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ACC 361:INTERNATIONAL FINANCE

topic seven option
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BY S MBEGU
 ACC 361: INTERNATIONAL FINANCE
2
OPTION
OPTION
Are financial derivatives (contracts) that give buyers the right, but not the
obligation, to buy or sell an underlying asset at an agreed-upon price and
date.
It may be Call options and put options form the basis for a wide range
of option strategies designed for hedging, income, or speculation.
Types of options
◦ Call options allow the holder to buy the asset at a stated price
within a specific timeframe.
◦ Put options allow the holder to sell the asset at a stated price
within a specific timeframe
◦ European Style Options: can be exercised only at expiration.
◦ American Style Options: can be exercised at any time prior to
expiration.
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 ACC 361: INTERNATIONAL FINANCE
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OPTION
FEATURES OF OPTION CONTRACTS
No Obligation to Buy or Sell:
the option holder has a right to buy or sell an underlying asset. He can
exercise this right at any time during the currency of the contract. But, in no
case, he is under an obligation to buy or sell. If he does not buy or sell, the
contract will be simply lapsed
Highly flexible:
On one hand, option contract are highly standardized and so they can be traded
only in organized exchanges. These instruments can be made according to the
requirements of the writer and user. Thus, it combines the features of ‘futures’ as well
as ‘forward’ contracts.
Down Payment: The option holder must pay a certain amount called ‘premium’ for
holding the right of exercising the option. This is considered to be the consideration
for the contract. If the option holder does not exercise his option, he has to forego this
premium. Otherwise, this premium will be deducted from the total payoff in
calculating the net payoff due to the option holder
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 ACC 361: INTERNATIONAL FINANCE
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OPTION
FEATURES OF OPTION CONTRACTS
Settement:
No money or commodity or share is exchanged when the contract is
written. Generally this option contract terminates either at the time of
exercising the option by the option holder or maturity whichever is earlier.
So, settlement is made only when the option holder exercises his option.
Suppose the option is not exercised till maturity, then the agreement
automatically lapses and no settlement is required.
Non — Linearity:
Unlike futures and forward, an option contract does not posses the property
of linearity. It means that the option holder’s profit, when the value of the
underlying asset moves in one direction is not equal to his loss when its
value moves in the opposite direction by the same amount.

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BY S MBEGU
 ACC 361: INTERNATIONAL FINANCE
5
OPTION
FEATURES OF OPTION CONTRACTS
Settement:
No money or commodity or share is exchanged when the contract is
written. Generally this option contract terminates either at the time of
exercising the option by the option holder or maturity whichever is earlier.
So, settlement is made only when the option holder exercises his option.
Suppose the option is not exercised till maturity, then the agreement
automatically lapses and no settlement is required.
Non — Linearity:
Unlike futures and forward, an option contract does not posses the property
of linearity. It means that the option holder’s profit, when the value of the
underlying asset moves in one direction is not equal to his loss when its
value moves in the opposite direction by the same amount.

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 ACC 361: INTERNATIONAL FINANCE
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OPTION
TERMS USED IN OPTION CONTRACTS
◦ Strike price: This refers to the rate at which the owner of the option can buy
or sell the underlying security if s/he decides to exercise the contract. The
strike price is fixed and does not change during the entire period of the
validity of the contract. It is important to remember that the strike price is
different from the market price. The latter changes during the life of the
contract.
◦ Contract size: The contract size is the deliverable quantity of an underlying
asset in an options contract. These quantities are fixed for an asset. If the
contract is for 100 shares, then when a holder exercises one option
contract, there will be a buying or selling of 100 shares.
◦ Expiration date: Every contract comes with a defined expiry date. This
remains unchanged until the validity of the contract. If the option is not
exercised within this date, it expires.

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OPTION
TERMS USED IN OPTION CONTRACTS
◦ Intrinsic value: An intrinsic value is the strike price minus
the current price of the underlying security.
◦ the time value of an option
◦ is the premium a rational investor would pay over its
current exercise value, based on the probability it will
increase in value before expiry.
◦ is the amount by which the option premium exceeds
the intrinsic value.
◦ Option Premium = Intrinsic Value + Time Value

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OPTION
TERMS USED IN OPTION CONTRACTS

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OPTION
PARTIES IN OPTION CONTRACTS

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OPTION
◦Status of an option
◦ a. In-the-money
◦ Call: Spot > strike
◦ Put: Spot < strike
◦ b. Out-of-the-money
◦ Call: Spot < strike
◦ Put: Spot > strike
◦ c. At-the-money
◦ Spot = the strike
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OPTION
◦Pricing an option
◦

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OPTION
◦Value of an option contract
◦

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OPTION
◦Value of an option contract
◦

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OPTION
◦Value of an option contract
◦

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OPTION
◦Payoff of an option contract
◦

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OPTION
◦Payoff of an option contract
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OPTION
◦Hedging with an option contract
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OPTION
◦Hedging with an option contract
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OPTION
◦Currency and Interest Rate Options
◦ An interest-rate option (IRO) gives the buyer the right to receive a
cash payment if market interest rate of a reference rate, usually the
(London Interbank Offered Rate (LIBOR), specified in the contract, is
higher or lower, depending on the option, than the strike rate of the
option.
◦ A call, sometimes referred to as a borrowers' option, increases in
value as interest rates rise; a put, sometimes referred to as
a lenders' option, increases in value if interest rates fall. The expiry
date is when the option can be exercised, which is 2 days before
the settlement date, sometimes known as the value date, unless the
currency is sterling, in which case the option is exercised on the
settlement date.

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