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Chapter 18
Derivatives and Risk Management
Options
• A right to buy or sell stock
–at a specified price (exercise price or "strike" price)
–within a specified time period
• The price of an option is called the "premium.”
Options to Buy Stock
• Call– Option to buy created by investors
• Warrants – Option to buy created by a
corporation
Option to Sell Stock
• Put– Option to sell stock at a specified
price within a specified time period
The Intrinsic Value of an Option
• Depends on the value of the underlying stock
• Is derived from the underlying stock
–hence the name "derivatives”
The Intrinsic Value of an Option to Buy Stock
• The difference between
–the price of the stock and
–the strike (exercise) price
In, Out, & At the Money Options
• An "in" the money call option: price of the stock exceeds the exercise price (positive intrinsic value)
• An "out" of the money call option: exercise price exceeds the price of the stock
• An "at" the money call option: exercise price equals the price of the stock
The Intrinsic Value of an Option
The Intrinsic Value of an Option
• An option cannot sell for less than its intrinsic value
• An option sells for its intrinsic value on the expiration date
Options & Leverage
• Options are purchased for their potential leverage
• Percentage return on option may exceed the percentage return on the underlying stock
The Time Premium of an Option
• Price of the option minus its intrinsic value
• Prior to expiration, an option sells for a time premium
• At expiration there is no time premium
The Time Premium of an Option
Chicago Board Options Exchange
• The first secondary market in options
• Option prices are reported in the financial press
• The "open interest:” number of contracts in existence
Profits & Losses to Buyers of Calls
• Maximum potential loss is the cost of the option
• Unlimited possible profits
Profits & Losses to Buyers of Calls
Profits, Buying Stock & Calls
• Calls
–limited loss
• Stock
–large possible loss
• Unlimited profit potential to either long position
Profits, Buying Stock & Calls
Writing Options
• Options are created ("written") by investors who either
–own the underlying stock: “covered” option writing
–do not own the underlying stock: “naked” option writing
Covered Call
• To write a covered call: buy the stock and sell the option
• Combines a long in the stock and a short in the option
• Covered call takes advantage of the disappearing time premium
• Profit is limited
Profit / Loss
• Profit/loss profile for covered call writing
Naked Call
• To write a naked call, sell the call
• The maximum possible profit is the sale price
• Since the writer does not own the stock, unlimited risk of loss if the price of the stock rises
Naked Call
Profit / Loss Compared
• When the buyer profits, the naked writer sustains a loss
• When the naked writer profits, the buyer sustains a loss
• The profit/loss on buying a call or writing a naked call are mirror images
Profit / Loss Compared
Puts
• An option to sell stock –at a specified price –within a specified time period
• Buy a put in anticipation of the stock's price declining
• Sell a put in anticipation of the stock's price remaining stable or rising
Put’s Intrinsic Value
• A put's intrinsic value rises as the price of the stock declines
Profit / Loss: Buying a Put
• Profit/loss profile for buying a put
Profit / Loss: Writing a Put
• Profit/loss profile for writing a put
Profit / Loss
• Once again the profit/loss profiles from buying a put and writing a put are mirror images
Profit / Loss
Stock Index Options
• Put and call options based on –an index of stock prices – instead of a specific stock
• Avoid the risk of selecting individual securities
• Capture movements in the market as a whole
Stock Index Call
• Buying a stock index call–a long position in the market–anticipates a market increase
• Selling a stock index call–a short position against the market–anticipates a market decline
Stock Index Put
• Buying a put is made in anticipation of a market decline
• Both buying a stock index put or selling an index call is made in anticipation of lower stock prices
Futures
• A formal agreement (contract) for
–the delivery (seller) or
–receipt (buyer) of a commodity
• Participants in futures markets are either
–speculators
–hedgers
Futures Contracts
• Contracts establish a futures price
• The current (spot) price may be
–Lower
–Higherthan the futures price
Positions
• Speculators buy or sell contracts in anticipation of price changes
• The long position anticipates price increases
• The short position anticipates price decreases
Open Interest• Number of contracts in existence
Closing a Futures Contract
• Close a position in a futures by entering into the opposite position
• A contract to sell "offsets" a contract to buy
• A contract to buy "offsets" a contract to sell
Futures and Leverage
• Futures offer large profits and losses
• The source of the leverage: the small margin requirement
• The margin requirement is a small percentage of the value of the contract
Margin
• Margin: a good faith deposit required of both
–the long position and
–the short position
Marking to the Market
• Futures positions are "marked to the market" daily
• Funds are transferred between accounts
Maintenance Margin
• A second margin requirement
• If funds in the account fall below the maintenance margin requirement, the investor receives a "margin call”
• Failure to meet the margin call results in the position being closed
Hedgers
• Buy and sell contracts to offset existing positions
• Are growers and other users of commodities
• Wish to reduce the risk of loss from price fluctuations
Hedgers
• Pass the risk of loss to the speculators
• Take the opposite positions of the speculators
• Forego the possibility of a large return to obtain future price certainty
Financial and Currency Futures
• Financial futures
–contracts for the future delivery of a financial asset
• Currency futures
–contracts for the future delivery of a currency
Stock Index Futures
• Based on an index of stock prices
• Speculators buy and sell stock index futures in anticipation of changes in stock prices
• Portfolio managers use stock index futures to hedge against movements in stock prices
Risk Management and Currency Futures Contracts
• Establishes a future price
• Manages exchange rate risk
Hedging Strategies
• If receiving a future payment, enter contract to sell the currency
• If making a future payment, enter contract to buy the currency
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