Chapter 1: Derivative: a contract between two parties providing for a payoff from one party to the other determined by the price of an asset, an exchange rate, a commodity price, or an interest rate. Derivative product is defined as financial contracts with settlement depending on the outcome of the underlying assets in the future. Advantages of OTC: terms can be tailored to specific needs of the parties, private market in which no one needs to know about the transactions, unregulated. Disadvantages of OTC: credit risk is higher, transaction size larger than what normal investors can handle. Chapter 8:Forward vs. Futures: definition: a contract between a buyer and a seller to purchase or sell something (the underlying) at a later date (maturity date) at a price (called forward/futures price) agreed upon today. Forward: unregulated, OTC traded, larger bet each contract, $84T mkt size, margin account usually required. Future: regulated and exchange traded margin account always required. Arbitrageurs attempt to profit from differences in the prices of otherwise identical spot and futures positions. Two rules: do not take any risk do not spend any money. Hedging: A) Long in the “underlying” → when the underlying price goes up, you will be happy, but sad when the price decreases. B) Short in the “underlying” → when the underlying price decreases, you will be happy, but sad when the price goes up. IF current position is type (a), sell forward/futures contracts to hedge. IF current position is type (b), buy forward/futures contracts to hedge. Ways to exit forward/futures contract: submit offsetting trade before or on last trading day. et your contract expire and wait for final settlement right after maturity date. For contracts with cash settlement: last trading date is the settlement date for contracts with delivery settlement: last trading date is the position date. Exchange for Physicals (EFP): the only type of permissible futures transaction that occurs off the floor of the exchange the holders of long and short positions get together and agree on a cash transaction that would close out their futures position. EFP market simply gives parties additional flexibility in making delivery, choosing the terms, and conducting such business when the exchanges are closed. Chapter 2:Call: the holder has the right to buy a specific amount (contract size) of the “underlying” at the predetermined “strike price” on (European Style) or before-or-on the maturity day (American Style). Put: the holder has the right to sell a specific amount (contract size) of the “underlying” at the predetermined “strike price” on (European Style) or before-or-on the maturity day (American Style). A bullish trader can choose to buy a call or short a put. A bearish trader can choose to buy a put or short a call. if your current position is long in the underlying, buy put options to hedge. If your current position is short in the underlying, buy call options to hedge. You cannot hedge by shorting options! Pro’s of hedging with options: Flexibility and profit potential. Chapter 3: Important five factors: S0 current stock price, X Exercise Price, r the applicable risk free rate applied during the duration of the option, St stock price at expiration, T length to maturity. S0 has a POSITIVE effect on CALL value, but a NEGATIVE effect on PUT value. X has a NEGATIVE effect on CALL, but a POSITIVE effect on PUT. R has a positive effect on CALL value, but a NEGATIVE effect on PUT. T always has a non-negative effect on American options,
b. (5 points)
How much would an investor who wanted to buy 1 contract of this option have had to spend (before considering any commission or fees)?
c. (10 points)
What is the formula for the intrinsic value of a call? What was the intrinsic value of the Dec. 118 call? Was this option “in the money” or “out of the money”? What was the time value of this option?
d. (8 points)
Was the Dec. 114 call in or out of the money? What was the intrinsic value of this option?…
Option prices almost always exceed intrinsic values. This excess, sometimes called the premium over parity, exists because buyers are willing to pay some price for potential future stock price movements.
19-6. Option prices almost always exceed intrinsic values. The difference reflecting the option's potential appreciation is typically referred to as the time value.…
– The seller of a call or put faces unlimited liability
as the price of the underlying asset could rise or
drop without limit.
Option pricing and valuation
2. Option valuation
• Value of option comes from two sources:
– Intrinsic value: Profit that could be made if
the option was immediately exercised.…
The holder of an American option has the right to exercise it immediately. The American option must therefore be worth at least as much as its intrinsic value. If it were not an arbitrageur could lock in a sure profit by buying the option and exercising it immediately.
Explain carefully the difference between writing a put option and buying a call option.
Writing a put gives a payoff of [pic]. Buying a call gives a payoff of [pic].…
It reflects E holders’ exposure to both business risk and financial risk.
βe = β0 + (β0 – βd) (D/E)
Optimal value calculation (limited to corporate taxation and bankruptcy costs)
For levered companies corporate taxation provides a tax shield because of the deductibility of
interest payments which increases company value, however, the probability of default imposes a
present value of bankruptcy costs burden on the company which decreases the company’s value.…
Value of an Option
Intrinsic Value of a
Where the time period = holding period / 365
Price of the Underlying – Strike Price
Note: options cannot have intrinsic value less than zero.…
Recall that the minimum (floor) value of a convertible is the maximum of: Straight or “intrinsic” bond value Conversion value The conversion option has value.
Litespeed, Inc., just issued a zero coupon convertible bond due in 10 years. The conversion ratio is 25 shares. The appropriate interest rate is 10%. The current stock price is $12 per share. Each convertible is trading at $400 in the market. What is the straight bond value? What is the conversion value?…
It reflects relative value rather than the intrinsic value which DCF valuation produces.
DCF analysis generates an intrinsic value as it relies on data specific to the firm. DCF analysis factors in time value of money, and thus is a forward-looking measure. However, there is uncertainty in forecasting future revenues, especially for private firms and those firms that produce little or no cash flows.…
Find present value of expected retirement obligation
2. Add the ARO cost to the carrying amount of the asset, create ARO liability
3. Amortize and expense the discount on the ARO (accretion expense)