3rd Exam 480
Option Price =
Intrinsic Value + Time Value
Option has two parts:
Intrinsic value - the value of the option if it is exercised immediately, and Time value of the option - the fee paid for the option's potential benefits.
Marking to Market
The clearing corporation also posts daily gains and losses on the contract to the margin account of the parties involved money is transferred from the winner to the loser Doing this each day ensures that sellers always have the resources to make delivery and buyers can always pay If someone's margin account falls below the minimum, the clearing corporation will sell the contracts, ending the person's participation in the market.
Notional Principle
agreed upon principle paid to switch interest rates
The intrinsic value of a put...
equals the strike price minus the market price of the underlying asset, or zero - which ever is greater.
What amount of time makes an option more valuable (more or less)
more
For an out of the money call the intrinsic value to the holder
no intrinsic value
Options transfer risk from
the buyer to the seller, so can be used for both hedging and speculation.
Time Value of the options
the fee paid for the option's potential benefits.
Derivatives are different from outright purchases because:
1) provide an easy way for investors to profit from price declines 2) derivatives transaction, one person's loss is always another person's gain
The option writer can take a large loss, so who does this?
1. Speculators willing to take the risk and bet that prices will not move against them. 2. Dealers called market makers who engage in the regular purchase and sale of the underlying asset.
Derivative Definition
A financial instrument whose value depends on, is derived from, the value of some other financial instrument (underlying asset)
Forward or Forward Contract Definition
An agreement between buyer and seller to exchange a commodity or financial instrument for a specified amount of cash on a prearranged future date Very difficult to resell - no central market
Suppose the market price of a bond is below the futures contract price
Buy the bond at the low price and sell a futures contract at the higher price, the difference is risk-free profit
Naked Options
Extremely risky --> you don't own the asset
Calculating Time Value
For a call option, we take the probability of a favorable outcome (a higher price), times the payoff. Increasing the standard deviation of the stock price, an increase in volatility, increases the option's time value
Two Types of Swaps
Interest Rate Credit Default
Market Makers Both
Own the underlying asset so they can deliver it, and Are willing to buy the underlying asset so they have it ready to sell to someone else
Swaps Definition
Swaps are contracts that allow traders to transfer risk just like other derivatives.
High volatility on options
The more variability there is in the asset's price, the more chance it has to move into the money. Therefore the option's time value increases with volatility in the price of the underlying asset. Increased volatility has no cost to the option holder - only benefits.
Define Arbitrage
The practice of simultaneously buying and selling financial instruments in order to benefit from temporary price difference
Purpose of Derivatives
To transfer risk from one person or firm to another Pro: derivatives increase the risk-carrying capacity of the economy as a whole Con: derivatives also allow individuals and firms to conceal the true nature of certain financial transactions
Credit Default Swaps (CDS)
a form of insurance that allow a buyer to own a bond or mortgage without bearing its full default risk
Interest Rate Swaps
allow one swap party to alter the stream of payments it makes or receives agreements between two counter parties to exchange periodic interest-rate payments over some future period, based on an agreed-upon amount of principal, called the notional principal
Forwards and Futures: Short Position benefits...
from declines in the price of the underlying asset
Forwards and Futures: Long Position benefits...
from increases in the price of the underlying asset
Future or Futures Contract Definition
is a forward contract that has been standardized and sold through an organized exchange The contract specifies that the seller (short position) will deliver some quantity of a commodity or financial instrument to the buyer (long position) on a specific date, called the settlement or delivery date, for a predetermined price
For in the money Call the intrinsic value to the holder is...
is the market price of the underlying asset minus the strike price.
Clearing Corporation: Futures and Forwards
operates like a large insurance company and is the counter party to both sides of the transaction They guarantee that the parties will meet their obligations lowers the risk buyers and sellers face
The clearing corporation requires both parties to a futures contract to place a deposit with the corporation. This is called...
posting margin in a margin account. This guarantees when the contract comes due, the parties will be able to meet their obligations
Speculators are betting on the prices of futures where the seller is betting...
that prices will fall (because they'd be guaranteed more)
Speculators are betting on the prices of futures where the buyer is betting...
that prices will rise (because they'd buy at a discount)
As long as there are arbitrageurs, on the day when a futures contract is settled
the price of a bond futures contract will be the same as the market price - or spot price - of the bond
Intrinsic Value
the value of the option if it is exercised immediately