Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 22 Chapter 22 Option 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 22 Option 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 22 Option Contracts • What is the relationship between the BlackScholes 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 22 Option 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 22 Option 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 Cj rd p ud p C ju 1 p C jd r The Binomial Option Pricing Model N n N! N j j j N j Co p 1 p max 0, u d S X r j 0 N j ! j! N n N! N j j j N j Co p 1 p u d S X r j m N j ! j! hj u d S j C jd C ju The Black-Scholes Valuation Model • Continuous changes rather than discrete • Geometric Brownian motion – volatility factor, s N d ln S X RFR 0.5s T s T C 0 SN d1 X e d1 S 12 T s T S RFR T 2 2 d 2 d1 s T 12 12 The Black-Scholes Valuation Model 1. 2. 3. 4. 5. Value is a function of five variables: Current security price Exercise price Time to expiration Risk-free rate Security price volatility C = f(S, X, T, RFR, s) Estimating Volatility • Mean and standard deviation of a series of price relatives N 1 R Rt N t 1 2 1 s Rt R N 1 t 1 N 2 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 BlackScholes model overvalued out-of-themoney call options and undervalued in-themoney 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 Internet Investments 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 topics Chapter 23 • Swap Contracts, Convertible Securities, and Other Embedded Derivatives