Financial Derivatives A focus on Options

By: Wayne Horak

Vincent Wedelich

Financial Management HBU

Professor: Dr. Allen Yan

Presentation Project

May 10, 2007

Financial Derivatives A focus on Options

Financial Derivatives

Forwards and Futures Swaps Black and Scholes model. What is an option? How to purchase or sell options on the open market. News Corp speculators make a huge profit on the

upcoming news that News Corp was being offered $60.00 per share.

How to mitigate risk by adding options to your portfolio. Financial Engineering.

Financial Derivatives

Financial derivatives are investments whose present value today or at some future date is derived.

It is derived entirely from the value of other assets,

The other asset is the underlying asset.

Forwards and Futures

Represents the obligation to buy (sell) a security or commodity at a pre-specified price, known as the forward price, at some future date

The most important financial forward market is the inter-bank forward market for currencies, particularly dollars for yen and dollars for Euros.

Obligation for both a contract to exchange an asset in the future at a specified price

Swaps

Swaps are sometimes called, to periodically exchange the cash flow of one security for the cash flow of another.

The last date of exchange determines the swap maturity.

An agreement to exchange a series of cash flows at specified prices and times.

Options

Gives their buyers the right,

but not the obligation,

To buy (call option) or sell (sell option) an underlying security at a pre-specified price, known as the strike price.

Black and Scholes

A major break through occurred in the valuation of derivatives when two finance professors at MIT,

Black and Scholes, came out with a formula that related the price of a call option to the price of the stock to which the option applies.

Black and Scholes

“The Black-Scholes Option Pricing Model (OPM), developed in 1973, helped give rise to the rapid growth in options trading.

This model, which has even been programmed into some hand-held and web-based calculators, is widely used by options traders”. (Brigham 2007 p 295)

Basics: What is an option?

Options are types of derivative contracts, including call options and put options,

The future payoffs to the buyer and seller of the contract are determined by the price of another security.

Basics: How do options work?

A call option is an agreement in which the holder has the right (but not the obligation) to exercise by buying an asset at the strike price on or before a future date.

A put option is an agreement in which the holder has the

right (but not the obligation) to exercise by selling an asset at the strike price on or before a future date.

The seller has the obligation to honor the terms of the contract.

Buying a call option - This is a graphical interpretation of the payoffs and profits generated by a call option as seen by the buyer. A higher stock price means a higher profit. Eventually, the price of the underlying security will be high enough to fully compensate for the price of the option.

Writing a call option - This is a graphical interpretation of the payoffs and profits generated by a call option as seen by the writer of the option. Profit is maximized when the strike price exceeds the price of the underlying security, because the option expires worthless and the writer keeps the premium.

Example of a call option on a stock

Buy a call: buyer expects that the price may go up. Pays a premium that buyer will never get back. Buyer has the right to exercise the option at the strike price.

Write a call: writer receives the premium. if buyer decides to exercise the option, writer has to sell the stock at the strike price.

Basics: How Do Options Work?

Since the option gives the holder a right and the seller an obligation, the buyer pays the option premium to the seller.

Traders in exchange-traded options do not usually interact directly, but through a clearing house.

The clearing house guarantees that an assigned seller will fulfill his obligation if the option is exercised.

Five Principal Factors Influencing Option Valuation

1. The price of the underlying security in relation to.

2. The strike price.

3. The cumulative cost required to hold a position in the security (including interest + dividends).

4. The time to expiration.

5. The estimate of the future volatility of the security's price. (Least known factor)

Trading Options

The most common way to trade stock options is trading standardized options contracts that are listed by various futures and options exchanges.

Currently there are six exchanges in the United States that list standardized options contracts based on underlying stocks.

Trading Options

Options Exchanges. – Philadelphia Stock Exchange (PHLX) – American Stock Exchange (AMEX), – NYSE in New York City– Chicago Board Options Exchange (CBOE)– International Securities Exchange (ISE)– Boston Options Exchange (BOX)

Over-The-Counter Contracts

Options contracts that are not traded on exchanges, but between two independent parties.

At least one of those parties is usually a large financial institution with a balance sheet big enough to underwrite such a contract.

Stock investors were surprised by word that News Corp was interested in buying Dow Jones & Co.

Some option buyers had positioned themselves for big gains in the shares.

Tuesday May 1, Dow Jones & Co. acknowledged that it was considering a proposal from News Corp to buy the company for $60 a share.

This sent the stock up more than 50%.

News Corp.’s interest in Dow Jones & Co.

Many option traders built they position by trading in options that would profit most from a jump in Dow Jones shares.

Most of this activity occurred on Monday April 30 which was far more heavier than usual.

News Corp.’s interest in Dow Jones & Co.

More than 4,300 call options on Dow Jones changed hands, nearly half of the volume of calls traded during the whole month of April.

The Dow Jones stock closed at $36.33 on Monday April 30 and spiked 50% closing at $54.46 on Tuesday.

News Corp.’s interest in Dow Jones & Co.

News Corp.’s interest in Dow Jones & Co.

Prior to May 1, call options picked up generally in April, and was particularly heavy on the 17th and 25th of the month.

Including Monday April 30, 10,000 call options on Dow Jones &Co changed hands.

This is compared to 7,000 call options during the entire first quarter.

This has many option traders crying foul.

Option strategies

Financial engineering– Options can be mixed in various ways to create an

unlimited number of payoff profiles.

Examples of Financial Engineering

– Buy a stock and a put– Buy a call with one strike price and sell a call with

another– Buy a call and a put with the same strike price

References:

– Financial Management Theory and Practice Eugene F. Brigham and Michael C. Ehrhardt Edition 11e 2007

– Forbes .com, Associated Press. May 1,2007

– MIT SLOAN SCHOOL OF MANAGEMENT

– Wall Street Journal, May 1, 2007 New Corp.

– Wikipedia. Option (Financial)

Questions?