FIN EXAM 4 20 multiple choice Friday May 1st 8 00 1 Elements of to an option a What is a listed call option i A call option gives its holder the right to purchase an asset for a specified price called the exercise or strike price on or before some specified expiration date 1 For example a September call option on IBM stock with exercise price 170 entitles its owner to purchase IBM stock for a price of 170 at any time up to and including the expiration date in September 2 The holder of the call option is not required to exercise the option She will choose to exercise only if the market value of the asset exceeds the exercise price ii Contracts expire on the Saturday following the third Friday of the expiration month iii Contracts may be sold prior to maturity iv If a call option holder wishes to purchase the stock he or she will exercise the option 1 The option holder must pay the exercise price to the option writer 2 Exercise prices are adjusted for stock splits and stock dividends but not cash dividends v The cost of an option is called the premium and it is a small percentage of the cost of the underlying asset 1 The option buyer pays the cost the option writer receives the cost at the time of sale of the option vi The purchase price of the option is called the premium i A put option gives its holder the right to sell an asset for a specified exercise or strike price on or before some expiration date 1 A September put on IBM with exercise price of 170 entitles its owner to sell IBM stock to the put writer at a price of 170 at any time before expiration in September even if the market price is less than 170 2 A put will only be exercised if the exercise price is greater than the price of the underlying asset only if its holder can deliver for the exercise price an asset with market value less than that amount ii One does not need to own the shares of the put option to exercise the put option 1 Upon exercise the investor s broker purchases the necessary shares of stock at the market price and b What is a listed put option immediately delivers or puts them to an option writer for the exercise price c The underlying company is not involved in the option market d Options are a zero sum game losses and gains to all positions net out to zero e Uses of options i To hedge changes in stock price ii Change your risk and return profile 1 For example buying a call is comparable to buying stock f See Slide 13 Ch 15 on margin 2 Option issuer maker responsibilities and interests a The purchase price of an option is called the premium i It represents the compensation the purchaser of the call must pay for the ability to exercise the option only when exercise is profitable b Sellers of call options 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 less than the market value of the asset If the option is left to expire worthless the writer of the call clears a profit equal to the premium income derived from the initial sale of the option c d But if the call is exercised the profit to the option writer is the premium income minus the difference between the value of the stock that must be delivered and the exercise price that is paid for those shares i If the difference is larger than the initial premium the writer will incur a loss e The writer of the call incurs losses if the stock price is high In that scenario the writer will receive a call and will be obligated to deliver a stock worth S for only X dollars i Payoff to a call writer S X if S X ii Payoff to a call writer 0 if S X 1 S value of the stock at expiration 2 X the exercise price 3 Influences to value valuation of options a We can identify at least six factors that should affect the value of a call option i Stock price ii Exercise price iii Volatility of the stock price iv The time to expiration v The interest rate vi The dividend rate of the stock If stock price increases the value of a call option increases If exercise price increases the value of a call option decreases If volatility of the stock price increases the value of the call option increases If the time to expiration increases the value of the call option increases If the interest rate increases the value of the call option increases If the dividend rate of the stock increases the value of the call option decreases think growth rates b If the stock price is greater than the exercise price on the expiration date the value of the call option will equal the difference between the stock price and the exercise price but if the stock price is less than the exercise price at expiration the call will be worthless 1 The net profit on the call is the value of the option 1 2 3 4 5 6 2 minus the price originally paid to purchase it If you hold a call on Fin Corp stock with an exercise price of 80 and Fin Corp is now selling at 90 you can exercise your option to purchase the stock at 80 and simultaneously sell the shares at the market price of 90 clearing 10 per share Yet if the shares sell below 80 you can sit on the option and do nothing realizing no further gain or loss The value of the call option at expiration equals a Payoff S X if S X b Payoff 0 if S X i S value of the stock at expiration ii X the exercise price c If S X the option expires with zero value The loss to the option holder in this case equals the price originally paid c While profits on call options increase when the asset price rises profits on put options increase when the asset price falls i A put will only be exercised if the exercise price is greater than the price of the underlying asset only if its holder can deliver for the exercise price an asset with market value less than that amount 1 The holder will not exercise unless the asset price is less 2 than the exercise price If Fin Corp shares were to fall to 70 a put option with exercise price 80 could be exercised to give a 10 payoff The holder would purchase a share for 70 and simultaneously deliver it to the put option writer for the exercise price of 80 a Payoff 0 if S X b Payoff X S if S X d Consider …