HES - Amsterdam School of Business

FRM for IFM/IBMS

6. Options
6.1 Calls and puts
An option on a commodity, stock or future gives the buyer of the options the right, but not the obligation, to buy or sell the underlying instrument at a specified price, the exercise price or strike price, at or until a specified date. Options are both OTC and exchange traded. OTC-options can be (but not always are) tailor made, exchange traded options are, like futures, standardized. CALL options give the buyer the right to buy, PUT options give the buyer the right to sell. Buying (to be exact an open-buy) results in a long options (call or put) position. Like with futures, an open-sell results in a short options position. A short option position differs from a long position though: The seller of an option has an obligation to sell (in the case of a call) or buy (in the case of a put) the underlying instrument if the buyer of the option wants to exercise his right to buy or sell. Of course the seller of the options doesnt give this right to the buyer for free, but sells it for a price, the option premium.

C ll a
Byr ue W r rite p m m re iu B e uy r

Pt u
W r rite p m m re iu

R h ig t

to b y u

O lig tio b a n

tose ll

R h ig t

to s ll e

O lig tio b a n

to b y u

The option premium is comprised of two components: premium = intrinsic value + time value

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February 04

J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

An option may be in the money, at the money or out of the money. Call option: Market price underlying instrument < strike price Market price underlying instrument = strike price Market price underlying instrument > strike price out of the money at the money in the money

Put option: in the money at the money out of the money

There are options directly on all kinds of spot instruments (mostly stocks and commodities), on futures, on swaps (swaptions) and even on options (compound options). With an option on a futures contract, the intrinsic value of the option is related to the futures price of the underlying instrument. Exercising the option results in a futures position. Options may be American or European style: American style: exercise of option possible at any moment until and at expiration. The intrinsic value is related to the spot price of the underlying instrument (or if the underlying instrument is a future on the futures price). European style: exercise of the option is only possible at expiration, the intrinsic value is related to the forward price of the underlying instrument.

6.2 How is an option priced?

The options premium theoretically depends on:

time until expiration intrinsic value, the difference between the exercise price and the market price of the underlying instrument volatility, historic, as implied by the market or assumed. interest rate(s) whether it is American or European style

These variables are put in a black box (some amended version of the CoxRoss-Rubinstein-, Black-Scholes- or Garman-Kohlhagen- models) which produces the (theoretical) price. On the website www.optionscentral.com an option pricing model is available.

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February 04

J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

The theoretical price of an option

Time Intrinsic value Interest rate Volatility

Computer

Theoretical or fair value

In the market place (anticipated changes in) supply and demand of the options or of their underlying instruments, the traders books, special situations, access to the underlying instrument may lead to a market price that differs from the theoretical price. Besides, there is a relationship between calls and puts with the same strike price that must always hold, else there is a profitable arbitrage opportunity:

Call - Put - Parity

When stock A trades at 40, Apr 40 calls on A at 4 and Apr 40 puts at 2, a profit of 2 can be made by buying stocks and 40-puts and selling 40-call at the prices given. This buying and selling will make the stock and put prices rise and the call price fall, until this arbitrage profit opportunity has disappeared. Generalized, and taking the interest cost of financing the stock and option position into account, buying the stock and put and selling the call while borrowing the amount needed will cost (put premium + stock price paid call premium received) x (1 + interest rate) while the stock will be sold at the exercise price There is Call-Put-Parity when there is no profit to be made from this trade so if: C = P + S X / (1+i)t where C= call premium P= put premium S= stock price X= options strike or exercise price (the same for call and put!)
Financial Risk Management Course p. 32 February 04

J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

i = interest rate

t = time until expiration

Summing up, the market price of an option depends on its theoretical (or fair) value and market forces:

The market price of an option

Supply Demand Call-put-parity Theoretical value Special factors The market place (in cyber space) Market price

6.3 Option Profit-Loss diagrams

The buyer of an option gets a long options position. For the premium he pays, has a limited downside risk (of 100% of his investment) and an unlimited, leveraged, upside potential. 86 dollar call @ 3 ct
1200% 1000% 800% RO I 600% 400% 200% 0%
10 11 11 10 11

-200%

70

74

86

90

78

82

94

$ at expiration

The buyer has three alternatives:

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98

HES - Amsterdam School of Business

FRM for IFM/IBMS

(1) sell to close (2) exercise (3) do nothing. The seller or writer of an option gets a short options position. For the premium he receives, he has a limited upside potential and an unlimited downside risk. 86 dollar call @ 3 ct
5 0
10 2 10 6 11 0 11 4

-10 ROI -15 -20 -25 -30 -35 $ at expiration

The seller has only two alternatives: (1) buy to close (2) wait. Or so it seems at first sight. Like all prudent traders earning money by trading, as opposed to gambling, option traders hedge their risk. They manage their position and will keep it close to delta neutral. To see how this is done, we have to learn

6.4 Advanced option properties: from gamma to zeta

The kinds of risks the writer of options meets concern changes in the option value because of:

changes in the spot or forward rate of the trading currency: hedge ratio or delta changes in the hedge ratio because of changes in the spot or forward rate: gamma time decay: theta changes in the price-volatility of the trading currency: vega (or sometimes zeta or kappa) changes in the interest rate of the pricing currency: rho. This effect is only minor.

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11 8

78

82

90

70

74

86

94

98

-5

February 04

J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

In particular for the hedger using options the delta and the vega are of interest: delta = ___change in option premium____

price change of trading currency The value is between 0 and 1. In option pricing models it is the chance that the option ends its life in-the-money. The further out of the money, the smaller the chance; the deeper in the money the bigger the chance it will indeed expire in the money. At expiration, the delta of an in-the-money option is 1 and the delta of an outof-the-money option is 0.
Call options delta 1 Stock price > strike: call in-the-money Graph of delta at expiration 0.5

Stock price < strike: call out-of-the-money 0 strike Price of stock

In the case of a put options, the option is in-the-money and the puts delta = 1 when stock price < strike.
Before expiration however, for an in-the-money option there always is the chance it will end up out-of-the-money, so the delta will be below 1. Likewise for an out-of-the-money option there is a chance it will end up inthe-money, so the delta will be above 0. Call options delta 1 Stock price > strike: call in-the-money Delta expiration 0.5 Delta with 20 days till expiration with 90 days till

Stock price < strike: call out-of-the-money 0 strike Price of stock

Financial Risk Management Course

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February 04

J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

The longer the time until expiration, the higher the chance a out-of-the-money option will still end up in the money so the higher the delta of out-of-themoney options and likewise the lower the delta of in the money options. When buying an at-the-money option (strike price = current price), in a perfect market the chances the option will either end up in- or out-of-the money are equal, so the delta is 0.5.

Delta value of an option

value of option

delta=0.5 T=90d 0 delta=1 $-rate T=0 delta=0 strike =current price at purchase
1

The delta of a call option is positive, the delta of a put option negative. The delta of the underlying instrument always is 1. The book, or total position, of an option trader consisting of a large number of options series, typically will have a total delta (= weighted sum of the deltas of the several options in his book) not far from zero (= delta-neutral). The trader thus avoids being too speculative (betting on a rise or fall of the underlying trading currency). For an option trader the gamma obviously is of great importance: when the underlying currencys price changes, the gamma gives the magnitude with which the deltas change, so how he has to adjust his position to maintain his delta. When the delta of the traders total position is positive, he is bullish on the trading currency, when the delta is negative he is bearish. A delta-neutral position is one of which the value does not change with (small) changes in the trading currencys value. A gamma-neutral position is one that remains delta-neutral with (small) changes in the trading currencys value. The writer of options, takes the greater risk, but has the time decay to his advantage: the part of the option premium that is not intrinsic value, so the time value or volatility premium, in the option premium, will decrease in time and will be zero at expiration.

Financial Risk Management Course

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February 04

J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

The time value of an option is highly influenced by the volatility of the price of the underlying instrument. As the time value or volatility premium increases with the price volatility, option traders will preferably sell options when volatility is high and buy options (back) when volatility is low.

6.5 Some option combinations and strategies

where X = exercise price, T = time until expiration

synthetic forward or future: buy call + sell put with same X and T (long forward position) sell call + buy put with same X and T (short forward position) synthetic call : buy put + buy forward synthetic put: buy call + sell forward bull spread: buy call with lower X + sell call with higher X, buy put with lower X + sell put with higher X

bear spread: sell call with lower X + buy call with higher X, sell put with lower X + sell put with higher X

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J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

Butterfly Three strike prices: low, middle, high buy call with low X, sell 2 calls with mid X, buy call with high X or buy put with low X, sell 2 puts with mid X, buy put with high X or buy put with low X, sell put with middle X, sell call with mid X, buy call with high X (note: Xhi - Xmid must equal Xmid - Xlow)

Straddle: Buy call + buy put with same X and T (long straddle) Sell call + sell put with same X and T (short straddle, in graph)

Strangle Buy put with lower X, buy call with higher X, same T (long strangle, in graph)) Sell ..... (short strangle)

Min-Max or Collar or Cylinder, sometimes at Zero cost: long currency + sell call + buy put, short currency + buy call + sell put

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J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

Zecro (zero cost ratio option) or Participating hedge long currency + buy put + sell less calls at same X, such that net premium is (close to) zer short currency + buy call + sell less put, such that net premium is (close to) zero. Depends on forward vs. spot prices

6.6 Options on interest rates: caps and floors

Caps and floors are (series of) cash settlement interest rate options, where the seller of the cap or floor is obliged to pay a sum based on the difference between the actual reference rate (typically LIBOR) at the time of exercise and the agreed upon cap or floor rate (the exercise rate of the option or series of options) at the wish of the buyer of the cap or floor. No payment is made if LIBOR is below the cap rate or above the floor rate as the option will of course not be exercised. Like FRAs, these are OTC instruments. Effectively, the buyer of a cap has the right to borrow at a certain maximum interest rate to apply to a certain principle amount for a certain time period or series of time periods in the future. The seller of the option has the obligation to "deliver" the rate agreed upon. Likewise the buyer of a floor has the right to invest at a minimum rate The main properties of an interest rate-option: the exercise rate (cap or floor rate) the reference rate: the rate index used (mostly an interbank offered eurorate, like LIBOR or EURIBOR). the expiration date of the option the interest rate period the principal amount the premium paid up front by the buyer (usually a percentage of the principal) the option type: European (exercisable at the expiration date) or American (exercisable until expiration). There are option with more complex features, as a group classed as "exotic options".

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J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

In practice, two parties (on of them a bank or option-dealer) agree today to a settlement at some date in the future (the option's expiration date) of the difference between two interest rates at the option's buyer's wish. While the seller of the option receives a premium up front for the risk he takes when entering the option agreement, at expiration there will only be a cah flow to the buyer or no cash flow. The rate difference is between the option's strike and the actual (reference) rate if and when the option is exercised. The settlement amount is computed as - the rate difference between reference and cap or floor rate - multiplied by the caps or floors notional principal and - prorated to the length of the holding period and - as settlement takes place at the exercise date instead of the maturity date, the present value of the settlement amount is paid - The buyer of a cap receives this amount from the seller if the actual rate at settlement is higher than the strike, - The buyer of a floor receives this amount from the seller of the option if the actual rate at settlement is lower than the strike. Example of Using a cap to hedge the future borrowing rate on the upside:
Company QR foresees in 6 months from now a 10 mln liquidity shortage for 3 months (now=March). Today 3m EURIBOR (ebr) is quoted at 3,35% and 9m-ebr 3,65%. QR pays ebr+0,8% to its house bank. The treasurer expects and fears rates to rise steeply over the next months.

To fix the upside of the future 3m rate now, it can buy a 3,5% cap on 3m euro-LIBOR with expiration in September, presently quoted by AB-bank at 15 basis points (= 15.000 for 10.000.000). Thus, QR transfers its interest rate exposure to 3m-rates rising over 3,5% to the bank. If the 3m rate in six months from now is above 3,5%, QR will then pay 3,50+0,80= 4,30%. If the 3m rate in six months from now is below 3,5%, QR will then pay the current 3m-LIBOR+0,80 (this is not PQs effective rate though; see below). If in six months from now 3m-ebr is 5.30%, the settlement amount will be 10.000.000 x (5,30% 3,50%) x 3/12 / (1+5,30%)3/12 = 44.423 to be paid by AB-bank to PQ at the exercise date of the cap = (in this case assumed to be) the starting date of the 6m loan taken by PQ. The effective interest rate on the 10 mln loan is:
10 mln x (5,30+0,80)% x (interest payment, cash outflow Dec) + 44.423 x (1+ 5,30%/4) (settlement of cap, cash inflow Sep) 15.000 x (1+3,65%x ) (cap premium payment, cash outflow Mch) = 122.913 4,92%

(or quick and dirty: 5,3+0,8 (5,33,5) + 0,15/ = 4,9%)

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J.S.Schoorl

HES - Amsterdam School of Business

FRM for IFM/IBMS

If in six months from now 3m-ebr is 3.30%, QR will let the option expire and there will be no cash flow from the bank to QR in September. The effective interest rate on the 10 mln loan will be: 10 mln x (3,30+0,80)% x + 15.000 x (1+3,65%x ) = 117.913 4,92% (or quick and dirty: 3,3+0,8 + 0,15/ = 4,9%) A cap can also be a series of options for a 3m roll-over loan for a longer period, up to several years out. Every three month a settlement like the one given above then takes place. A floor works the same way for a future investor, putting a floor under the future investment rate of return.

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