Options n Derivatives FINAL

8/13/2019 Options n Derivatives FINAL

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INTRODUCTION TO DERIVATIVES

Financial markets are, by nature, extremely volatile and hence the riskfactor is an important concern for financial agents. To reduce this risk,the concept of derivatives comes into the picture.Derivatives are products whose values are derived from one or morebasic variables called bases. These bases can be underlying assets (forexample forex, equity, etc), bases or reference rates. For example,wheat farmers may wish to sell their harvest at a future date to eliminatethe risk of a change in prices by that date. The transaction in this casewould be the derivative, while the spot price of wheat would be theunderlying asset.Derivati ves are an important class of nancial instruments that arece ntral to todays nancial and trade markets. They offer various typesof risk protection and allow innovative investment strategies.Derivatives may be traded for a variety of reasons.

1. HedgingA derivative enables a trader to hedge some preexisting risk by takingpositions in derivatives markets that offset potential losses in theunderlying or spot market.

2. SpeculationAnother motive for derivatives trading is speculation (i.e. takingpositions to profit from anticipated price movements). In practice, it maybe difficult to distinguish whether a particular trade was for hedging orspeculation, and active markets require the participation of bothhedgers and speculators.

3. ArbitrageurA third type of trader, called arbitrageurs, profit from discrepancies inthe relationship of spot and derivatives prices.

As defined above, the value of a derivative instrument depends uponthe underlying asset. The underlying asset may assume many forms:

Commodities including grain, coffee beans, orange juice; Precious metals like gold and silver; Foreign exchange rates or currencies; Bonds of different types, including medium to long term negotiable

debt securities issued by governments, companies, etc. Shares and share warrants of companies traded on recognized

stock exchanges and Stock Index; Short term securities such as T-bills; Over-the Counter (OTC) money market products such as loans or

deposits.


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INTRODUCTION TO OPTIONS

Options can be defined as:

A contract that gives the buyer the right but not the obligation, tobuy or sell a specific amount of a given stock, commodity,currency, index, or debt, at a specified price during a specifiedperiod of time.

In finance, an option is a derivative financial instrument that establishesa contract between two parties concerning the buying or selling of anasset at a reference price. The buyer of the option gains the right, butnot the obligation, to engage in some specific transaction on the asset,while the seller incurs the obligation to fulfill the transaction if sorequested by the buyer.

The asset on which an option contract is based is commonly referred toas the underlying security. Options are categorized as derivativesecurities because their value is derived in part from the value andcharacteristics of the underlying security. For instance, a stock optioncontract's unit of trade is the number of shares of underlying stockwhich are represented by that option. Generally speaking, stock optionshave a unit of trade of 100 shares. This means that one option contractrepresents the right to buy or sell 100 shares of the underlying security.

Every financial option is a contract between the two counterparties withthe terms of the option specified in a term sheet. Option contracts maybe quite complicated; however, at minimum, they usually contain thefollowing specifications:

whether the option holder has the right to buy (or the right to sell . the quantity and class of the underlying asset(s) (e.g., 100 shares

of XYZ Co. B stock) the strike price, also known as the exercise price, which is the price

at which the underlying transaction will occur upon exercise

the expiration date, or expiry, which is the last date the option canbe exercised the settlement terms, for instance whether the writer must deliver

the actual asset on exercise, or may simply tender the equivalentcash amount

the terms by which the option is quoted in the market to convert thequoted price into the actual premium- the total amount paid bythe holder to the writer of the option.


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Option buyers pay a price for the right to buy or sell the underlyingsecurity. This price is called the option premium. The premium is paid tothe writer, or seller, of the option. In return, the writer of a call option isobligated to deliver the underlying security (in return for the strike priceper share) to an option buyer if the call is exercised and, likewise, thewriter of a put option is obligated to take delivery of the underlyingsecurity (at a cost of the strike price per share) from an option buyer ifthe put is exercised. Whether or not an option is ever exercised, thewriter keeps the premium. Premiums are quoted on a per share basis.

BENEFITS OF OPTIONS

1. Orderly, Efficient and Liquid Markets

Standardized option contracts provide orderly, efficient, and liquidoption markets. Except under special circumstances, all stock optioncontracts are for 100 shares of the underlying stock. The strike price ofan option is the specified share price at which the shares of stock will bebought or sold if the buyer of an option, or the holder, exercises hisoption. Strike prices are listed in increments of 2.5, 5, or 10 points,depending on the market price of the underlying security, and only strikeprices a few levels above and below the current market price aretraded.As a result of this standardization, option prices can be obtainedquickly and easily at any time during trading hours. Additionally, closing

option prices (premiums) for exchange-traded options are publisheddaily in many newspapers. Option prices are set by buyers and sellerson the exchange floor where all trading is conducted in the open,competitive manner of an auction market.

2. Flexibility

Options are an extremely versatile investment tool. Because of theirunique risk/reward structure, options can be used in many combinationswith other option contracts and/or other financial instruments to create

either a hedged or speculative position.3. Leverage

A stock option allows you to fix the price, for a specific period of time, atwhich you can purchase or sell 100 shares of stock for a premium(price) which is only a percentage of what you would pay to own thestock outright. That leverage means that by using options you may beable to increase your potential benefit from a stock's price movements.

4.

Limited Risk For Buyer


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Unlike other investments where the risks may have no limit, optionsoffer a known risk to buyers. An option buyer absolutely cannot losemore than the price of the option, the premium. Because the right to buyor sell the underlying security at a specific price expires on a given date,the option will expire worthless if the conditions for profitable exercise orsale of the contract are not met by the expiration date. An uncoveredoption seller (writer of an option), on the other hand, may face unlimitedrisk.

HISTORY OF OPTIONS

First Account of Options 332 B.C

The very first account of options was mentioned in Aristotle's book

named "Politics", published in 332 B.C.Aristotle mentioned a mannamed Thales of Miletus.Thales predicted a huge olive harvest in theyear that follows. Understanding that olive presses would be in highdemand following such a huge harvest, Thales could turn a huge profit ifhe owned all of the olive presses in the region, however, he didn't havethat kind of money.Instead,He used a small amount of money asdeposit to secure the use of all of the olive presses in the region, nowknown as a call option.By controlling the rights to using the olivepresses through an option (even though he didn't name it "option" then),Thales had the right to either use these olive presses himself when

harvest time came (exercising the options) or to sell that right to peoplewho would pay more for those rights (selling the options for a profit).

Tulip Mania of 1636

The tulip mania of 1636 in Europe is a classic economics and financecase study where herding behavior created a surge in demand whichcause the price of a single commodity, tulips in this case, to soar toridiculous prices. This surge in price begun the first mass trading ofoptions in recorded history.As the price of tulip bulbs increased almost

on a daily basis, Dutch dealers, which was the biggest producer of tulipbulbs then, started tulip bulb options trading so that producers couldown the rights to owning tulip bulbs in advanced and secure a definitebuying price.Mass speculative interest in tulip bulbs options led topeople from all level of society buying those options.However after theprice bubble burst almost all options speculators were wiped out as theiroptions fell out of the money and worthless.

Options Trading in London in 1700 to 1860

Even though options trading gained a bad name, it doesn't stopfinanciers and investors from acknowledging its speculative power


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through its inherent leverage. Put and Call options were given anorganised market towards the end of the seventeenth century inLondon. With the lessons learnt from the tulip mania still fresh in mind,trading volume was low as investors still feared the "speculative nature"of options. In fact, there was growing opposition to options trading inLondon which ultimately led to options trading being declared illegal in1733. Since 1733, options trading in London was illegal for more than100 years until it was declared legal again in 1860.

Options Trading in USA in 1872 Russell Sage, a well known American Financier born in New York, wasthe first to create call and put options for trading in the US back in 1872.The options that Russell Sage created where the first OTC options inthe US and were unstandardized and highly illiquid.

Black-Scholes Model

The Black-Scholes Model was first discovered in 1973 by Fischer Blackand Myron Scholes, and then further developed by Robert Merton. Itwas for the development of the Black-Scholes Model that Scholes andMerton received the Nobel Prize of Economics in 1997 (Black hadpassed away two years earlier). The idea of the Black-Scholes Modelwas first published in "The Pricing of Options and Corporate Liabilities"of the Journal of Political Economy by Fischer Black and Myron Scholes

and then elaborated in "Theory of Rational Option Pricing" by RobertMerton in 1973.

CBOE and OCC formed in 1973

About 100 years following the introduction of options trading to the USmarket by Russell Sage, the most important event in modern optionstrading history took place with the formation of the Chicago Board ofExchange (CBOE) and the Options Clearing Corporation (OCC) in1973. The formation of both institutions truly is a milestone in the history

of options trading and have defined how options are traded over apublic exchange the way it is traded today.The most important function of the CBOE is in the standardisation ofstock options to be publicly traded. Prior to the formation of the CBOE,options were traded over the counter and were highly unstandardized,leading to an illiquid and inefficient options trading market. In order foroptions to be openly traded, all options contracts need to bestandardized. So in 1973 the general public is able to trade call optionsunder the performance guarantee of the OCC and the liquidity providedby the market maker system. This structure continues to be used today.

By 1977, put options were introduced by the CBOE, creating the optionstrading market that we know today.


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TYPES OF OPTIONS

1. Call option

Call option is a contract that allows the buyer the right but not theobligation to buy an underlying asset, at a specific price and aspecific time.

A call option, often simply labeled a "call", is a financial contractbetween two parties, the buyer and the seller of this type ofoption.

The seller (or "writer") is obligated to sell the commodity orfinancial instrument should the buyer so decide. The buyer pays afee (called a premium) for this right.

The buyer of a call option wants the price of the underlyinginstrument to rise in the future; the seller either expects that it will

not. The call buyer believes it's likely the price of the underlying asset

will rise by the exercise date. The risk is limited to the premium.The profit for the buyer can be very large, and is limited by howhigh underlying's spot rises. When the price of the underlyinginstrument surpasses the strike price, the option is said to be "inthe money".

2. Put option Put option is a contract that allows the buyer the right but not the

obligation to sell an underlying asset, at a specific price and aspecific time.

The seller (or "writer") is obligated to buy the commodity orfinancial instrument should the buyer (holder) so decide. Thebuyer pays a fee (called a premium) for this right.

The buyer of a put option wants the price of the underlyinginstrument to fall in the future, while the seller expects a pricerise. The advantage of buying a put is that the option owner's risk ofloss is limited to the premium paid for it.

3. European Option

European option is an option hat can only be exercised at the endof its life, at its maturity.

European options tend to sometimes trade at a discount to itscomparable American option. This is because American optionsallow investors more opportunities to exercise the contract.


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INTRODUCTION TO OPTION MARKETS

The exchange where most of the buying and selling of options contractstake place is called the options market . The most common way oftrading options is through standardized options contracts. These arelisted in various futures and options exchanges. The listing of thecontracts and their respective prices is done using ticker symbols.

These exchanges publish the options prices continuously and createlive options markets for options trading. Thus, the exchange offers thetrading parties a platform to discover prices and execute transactions.These exchanges assume the role of intermediaries for buyers andsellers.

Options are also traded via over-the counter exchanges.

TYPES OF OPTION MARKETS

1. Over-The-Counter Market

A decentralized market of options not listed on an exchange wheremarket participants trade over the telephone, facsimile orelectronic network instead of a physical trading floor.

There is no central exchange or meeting place for this market. OTC options (or dealer options) are private transactions between

two parties. The absence of a large and standardizedintermediary system makes the transactions quick but alsoincreases the risk of one of the parties defaulting on their part ofthe deal.

The market value of the traded option is difficult to judge becausethere is no centralized price monitoring system like an exchange.However, these transactions are often much more flexible andcan be customized to suit the needs of the two parties. Thisaspect makes these options very versatile and adaptable.

OTC deals are the result of discussion and negotiation betweentwo counterparties, without the intervention and/or regulation ofa market-exchange. The terms and conditions of the trades arecompletely deal-specific and are formalised by a legal documentcalled the confirmation document.

Option types commonly traded over the counter include:o Interest rate optionso Currency cross rate optionso Options on swaps


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2. Organized Options Market

A centralized market of options where parties trade standardizedoption contracts that have been defined by an exchange.

Exchange traded options have standardized contracts, and aresettled through a clearing house with fulfillment guaranteed by thecredit of the exchange.

Since the contracts are standardized, accurate pricing models areoften available.

Exchange-traded options include:o Stock options,o Commodity optionso Bond options and other interest rate optionso Stock market index options or, simply, index options ando

Options on futures contractsPARTICIPANTS OF OPTIONS MARKETS

1. Buyers

Buyers refers to the parties that purchase option contracts.The buyerspay a fee known as premium to purchase the right but not obligation tobuy or sell a particular underlying asset at a specific price.

2. Sellers

Sellers refer to the parties that write or sell option contracts. The writersells the right but not obligation to buy or sell a particular underlyingasset at a specific price.The seller however has the obligation toexecute the contract of the buyer wishes to do so.


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BASIC TRADES OR POSITIONS IN THE OPTIONS MARKET

There are two sides to every options contracts. On one side is theinvestor who has taken the long postion (i.e. bought the option). On theother side is the investor who has taken the short position (i.e. sold orwritten the option). The writer of an option receives cash up front, buthas potenti al liabilities later. The writers profit or loss is the reverse ofthat of the purchaser of the option.The profit or loss depends on theoption positions.There are four types of option positions:

1. Long position in call option

When a trader believes that the price of a stock would appreciate,he/she can acquire the right to buy an option rather than just opting topurchase the stock. If the price of the stock moves above the exerciseprice by more than the premium, the trader earns a profit.Example:Profit from buying one European call option: option price = $5, strikeprice = $100.


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2. Long position in put option

When a trader believes that the price of a stock would depreciate,he/she can acquire the right to buy an option rather than just opting tosell the stock. If the price of the stock moves above the exercise priceby more than the premium, the trader will not exercise the option.Example:Profit from buying a European put option: option price = $7, strike price= $70

3. Short position in Call option

When a trader believes that the price of a stock would depreciate,he/she can sell the right to buy an option. In this case the profit is limitedbut the loss is unlimited.Example:Profit from writing one European call option: option price = $5, strikeprice = $100


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4. Short position in Put option

When a trader believes that the price of a stock would appreciate ,he/she can sell a put option.This will give the trader an obligation to buythe stock from the put buyer. In this case the profit is limited but the lossis unlimited.

Example:Profit from writing a European put option: option price = $7, strike price= $70

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Options n Derivatives FINAL