FIN 401 Lecture Notes - Lecture 8: Call Option, Option Contract, Put Option

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March 20, 2018 Lecture 8 – FIN300

Risk and the Pricing of OPTIONS (CHAPTER 13)

Options

• Option contract: agreement that gives the owner the right, but not the obligation, to buy

or sell an asset for a specific price on or before a specified date

o Strike/exercise price: the specified price at which the underlying asset will be

traded

o Expiration date: the specified date on or before which the option can be exercised

o Exercising the option: the act of buying or selling the asset via the option contract

• Options can be American or European

o American options can be exercised any time up to and including the expiration

date

o European options can be exercised only on the expiration date

• Option premium – the purchase price of the option

Two Basic Types of Options

 Call option – gives the owner the right, but not the obligation, to buy the underlying asset

 Put option – gives the owner the right but not the obligation, to sell the underlying asset

Rights and Obligations

• The buyer of the option has the right to exercise the option, but the option seller is

obligated

o Call – option seller is obligated to SELL the asset if the option is exercised

o Put – option seller is obligated to BUY the asset if the option is exercised

• Option seller is also called the “writer”

An Option Contract Illustration

Suppose you plan to buy a FIN 401 textbook 5 months from now. You are offered the following

option contract:

The buyer of the option has the right to buy 1 copy of the FIN 401 textbook from the option seller

at $120 on August 31st, 2018. The option buyer needs to pay the seller $3 for this right.

Call Option Illustration

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March 20, 2018 Lecture 8 – FIN300

Payoff and Profit of the Call Option

• Call buyer’s payoff & profit:

o If bookstore price = $150

▪ Payoff = 150 – 120 = 30

▪ Profit = 30 – 3 = 27

o If bookstore price = $100

▪ Payoff = 0

▪ Profit = 0 – 3

Payoff Profiles – Call Options

Option Payoffs – Call Options

• The value of a call option at expiration is called the intrinsic value

o C1 = Max(S1 – E, 0)

▪ C1 = value of call option

▪ S1 = underlying asset price

▪ E = exercise price

o If S1 < E, then the payoff is 0

o If S1 > E, then the payoff is S1 – E

• Assume that the exercise price is $35

Put Option Contract Illustration

Suppose you plan to sell your FIN 401

textbook less than 2 months from now. You are

offered the following option contract:

The buyer of the option has the right to sell 1

copy of the FIN 401 textbook to the option

seller at $120 on April 30th, 2018. The buyer

needs to pay the seller $3 for this right.

Payoff and Profit of the Put Option

• Put buyer’s payoff & profit:

o If bookstore price = $150

▪ Payoff = 0

▪ Profit = 0 – 3 = -3

o If bookstore price = $100

▪ Payoff = 120 – 100 = 20

▪ Profit = 20 – 3 = 17

• Call writer’s payoff & profit:

o If bookstore price = $150

▪ Payoff = 120 – 150 = -30

▪ Profit = 3 – 30 = -27

o If bookstore price = $100

▪ Payoff = 0

▪ Profit = 3

• Put writer’s payoff & profit:

o If bookstore price = $150

▪ Payoff = 0

▪ Profit = 3

o If bookstore price = $100

▪ Payoff = 100 – 120 = -20

▪ Profit = 3 – 20 = -17

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Document Summary

Risk and the pricing of options (chapter 13) Call option gives the owner the right, but not the obligation, to buy the underlying asset. Put option gives the owner the right but not the obligation, to sell the underlying asset. Suppose you plan to buy a fin 401 textbook 5 months from now. The buyer of the option has the right to buy 1 copy of the fin 401 textbook from the option seller at on august 31st, 2018. The option buyer needs to pay the seller for this right. Suppose you plan to sell your fin 401 textbook less than 2 months from now. The buyer of the option has the right to sell 1 copy of the fin 401 textbook to the option seller at on april 30th, 2018. The buyer needs to pay the seller for this right.

Related Questions

Problem 2

The writer of a regular exchange-listed put-option on a stock:

Has the right to buy 100 shares of the underlying stock at the market price.

Has the right to sell 100 shares of the underlying stock at the exercise price.

Has the obligation to buy 100 shares of the underlying stock at the exercise price.

Has the obligation to sell 100 shares of the underlying stock at the exercise price.

Has the obligation to buy 100 shares of the underlying stock at the market price.

please really need some help with these questions

Problem 3

Suppose an investor have a put option. What will happen if the stock price on the exercise date is below the exercise price?

A. The seller will need to deliver stock to the owner of the option. B. The seller will be obliged to buy stock from the owner of the option. C. The owner will not exercise his option.
D. The option will extend for nine more months.
E. None of the above options.

Problem 5

Suppose an investor sells one share of stock and buys a call option on the stock. What will be the value of her investment on the final exercise date if the stock price is above the exercise price? (Ignore transaction costs.)

A. The value of two shares of stock.
B. The value of one share of stock plus the exercise price. C. The exercise price.
D. The value of one share of stock minus the exercise price.

E. None of the above options.

Problem 9

All else equal, as the underlying stock price decreases:

A. The put price increases.
B. The put price decreases.
C. The call price increases.
D. There is no effect on put price.
E. The put price can either increase, decrease, or remain the same.

Problem 10

All else equal, as the underlying stock volatility decreases:

A. The put price increases.
B. The put price decreases.
C. The call price increases.
D. There is no effect on put price.
E. The put price can either increase, decrease, or remain the same.

erinbutterfly833

The current price of a particular stock is $80. Each week the stock price goes up 15% or down 10% with some probability. a.) Find probabilities that the stock goes up or down which give that the expected return from investing in this stock is $0. These probabilities are called the ârisk neutralâ probabilities. b.) An American call option is a contract giving the buyer of the contract the right, but not the obligation to buy the stock at a future date (called the expiration date) from the seller for a predetermined price (called the strike price). Suppose you are interested in buying a call option which expires in three weeks with a strike price of $110. If the stock price is above $110 at the end of three weeks, then you can buy the stock for a lower price than it is worth, and you effectively earn the difference between the stock price and the strike price. If the stock price is below $110, the option expires worthless. What would a fair price for this option be (that is, how much is the expected earnings from this contract) if the probabilities that the stock goes up or down are given by your answer to part (a)? c.) Rather than using the probabilities in part (a), if banks offer an interest rate on cash holdings, it is common practice in financial modeling to find ârisk neutralâ probabilities so that the expected return on the stock is the same as the interest rate. Find these probabilities if the current interest rate is 5% per week. d.) What is the expected earnings from an American call option which expires in three weeks with a strike price of $110 under the probabilities from part (c)? (Note that the âpresent valueâ of $1 in three weeks is $1/(1.05)3= 0.86 since if we invest 86 cents at the interest rate, it will be worth $1 in three weeks). What is the present value of the American call option?

I. Fill in the blank using a number of terms listed below (@1 point). Annuity due, Asset Mgmt ratio, Call, Comparisons, Comparative ratio analysis, Corporation, Covered, Current Ratio, DSO, Du Pont Equation , Equal, Future performance, Greater, Higher, In-the-money, Less, Liquidity, Lower, Option, Ordinary Annuity, Out-of-the-money, Percentage, Perpetuity, Put, PV, Quick, Reduced, TIE, TATO, Trend Analysis, Writer 11. The payment or receipt of equal amounts, at the end of a series of equal periods, for a specified amount of time is called a(n) _______________. 12. When a loan is amortized over a five year term, the amount of interest paid is ________________ each year. 13. You have just won a $5 million lottery to be received in twenty annual equal payments of $250,000. What will happen to the present value of your winnings if the interest rate increases? It will be worth _________________. 14. The more frequent the compounding the _________________ the effective interest rate. 15. More frequent compounding results in _______________ future values and _______________ present values than less frequent compounding at the same nominal interest rate. 16. A(n) _______________ is a financial instrument that agrees to pay an equal amount of money per period into the indefinite future (i.e. forever). 17. A(n) _________________ is a contract which gives its holder the right to buy(or sell) an asset at some predetermined price within a specified period of time. 18. The seller of an option is called the option __________________. 19. An investor who writes call options against stock held in his or her portfolio is said to be selling _______________ options. 20. When the exercise price exceeds the current stock price, a call option is said to be _____________________; however, when the exercise price is less than the current price of the underlying stock, a call option is _________________. 21. An option which gives you the right to sell a stock at a specified price within some future period is called a(n) ______________ option.

FIN 401 Lecture Notes - Lecture 8: Call Option, Option Contract, Put Option

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