chapter 14 options markets financial markets and institutions
DESCRIPTION
TRANSCRIPT
1
Chapter 14
Options Markets
Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
2
Chapter Outline
Background on options Speculating with stock options Determinants of stock option premiums Explaining changes in option premiums Hedging with stock options Using options to measure a stock’s risk
3
Chapter Outline (cont’d)
Options on ETFs and stock indexes Options on futures contracts Hedging with options on futures Institutional use of options markets Globalization of options markets
4
Background on Options
A call option grants the owner the right to purchase a specified financial instrument for a specified price (exercise or strike price) within a specified period of time Grants the right, but not the obligation, to purchase the specified
investment The writer of a call option is obligated to provide the instrument
at the price specified by the option contract if the owner exercises the option
A call option is: In the money when the market price of the underlying security
exceeds the strike price At the money when the market price is equal to the strike price Out of the money when the market price is below the strike price
5
Background on Options (cont’d)
A put option grants the owner the right to sell a specified financial instrument for a specified price within a specified period of time Grants the right, but not the obligation, to sell the
specified investment A put option is:
In the money when the market price of the underlying security is below the strike price
At the money when the market price is equal to the strike price
Out of the money when the market price is above the strike price
6
Background on Options (cont’d)
Call and put options specify 100 shares for stocks Premiums paid for call and put options are determined
through open outcry on the exchange floor Participants can close out their option positions by taking
an offsetting position The gain or loss is determined by the premium paid when
purchasing the option and the premium received when selling the option
American-style options can be exercised at any time prior to expiration
European-style options can be exercise only just before expiration
7
Background on Options (cont’d)
Markets used to trade options The CBOE:
Is the most important exchange for trading options Serves as the market for options on more than 1,500
different stocks Lists standardized options Accounts for about 51 percent of all option trading
Options are also traded on the AMEX, Philadelphia Stock Exchange, Pacific Stock Exchange, and the International Securities Exchange
8
Background on Options (cont’d) Markets used to trade options (cont’d)
Listing requirements Each exchange has its own requirements One key requirement is a minimum trading volume of the
underlying stocks Role of the Options Clearing Corporation (OCC)
The OCC serves as a guarantor on option contracts traded in the U.S.
Regulation of options trading The SEC and the various option exchanges regulate option
trading Regulations:
Are intended to ensure fair and orderly training Attempt to prevent insider trading Attempt to prevent price fixing among floor brokers
9
Background on Options (cont’d) How option trades are executed
Floor brokers execute transactions desired by investors
Some orders are executed electronically without a floor broker
Market-makers: Can execute stock option transactions for customers Trade options on their own account May facilitate a buy order for one customer and a sell order
for a different customer Earn the difference between the bid price and the ask price
for the option
10
Background on Options (cont’d) Types of orders
A market order results in the immediate purchase or sale of an option at the prevailing market price
With a limit order, the transaction will occur only if the market price is no higher or lower than a specified price limit
Online trading Many online brokerage firms, like E*Trade and
Datek, facilitate options orders
11
Background on Options (cont’d)
Stock option quotationsFinancial newspapers and some local
newspapers publish quotations for stock options (see next slide)
Options with higher exercise prices have lower call premiums and higher put premiums
Options with a longer maturity have higher call option premiums and higher put option premiums
12
Background on Options (cont’d)
Stock option quotations (cont’d)
Strike Exp. Vol. Call Vol. Put
McDonald’s 45 Jun 180 4 1/2 60 2 3/4
45 Oct 70 5 3/4 120 3 3/4
50 Jun 360 1 1/8 40 5 1/8
50 Oct 90 3 1/2 40 6 1/2
13
Speculating with Stock Options
Speculating with call options Call options can be used to speculate on the expectation of an
increase in the price of the underlying stock Assuming that the buyer of the option sells the stock when
exercising the option and that the writer will obtain the stock only when the option is exercised, the writer’s net gain is the buyer’s net loss, assuming zero transaction costs
The maximum loss for the buyer of a call option is the premium, while the maximum gain is unlimited
The maximum gain for the writer of a call option is the premium, while the maximum loss is unlimited
14
Speculating with Call Options
Pete expects ABC stock to increase from its current price of $90 per share. He purchases a call option on ABC stock with an exercise price of $92 for a premium of $4 per share. ABC stock rises to $97 prior to the option’s expiration date. If Pete exercises the option and immediately sells the shares in the market, what is his net gain from the transaction?
share per 1$4$92$97$
15
Speculating with Call Options (cont’d)Draw the contingency graph for the buyer of the call option and the writer of the call option.
-4
0 0
496
96
Buyer’s Perspective Writer’s PerspectiveProfit
Stock PriceAt Expiration
16
Speculating with Stock Options (cont’d) Speculating with call options (cont’d)
Assume that ABC stock has three call options available: Call option 1: Exercise price = $87; Premium = $7 Call option 1: Exercise price = $90; Premium = $5 Call option 1: Exercise price = $92; Premium = $4
The risk-return potential varies among the several options that are available
The contingency graph for all three options is shown on the next slide
The graph can be revised to reflect returns for each possible price per share of the underlying stock
17
Speculating with Stock Options (cont’d)
-4
096
Call option 3
Call option 2
95
-5
-7
94
Call option 1
Profit or LossPer Share
Stock Price of ABC Stock
18
Speculating with Stock Options (cont’d) Speculating with put options
Put options can be used to speculate on the expectation of a decrease in the price of the underlying stock
The maximum gain for the buyer of a put option is the exercise price less the premium, while the maximum loss is the premium
The maximum loss for the writer of a put option is the exercise price less the premium, while the maximum gain is the premium
19
Speculating with Put Options
Mary expects XYZ stock to decrease from its current price of $54. Thus, she purchases a put option on XYZ stock with an exercise price of $53 and a premium of $2. If the stock price of XYZ stock is $47 when the option expires, what is Mary’s net gain?
share per 4$2$47$53$
20
Speculating with Put Options (cont’d)Draw the contingency graph for the buyer of the put option and the writer of the put option.
-2
0 0
251 51
Buyer’s Perspective Writer’s PerspectiveProfit
Stock PriceAt Expiration
51
51
21
Speculating with Stock Options (cont’d) Excessive risk from speculation
Firms should closely monitor the trading of derivative contracts by their employees to ensure that derivatives are being used within the firm’s guidelines
Firms should separate the reporting function from the trading function so that traders cannot conceal trading losses
When firms receive margin calls on derivative positions, they should recognize that there may be potential losses on their derivative instruments
22
Determinants of Stock Option Premiums The option premium must be sufficiently high to
equalize the demand by buyers and the supply that sellers are willing to sell
Determinants of call option premiums Influence of the market price
The higher the existing market price of the underlying financial instrument relative to the exercise price, the higher the call option premium
Influence of the stock’s volatility The greater the volatility of the underlying stock, the higher the
call option premium Influence of the call option’s time to maturity
The longer the call option’s time to maturity, the higher the call option premium
23
Determinants of Stock Option Premiums (cont’d) Determinants of put option premiums
Influence of the market price The higher the existing market price of the underlying
financial instrument relative to the exercise price, the lower the put option premium
Influence of the stock’s volatility The greater the volatility of the underlying stock, the higher
the put option premium
Influence of the put option’s time to maturity The longer the call option’s time to maturity, the higher the
put option premium
24
Explaining Changes in Option Premiums Economic conditions and market conditions can cause
abrupt changes in the stock rice or in the anticipated volatility of the stock price This would have a major impact on the stock option premium
Indicators monitored by participants in the option market Option market participants closely monitor the indicators that
are monitored for stocks: Economic indicators, industry-specific conditions, firm-specific
conditions
25
Hedging with Stock Options
Mutual funds, insurance companies, and pension funds manage large stock portfolios and use options on stocks and stock indexes to hedge
Hedging with call options A covered call involves the sale of a call option with
a simultaneous long position in the stock
26
Writing A Covered Call
Philly Mutual Fund owns 100 shares of ABC stock. Philly believes that the stock price will decline temporarily from its current price of $90, but does not want to liquidate its position because of transaction costs. Consequently, Philly writes one call option on ABC stock with an exercise price of $88 and a premium of $6. Construct a contingency graph showing Philly’s position with covered call writing and without covered call writing.
27
Writing A Covered Call (cont’d)
With Covered Call Writing
0
3
8885
Without Covered CallWriting
90
28
Hedging with Stock Options (cont’d) Hedging with put options
If an institution with a long position in a stock is concerned about a decline in the stock price, it could hedge against a temporary decline by purchasing put options on that stock
Put options are typically used to hedge when portfolio managers are concerned about a temporary decline in a stock’s value
29
Using Options to Measure a Stock’s Risk Stock options can be used to drive the
market’s anticipation of a stock’s standard deviation over the life of the option The option-pricing model can be used to derive the
implied standard deviation of a stock The implied standard deviation increases when a
firm experiences an event that creates more uncertainty
30
Options on ETFs and Stock Indexes An ETF option provides the right to trade a
specified ETF at a specified price by a specified expiration date Since ETFs are traded like stocks, options on ETFs
are traded like options on stocks Investors who exercise a call option on an ETF
would receive delivery of the ETF in their account
31
Options on ETFs and Stock Indexes (cont’d) A stock index option provides the right to trade a
specified stock index at a specified price by a specified expiration date Options are offered on the S&P 100 index, the S&P 500 index,
S&P SmallCap 600 Index, Dow Jones Industrial Average, Nasdaq 100 Index, Goldman Sachs Internet Index, among others
If an index option is exercised, the cash payment is equal to a specified dollar amount multiplied by the difference between the index level and the exercise price
Speculators who anticipate a sharp increase in the stock market would purchase call options on an index
Speculators who anticipate a decrease in the stock market would purchase put options on an index
32
ETFs for Which Options Are Traded Indexes for Which Options Are Traded
iShares Nasdaq Biotechnology Asia 25 Index
iShares Goldman Sachs Technology Index Euro 25 Index
iShares Goldman Sachs Software Index Mexico Index
iShares Russell 1000 Index Fund Dow Jones Industrial Average
iShares Russell 1000 Value Index Fund Dow Jones Transportation Average
iShares Russell 1000 Growth Index Fund S&P 100 Index
Energy Select Sector SPDR S&P 500 Index
Financial Select Sector SPDR S&P SmallCap 600 Index
Utilities Select Sector SPDR Nasdaq 100 Index
Health Care Select Sector SPDR Russell 1000 Index, etc.
33
Options on ETFs and Indexes (cont’d) Hedging with stock index options
Portfolio managers consider purchasing put options on a stock index to protect against stock market declines
The put options should be purchased on the stock index that most closely mirrors the portfolio to be hedged
The greater the market downturn, the greater the decline in the market value of the portfolio, but the greater the gain from holding put options on a stock index
Hedging with long-term stock index options Long-term equity anticipations (LEAPs) have expiration dates
at least two years ahead with a lower premium
34
Options on ETFs and Indexes (cont’d) Dynamic asset allocation with stock index options
Dynamic asset allocation involves switching between risky and low-risk investment positions over time in response to changing expectations
e.g., portfolio managers purchase call options under favorable conditions and put option under unfavorable conditions
e.g., write call options when the stock market is expected to be very stable
Portfolio managers can select the exercise price that provides the desired protection
e.g., buy put options with an exercise price of 380 if the current level of the index is 400 and a 5 percent loss is acceptable
35
Options on ETFs and Indexes (cont’d) Using index options to measure the market’s
risk A stock index’s implied volatility can be derived from
information about options on that stock index Impact of the September 11 Crisis on the implied
volatility of stock indexes The attacks caused more uncertainty about the future
value of stocks Implied volatility increased when the markets reopened on
September 17
36
Options on Futures Contracts
An option on a futures contract allows the right to purchase or sell that futures contract for a specified price within a specified period of time Options on futures grant the power to take the
futures position if favorable conditions occur but the flexibility to avoid the future position if unfavorable conditions occur
Options are available on stock index futures and on interest rate futures
37
Options on Futures Contracts (cont’d) Speculating with options on futures
Speculation based on an expected decline in interest rates
Speculators may consider purchasing a call option on Treasury bond futures
When interest rates decline, buyers of call options would sell the option just before expiration
If interest rates rise, buyers of call options will let the options expire
Speculators who expect interest rates to remain stable or decline could sell put options on Treasury bond futures
38
Speculating on a Decrease in Rates with Options on Futures Kevin Phelps expects interest rates to decline and purchases a call option on Treasury bond futures with an exercise price of 92–40. The option has a premium of 2–00. Shortly before the expiration date, the price of Treasury bond futures rises to 95–00. Kevin exercises the option and closes out the position by selling an identical futures contract. What it is net gain from this strategy?
%75.18
000,2$
375$ROI
375$000,2$625,92$000,95$gain Net
39
Options on Futures Contracts (cont’d) Speculating with options on futures (cont’d)
Speculation based on an expected increase in interest rates
Speculators who expect interest rates to increase could purchase a put option on Treasury bond futures
If interest rates rise, the speculator can exercise the option to sell futures at the exercise price and purchase futures at a lower price than the price at which they sold futures
If interest rates decline, the speculators will let the options expire
Speculators who anticipate an increase in interest rates may consider selling call options on Treasury bond futures
40
Speculating on an Increase in Rates with Options on Futures Barnie Blythe expects interest rates to increase and purchases a put option on Treasury bond futures with an exercise price of 98–00 and a premium of 2–00. Just prior to the expiration date, the price of Treasury bond futures is valued at 94–12. What is Barnie’s net gain from this strategy if he exercises the option and closes out the position by purchasing an identical futures contract?
%63.90
000,2$
50.812,1$ROI
50.812,1$000,2$50.187,94$000,98$gain Net
41
Hedging with Options on Futures
Hedging with options on interest rate futures Financial institutions commonly hedge bond or mortgage
portfolios using options on interest rate futures The position is designed to create a gain that can offset a loss
on the bond or mortgage portfolio Put options on futures offer more flexibility than selling futures
but require a premium Institutions wishing to hedge against interest rate risk should
compare outcomes from selling futures contract versus buying put options on interest rate futures
42
Hedging with Options on Futures (cont’d) Hedging with options on stock index futures
The position taken on the options contract is designed to create a gain that can offset a loss on the stock portfolio
Determining the degree of the hedge with options on stock index futures
The higher the strike price relative to the prevailing index value, the higher the price at which the investor can lock in the sale of the index, but the higher the premium
Selling call options to cover the cost of put options Selling call options can generate some fees to help cover the cost
of purchasing put options
43
Institutional Use of Options Markets
Options positions are sometimes taken by financial institutions for speculative purposes, but more commonly for hedging
Savings institutions and bond mutual funds use options on interest rate futures to hedge interest rate risk
Stock mutual funds, insurance companies, and pension funds use stock index options and options on stock index futures to hedge stock portfolios
44
Institutional Use of Options Markets (cont’d) Options as compensation
Some institutions distribute call options on their own stock to their managers as compensation
Managers may have an incentive to make decisions that increase the stock’s value
Distortion between performance and option compensation Many option compensation programs do not account for general
market conditions e.g., managers who received option during the 2001–2002 period
may have earned low compensation even if their firm performed relatively well
45
Institutional Use of Options Markets (cont’d) Options as compensation (cont’d)
How stock option compensation can destroy shareholder value Managers may be enticed to manipulate the stock’s price upward in
the near future even if it adversely affects the stock price in the future e.g., use accounting methods that defer expenses and accelerate
revenue reporting Reporting option compensation as an expense
The FASB has been unwilling to require firms to report this expense on the income statement
Earnings will appear higher when a firm uses stock options to compensate its managers
46
Globalization of Options Markets
Options on stock indexes of various countries are available The existence of options on foreign stock indexes allows portfolio
managers to hedge or speculate based on forecasts of foreign market conditions
Currency options contracts A currency call option provides the right to purchase a specified
currency for a specified price within a specified period of time A currency put option provides the right to sell a specified currency
for a specified price within a specified period of time Corporations use currency options to hedge foreign payables and
receivables Speculators purchase put options on currencies they expect to
weaken against the dollar