Name : Noer Rachmadhani Hernirat

NIM : 1810523011

READING SUMMARY/ REVIEW

CHAPTER 19
Understanding Derivative Securities : Options
No Main Topic/ Issues Sub-Topic/ Issues Summarry page
Financial derivatives have several important applications, including
risk management, Trading, efficiency, and speculation. WHY
OPTIONS MARKETS? Several reasons have been advanced,
including the following :
1. Puts and calls expand the opportunity set available to investors,
making available riskreturn combinations that would otherwise
be impossible or that improve the risk-return characteristics of
a portfolio.
Why Have Derivative 2. An investor can establish a position with options for a much
1 505
Securities? smaller investment than required with the security itself. The
buyer’s maximum loss is known in advance. If an option
expires worthless, the most the buyer can lose is the cost
(price) of the option.
3. Options provide leverage—the chance to magnify percentage
gains.
4. Using options on a market index such as the S&P 500, an
investor can participate in market movements with a single
trading decision.
2 Introduction to Options Rights to buy or sell a stated number of shares of a security 505 &
Options within a specified period at a specified price. Call An option to buy 506
 a
specified number of shares of stock at a stated price within a
specified period.Put An option to sell a specified number of shares
of stock at a stated price within a specified period.
Long-Term Equity Anticipation Securities (LEAPS), Puts and
LONG-TERM
calls 506
OPTIONS
with longer maturity dates, up to two years.
Important options terms include the following:
1. Exercise (strike) price.The per-share price at which the
common
2. stock may be purchased from (in the case of a call) or sold to a
Understanding OPTIONS writer (in the case of a put)
3 507
Options TERMINOLOGY 3. Expiration date.The date an option expires
4. Option premium. The price paid by the option buyer to the
seller of the option

Option premium = option price

HOW OPTIONS WORK The buyer and the seller of a particular option have opposite 508 –
expectations about the likely performance of the underlying stock, 509
and therefore the performance of the option.
1. The call writer expects the price of the stock to remain
roughly steady or perhaps move down.
2. The call buyer expects the price of the stock to move
upward, and relatively soon.
3. The put writer expects the price of the stock to remain
roughly steady or perhaps move up.
4. The put buyer expects the price of the stock to move down,
and relatively soon.
Unlike a buyer, who is not obligated to act, a writer may be assigned
to take action in the form of making or taking delivery of the
stock.Most call and put investors simply sell their options in the
open market. Therefore, they close out their positions before the
 expiration date.
The Options Exchanges .There are several options exchanges, such
as: the Chicago Board Options Exchange (CBOE), the American,
NASDAQ OMX PHLX, the International Securities Exchange (ISE)
in New York, BATS Exchange Options Market, and the NYSE
Arca.Options exchanges make puts and calls a success by
standardizing the exercise date and exercise price of contracts. One
Coca-Cola May 45 call option is identical to every other Coca-Cola
THE MECHANICS OF 509 &
May 45 call option. Options Clearing Corporation (OCC) Stands
TRADING 510
between buyers and sellers of options to ensure fulfillment of
obligations. The OCC becomes the buyer for every seller and the
seller for every buyer, guaranteeing that all contract obligations will
be met. This prevents the problems that could occur as buyers
attempted to force writers to honor their obligations. A writer of a
put or call can buy the exact same option and cancel the position at
any time (except in the case of assignment).
The simplest way to do this is to examine their value at expiration.
1. At expiration, an option’s payoff is simply the greater of $0
or the proceeds from the transaction.
2. The profit takes into account the cost of the transaction
Payoffs and Profits
4 from Basic Option 511
Positions
.

Options graphs showing their payoffs and profits are distinguished

by the two-line segments needed to describe the payoffs and profits.
CALLS Buying a Call Consider first the buyer of a call option. At 511 –
expiration, the investment value or payoff to the call holder is 513
 Selling (Writing) a Call A call writer of an uncovered (naked) call
incurs losses if the stock’s price increases.

Options trading is a zero-sum game. What the option buyer (writer)

gains, the option writer (buyer) loses.
Buying a Put A put buyer makes money if the price of the stock
decline

Selling (Writing) a Put The payoff pattern for the put writer is the 513
PUTS
mirror image of that for the put buyer. Some Observations on -515
Buying and Selling Options Options are attractive because of the
small investment required and the potentially large payoff.
According to the
studies that have been done, the odds favor the sellers. Writing calls
produces steady, although not extraordinary, returns. Call buying is
often unprofitable.
Some Basic Options Hedge, A strategy using derivatives to offset or reduce the risk 515 &
5
Strategies resulting from exposure to an underlying asset. 516
COVERED CALLS Covered Call , A strategy involving the sale of a call option to 516 &
supplement a long position in an underlying asset. 517
 Writing a covered call is typically regarded as a conservative
strategy because it reduces the cost of owning the stock.
Protective Put, A strategy involving the purchase of a put option as
a
supplement to a long position in an underlying asset

517 &
PROTECTIVE PUTS
518

A protective put offers some insurance against a decline in the stock

price. The cost if the insurance turns out not to be needed is the cost
of the put.
Portfolio Insurance, An asset management technique designed to
provide a portfolio with a lower limit on value while permitting it to
benefit from rising security prices. Synthetic Options Created by a
PORTFOLIO 518 –
combination of two options or an option and shares. It should also
INSURANCE 520
be noted that portfolio insurance is not costless. The costs include:
1. The cost of the option itself
2. An opportunity cost.
6 Option Valuation A GENERAL In this section we examine the determinants of the value of a put or 520 &
FRAMEWORK call. Special terminology is used to describe the relationship 521
between the exercise price of the option and the current stock price.
If the price of the common stock, S, exceeds the exercise price of a
call, E, the call is said to be in the money and has an immediate
exercisable value. On the other hand, if the price of the common is
 less than the exercise price of a call, it is said to be out of the money.
These same definitions also apply to puts, but in reverse. In
summary,
If S ˃ E, a call is in the money and a put is out of the money:
If S ˂ E, a call is out of the money and a put is in the money:
If S = E, an option is at the money.
Intrinsic value of a call = Maximum (S0 – E), 0
Intrinsic value of a put = Maximum (E - S0 ), 0
An option’s premium almost never declines below its intrinsic
value. Arbitrageurs Investors who seek discrepancies in security
INTRINSIC VALUES prices in an 521 &
AND TIME VALUES attempt to earn riskless returns. Option prices almost always exceed 522
intrinsic values, with the difference reflecting the option’s potential
appreciation typically referred to as the time value.
Time value = Option price - Intrinsic value
Premium or Option price = Intrinsic value + Time value
The value of an option must be related to the value of the underlying
security. The basic relationship is most easy to understand by
considering an option immediately prior to expiration, when there is
no time premium. If the option is not exercised, it will expire
immediately, leaving the option with no value. Obviously, investors
will exercise it only if it is worth exercising. At expiration, a call
BOUNDARIES ON 523 &
must have a value that is the maximum of 0 or its intrinsic value. For
OPTIONS PRICES 524
puts the situation is reversed. At expiration, a put must have a value
that is the maximum of 0 or its intrinsic value.A put’s strike price is
its maximum intrinsic value. The maximum price for a call is the
price of the underlying stock. The lower boundary for a call is the
price of the option at expiration, which must be either zero or its in-
the-money value.
THE BLACK– Black–Scholes model , A widely used model for the 525 &
SCHOLES MODEL valuation of call options. These five variables, all but the last of 526
which are directly observable in the market, are as follows:
 1. The price of the underlying stock
2. The exercise price of the option
3. The time remaining to the expiration of the option
4. The interest rate
5. The volatility of the underlying stock
The time value of an option is greatest when the market price and
the exercise price are equal. The Black–Scholes option-pricing
formula can be expressed as

Where,
C = the price of the call option
S = current market price of the underlying common stock
N(d1) = the cumulative density function of d1
E = the exercise price of the option
e = the base of natural logarithms = approximately 2.71828
r = the continuously compounded riskless rate of interest on an
annual basis
t = the time remaining before the expiration date of the option,
expressed as a fraction of a year
N(d2) = the cumulative density function of d2
To find d1 and d2, it is necessary to solve these equations :

Where,
In(S/E) = the natural log of (S/E)
σ = the standard deviation of the annual rate of return on the
 underlying common stock
Implied Volatility, The volatility of an option based on the other
parameters determining its value
Put-Call Parity , The formal relationship between a call and a put
on the same item which must hold if no arbitrage is to occur.
PUT OPTION Ultimately we can express the put-call parity relationship as : 528
VALUATION

Hedge Ratio, The ratio of options written to shares of stock held

long in a riskless portfolio. Delta A measure of how much the
theoretical value of an option should change for a $1.00 change in
528 &
HEDGE RATIOS the underlying stock. The hedge ratio for an option, commonly
529
referred to as the option’s delta, indicates the change in the price of
the option for a $1 change in the price of the common. Since the
hedge ratio with a call option is N(d1), for a put option it is N(d1) - 1.
Options contracts are important to investors in terms of the two
dimensions of every investment decision that we have emphasized
throughout this book—the return and risk from an asset or portfolio.
An Investor’s WHAT PUTS AND
Options can be used for various types of hedging, which are 529 &
7 Perspective on Puts CALLS MEAN TO
concerned with risk management. Options also offer speculators a 530
and Calls INVESTORS
way to leverage their investment with a strict limit on downside
risk.The important point about options and their impact on portfolio
ret.
The current emphasis by the options markets and the brokerage
industry is on educating investors as to how options can be used
efficiently as part of their portfolio. Investors have continued to
THE EVOLUTIONARY 530 &
learn how to hedge their risk using derivatives. Options today are
USE OF OPTIONS 531
increasingly valued in strategic portfolio management because they
allow investors to create strategies that expand the set of outcomes
beyond what could be achieved in the absence of options.
Stock-Index Options, Option contracts on a stock market index such
8 Stock-Index Options 531
as the S&P 500.
 An investor in stock-index options can make market decisions rather
than individual stock decisions. Overall, stock-index options are
similar to equity options on individual stocks. As usual, the exercise
THE BASICS OF price and the expiration date are uniformly established. Investors
531 &
STOCK-INDEX buy and sell them through their broker in the normal manner. Index
532
OPTIONS option information is read in the same manner as that for stock
options. Unlike stock options which require the actual delivery of
the stock upon exercise, buyers of index options receive cash from
the seller upon exercise of the contract.
The strategies with index options are similar to those for individual
stock options. Investors expecting a market rise buy calls, and
investors expecting a market decline buy puts. The maximum losses
STRATEGIES WITH
from these two strategies—the premiums—are known at the outset 532 &
STOCK-INDEX
of the transaction. The potential gains can be large because of the 533
OPTIONS
leverage involved with options. As with any option, the investor
buying an index option has a limited loss of known amount—the
premium paid.
Stock index put options allow a portfolio manager to hedge equity
market risk by limiting a portfolio’s downside exposure while
THE POPULARITY OF
retaining the upside potential. Stock-index options appeal to
STOCK-INDEX 534
speculators because of the leverage they offer. A change in the
OPTIONS
underlying index of less than one percent can result in a change in
the value of the contract of 15 percent or more.
Name : Noer Rachmadhani Hernirat
NIM : 1810523011

READING SUMMARY/ REVIEW

CHAPTER 20
Understanding Derivative Securities: Futures
No Main Topic/ Issues Sub-Topic/ Issues Summarry page
There are two types of cash markets, spot markets and forward
markets:
(1) Spot markets are markets for immediate delivery.
(2) Forward markets are markets for deferred delivery.
The forward price is the price of an item for deferred delivery. The
An Overview of WHY FUTURES asset is delivered in the future at a price that is agreed upon today. 541 –
1
Futures Markets MARKETS? An organized futures exchange standardizes the nonstandard 543
forward contracts, establishing such features as contract size,
delivery dates, and condition of the items that can be delivered. Only
the price and number of contracts are left for futures traders to
negotiate. Price discovery and hedging (price risk management) are
the primary functions of futures markets.
futures exchanges can be divided into two broad categories:
WHAT IS TRADED IN
1. Commodities: agricultural, metals, and energy-related
THE FUTURES 543
2. Financials: foreign currencies and debt and equity
MARKETS?
instruments
 U.S. futures exchanges have traditionally operated with a trading
floor (a “pit”) where traders and brokers come together in an
auction-style, open-outcry market. This means that they
The Structure of U.S. FUTURES 544 &
2 communicate with each other verbally and with hand signals. A
Futures Markets EXCHANGES 545
futures customer submits an order which goes to a floor broker on
the trading floor to be executed with other floor brokers representing
other customers or with floor traders trading for their own accounts.
European futures exchanges are very competitive. Most of these
systems are now fully automated order-matching systems. Japan,
FOREIGN FUTURES which banned financial futures until 1985, has been very active in
545
MARKETS developing futures exchanges. Commodity futures markets account
for most of the futures trading. Japan has several commodity futures
exchanges, each of which trades specific contracts
The clearinghouse, and not another investor, is on the other side of
THE
every futures transaction and ensures that all payments are made as 546
CLEARINGHOUSE
specified.
Forward Contract , A commitment today to transact in the future at
a price that is currently determined, with no funds having been
exchanged. Swap, An agreement between parties to exchange
The Mechanics of FUTURES 546 &
3 streams of cash flows over some future period. Forward contracts
Trading CONTRACTS 547
involve credit risk—either party can default on their obligation.
Futures Contract, Agreement providing for the future exchange of a
particular asset at a currently determined market price.
Short Position, An agreement to sell an asset at a specified future
date at a specified price. Long Position, An agreement to purchase
an asset at a specified future date at a specified price. Like options,
547 &
BASIC PROCEDURES futures trading is a zero-sum game. The gains and losses on all
548
positions net to zero. A futures contract involves an obligation—
either offset occurs, or delivery occurs. Offset Liquidation of a
futures position by an offsetting transaction
MARGIN Futures Margin, The earnest money deposit made by a transactor 548 &
to ensure the completion of a contract Initial Margin In dollar terms, 549
 the initial equity an investor has in a margin transaction.
Maintenance Margin , The amount of funds that must be on hand at
all times as equity. Margin Call, A demand from the broker for
additional cash or securities as a result of the actual margin
declining below the
maintenance margin. Marked To The Market , The daily posting of
all profits and losses in an investor’s account.
By taking a position opposite to that of one already held, at a price
set today, hedgers plan to reduce the risk of adverse price
Using Futures fluctuations—that is, to hedge the risk of unexpected price changes.
4 HEDGERS 551
Contracts In effect, this is a form of insurance. The hedged position has a
smaller chance of a low return but also a smaller chance of a high
return. Thus, hedging reduces the variance in the outcome
The key to any hedge is that a futures position is taken opposite to
the position in the cash market. Because transactors can assume two
basic positions with futures contracts, long and short, there are two
basic hedge positions: the short (sell) hedge and the long (buy)
hedge.
HOW TO HEDGE 1. Short Hedge , A transaction involving the sale of futures (a
552
WITH FUTURES short position) while holding the asset (a long position).
2. Long Hedge , A transaction where the assetis currently not
held but futures are purchased to lock in current prices.
Basis, The difference between the futures price of an item and the
spot price of the item.
Basis = Cash price - Futures price
SPECULATORS Speculators are willing to assume the risk of price fluctuations, 553
hoping to profit from them.The potential advantages of speculating
in futures markets include
1. Leverage. The magnification of gains (and losses) can easily
be 10 to 1.
2. Ease of transacting. An investor who thinks interest rates
will rise will have difficulty selling bonds short, but it is very
 easy to take a short position in a Treasury bond futures
contract.
3. Transaction costs. These are often significantly smaller in
futures markets.
CALCULATING THE The return on investment can be stated as : 543 &
RATE OF RETURN ON 544
Financial Futures , Futures contracts on financial assets. There are
5 Financial Futures three broad types of financial futures: currency futures, interest rate 554
futures, and equity futures.
Hedging with Foreign Currency Futures Companies often use
currency futures when they are exposed to foreign exchange risk.
Investors can use currency futures to protect their positions in
FOREIGN CURRENCY foreign securities, thereby earning what the foreign securities offer
555
FUTURES without being adversely affected by exchange rate movements.
Speculating with Foreign Currency Futures Investors can speculate
on the differences in exchange rates between two countries, based
on their beliefs about what is going to happen.
INTEREST RATE Hedging with Interest Rate Futures. an example of using interest rate 556
FUTURES futures to hedge an investment position. Our objective is simply to -558
illustrate the basic concepts.
Short Hedge. The actual mechanics of executing a short hedge such
as this (also called an inventory hedge) require the hedger to
determine the hedge ratio, or the number of contracts to be sold.
This is a function of the value of the long position in the asset and
the value of each futures contract.
Long Hedge. An alternative hedge is the anticipatory hedge, a long
hedge, whereby an investor purchases a futures contract as an
alternative to buying the underlying security. At some designated
time in the future, the investor will purchase the security and sell the
futures contract. This results in a net price for the security position at
the future point in time which is equal to the price paid for the
 security minus the gain or loss on the futures position.
Speculating with Interest Rate Futures. The usefulness of interest
rate futures for pursuing such a strategy is significant. A speculator
who wishes to assume a short position in bonds cannot do so readily
in the cash market (either financially or mechanically). Interest rate
futures provide the means to short bonds easily.
STOCK-INDEX Hedging with Stock-Index Futures Common stock investors hedge 558 –
FUTURES with financial futures for the same reasons that fixed-income 563
investors use them. Investors, whether individuals or institutions,
may hold a substantial stock portfolio that is subject to the risk of
the overall market, that is, systematic risk.
Short Hedges. A short hedge can be implemented by selling a
forward maturity of the contract. The purpose of this hedge is to
offset (in total or in part) any losses on the stock portfolio with gains
on the futures position. To implement this defensive strategy, an
investor would sell one or more index futures contracts. Ideally, the
value of these contracts would equal the value of the stock portfolio.
If the market falls, leading to a loss on the cash (the stock portfolio)
position, stock-index futures prices will also fall, leading to a profit
for sellers of futures.
Long Hedges The long hedger, while awaiting funds to invest,
generally wishes to reduce the risk of having to pay more for an
equity position when prices rise. Potential users of a long hedge
include the following:
1. Institutions with a regular cash flow that use long hedges to
improve the timing of their positions.
2. Institutions switching large positions who wish to hedge
during the time it takes to complete the process. (This could
also be a short hedge.).
Limitations of Hedging with Stock-Index Futures Although hedging
with stock-index futures can reduce an investor’s risk, typically risk
cannot be eliminated completely. As with interest rate futures, basis
 risk is present with stock-index futures. It represents the difference
between the price of the stock-index futures contract and the value
of
the underlying stock index
Basis risk as it applies to common stock portfolios can be defined as
the risk that remains after a stock portfolio has been hedged.
Index Arbitrage Exploitation of price differences between stock-
index futures and the index of stocks underlying the futures contract.
Stock-index futures are effective instruments for speculating on
movements in the stock market because:
1. Minimal costs are involved in establishing a futures position.
2. Stock-index futures mirror the market, offering just as much
risk.
Another form of speculation involves spreaders, who establish both
long and short positions at the same time. Their objective is to profit
from changes in price relationships between two futures contracts.
Spreads include the following:
1. The intramarket spread, also known as a calendar or time
spread.
2. The intermarket spread, also known as a quality spread.
Single stock futures are standardized agreements between two
6 Single Stock Futures parties to buy or sell 100 shares of a specified stock in the future at a 563
price determined today.