Option and Exercise Price Essay

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Business and Economics

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


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 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.



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


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




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

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.



Options: basics
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 ($)


Terminal stock price

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