Chapter 15- Options market

- Derivative securities or derivatives derive their price from one or more underlying assets
(options, futures, swaps); they can be powerful tools for hedging and speculation
- Options are written on the common stock, stock indexes, foreign exchange precious
metals, agricultural commodities, and interest rates

- Call option is the right to buy (but not an obligation) an asset at a specified exercise price
on or before a specified expiration date
- Sellers of call options are writers
- exercise or strike price is a price set for calling (buying) an asset or putting (selling) an
asset
- Premium is a purchase price of an option
- If the option is left to expire worthlessly, the call writer s profit is the premium collected
when the option was initially sold
- If the call is exercised, the profit is the premium minus the difference between the value
of the stock that must be delivered and the exercise price paid for those shares→ if that
difference is larger than the initial premium, the writer incurs a loss.

- Put option- is the right to sell an asset at a specified exercise price on or before a
specified expiration date
- Profits on put options increase when the asset price falls
- In the money is an option where exercise would generate a positive cash flow
- Out of the money is an option that, if exercised would produce a negative cash flow-
they are never exercised
- At the money- is an option where the exercise price equals the asset price
- Options contracts are standardized by allowable expiration dates and exercise prices for
each listed option

- American option can be exercised on or before its expiration

- European option can be exercised only at expiration
- Index options- a call or put based on a stock market index such as the S&P 500
- Futures options give their holders the right to buy or sell a specified futures contract,
using as futures price the exercise price of an option
- Foreign currency options offer the right to buy or sell a specified quantity of foreign
currency for a specified number of US dollars
- Interest rate options – traded on Treasury notes and bonds, Treasury bills, and
government bonds of other major economies such as the UK or Japan
- Options can be used either to lever up an investor’s exposure to an asset price or to
provide insurance against the volatility of asset price → popular options strategies
include covered calls, protective puts straddles and spreads
- Purchasing call options is a bullish strategy; the calls provide profits when stock prices
increase
- Writing calls is bearish while writing puts is bullish

- Protective put is an asset combined with a put option that guarantees minimum proceeds
equal to the puts exercise price
- Risk management refers to the strategies that limit the risk of the portfolio
- Covered calls are writing a call on an asset together with buying an asset
- Straddle is a combination of a call and a put, each with the same exercise price and
expiration date (good for unpredictable movements, investors are always ready, except
when there is no movement in the stock price)
- Strips and straps are variations of straddle
- Spread is a combination of two or more call options or puts options on the same asset
with differing exercise prices or times to expiration
- A time spread refers to the sale and purchase of options with different expiration dates
- Collar is an options strategy that brackets the value of a portfolio between two bounds

- Callable bond is a combination of a straight bond (a bond with no option features such
as callability or convertibility) bundled with the issuance of a call option by the investor
to the bond-issuing firm
- A bond's conversion value equals the value it would have if you converted it into stock
immediately

- Convertible bond is in fact a straight bond plus a valuable call option

- When stock prices are low, the straight bond value is effective lower bound, and the
conversion option is nearly irrelevant

- Warrant is an option issued by the firm to purchase shares of the firm's stock (they are
generally protected against stock splits and dividends)
- Fully diluted earnings per share means that all convertible securities and warrants are
exercised

Collateralized Loans
- Many loan arrangements require that the borrower put up collateral to guarantee the loan
will be paid back
- In the event of default, the lender takes possession of the collateral
- A nonrecourse loan gives the lender no recourse beyond the right to collateral
 Exotic options
- Asian options are options with payoffs that depend on the average (rather than final)
price of the underlying asset during at least some portion of the life of the option
- Currency-translated options have either an asset or exercise prices denominated in
foreign currency
- Digital options also called binary or bet options have fixed payoffs that depend on
whether a condition is satisfied by the price of the underlying asset

Summary:
- Calls are worth more when the exercise price is lower, while puts are worth more when
the exercise price is higher (both options are generally worth more when the time until
expiration is longer)
- Options are traded on stocks, stock indexes, foreign currencies, fixed-income securities,
and several futures contracts
- Options can be used either to lever up an investor’s exposure to an asset or to provide
insurance against the volatility of asset prices (popular strategies include covered calls,
protective puts, straddles, and spreads)
- Many commonly traded securities embody option characteristics- callable bonds,
convertible bonds, warrants

Key formulas:

Chapter 16- Option Valuation

- Intrinsic value of the option is the value an option would have if it were about to expire
- Intrinsic value is set equal to zero for out-of-the-money options or at-the-money options
- Time value of the option is the difference between an options price and its intrinsic
value (the value it would have if it were expiring immediately)
- The volatility lies in the right not to exercise if doing so would be unprofitable
- As the stock price continues to increase, the option approaches the adjusted intrinsic
value- the stock price minus the present value of the exercise price
- Six variables that affect the value of the option: the stock price, the exercise price, the
volatility of stock price, the time to expiration, the interest rate, and the dividend rate on
stock
- The calls value should increase with the stock price and decrease with the exercise price
because its payoff if exercised equals St-X
- Call option values also increase with the volatility of the underlying stock price
- Longer time of expiration increases the value of the call option (for more distant
expiration dates, there is more time for unpredictable future events to affect price,s and
the range of likely stock prices increases
Binomial option pricing- Two-state option pricing
- The possibilities are illustrated in the value tree
- Because the portfolio replicates the payoff of several calls, we call it the replicating
portfolio
- If the option were underpriced, we would simply reverse the arbitrage strategy; buy the
option, and sell the stock short to eliminate price risk
- Payoff cannot be negative

- Binomial model is an options valuation model predicated on the assumption that stock
prices can move only two values over any short time period (multiperiod approach to
option pricing)
- More realistic model with more subperiods means the bell-shaped probability curve
- The spread between up and down movements in the price of the stock reflects the
volatility of its rate of return
- Both higher deviation and longer holding periods make future stock prices more
uncertain

- Dynamic hedging or delta hedging is the continued updating of the hedge ratio as time
passes (by continuously revising the hedge position, the portfolio remains hedged over
the coming small interval

Black-Scholes Option Valuation

- An option pricing formula is easier to use than the algorithm involving the binomial
model
- Black-Scholes pricing formula is a formula to value an option that uses the stock price,
the risk-free interest rate, the time to expiration, and the standard deviation of the stock
return (the formula is based on some simplifying abstractions that make the formula only
approximately valid
- The option value does not depend on the expected rate of return on a stock
- This version of the formula is predicated on the assumption that the underlying asset has
a constant dividend (or income) yield
- The interest rate used is the money market rate for a maturity equal to that of the option,
and the dividend yield is usually reasonably predictable, at least over short horizons
- Implied volatility is the standard deviation of stock returns that is consistent with an
option’s market value (the volatility level for the stock implied by the option price

The Put-Call Parity Relationship

- European put and call options are linked together in an equation known as put-call parity
relationship
- Put-call parity relationship is an equation representing the proper relationship between
put and call prices (if the relationship is ever violated, an opportunity for arbitrage arises)

P= C - S0 + PV(X) + PV(Dividends)
- Most listed options are American style, they offer opportunity of early exercise (before an
expiration date)

- Hedge ratio or delta is the number of shares of stock required to hedge the price risk of
holding one option
- Call option has a positive hedge ratio (delta), and the put option has a negative hedge
ratio
- Dollar movements in options are less than dollar movements in the stock price, the rate of
return volatility of options is nevertheless greater stock return volatility because options
sell at lower prices

- Option elasticity is the percent change in option price per percent change in stock price
- Portfolio insurance are portfolio strategies that limit investment losses while
maintaining upside potential

Summary:
Option values may be viewed as the sum of intrinsic value plus time or “volatility” value
(the right not to exercise if the stock price moves against the holder)
Call options are more valuable when the exercise price is lower, when the stock price is
higher, when the time to expiration is greater, when the stock’s volatility is greater and
when dividends are lower
Options may be prices relative to the underlying stock price using a simple two-period ,
two-state pricing model
Although option deltas are less than one, call options have elasticities greater than one;
the rate of return on a call (as opposed to dollar return) responds more than one-for-one
with stock price movements
Portfolio insurance can be obtained by purchasing a protective put option on an equity
position
Empirically, implied volatilities derived from the Black-Scholes model tend to be lower
on options with higher exercise prices; this suggests that option prices reflect the
 possibility of the sudden dramatic decline in stock prices; such crashes are inconsistent
with Black-Scholes assumptions

Key formulas:

Chapter 17- Futures Market and Risk Management

- A futures or forward contract carries the obligation to go through with the agreed-upon
transaction
- Forward arrangements offer a powerful means to hedge other investments and modify
portfolio characteristics

- Forward contract is an agreement calling for future delivery of an asset at an agreed-

upon price (regardless of the market price at maturity)
- Forward contracting is more informal and flexible than futures contracts
- Futures contracts also differ from forwards contracts in that they call for daily settling up
any gains or losses in the contract

- The futures contract calls for delivery of commodity at a specified delivery or maturity
date, for agreed upon price, futures price to be paid on a futures contract at maturity
- The place and means of the delivery of commodity are specified as well (although the
futures contract technically calls for the delivery of an asset, delivery rarely occurs)

- Long position is when the futures trader commits to buying an asset (buys a contract)
- Short position is when the futures trader commits to delivering the asset (sells a contract)
- The trader holding a long position profits from the price increases; the short position’s
loss equals the long position’s gain

Profit to long = Spot price at maturity- Original futures price

Profit to short = Original futures price - Spot price at maturity

- The futures contract is a zero-sum game, with losses and gains to all positions netting out
to zero; every long position is offset by a short position
- Unlike the payoff of a call option, the payoff of a long futures position can be negative;
this will be the case if the spot price falls below the original futures price
- Unlike the holder of a call, who as an option to buy, the long futures trader cannot simply
walk away from the contract; the futures investor is exposed to considerable losses if the
asset price falls significantly (investor in the call cannot lose more than the cost of an
option)

- Futures are traded in four broad categories: agricultural commodities, metals and
minerals, foreign currencies and financial futures (fixed-income securities and market
indexes)
- Single-stock futures is a contract on the shares of an individual company

- Clearinghouse is established by exchanges to facilitate trading; it interposes itself as an

intermediary between two traders (it is the trading partner of both traders, long and short),
it is neutral; it makes it possible for traders to liquidate positions easily
- In the absence of the clearinghouse, the long position would be obligated to pay the
futures price to the short position, and the short position would be obligated to deliver the
commodity

- If you are currently long and want to undo your position , you simply instruct your broker
to enter the short side of the contract, that is reversing trade; the exchange nets out your
long and short positions, reducing your net position to zero

- Open interest is the number of contacts outstanding (long and short positions are not
counted separately, meaning that open interest can be defined as either the number of
long or short contracts outstanding)

- Marking to market is the daily settlement of obligations on futures positions (the

process by which profits or losses accrue to traders)

- Maintenance margin is an established value below which a trader’s margin may not fall;
reaching the maintenance margin triggers the maintenance call
- Convergence property is the convergence of futures prices and spot prices at maturity of
the futures contract
- Cash settlement is the cash value of the underlying asset (rather than the asset itself)
delivered to satisfy the contract
- If the contract is reversed before the maturity date, the delivery does not happen
- Hedging and speculating have two polar uses of futures market; speculator uses a futures
contract to profit from movements in the futures prices (takes a long position), a hedger
uses uses them to protect himself against the price movements (short position)
- Hedging a position using futures on another asset is called cross-hedging
- Basis is the difference between the futures price and the spot price
- Basis risk is the risk attributable to uncertain movements in the spread between a futures
price and a spot price
- Spread (futures) is taking a long position in a futures contract of one maturity and a
short position in a contract of different maturity, both on the same asset
- Spot-futures-parity theorem of cost-of-carry relationship describes the theoretically
correct relationship between spot and futures prices; violation of the parity relationship
gives rise to arbitrage opportunities
- If the positions offset each other, the portfolio is perfectly hedged

Spreads
- If the rf>d, the futures price will be higher on longer-maturity contracts; when rf<d, the
reverse will be true
- Futures price for different maturity dates should all move in unison, for all are linked to
the same spot price through the parity relationship

Stock-Index Futures
- These contracts are settled by a cash amount equal to the value of the stock index in
question of the contract maturity date times a multiplier that scales the size of contract

Creating synthetic stock positions

- Index futures let investors participate in broad market movements without actually
buying or selling large number of stocks (futures represent the synthetic holdings of the
market position)

- Index arbitrage is a strategy that exploits divergences between actual futures prices and
their theoretical correct parity values to make a riskless profit
- If the futures price is too high, short the futures contract and buy the stocks in the index
- If it is too low, buy futures and short the stock

- Program trading refers to the coordinated buy orders and sell orders of entire portfolios,
often to achieve index arbitrage objectives
 Foreign exchange Futures
- The forward market exchange is relatively informal, it is simply a network of banks and
brokers that allows customers to enter forward contracts to trade currency in the future at
a currently agreed-upon rate of exchange
- Futures contracts are much more standardized

Interest rate futures

- These contracts allow traders to hedge against interest rate risk in wide spectrum of
maturities from very short (T-bills) to long term ( T-bonds)
- Price value of basis point (PVBP) is the change in value of a fixed -income security
resulting from a one-basis-point change in its yield to maturity

PVBP = Change in portfolio value/ Predicted change in yield

- Cross-hedging is hedging a position in one asset by establishing an offset position in a

related, but different asset (hedging vehicle is a different asset than the one to be hedged)
- If there is a slippage between prices or yields of two assets, the hedge will not be perfect

Swaps
- Swaps are multiperiod extensions of forward contracts
- Foreign exchange swap is an agreement to exchange a sequence of payments
denominated in one currency for payments in another currency at an exchange rate
agreed to today
- Interest rate swaps are contracts between two parties to trade cash flows corresponding
to different interest rates ( they call for the exchange of a series of cash flows
proportional to a given interest rate for a corresponding series of cash flows proportional
to a floating interest rate)
- A manager who hold a fixed-rate portfolio can transform it into a synthetic floating-rate
portfolio by entering a pay fixed-receive floating swap and can later transform it back by
entering the opposite side of a similar swap

Summary:
- Forward contracts are arrangements that call for the future delivery of an asset at a
currently agreed-upon price; the long trader is obligated to purchase the good, and the
short trader is obligated to deliver it; if the price at a maturity of the contract exceeds the
forward price, the long side benefits the virtue by acquiring the good at the contract price
- A futures contract is similar to a forward contract, differing most importantly in the
aspects of standardization and marking to market, which is the process by which gains
 and losses on futures contract positions are settled daily (in contracts, forwards contracts
call for no cash exchanges until the contract maturity
- Futures contracts are traded on organized exchanges that standardize the size of the
contract, the grade of a deliverable asset, the delivery date and the delivery location,
traders negotiate only a contract price
- The long positions gain or loss on a contract held between times 0 and t is Ft-F0, because
Ft=Pt at maturity, the longs profit if the contract is held until maturity is Pt-F0, where the
Pt is the spot price at the time T and F0 is the original futures price; the gain or loss to
short position is F0-Pt
- Futures contracts may be used for hedging or speculating; speculators use the contract to
take a stand on the ultimate price of an asset; short hedgers take short positions in
contracts to offset any gains or losses on the value of an asset already held in inventory;
long hedgers take long positions in futures contracts to offset gains or losses in the
purchase price of a good
- The spot-futures parity relationship states that the equilibrium futures price on an asset
providing no service or payments (such as dividends) is F0= P0(1+rf)^t; if the futures
price deviates from the value, then market participants can earn arbitrage profits
- If the asset provides services or payments with yield d, the parity relationship becomes
F0=P0(1+rf-d)^t (this model is also called the cost-carry model because it states that the
futures price must exceed the spot price by the net cost of carrying the asset until maturity
date T
- Interest rate futures allow for hedging against interest rate fluctuations, the most actively
traded contract is for Treasury bonds
- The interest rate swap market is a major component of he fixed-income market (in these
arrangements, parties exchange the interest payments on fixed versus floating rate bonds

Key formulas: