FIN9797 Options Markets
Midterm Topic Review
Forwards and Futures
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Definitions: Forward price, value of forward position, delivery price, maturity
Pricing is based on replication: The cost of buy and carry.
o Pricing formula: Forward price F=S*exp(r-q)*t (r –interest rate, q-dividend yield for
stock, foreign interest rate for currency).
o In the presence of discrete dividends (benefits), costs (such as storage), F=S*exp(r-q)*t –
Future Value of Dividends (& other dollar benefits) + Future Value of Dollar Costs (e.g.,
storage)
o If the market price differs from replication cost, you can do an arbitrage trade: Buy the
cheap one, sell the expensive one.
Values of forward positions: N*exp(-r (T-t))(F-K), where N is the size of the position, negative for
short.
Appreciate the difference between forward price and the value of a forward contract, the
difference between the forward price F and the delivery price K
Payoff at expiration (S-K for long, K-S for short), Can make adjustments for stock splits, can plot
the payoff function as well as answering questions on payoffs at given situations
Options
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Definitions: Call/put, long/short, American/European, strike, expiry
o Moneyness: At the money, out of the money, in the money – Focus on the definition
based on forward instead of spot
o Intrinsic versus time value: Option Value = Intrinsic Value+ Time Value
o Call option intrinsic value = max(0, exp(-r (T-t))(F-K))
o Put option intrinsic value = max(0, exp(-r (T-t)) (K-F))
o Payoff (max(0, S-K) for call, max(0,K-S) for put, negative for short)
Strategies
o Given a portfolio, understand the payoff: Can plot the payoff function, and answer
questions on payoffs under specific situations
o Given a payoff plot, know how to create it using options/forwards/bonds
o Understand the names, payoffs, usages of the common combo contract: bull spread,
bear spread, butterfly, straddle, strangle, risk reversal
Option behavior
o Strike/maturity relation creates arbitrage bounds
o Exposure (to forward and volatility): Understand how option prices move with the
underlying forward (spot, interest rate, dividend) and volatility
o Lower/upper bounds, put-call parity: Arbitrage trading when bounds/relations are
violated