Chapter 9

Future/ Future contract

(big in the commodities market, used by ranchers and farmers a lot- unknown factors in harvest yield => ex. hurricane in south impacts corn fields)

Clearing corporations guarantee the obligation embodied in the option * Those of the option writer) are/ can be met

- Option write is required to post margin - Option holder incurs no obligation

Options transfer risk from the buyer to the seller, used for...

-Hedging -Speculation -If you want to purchase an asset in the future, a call option ensure that the cost of buying the asset will not rise -If you want to sell an asset in the future, a put option ensures that the price of the asset will not decrease

Investors only need the margin to purchase a future contracts Typically the margin is ______ or less of the underlying asset

10%

Credit Default Swaps (CDS)

A form of insurance that allows a buyer to own a bond or mortgage without bearing its full default risk This allows lenders to insure themselves against default risk

FORWARD/ forward contract

Agreement between buyer and seller to exchange a commodity or financial instrument for a specified amount of cash on a pre-arranged future date. Customized (so they are hard to sell)

American Option vs. European Option

American can be exercised on any date from the time they're written to the expiration date European can be exercised only on day it expires

two types of calls and puts

American option European option

Interest Rate Swap

An agreement between 2 counter parties to exchange periodic interest rate payments over some future period based on an agreed upon amount of principal (the notional principal)

On the settlement date, the price of futures contract must equal price of the underlying asset the seller is obligated to deliver

As long as there are arbitragers the price of a bond futures contract will be the same as the market (or spot) price of the bond

When the price of a stock is:Equal to the strike price

At the money

Why worth at least $15 ?

Because now we have the right to sell 100 shares at $690 even though the current price is only $675 Your put option is in the money

Why $10?

Because you have the right to buy the shares at $40 when everyone else has to pay the market price of $50. So the right is worth $10 (it's intrinsic value would be $10)

Using options: If you think that interest rates will fall, you can...

Buy a bond, but that's expensive Buy a future contract taking a long position, low investment with high risk Buy a call option that only pays off if the interest rates fall

Option Holder is the

Buyer

The option writer (seller) is obligated to sell shares/securities of the ________ option, and the option holder (buyer) has the option to ______ shares securitities

Call Buy

Purpose of clearing corporation

Clearing corporation guarantees that the parties meet their obligations Also ensue that there is lower risk involved for the two parties Work as monitors and incentivizors

What is posting margin in a margin account?

Clearing corporations require both parties of futures contracts to place a deposit with them Guarantees that when a contract becomes due, the parties will be able to meet their obligations

Go back and look at the chart now (IMPORTANT)

Do it

market makers

Engage in regular market participation of the underlying assets Own underlying assets so they can deliver it to the option users Willing to buy the underlying assets so they have it ready to sell to someone else Writing a call option (as the underlying asset owner) that obligates you to sell it at a fixed price is not that risky Market makers write options to get fees from the buyers Market makers want to ensure that markets clear

Time Value of an option

Fee paid for the options potential benefits *Option value= intrinsic value + Time value

Derivative Definition

Financial instrument whos value depends on, and is derived from the value of some other financial instrument called the underlying asset.

Future/Future Contract details

Forward contract that has been standardized and sold through an organized exchange No payments are made when the contract is agreed upon Two parties make an agreement with a clearing corporation Hedging and Speculating Margin accounts and marking to market

Types of Derivatives

Forwards, futures, options, swaps

___________ volatility has no cost to the option holder, only benefits

Increased

floating interest rate

Interest rate will change over time, want to get rid of the risk so someone offers you a fixed interest rate and they'll pay all of your floating interest payments.

Pricing Options: Options have two parts

Intrinsic value Time value of option

For a call options an in the money call...

Intrinsic value to holder = market price of the underlying asset - Strike price

True/False: An at the money or out of the money call has intrinsic value

No an at the money or out of the money call does not have intrinsic value

PUT OPTION: - Suppose it's March 1st, AAPL is at $700.00 per share and you know that AAPL earnings and profits are going to be down when they're released tomorrow - You can buy AAPL March put option contract for $2.00 (per share), or $200 per contract Scenario 1: - News comes out and AAPL sales were terrible, so the price of AAPL drops to $675 per share

Now your $690 put option will be priced at $15.00 (or more) and you can sell it for $1,500.00 ($15 per share * 100 shares), making a $1,300.00 profit ($1,500 - $200)

Simple example of interest rate swap

One party agrees to make payments based on a fixed interest rate and in exchange the counterparty agrees to make payments based on a floating interest rate

Risk of Interest Rate Swaps

One party could default Not very risky because the other side can enter into an agreement to replace the one that failed

Buyers of futures are betting that prices will _________

RISE

Derivatives can ________ risk One persons _______ is another persons _________. (Zero Sum) Used as ______ against __________ _____________>

Reduce loss, gain insurance, future events

Option Writer is the

Seller

Examples of underlying assets

Stocks Bonds Wheat Snowfall (using the weather patterns to bet on)

For a call

Take the probability of a favorable outcome (higher price) * payoff Increasing the standard deviation of the stock price increases the options time value

Example 2- if the price of a specific bond is higher in one market than the other

The arbitrager can buy at the low price and sell at the high price This increases demand in one market and supply in another Increase in demand raises the price in that market This increase in supply lowers the price in the other market This cycle continues until prices are equal in both markets

Trade one call option contract of Microsoft (MSFT) with a strike price of $40 which expires in 2 months Priced at $2.00 per share Which costs $200 per contract Trading or buying one call option contract of MSFT gives the right to buy 100 shares of MSFT at $40 per share anytime between now and the 3rd Friday in the expiration month Scenario 1: MSFT goes to $50

The call option to buy MSFT at a strike price of $40 will be priced at least $10, or $1000 per contract

Scenario 2: MSFT stays at $40 Trade one call option contract of Microsoft (MSFT) with a strike price of $40 which expires in 2 months Priced at $2.00 per share Which costs $200 per contract Trading or buying one call option contract of MSFT gives the right to buy 100 shares of MSFT at $40 per share anytime between now and the 3rd Friday in the expiration month

The option is at the money It will expire worthless The option holder will have lost only the $200 cost that was paid for the 1 option contract

Scenario 3: MSFT drops below $40 Trade one call option contract of Microsoft (MSFT) with a strike price of $40 which expires in 2 months Priced at $2.00 per share Which costs $200 per contract Trading or buying one call option contract of MSFT gives the right to buy 100 shares of MSFT at $40 per share anytime between now and the 3rd Friday in the expiration month

The option is out of the money There is no reason to exercise the option The option holder will do nothing and only incur a $200 cost paid for 1 option contract

Example: a July 2016 call option on 100 shares of Apple stock at a strike price of $100 gives the option holder the right to buy 100 shares of Apple stock for $100 each prior to the 3rd Friday of July 2016

The writer of a call option must sell the shares if and when the holder chooses to use it The holder of the call is not required to buy the shares → they have the option if it is beneficial

Contractual agreement between two investors that obligates one to make a payment to the other, depending on the movement of interest rates over the next year.

This is an interest rate futures contract

T/F: Option contracts typically come in bundles of 100 shares

True

Intrinsic value:

Value of the option if it is exercised immediately

Intrinsic Value:

Value of the option if it were to be priced today

Why do clearing corporations "mark the market"

We do this because it ensures that sellers always have the resources to make delivery and buyers can always pay (daily) If someone's margin account falls below the minimum, the clearing corporation will sell the contracts ending the persons participation in the market

Call is _________ line, put is __________ line

above below

who uses interest rate swaps

banks and governments debt managers

The longer the time to expiration, the ________ the likely payoff when the option does expire and therefore the _______ valuable it is

bigger more

When the tApple stock price exceeds the option strike price of $100, the option holder can either ______ _______ (buy) the 100 shares by executing the option or _________ the option for a profit

call away sell

(Buyer of CDS): If the lendee __________ , the seller of the CDS agrees to pay the buyer (the amount defaulted)

defaults

When the price of a stock is: Above the strike price, then ...

exercising the option is profitable and the option is said to be "in the money"

time value=

expected present value of the payoff

Sellers of futures are betting that prices will ________

fall

Put Options definition

gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date The writer of the option is obliged to buy the shares should the holder choose to exercise the option This means if you think the price of a stock is going to decrease, you buy a put option. When the stock price decreases, it's worth less in the market and you are able to sell it for more

Coins example for arbitrage

gold coins are worth a dollar and banks send gold coins for a dollar for dollar exchange, someone max out their credit card to buy all the gold coins and are getting a 1-5% return and then take gold coins back to bank to receive money to pay off credit card debt This earns them free money just for using their credit card

marking to market

in the futures market, a daily settlement in which the exchange transfers funds from a buyer's account to a seller's account or vice versa, depending on changes in the price of the contract

When the price of a stock is: Below the strike price

out of the money

Arbitrage

practice of simultaneously buy and selling financial instruments in order to benefit from temporary price differences ( Arbitragers)

If you're wrong and interest rates _______, you only incur the cost of the rice of the option

rise

Option definition: An agreement between two parties where the ________ is an option writer and the ________ is an option holder

seller buyer

For a put option...Intrinsic value to holder=

strike price - market price of the underlying asset or zero (whichever is greater)

The option writer wins when:

the option is not exercised

Call Options

the right to buy a given quantity of an underlying asset at a predetermined price (strike/exercise price) on or before a specific date

Purpose of a derivative is to:

transfer risk from one person or firm to another.

The likelihood that an option will pay depends on the ____________ of the price of the underlying asset

volatility