Options and Financial Markets: Concepts, Types, and Valuation, Study notes of Economics

Download Options and Financial Markets: Concepts, Types, and Valuation and more Study notes Economics in PDF only on Docsity! Financial option: gives right to purchase (call) or sell (put) an asset at a fixed (strike/exercise) price in the future. → option writer (on other side of the contract) Exercising: actually buying or selling the option American option: allow holders to exercise the option from now till expiration date (the right to buy/ sell for a longer period is more valuable) European option: only on expiration date Option buyer/holder holds right to exercise → long position → payoff at maturity other way around Option seller/writer → short position (obligation to fulfill the contract) --> payoff at maturity other way around (not held as investment, more as insurance to hedge other risk) Option premium (market price option) → compensates seller for risk of loss in case holder exercises Open interest: total number of outstanding contracts of an option At-the-money: exercise price equals current price (deep) In-the-money: payoff from exercising is positive (call options with strike price < current stock price, put options with strike prices > current stock price) (deep) Out-of-the-money: payoff from exercising is negative (call strike > current, put strike < current) A stock index put option can be used to offset losses portfolio in market downturn → using an option to reduce risk (hedging) → speculate/bet on direction in which market is going to move → betting on a rise, call Short position’s cash flows are negative of long position’s (can only pay money) Risk of a call option is relative to risk of the stock (more relative when out-of-the-money) Put position has a higher return with low stock prices (stock positive beta then put negative beta) → the deeper out-of-the-money the more negative its beta and lower the return Straddle: combining put and call > 0 when stock price does not equals strike price → when stock is very volatile Butterfly spread: makes money when stock and strike prices are far apart (combination of put and calls) Portfolio insurance: holding stocks and put options or purchasing a bond and a call option → both have same payoff hence price Put-call parity: price of European call equals price stock plus identical put minus price of a bond maturing on exercise date Call option → levered position in stock plus insurance against a drop in stock price An American option cannot be worth less than its European counterpart or intrinsic value A put option cannot be worth more than its strike price A call option cannot be worth more than the stock itself Intrinsic value: value option if immediately expired (amount by which currently in-the-money) Time value: difference between current option price and intrinsic value American option: the longer the time to exercise date, the more valuable the option → An american option with a later exercise date cannot be worth less than an otherwise identical American option with an earlier exercise date An European option with a later date may trade for less than one with earlier date The value of an option generally increases with the volatility of the stock Price of any call option on a non-dividend-paying stock always exceeds its intrinsic value → it is never optimal to exercise a call option on a non-dividend paying stock early (better sell) An American call on a non-dividend-paying stock has the same price as its European counterpart When a stock pays dividends, exercising early is valuable for calls and puts. An American option then can also exceed price of European option. Equity as a call option: if assets > required debt payment equity holders receive debt-assets (equivalent to call option on assets with strike price equal to required debt payment) Debt as an option: debt holders fully repaid if assets> debt. Otherwise, debt holders receive value assets (payoff to debt equals assets - equity call option) When assets < debt put is in-the-money → put option will will be exercised and debt - assets is received