Unit 16

Options Contract Definition

A contract through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period Each option represents 100 shares of underlying stock

Differences between American and European style options

American style means the option can be exercised at any time the holder wishes, up to the expiration date. European-style options may only be exercised on the last trading day before the expiration date.

When contrasting preemptive rights and warrants, it would be correct to state that, at issuance, A) rights have intrinsic value while warrants have intrinsic and time value. B) rights have intrinsic and time value while warrants only have time value. C) rights have intrinsic and time value while warrants only have intrinsic value. D) rights have time value while warrants have intrinsic and time value.

B. At the time of issuance, preemptive rights always offer the stock at a price below the current market thus creating intrinsic value. Although rights rarely are effective for longer than 45-60 days, that does represent time value. On the other hand, warrants are always issued with an exercise price above the current market (no intrinsic value) but do have time value. U16LO3

Straddle

Buyer profits from stock price volatility Seller profits from stock price staying stable

Strategy for Put options

Buying -Bearish strategy -Profit if the underlying stock's price decreases Selling -Neutral to bullish strategy -If stock price rises, option expires -Income strategy -Writer keeps premium

Strategy for call options

Buying -Bullish strategy -Profit if the underlying stock's price rises Selling -Neutral to bullish strategy -If stock price falls, option expires -Income Strategy -Writer keeps premium

Risks of forwards/futures

Counter-party risk (forwards) Lack of liquidity (forwards) Daily margin (futures) Guess wrong

In contrast with a typical forwards contract, futures contracts have: A) greater counter-party risk. B) nonstandard terms. C) less liquidity. D) standardized terms.

D. Futures are contracts that trade on exchanges and have standardized terms, in contrast with forwards contracts, which are customized instruments. A futures clearinghouse reduces counter-party risk by guaranteeing the performance of buyers and sellers. Because futures contracts trade on organized exchanges and have standardized terms, they are more liquid than forwards contracts. U16LO4

Warrant

Don't need to be existing shareholder Grant the owner the right to purchase securities from the issuer at a specified price -Long term -Issued with exercise price above CMV Often offered as a sweetener with bonds or preferred stock to increase marketability Rights and warrants are considered derivatives because their value is derived from the underlying security No voting rights

Right

Issued to existing shareholders Subscription rights/Stock rights -Right to maintain percentage ownership -Short term 45-60 days -Exercise if below market or sell -Purchase price below current market value -Rights can be sold They are given (not sold) to existing holder of the common stock. If not used they will expire

Benefits of forwards/futures

Limit future price risk Lock in profit expense

Risks of using options

Long -Guess wrong - Lose most or entire premium paid -Time decay - option expires -Inability to exercise -European style - exercise only at expiration -American style - exercise any time Short -Profit generally limited to premium received -Have no choice if option is exercised -Uncovered call has unlimited risk

Customer forward or futures positions

Long (buyer takes) -Obligated to take delivery Short (seller makes) -Obligated to make delivery

Benefits of using options

Long position -Leverage increases return percentage -Less capital at risk -Long put has less risk than short stock sale -Insurance (hedging) Short position -Income from the premium -Partial hedge -Call hedges long stock position to extent of premium -Put hedges short stock position to extent of premium

Call

Not issued by underlying asset

Options Contract - Seller's obligation

Obligation to buy or sell securities Shorts the position Receives the premium

Put

Owner has right to sell stock Seller has obligation to buy

Call options

Owner has the right to buy stock Seller has obligation to sell

Options contract - Buyer's right

Owns the right to purchase or sell the securities Long the position Pays premium

Forward Contracts (Commitments)

Two party contract -Primarily between grower and producer Non-liquid Non-standardized Terms negotiated

Standardized terms of an option contract

Underlying asset Expiration month -LEAPS may be written for up to 39 months, all others a maximum of nine months -Long-term Exercise (strike) price

Cost of using options

Commissions to buy or sell

Future Contracts

Exchange traded If the seller does not own the commodity, his potential loss is unlimited because he has promised delivery and must pay any price to acquire the commodity to deliver. May be highly leveraged Futures are most commonly used by speculators while forwards are used by producers.

The five components of a typical forward contract

quantity of the commodity quality of the commodity time of delivery place for delivery price to be paid at delivery