FIN4504 INVESTMENTS FINAL EXAM STUDY GUIDE 1 Elements of to an option An option is defined as the right not the obligation to buy or sell an asset at a fixed price before a predetermined date Underlying Asset refers to the asset to be exchanged if the option is exercised If a call option holder wishes to purchase the stock they will exercise the option buy at a preset price Exercise prices are adjusted for stock splits and stock dividends but not cash dividends The cost of an option is called the premium and it is a small percentage of the cost of the underlying asset Underlying Asset refers to the asset to be exchanged if the option is exercised The option buyer pays the cost the option writer receives the cost at the time of sale of the option The underlying company is not involved in the option market Options are a zero sum game An option is a contract giving the holder the right to buy 100 shares of stock at a preset price called the exercise or strike price o Strike Price Exercise Price refers to the pre determined price at which the underlying asset can be bought or sold The lower you option s strike price the more valuable your option is Expirations of 1 2 3 6 9 months and sometimes 1 year are normal contract periods Contracts expire on the Saturday following the third Friday of the expiration month o Expiry Date refers to the date on which that the option contact and hence the right to exercise will expire Contracts may be sold prior to maturity Friday is the last day you can exercise ability to buy at preset price Option contracts are usually found in real estate o Contract Size refers to the amount of the underlying asset that one option contract represents A Call option gives the holder the right to buy the shares underlying asset A Put option gives the holder the right to sell the index underlying asset Types of options o Listed Options o OTC Options o Index Options o Options on Futures o Foreign Currency Options o Interest Rate Options o Exotic Options 2 Option issuer maker responsibilities interests Issuer writer a legal entity that develops registers and sells securities for the purpose of financing its operations o Issuers are legally responsible for the obligations of the issue and for reporting financial conditions material developments and any other operational activities as required by the regulations of their jurisdictions o Required to file with regulators such as Securities and Exchange Commission SEC OCC is jointly owned by option exchanges OCC backs performance of both counterparties To limit OCC s risk option seller or writer must post margin Margin varies with option price and whether the option position is covered or exposed When an option is exercised an option seller is randomly selected If a call is exercised the selected call writer must deliver 100 shares of stock in exchange for receiving the strike price If a put is exercised the selected put writer must purchase 100 shares of stock at the strike price o Covered or exposed A covered call writer can post the stock to satisfy the margin requirement a naked call writer must post cash 3 Influences to value valuation of options Determinants of call option values If this variable is greater The value of a call option is Stock Price S Exercise price E or X Volatility Time to expiration T Interest rate rf Dividend payouts Greater Lower Greater Greater Greater Lower Interest rate r Buying a call is an alternative to buying stock on margin At higher interest rates buying on margin costs more hence the competing alternative the call is worth more A higher interest rate lowers the PV of E thereby lowering the put value In concept the most you can get from a put is E and the lower the PV of X the lower the value of the put In concept buying a put is equivalent to shorting the stock and investing the proceeds in E With a higher interest rate the bond you are buying is worth less A call option should not be exercised prior to maturity unless a stock is about to pay a sufficiently large dividend In some situations it may be profitable to exercise a put prior to expiration o At sufficiently low stock prices it makes sense to go ahead and exercise the put get the proceeds from the sale and reinvest them until option maturity at r o This can have a bigger payoff than any further possible decline in stock price in this case early exercise is desirable The underlying price and strike price determine the intrinsic value o If underlying prices increase call prices increase and put prices decrease o If underlying price decreases call prices decrease and put prices increase The strike exercise price determines if the option has any intrinsic value Intrinsic value is the difference between the strike price of the option and the current price of the underlying Stock price minus exercise price or the cash flow that could be attained by immediate exercise of an in the money call option S0 K for a call Intrinsic value is set to 0 for out of the money or at the money options The time until expiration and volatility determine the probability of a profitable move o Volatility degree to which price moves regardless of direction up down It is basically the measure of the speed and magnitude of the underlying s price changes The greater the expected volatility the higher the option value Time Value Difference between the premium price call price and intrinsic value The premium increases as option strike price becomes more favorable in relation to the current underlying price The premium decreases as option strike price is less favorable in relation to the underlying o The longer the time until expiration the higher the option price o The shorter the time until expiration the lower the option price The interest rates determine the cost of money o As interest rates rise call prices will increase and put prices will decrease o This is because of the costs associated with owning the underlying the purchase will incur either interest expense if the money is borrowed or lost interest income if existing funds are used to purchase the shares o As interest rates fall call prices decrease and put prices will increase Dividends can cause an adjustment to share price o If dividends rise call prices will decrease and put prices will increase o If dividends fall call prices will increase and put prices will decrease Dividends reduce the likelihood of early exercise 4 In Out of the money options In the money An option where exercise would