OPTION PRICING Lecture 1 Introduction What

OPTION PRICING

Lecture 1: Introduction

What is an option ? u A security, which gives the owner the right, but not the obligation, to buy (sell) an asset for a specific price at a future point in time

History u Options (standardized) based on stocks were for the first time traded in 1973 at Chicago Board of Options Exchange (CBOE). u Standardized options came to Europe (Amsterdam) in 1978. u Suomen Optiomeklarit (SOM) started trading in a larger scale in Finland 2. 5. 1988.

u Trading in options has been by far largest in FOX-options (FOX=Finnish Options Index), consisting of the 25 most traded stocks on Helsinki stock exchange, weighted by their share of the turnover. u The FOX-basket is updated every six months.

Terminology u Call option: gives the holder the right, but not the obligation to buy a specific stock in the future. u Put option: gives the holder the right, but not the obligation to sell a specific stock in the future. u American option: can be exercised any time before the day of expiration. u European option: can be exercised only on the day of its expiration.

u Striking price: the price at which one has the right to buy (sell) the underlying asset. (We will during the course discuss european options)

Applications of Options u Option pricing u Firm valuation (leveraged) u Capital budgeting u Other applications (Insurance valuation etc. )

Opportunities enabled with options u Better possibilities to make investments according to investors’ risk and return preferences. u The increasing possibilities to choose investment strategies are also increasing the need for better knowledge of the different financial instruments.

Options have two main functions on the market: 1. Give protection against the risk in stock ownership. With a small capital investment in options You can control the risk of a large position in a stock (or portfolio). 2. Option prices tend to change very much (High volatility). Risk lovers can make huge and quick profits.

An intuitive example: Buy: 100 call options on Kymmene Striking price: 135 mu Current stock price: 132 mu Call option price: 1 mu/share.

Two possible outcomes: • • If the price of Kymmene on due date is 135 mu or less, the call option is worthless and you lose your investment (1 mu*100 call options=) 100 mu. The option is “out of the money”.

2. Stock price on due date 140 mu. u Recall that the Striking Price is 135 mu Buy 100 shares 13 500 mu (100 * striking price) Sell 100 shares 14 000 mu Profit + 500 mu Options - 100 mu Net profit + 400 mu u This option is “in the money”.

u The most important feature of an option is its ability to generate huge profits with a small investment (leverage). u If You had bought a put option in the above example, You would have profited only when the stock price had fallen below the striking price.

The parties of an option contract: There are two parties in each option contract: u The one who buys the option (Long position) u The one who writes the option (Short position)

Example (cont. on the previous example) The option writer got 100 mu for the call option contracts he wrote. u If the stock price on due date was below 135 mu, the options would have been worthless and the option writer’s net profit had been 100 mu. u If the stock price exceeded 135 mu, the option writer had to pay the option holder the difference, in one way or another.

u The potential loss for the option writer is theoretically unlimited The writer has to prove that he is capable of fullfilling his obligation by giving a collateral to the broker. u This collateral is continuously monitored and adjusted.

Interesting addresses on the Internet u The Chicago Mercantile Exchange http: //www. interaccess. com: 80/cme/ u The Chicago Board of Trade http: //www. cbot. com u The London International Financial Futures and Options Exchange http: //www. liffe. com u An Option pricer http: //slag. capmkt. com/cgi-bin/robert/optionpricer

More addresses. . . u Portfolio Challenge (competition) http: //pawws. secapl. com u The Basics of Trading Options http: //www. teleport. com/~futures /options. html u A Link to some other related servers http: //www. yahoo. com/economy/markets_and_investm ents/futures_and_options/ u Goethe Investment Club http: //www. wiwi. uni-frankfurt. de/AG/JWGI/ u US Stock price data: http: //www. ai. mit. edu/stocks/graphs. html