the o Everyone deals only with the OCC guarantees contract performance Option writers are required to post margin to guarantee that they can fulfill their contract buyer obligations Index Option