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Options A

Options A

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Published by: zoe on Dec 22, 2009
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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/20081
Options
Option is an agreement that gives the buyer
the right but not theobligation
to buy or sell a given asset (such as a share) to a pre-determined price at a given time (European type), or within the givenperiod (American type). An option is equivalent to 100 shares.The seller on the other hand, is always
obliged 
to deliver or buy theasset if the buyer so wishes!
NOTATION- definitions
S = ”
 stock
price, (the actual share price): The underlying asset onwhat the contract is signed.
E = ”
exercise
price, (or strike price): The pre-determined price thatthe seller will buy or sell if the buyer wishes.
t = “
expiration date
, (or maturity date): t = 0 means maturity date(time is counted backwards). European options are exercised atmaturity (and traded of course all time). American options areexercised any time upp to maturity.
C
E
= “
Call-option premium for price E
: What the buyer pays, theseller receives.
P
E
= “
 Put-option premium for price E
: What the buyer pays, theseller receives.
r = risk-free interest rate
(constant)The following 4 option possibilities (2 for buyers & 2 for sellers)exist:
 
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/20082
Call options
 
 Buy a call (owner)
One buys a call option today at a given E (say $50), and hopes that Sin the future will exceed E + C
E
in order to profit from that. Thepremium to pay is C
E
. No security is required. Check the figurebelow.
 
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
22-9
Call Option Payoffs at expiration
-201009080706001020304050 -40200-604060Stock price ($)
   O  p   t   i  o  n  p  a  y  o   f   f  s   (   $   )
Buya call
Exercise price = $50
 
Sell (Write) a call (issuer)
One receives a C
E
today and hopes that S in the future will be below E(say $50), so that the buyer’s call option will be worthless and will notbe exercised. If the price rises > E he looses, because he must sell it atE.In order to issue a call option, it is required high security (money orshares should be deposited). This is because, if S in the future rises to
 
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/20083
say $100, the owner of the call option has the right to buy the stock atE = $50! Check the figure below.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
22-10
Call Option Payoffs at expiration
-201009080706001020304050 -40200-604060Stock price ($)
   O  p   t   i  o  n  p  a  y  o   f   f  s   (   $   )
Write a call
Exercise price = $50
 
Put options
 
 Buy a put (owner)
Assume that you want to secure your shares (you are afraid of a pricefall, but you do not want to sell the shares now).You buya put option today at a given E (say $50). (i) If S falls belowE, you do not care, because you have the right to sell your shares at E> S. In that case you gain the difference between E - S. (ii) If S doesnot fall, you have just lost the premium you have paid, P
E
. Rememberyou are not forced to sell it! No security is required. Check the figurebelow.

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