W1: financial options

• derivative - financial instrument that is based on the value of another financial instrument or an underlying asset
• types of derivatives:

  • options
  • forwards
  • futures
  • swaps
• Over-the-counter (OTC) derivatives - customised derivative contracts that are individually negotiated between two parties
• financial option - contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset at a fixed price, on or before a specified future date
• call option - option that gives holder right to buy an asset
• put option - option that gives the holder the right to sell an asset
• an investor exercises a call option if the:

  market price > exercise price
• an investor exercises a put option if the:

  market price < exercise price
• the option writer (seller) has the obligation to honour the contract if the holder decides to exercise the option
• expiration date - last date on which an option holder has the right to exercise the option
• exercise (strike) price - price at which an option holder buys or sells the underlying asset when the option is exercised
• american option - option that allows the option holder to exercise the option on any date, up to the expiration date
• european option - option that allows the option holder to exercise the option only on the expiration date
• the option seller has a short position in the contract
• the option buyer (holder) has a long position in the contract
• option premium - upfront fee the buyer of the option pays for the option to the seller of the option
• if the share price is less than the exercise price of a call option, do you exercise the option?

  NO
• if the share price is more than the exercise price of the put option, do you exercise the option?

  NO
• what is the value of a call option where the exercise price is more than the market price?

  0
• what is the value of a put option where the exercise price is less than the market price?

  0
• put-call parity: price of the underlying asset + price of put = price of call + PV(exercise price)
• the put-call parity only holds if the put and call have the same:

  1. exercise price
  2. expiration date
  3. zero-coupon bond has same maturity date