Financial Markets (Bilingual Teaching)
example, hedge commercial paper rate exposure with T-bills futures 3) Liquidity risk
? Price distortions if a contract is not widely traded ? Need a counterparty to close position 4) Credit risk
? Counterparty defaults
? Not a risk on exchange-traded contracts where exchange serves as the counter-party 5) Prepayment risk
? Assets (e.g. loans) prepaid sooner than their designated maturity
? Leaves hedger without an offsetting spot position in a speculative position 6) Operational risk
? Inadequate management or controls
? For example, hedging firm’s employees do not understand how futures contract values respond to market conditions ? Lack of controls may result in speculative positions
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Financial Markets (Bilingual Teaching)
Chapter 10Options Markets
1. Backgrounds of Options
1) Def. : An option contract grants the buyer, who has paid a
premium to the seller (writer), the right to buy or sell the underlying asset at a stated price within a specific period of time
? The premium paid to the writer is the cost of the option; Seller or writer of the option contract receives the premium up front; Has an ongoing obligation to sell (call) or buy (put) if the buyer decides to exercise the option contract
? Buyer has the ―option,‖ but not the obligation, to exercise the option
2) A call option buyer has right but not the obligation to buy
the underlying asset at a set exercise or ―strike‖ price for a specified period of time
? ―In-the-money‖ means the call option’s strike or exercise price is lower than the market price for the underlying financial instrument; The holder of the call can buy the stock at a price below the current market price; The call premium (price) of the option would also be higher by the
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Financial Markets (Bilingual Teaching)
―in-the-money‖
? At-the-money means the strike price equals the market price of the underlying asset
3) A put option buyer has the right but not the obligation to
sell the underlying asset at a set ―strike‖ price for a specified period of time; Put options give the investor an opportunity to make money from falling prices
? In-the-money means the put option’s strike or exercise price is higher than the market price for the underlying financial instrument; Investor has locked in a sale price, making the price of the option (premium) higher as the stock price decreases
? At-the-money means the strike price equals the market price of the underlying asset
4) Note components of an option: specific quantity of asset,
price, and time period
5) Current market price of the underlying asset or financial
instrument is called the spot price
6) Expiration is the date when the contract matures
? American-style options contracts can be exercised any time up until they expire; European-style options can only be exercised just before their expiration
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Financial Markets (Bilingual Teaching)
7) Option contracts guaranteed by a clearinghouse to make
sure sellers or writers fulfill their obligations 2. Speculating with Call Options
1) BUY A CALL: Speculator thinks a stock price will
appreciate above a particular strike price
2) Buyer of call pays premium for the right but not the
obligation to buy stock at the strike price
3) If the stock price appreciates above the strike price the
option contract is in-the-money and buyer of the call would exercise or sell the option at a price including the ―in-the-money‖ and a premium
4) If the stock price does not appreciate, buyer of the call does
not exercise and losses are limited to the cost of the premium—buyer able to share in appreciation without large investment
3. Speculating with Put Options
1) BUY A PUT: Speculator thinks a stock price will
depreciate below a particular strike price
2) Buyer of put pays premium for the right but not the
obligation to sell stock at the strike price
3) If the stock price depreciates below the strike price the
option contract is in-the-money and buyer of the put would
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Financial Markets (Bilingual Teaching)
exercise
4) If the stock price does not depreciate, buyer of the put does
not exercise and losses are limited to the cost of the premium
4. Determinants of Call Option Premiums 1) Market Price of the Underlying Asset
? The greater the current market price of the underlying asset compared to the exercise price, the higher the premium for a call option
? ―Under Water‖ option has less chance of being ―in-the-money‖ and the premium is less 2) Time to Maturity of the Option Contract
? the longer the time to maturity, the higher the premium; Owner will have increased chance for the option to be ―in-the-money‖ with more time available 3) Volatility of the Underlying Asset
? Greater volatility of the underlying financial asset means higher call option premiums; Volatile price means a higher chance price will go well above strike 5. Determinants of Put Option Premiums 1) Market Price of the Underlying Asset
? The lower the current market price of the underlying asset
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