Option and Exercise Price Essay

Submitted By 3015500
Words: 2220
Pages: 9

4/9/2013

Business and Economics

Case Studies in Finance
Technical Content for Porsche Volkswagen CSX
Instructor: Maria Strydom

Go8

AFF5300 Case Studies in Finance

Business and Economics

Technical Content
Readings: Chapter 5 from John C. Hull “Risk management and financial institutions”
International Edition (2nd). Pearson. Available from the M onash library

Derivatives and their use

Derivatives
Derivatives are a form of contingent claim – their value is contingent upon that of some underlying asset (or other variable).
It is a contract between two parties that specifies payment (or delivery of goods) whereby payment needs to be made.

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Who are users of derivatives
 Hedgers
– mainly interested in protecting themselves against adverse price changes
– want to avoid risk

 Speculators
– hope to make money in the markets by betting on the direction of prices
– “accept” risk

 Arbitrageurs
– arbitrage involves locking into riskless profit by simultaneously entering into transactions in two or more markets Hedge Funds vs. Mutual Funds
Hedge Fund

Mutual Fund

 Transparency: Limited Liability
Partnerships that provide only minimal disclosure of strategy and portfolio composition

 Transparency: Regulations require public disclosure of strategy and portfolio composition

 Investment strategy: Very flexible, funds can act opportunistically and make a wide range of investments
 Often use shorting, leverage, options
 Liquidity: Often have lock-up periods, require advance redemption notices  Investment strategy: Predictable, stable strategies, stated in prospectus
 Limited use of shorting, leverage, options  Liquidity: Can often move more easily into and out of a mutual fund

9/04/2013

Quiz
1. Mutual funds and hedge funds differ in several ways. Mutual funds are know to: (a) Have better liquidity and flexible investment strategies
(b) Often uses shorting, leverage and options and have lock-up periods
(c) Have predictable investment strategies and limited use of options
(d) Have very flexible investment strategies and limited liquidity

AFF5300 Case Studies in Finance

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Derivatives
Two main types of derivative contracts:
ETD (exchange traded derivative) – traded through exchanges (i.e. CBOT / CME = CME Group)
OTC (over the counter) – do not go through an exchange or other intermediary

Derivatives
Exchange Traded Derivatives (ETD)
- Standard contracts defined by the exchange
- Trades options and futures
Over the counter (OTC)
- Trades typically between two fin/institutions or between a fin/institution and one of its clients.
- Done over the phone, terms of contract depend on parties involved.
- Involves some credit risk (counterparty default)
- Forward contracts and swaps

Options: basics
An option gives its owner the right to buy or sell
(calls and puts) an asset at a fixed price anytime on or before a set date - depending on whether
European (exercisable only at expiration date) or
American (exercisable anytime up to expiration date) option.
i.e. Share options – the right to buy or sell a share at a fixed price on or before a future date.

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Options: basics
Terminology:
Exercising the option – buying (call) or selling (put) the underlying asset via the option contract
Strike price / Exercise price – the fixed price specified in the option contract at which the holder of the option can buy or sell the underlying
Exercise/Expiration date – options have a limited life. The last day it can be exercised = exercise/expiry date.

Options: basics
Call option: gives owner the right (not obligation) to buy asset at fixed price during particular period.
You can have a long or short call option:
Long call: “buying the right to buy”
Profit ($)

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Terminal stock price

Options: basics
Call option: gives owner the right (not obligation)
to…