Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 22

Chapter 22Option Contracts

Questions to be answered:

• How are options traded on exchanges and in OTC markets?

• How are options for stock, stock indexes, foreign currency, and futures contracts quoted in the financial press?

• How can investors use option contracts to hedge an existing risk exposure?

Chapter 22Option Contracts

• What are the three steps in establishing the fundamental “no arbitrage” value of an option contract?

• What is the binomial (or two-state) option pricing model and in what ways is it an extension of the basic valuation approach?

• What is the Black-Scholes option pricing model and how does it extend the binomial valuation approach?

Chapter 22Option Contracts

• What is the relationship between the Black-Scholes and the put-call parity valuation models?

• How does the payment of a dividend by the underlying asset impact the value of an option?

• How can models for valuing stock options be adapted to other underlying assets, such as stock indexes, foreign currency, or futures contracts?

Chapter 22Option Contracts

• How do American- and European-style options differ from one another?

• What is implied volatility and what is its role in the contract valuation process?

Chapter 22Option Contracts

• How do investors use options with the underlying security or in combination with one another to create payoff structures tailored to a particular need or view of future market conditions?

• What differentiates a spread from a straddle, a strangle, or a range forward?

Derivatives

• Forwards– fix the price or rate of an underlying asset

• Options– allow holders to decide at a later date whether

such fixing is in their best interest

Option Market Conventions

• Option contracts have been traded for centuries

• Customized options traded on OTC market

• In April 1973, standardized options began trading on the Chicago Board Option Exchange

• Options Clearing Corporation (OCC) acts as guarantor of each CBOE -traded options

Price Quotations for Exchange-Traded Options

• Equity options– CBOE, AMEX, PHLX, PSE– typical contract for 100 shares– require secondary transaction if exercised– time premium affects pricing

Price Quotations for Exchange-Traded Options

• Stock index options– only settle in cash

• Foreign currency options– allow sale or purchase of a set amount of non-USD

currency at a fixed exchange rate– quotes in USD

• Options on futures contracts – Give the right, but not the obligation, to enter into a

futures contract on an underlying security or commodity at a later date at a predetermined price

The Fundamentals of Option Valuation

• Risk reduction tools when used as a hedge

• Forecasting the volatility of future asset prices– direction and magnitude

• Hedge ratio is based on the range of possible option outcomes related to the range of possible stock outcomes

• Risk-free hedge buys one share of stock and sells call options to neutralize risk

• Hedge portfolio should grow at the risk-free rate

The Binomial Option Pricing Model

• Two-state option pricing model– up movement or down movement– forecast stock price changes from one subperiod to

the next• up change

• down change

• number of subperiods

r

CpCpC jdjuj

1du

drp

The Binomial Option Pricing Model

njNjjNjN

jo rXSdupp

jjN

NC

,0max1

!!

!

0

njNjjNjN

mjo rXSdupp

jjN

NC

1

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!

jujd

jj CC

Sduh

The Black-Scholes Valuation Model

• Continuous changes rather than discrete

• Geometric Brownian motion– volatility factor, 21TT

S

S

210 dNeXdSNC TRFR

2121 5.0Sln TTRFRXd

2112 Tdd

The Black-Scholes Valuation Model

Value is a function of five variables:

1. Current security price

2. Exercise price

3. Time to expiration

4. Risk-free rate

5. Security price volatility

C = f(S, X, T, RFR, )

Estimating Volatility

• Mean and standard deviation of a series of price relatives

2

1

2

1

1

1

1

N

tt

N

tt

RRN

RN

R

Problems With Black-Scholes Valuation

• Stock prices do not change continuously

• Arbitrageable differences between option values and prices (due to brokerage fees, bid-ask spreads, and inflexible position sizes)

• Risk-free rate and volatility levels do not remain constant until the expiration date

Problems With Black-Scholes Valuation

• Empirical studies showed that the Black-Scholes model overvalued out-of-the-money call options and undervalued in-the-money contracts

• Any violation of the assumptions upon which the Black-Scholes model is based could lead to a misevaluation of the option contract

Option Valuation: Extensions and Advanced Topics

• Valuing European-style put options

• Valuing options on dividend-bearing securities

• Valuing American-style options

• Stock index options

• Foreign currency options

• Futures options

Option Trading Strategies

• Options are a leveraged alternative to making a direct investment in the asset on which the contract is based

• Put options could be used in conjunction with an existing portfolio to limit the portfolio’s loss potential

Option Trading Strategies

• Protective put options

• Covered call options

• Straddles, strips, and straps

• Strangle

• Chooser options

• Spreads

• Range forwards

The InternetInvestments Online

http://www.cboe.com/

http://www.optionmax.com

http://www.finance.wat.ch/cbt/options

http://www.coveredcall.com

End of Chapter 22–Option Contracts

Future topicsChapter 23

• Swap Contracts, Convertible Securities, and Other Embedded Derivatives