29/09/2013

MechanicsofOptionsMarkets
Chapter9

Fundamentals of Futures and Options Markets, 8th Ed, Ch 9, Copyright John C. Hull 2013

ConfusionofConfusions.
JosedelaVega,Amsterdam(1688)
LlamronlelosFlamencosOpsie,derivadodelverbo
latino Optio Optionis, que significa eleccin, por
latinoOptioOptionis,quesignificaeleccin,por
quedaraeleccindelquelodaelpoderpediro
entregarlapartidaalquelorecibe...puesdeseaelque
desembolsaelpremioelegirloquemsconvenga,yen
faltasiemprepuededejardeelegirloquedesea
Hayamarrasqueaseguranlosestragosyncoras
queresistenlasborrascas.Dadopsies ysabrisel
lmitedelaprdida,pudiendoexcederlagananciaala
fantasaysermayoranelaumentoquela
esperanza

29/09/2013

CallOption
Isacontractthatgivestheholdertheright,
butnottheobligation,tobuyacertainasset
at a fixed price (Strike, K) up to a specified
atafixedprice(Strike,K)uptoaspecified
timeindependentlyoftheassetprice(S).

LongCall
(Figure9.1,Page212)

ProfitfrombuyingoneEuropeancalloption:optionprice=
$5 strike price $100
$5,strikeprice=$100.
30 Profit($)
20
10
70
0
5

80

90

Terminal
stockprice($)

100

110 120 130

Fundamentals of Futures and Options
Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

29/09/2013

ShortCall
(Figure9.3,page213)

ProfitfromwritingoneEuropeancalloption:optionprice=$5,
strike price $100
strikeprice=$100
Profit($)
5
0

110 120 130

70

80

90

100

10

Terminal
stockprice($)

20
30
Fundamentals of Futures and Options
Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

PutOption
Isacontractthatgivestheholdertheright,
butnottheobligation,tosellacertainassetat
a fixed price (Strike K) up to a specified time
afixedprice(Strike,K)uptoaspecifiedtime
independentlyoftheassetprice(S).

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LongPut
(Figure9.2,page213)

ProfitfrombuyingaEuropeanputoption:optionprice=$7,
strikeprice=$70
30 Profit($)
20
10
0
7

Terminal
stockprice($)
40

50

60

70

80

90

100

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

ShortPut
(Figure9.4,page214)

ProfitfromwritingaEuropeanputoption:optionprice=$7,
strike price $70
strikeprice=$70
Profit($)
7
0

40

50

Terminal
stockprice($)

60
70

80

90

100

10
10
20
30
Fundamentals of Futures and Options
Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

29/09/2013

Europeanvs.AmericanOptions
Europeanoptionscanonlybeexercisedatthe
maturityofthecontract.
t it f th
t t
Americanoptionscanbeexercisedatanytime
untilthematurityofthecontract.

Out,AtandIntheMoneyOptions
AcalloptionisOut ofthemoneyifthepriceof
theasset(S)isbelowthestrike(K)priceofthe
option.Ifweexercisetheoptionwewillincurina
p
p
loss.
I.e.:S=100;K=120.(S K)= 20

AcalloptionisAt themoneyifthepriceofthe
assetisequaltothestrikeprice.Thegainof
exercisingtheoptionis0.
I.e.:S=120;K=120.(S
I e : S = 120; K = 120 (S K)=0
K) = 0

AcalloptionisIn themoneyifthepriceofthe
assetisgreaterthanthestrikeprice.Ifwe
exercisetheoptionwewillhaveagain.
I.e.:S=140;K=120.(S K)=20

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OptionsValue
Callvalueatexpiration
Putvalue atexpiration

Long
Max (SK;0)
Max (KS;0)

Long
Callvaluetoday ertMax (SK;0)
Putvalue today ertMax (KS;0)

CallFinancialOption,
Intrinsicvs.Temporalvalue
St k
Stock
Price

$190

$10
TemporalValue
Premium=Temporal+IntrinsicValue
Premium=$10+$20

IBM
Price
$20
$
IntrinsicValue
=SK

$170

Strike
Price

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CallOption,
Intrinsicvs.Temporalvalue
WhenS
TimeValue IntrinsicValue0
Option
Price

TimeValue, value.
ValueofOptionality
MAXIMUM
VALUE
IntrinsicValue

K(Strike)

O
Outofthemoney

ST(UnderlyingAsset)
Inthemoney

Atthemoney

TimeValueoftheOption
ThetwomostimportantfactorsinTimeValue:
Timetoexpiration,thebiggerthetimethebigger
thevalue.
Volatility,thebiggerthevolatilitythebiggerthe
value.
Price of a call option vs. volatility

4.5
4

Call option price

35
3.5
3
2.5
2
1.5
1
0.5
0

10

20

30

40
Volatility in %

50

60

70

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OptionsValue:BlackScholesMerton
(BSM)Formula(Calloption)
C SN d1 Ke rT N d 2
log
d1

S 2
r
T
K
2
T

log
d2

S 2
r
T
K
2
T

Where:

S:Underlyingassetprice(HowdowecalculateSofastock?)
K:Strikeprice
p
T:Timetomaturity(expiration)oftheoption
r:Riskfreerate
s:Volatilityofreturnsoftheunderlyingasset
N():CumulativedistributionfunctionoftheN(0,1)distribution.

UnderstandingBSMFormula
(CallOption)
Roughlyspeaking,youcanthinkofN(d2)astheprobabilityof
exercisingtheoption,timesthepresentvalueofthestrikeprice
(KertN(d2))
AndN(d
And N(d1)ameasurehowfarinthemoneytheoptionisexpected
) a measure how far in the money the option is expected
tobeifitdoesexpireinthemoneytimesthestockprice(SN(d1))
In the Money
S
K
r
T = 50 days

At the Money
100
60
5%
0,13 yrs.
25%

d1
d2

5,78
5,69

SN(d1)

100,00
59,61

-rT

Ke N(d2)
Option Price

40,39

S
K
r
T = 50 days

N()
1,00
1,00

Out of the Money

60
60
5%
0,13 yrs.
25%

d1
d2

0,12
0,03

SN(d1)

32,80
30,45
2,35

-rT

Ke N(d2)
Option Price

S
K
r
T = 50 days

N()
0,55
0,51

40
60
5%
0,13 yrs.
25%

d1
d2

-4,38
-4,47

SN(d1)
Ke N(d2)

0,00
0,00

Option Price

0,00

-rT

N()
0,00
0,00

29/09/2013

UnderstandingBSMFormula
(CallOption)Increasein.
In the Money
S
K
r
T = 50 days

At the Money
100
60
5%
0,13 yrs.
50%

d1
d2

2,96
2,78

SN(d1)

99,85
59,45

-rT

Ke N(d2)
Option Price

S
K
r
T = 50 days

N()
1,00
1,00

60
60
5%
0,13 yrs.
50%

d1
d2

0,13
-0,05

SN(d1)

33,01
28,52
4,49

-rT

Ke N(d2)

40,40

Out of the Money

Option Price

S
K
r
T = 50 days

N()
0,55
0,48

40
60
5%
0,13 yrs.
50%

d1
d2

-2,12
-2,30

SN(d1)
Ke N(d2)

0,68
0,63

Option Price

0,04

-rT

N()
0,02
0,01

UnderstandingBSMFormula
(CallOption)IncreaseinT.
In the Money
S
K
r
T = 50 days

At the Money
100
60
5%
1 yrs.
25%

d1
d2

2,37
2,12

SN(d1)

99,11
56,10

-rT

Ke N(d2)
Option Price

43,01

S
K
r
T = 50 days

N()
0,99
0,98

Out of the Money

60
60
5%
1 yrs.
25%

d1
d2

0,33
0,08

SN(d1)

37,64
30,24
7,40

-rT

Ke N(d2)
Option Price

S
K
r
T = 50 days

N()
0,63
0,53

40
60
5%
1 yrs.
25%

d1
d2

-1,30
-1,55

SN(d1)
Ke N(d2)

3,89
3,48

Option Price

0,42

-rT

N()
0,10
0,06

29/09/2013

Othervaluationmethods
ApartfromBSMthereexistsomeother
alternative methods of valuation
alternativemethodsofvaluation:
BinomialmethodCox,RossandRubinstein(1979).
Themethodisverytransparentandcanbebetter
understandandexplainedthanBSM.
MonteCarlosimulation,veryusefulbecausewedont
need to estimate the volatility () of the project
needtoestimatethevolatility()oftheproject.
LongstaffandSchwartz(2001)forthevaluationof
americanoptions.Speciallyusedinthevaluationof
abandonoptions.

IsthereanOptimalValuationMethod?
Theanswerisyes,anddependsonlyonthe
projectweareanalyzing,andtheavailable
j t
l i
d th
il bl
informationthatwehave.
Donotdependsontheexpectedresultofthe
calculationmethod.Because

10

29/09/2013

ExistConvergenceinthedifferent
valuationmethods
OntheleftwecanseetheconvergencebetweenBSMandMonte
Carlomethods.
g
p
(
)
OntherightitscomparedtheBSMandBinomialmethods(Hull).

Convergencedemonstrationbetweenbinomialandregressionis
doneinSmith(2005)andBrandao,Dyer,Hahn(2005)

Naked positions.LongCall andshortcall

Beneficio de un inversor largo en call sobre Repsol a 25,00 con prima 0,80
Repsol a 24
Repsol a 25
Repsol a 25,8
Compra Accin
Venta Accin
Prima de la Opcin
Resultado Terico
Decisin
Resultado Final

(25,00)
24,00
(0,80)
((1,80))
No Ejerce
(0,80)

(25,00)
25,00
(0,80)
((0,80))
No Ejerce
(0,80)

Long Position

Beneficio

Beneficio

Outofthe
money

Athte
money

Inthe
money

Repsol a 26

(25,00)
25,80
(0,80)
0,00
Ejerce
0,00

(25,00)
26,00
(0,80)
0,20
Ejerce
0,20

Short Position

0,80

25
25,80
,

25

25,80
,

0,80
CotizacindelSubyacente(S)

CotizacindelSubyacente(S)

11

29/09/2013

Naked positions.LongPut andshortPut

Beneficio de un inversor largo en put sobre Repsol a 25,00 con prima 1,20
Repsol a 23
Repsol a 23,8
Repsol a 25
Compra Accin
Venta Accin
Gasto por Prima
Resultado Terico
Decisin
Resultado Final

(23,00)
25,00
(1,20)
0,80
Ejerce
0 80
0,80

(23,80)
25,00
(1,20)
0,00
Ejerce
0 00
0,00

Long Position

Beneficio

Beneficio
Inthe
money

Athte
money

Repsol a 26

(25,00)
25,00
(1,20)
(1,20)
No Ejerce
(1 20)
(1,20)

(26,00)
25,00
(1,20)
(2,20)
No Ejerce
(1 20)
(1,20)

Short Position

1,20

Outofthe
money

23,80

25
25
23,80
1,20

CotizacindelSubyacente(S)

CotizacindelSubyacente(S)

Resultsofthecombinationofthe
underlyingassetandanoption
Long Stock + Long Put
Compra de 1.000 Acciones de BBVA a 17 y 10 Put (1/100) @ 18 . Prima 1,50

BBVA a 16 BBVA a 17 BBVA a 18 BBVA a 19 BBVA a 20

+
S
K

Resultado Acciones

(1.000)

1.000

Prima Opcin

(1.500)

(1.500)

(1.500)

(1.500)

(1.500)

Decisin

Ejerce

Ejerce

Ejerce

No Ejerce

2.000

No Ejerce

3.000

Resultado Put

2.000

1.000

0,00

0,00

0,00

Resultado Final

(500)

(500)

(500)

500

1.500

B Long Stock + Short Call

+
Compra de 1.000 Acciones de SAN a 12 y Venta de 10 Call (1/100) @ 13 . Prima 0,30
SAN a 11
Resultado Acciones
Prima Opcin
Resultado Call

Resultado Final

SAN a 12

SAN a 13

SAN a 14
2.000

SAN a 15

(1.000)

1.000

(300)

(300)

(300)

(300)

(300)

(1.000)

(2.000)

3.000

(1.300)

(300)

700

700

700

12

29/09/2013

Resultsofthecombinationoftheunderlying
assetandanoption.Summary
Short Stock + Long Call

Long Stock + Long Put

B

K
S

S
K

B Long Stock + Short Call

Short Stock + Short Put

AssetsUnderlying
ExchangeTradedOptions
Page215216

Stocks
ForeignCurrency
StockIndices
Futures

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

26

13

29/09/2013

Specificationof
ExchangeTradedOptions

Expirationdate
Expiration
date
Strikeprice
EuropeanorAmerican
CallorPut(optionclass)

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

27

MarketMakers
Mostexchangesusemarketmakersto
f ilit t
facilitateoptionstrading
ti
t di
Amarketmakerquotesbothbidandask
priceswhenrequested
Themarketmakerdoesnotknowwhetherthe
individual requesting the quotes wants to buy
individualrequestingthequoteswantstobuy
orsell

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

28

14

29/09/2013

Margin(Page222224)
Marginisrequiredwhenoptionsaresold
Forexample,whenanakedcalloptioniswritteninthe
US,themarginisthegreaterof:
1 Atotalof100%oftheproceedsofthesaleplus20%
oftheunderlyingsharepricelesstheamount(ifany)
bywhichtheoptionisoutofthemoney
2 Atotalof100%oftheproceedsofthesaleplus10%
oftheunderlyingshareprice

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

29

Warrants
Warrantsareoptionsthatareissuedby
a corporationorafinancialinstitution
Thenumberofwarrantsoutstandingis
determinedbythesizeoftheoriginal
issueand changesonlywhentheyare
exercised or when they expire
exercisedorwhentheyexpire

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

30

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29/09/2013

Warrants
(continued)

Theissuersettlesupwiththeholder
whenawarrantisexercised
h
i
i d
Whencallwarrantsareissuedbya
corporationonitsownstock,exercise
willusuallyleadtonewtreasurystock
being issued
beingissued

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

31

EmployeeStockOptions
(seealsoChapter14)

Employeestockoptionsareaformofremuneration
i
issuedbyacompanytoitsexecutives
db
i
i
Theyareusuallyatthemoneywhenissued
Whenoptions are exercisedthecompanyissues
morestockandsellsittotheoptionholderforthe
strikeprice
Expensedontheincomestatement

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

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29/09/2013

ConvertibleBonds
Convertiblebondsareregularbondsthat
can be exchanged for equity at certain
canbeexchangedforequityatcertain
timesinthefutureaccordingtoa
predeterminedexchangeratio
Usuallyaconvertibleiscallable
Thecallprovisionisawayinwhichthe
i
issuercanforceconversionatatimeearlier
f
i
i
li
thantheholdermightotherwisechoose
Fundamentals of Futures and Options
Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

33

Warrants
W
Warrantsareoptionsthatareissued(or
t
ti
th t
i
d(
written)bya corporationorafinancial
institution
Thenumberofwarrantsoutstandingis
determinedbythesizeoftheoriginalissue&
y
g
changesonlywhentheyareexercisedor
whentheyexpire
Fundamentals of Futures and Options
Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

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17

29/09/2013

Warrants
(continued)

Warrantsaretradedinthesamewayas
y
stocks
Theissuersettlesupwiththeholderwhen
awarrantisexercised
Whencallwarrantsareissuedbya
corporation on its own stock exercise will
corporationonitsownstock,exercisewill
leadtonewtreasurystockbeingissued

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

35

ExecutiveStockOptions
Optionissuedbyacompanytoexecutives
Whentheoptionisexercisedthecompany
issuesmorestock
Usuallyatthemoneywhenissued

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

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29/09/2013

ConvertibleBonds
Convertiblebondsareregularbondsthat
canbeexchangedforequityatcertain
timesinthefutureaccordingtoa
predeterminedexchangeratio

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

37

ConvertibleBonds
(continued)

Very
Veryoftenaconvertibleiscallable
often a convertible is callable
Thecallprovisionisawayinwhichthe
issuercanforceconversionatatimeearlier
thantheholdermightotherwisechoose

Fundamentals of Futures and Options

Markets, 8th Ed, Ch 9, Copyright
John C. Hull 2013

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