Chapter 12: Financial Instruments II (Derivatives)

Variables affecting option value

1. the current stock price 2. the strike price 3. time to maturity 4. the volatility (variance) of the underlying stock price 5. the risk-free rate 6. dividend yield

At-the-money option

At-the-money option is when the strike price equals the asset price such that an exercise of the option yields no profit or loss for the holder or issuer outside of the option premium paid: that is, S = X.

Black-Scholes formula

Black-Scholes formula is the mathematical formula that calculates the theoretical value of an option.

Call option

Call option is a derivative that grants the right but not the obligation to buy a specified asset at a specified strike price by a specified maturity or expiration date.

Derivative

Derivative is a financial instrument whose value derives from​ some other thing, the most common derivatives being futures and options. A derivative is a security instrument that derives its value from some other thing. In simple terms, it is a financial bet on the future value of a thing. Accordingly, a derivative transaction is always a zero sum transaction, meaning that a winner's gain of x is always matched by a loser's loss of x. The "thing: bet upon can be anything: plain vanilla derivatives can be tied to publicly traded stocks or bonds or market indices, but exotic derivatives can be tied to the weather, political developments, or other exotic securities.

Exercise value

Exercise price is the price at which a holder of an option can exercise the right to buy or sell an asset from or to the writer of the option. For example, a call option with an exercise price of $100 gives the option holder the right to buy the specified asset​ for $100, irrespective of market price, by the maturity date of the option.

Forward contract

Forward contract is a customized, non-exchange traded derivative where two parties agree to transact for the purchase and sale of an underlying asset in the future for a specific price. Unlike an option, a forward or futures contract obligates the parties to execute the contract at the agreed-upon​ maturity date, though the parties can settle by paying the cash difference rather than actually exchanging the physical asset.

Futures contract

Futures contract is a standardized, exchange-traded derivative (meaning that contract terms and the underlying asset are standardized and set by the rules of an exchange) where two parties agree to transact for the purchase and sale of an underlying asset in the future for a specific price.

Hedging

Hedging is the process of reducing or eliminating the exposure to a particular risk. It is typically accomplished through​ the use of derivatives.

Holder

Holder is the purchaser of an option.

In-the-money option

In-the-money option is an option that, if exercised, would result in a gain to the option holder and thus could be exercised at the specific point in time. For a call option, it means that the strike price is less than the asset price (S > X). For a put option, it means that the strike price is more than the asset price (X > S).

Issuer (writer)

Issuer (writer) is the seller of an option in a derivative transaction.

Important Derivatives Terms (F.Y.I.)

Issuer or writer: The person who issues at the option contract to the holder, and thus is obligated to purchase or sell an asset at maturity if the holder exercises the option. Holder: The person who has the right, but not the obligation, to purchase or sell an asset at maturity upon the payment of an option premium to the issuer. Long: The term used to denote the purchase of a security, or the purchase of a financial option. The long position is held by the buyer. Short: The term used to denote the sale of a security or the sale of a financial option. Th short position is held by the seller.

Long position

Long position is the position in a financial transaction representing the purchase of the security or asset.

Option

Option is a derivative that grants the right but not the obligation to buy or sell a specified​ asset for a specified strike price by a specified maturity or expiration date. Options are fundamentally divided into call options and put options.

Out-of-the-money option

Out-of-the-money option is an option that, if exercised, would result in a loss to the option holder and thus would not be exercised. For a call option, it means that the strike price is greater than the asset price (X > S). For a put option, it means that the strike price is less than the asset price (S > X).

Put option

Put option is a derivative that grants the right but not the obligation to sell a specified asset for a specified strike price by a specified maturity or expiration date.

Put-call parity

Put-call parity is the mathematical relationship between the values of the call option and the put option, the exercise price, and the asset price. It is stated as: the stock price S plus the price of the put option P must equal the call option C plus strike price X discounted to present value. S+P = C+(X/(1+R)^T)

Option contract terms

S = current price of the asset X = strike price P = writer's option premium T = time

Short position

Short position is the position where an investor has sold the financial asset.

Uses of Derivatives

Speculation: increase the leverage in a transaction for the purchase of the underlying assets. The same amount of money that can be used to invest in the underlying asset can be used in a derivative transaction to control far greater quantities of the underlying asset. Hedging: sell unwanted risk to another

Strike price

Strike price is the price at which the holder of a call option can buy an asset from the issuer, or the price at which the holder of a put option can sell an asset to the issuer.

Swap

Swap is a financial transaction in which one party will "swap" some asset or thing with a counterparty for some other asset or thing. Typical swaps are interest rate swaps and currency swaps. In an interest rate swap, two parties will swap a variable rate interest obligation for a fixed rate obligation. In this way, a party who is exposed to the risk of variable interest rates will obtain a fixed interest rate. In a currency swap, two parties will swap​ currencies. In this way, a party wp des not wish to be exposed to a particular currency can eliminate the risk by swapping with the desired currency held by a counterparty.

American option

The option to purchase the asset at any time up to the maturity is called the "American option."

European option

The option to purchase the asset only at the maturity date is called a "European option."

Volatility

Volatility - see "variance." In more general usage, volatility connotes the quality of variance in the market price of an asset or index.