Options n Derivatives FINAL

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INTRODUCTION TO DERIVATIVES Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset. Derivatives are an important class of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies. Derivatives may be traded for a variety of reasons. 1. Hedging A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. 2. Speculation Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators. 3. Arbitrageur A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices. As defined above, the value of a derivative instrument depends upon the underlying asset. The underlying asset may assume many forms:  Commodities including grain, coffee beans, orange juice;  Precious metals like gold and silver;  Foreign exchange rates or currencies;  Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc.  Shares and share warrants of companies traded on recognized stock exchanges and Stock Index;  Short term securities such as T-bills;  Over-the Counter (OTC) money market products such as loans or deposits.

INTRODUCTION TO OPTIONS Options can be defined as: “A contract that gives the buyer the right but not the obligation, to buy or sell a specific amount of a given stock, commodity, currency, index, or debt, at a specified price during a specified period of time.” In finance, an option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in some specific transaction on the asset, while the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The asset on which an option contract is based is commonly referred to as the underlying security. Options are categorized as derivative securities because their value is derived in part from the value and characteristics of the underlying security. For instance, a stock option contract's unit of trade is the number of shares of underlying stock which are represented by that option. Generally speaking, stock options have a unit of trade of 100 shares. This means that one option contract represents the right to buy or sell 100 shares of the underlying security. Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:  whether the option holder has the right to buy (or the right to sell .  the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock)  the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise  the expiration date, or expiry, which is the last date the option can be exercised  the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount  the terms by which the option is quoted in the market to convert the quoted price into the actual premium-–the total amount paid by the holder to the writer of the option.

Option buyers pay a price for the right to buy or sell the underlying security. This price is called the option premium. The premium is paid to the writer, or seller, of the option. In return, the writer of a call option is obligated to deliver the underlying security (in return for the strike price per share) to an option buyer if the call is exercised and, likewise, the writer of a put option is obligated to take delivery of the underlying security (at a cost of the strike price per share) from an option buyer if the put is exercised. Whether or not an option is ever exercised, the writer keeps the premium. Premiums are quoted on a per share basis. BENEFITS OF OPTIONS 1. Orderly, Efficient and Liquid Markets Standardized option contracts provide orderly, efficient, and liquid option markets. Except under special circumstances, all stock option contracts are for 100 shares of the underlying stock. The strike price of an option is the specified share price at which the shares of stock will be bought or sold if the buyer of an option, or the holder, exercises his option. Strike prices are listed in increments of 2.5, 5, or 10 points, depending on the market price of the underlying security, and only strike prices a few levels above and below the current market price are traded.As a result of this standardization, option prices can be obtained quickly and easily at any time during trading hours. Additionally, closing option prices (premiums) for exchange-traded options are published daily in many newspapers. Option prices are set by buyers and sellers on the exchange floor where all trading is conducted in the open, competitive manner of an auction market. 2. Flexibility Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to create either a hedged or speculative position. 3. Leverage A stock option allows you to fix the price, for a specific period of time, at which you can purchase or sell 100 shares of stock for a premium (price) which is only a percentage of what you would pay to own the stock outright. That leverage means that by using options you may be able to increase your potential benefit from a stock's price movements. 4. Limited Risk For Buyer

Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller (writer of an option), on the other hand, may face unlimited risk. HISTORY OF OPTIONS  First Account of Options 332 B.C The very first account of options was mentioned in Aristotle's book named "Politics", published in 332 B.C.Aristotle mentioned a man named Thales of Miletus.Thales predicted a huge olive harvest in the year that follows. Understanding that olive presses would be in high demand following such a huge harvest, Thales could turn a huge profit if he owned all of the olive presses in the region, however, he didn't have that kind of money.Instead,He used a small amount of money as deposit to secure the use of all of the olive presses in the region, now known as a call option.By controlling the rights to using the olive presses through an option (even though he didn't name it "option" then), Thales had the right to either use these olive presses himself when harvest time came (exercising the options) or to sell that right to people who would pay more for those rights (selling the options for a profit).  Tulip Mania of 1636 The tulip mania of 1636 in Europe is a classic economics and finance case study where herding behavior created a surge in demand which cause the price of a single commodity, tulips in this case, to soar to ridiculous prices. This surge in price begun the first mass trading of options in recorded history.As the price of tulip bulbs increased almost on a daily basis, Dutch dealers, which was the biggest producer of tulip bulbs then, started tulip bulb options trading so that producers could own the rights to owning tulip bulbs in advanced and secure a definite buying price.Mass speculative interest in tulip bulbs options led to people from all level of society buying those options.However after the price bubble burst almost all options speculators were wiped out as their options fell out of the money and worthless.  Options Trading in London in 1700 to 1860 Even though options trading gained a bad name, it doesn't stop financiers and investors from acknowledging its speculative power

through its inherent leverage. Put and Call options were given an organised market towards the end of the seventeenth century in London. With the lessons learnt from the tulip mania still fresh in mind, trading volume was low as investors still feared the "speculative nature" of options. In fact, there was growing opposition to options trading in London which ultimately led to options trading being declared illegal in 1733. Since 1733, options trading in London was illegal for more than 100 years until it was declared legal again in 1860.  Options Trading in USA in 1872 Russell Sage, a well known American Financier born in New York, was the first to create call and put options for trading in the US back in 1872. The options that Russell Sage created where the first OTC options in the US and were unstandardized and highly illiquid.  Black-Scholes Model The Black-Scholes Model was first discovered in 1973 by Fischer Black and Myron Scholes, and then further developed by Robert Merton. It was for the development of the Black-Scholes Model that Scholes and Merton received the Nobel Prize of Economics in 1997 (Black had passed away two years earlier). The idea of the Black-Scholes Model was first published in "The Pricing of Options and Corporate Liabilities" of the Journal of Political Economy by Fischer Black and Myron Scholes and then elaborated in "Theory of Rational Option Pricing" by Robert Merton in 1973.  CBOE and OCC formed in 1973 About 100 years following the introduction of options trading to the US market by Russell Sage, the most important event in modern options trading history took place with the formation of the Chicago Board of Exchange (CBOE) and the Options Clearing Corporation (OCC) in 1973. The formation of both institutions truly is a milestone in the history of options trading and have defined how options are traded over a public exchange the way it is traded today. The most important function of the CBOE is in the standardisation of stock options to be publicly traded. Prior to the formation of the CBOE, options were traded over the counter and were highly unstandardized, leading to an illiquid and inefficient options trading market. In order for options to be openly traded, all options contracts need to be standardized. So in 1973 the general public is able to trade call options under the performance guarantee of the OCC and the liquidity provided by the market maker system. This structure continues to be used today. By 1977, put options were introduced by the CBOE, creating the options trading market that we know today.

TYPES OF OPTIONS 1. Call option  Call option is a contract that allows the buyer the right but not the obligation to buy an underlying asset, at a specific price and a specific time.  A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option.  The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.  The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not.  The call buyer believes it's likely the price of the underlying asset will rise by the exercise date. The risk is limited to the premium. The profit for the buyer can be very large, and is limited by how high underlying's spot rises. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money". 2. Put option  Put option is a contract that allows the buyer the right but not the obligation to sell an underlying asset, at a specific price and a specific time.  The seller (or "writer") is obligated to buy the commodity or financial instrument should the buyer (holder) so decide. The buyer pays a fee (called a premium) for this right.  The buyer of a put option wants the price of the underlying instrument to fall in the future, while the seller expects a price rise.  The advantage of buying a put is that the option owner's risk of loss is limited to the premium paid for it.

3. European Option  European option is an option hat can only be exercised at the end of its life, at its maturity.  European options tend to sometimes trade at a discount to its comparable American option. This is because American options allow investors more opportunities to exercise the contract.

 European options normally trade over the counter.  A buyer of an European option that does not want to wait for maturity to exercise it can sell the option to close the position. 4. American Option  American option is an option that can be exercised anytime during its life, which can be prior to its maturity.  Since investors have the freedom to exercise their American options at any point during the life of the contract, they are more valuable than European options which can only be exercised at maturity.

INTRODUCTION TO OPTION MARKETS The exchange where most of the buying and selling of options contracts take place is called the options market. The most common way of trading options is through standardized options contracts. These are listed in various futures and options exchanges. The listing of the contracts and their respective prices is done using ticker symbols. These exchanges publish the options prices continuously and create live options markets for options trading. Thus, the exchange offers the trading parties a platform to discover prices and execute transactions. These exchanges assume the role of intermediaries for buyers and sellers. Options are also traded via over-the counter exchanges. TYPES OF OPTION MARKETS 1. Over-The-Counter Market  A decentralized market of options not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor.  There is no central exchange or meeting place for this market.  OTC options (or dealer options) are private transactions between two parties. The absence of a large and standardized intermediary system makes the transactions quick but also increases the risk of one of the parties defaulting on their part of the deal.  The market value of the traded option is difficult to judge because there is no centralized price monitoring system like an exchange. However, these transactions are often much more flexible and can be customized to suit the needs of the two parties. This aspect makes these options very versatile and adaptable.  OTC deals are the result of discussion and negotiation between two counter- parties, without the intervention and/or regulation of a market-exchange. The terms and conditions of the trades are completely deal-specific and are formalised by a legal document called the confirmation document.  Option types commonly traded over the counter include: o Interest rate options o Currency cross rate options o Options on swaps

2. Organized Options Market  A centralized market of options where parties trade standardized option contracts that have been defined by an exchange.  Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange.  Since the contracts are standardized, accurate pricing models are often available.  Exchange-traded options include: o Stock options, o Commodity options o Bond options and other interest rate options o Stock market index options or, simply, index options and o Options on futures contracts PARTICIPANTS OF OPTIONS MARKETS 1. Buyers Buyers refers to the parties that purchase option contracts.The buyers pay a fee known as premium to purchase the right but not obligation to buy or sell a particular underlying asset at a specific price. 2. Sellers Sellers refer to the parties that write or sell option contracts. The writer sells the right but not obligation to buy or sell a particular underlying asset at a specific price.The seller however has the obligation to execute the contract of the buyer wishes to do so.

BASIC TRADES OR POSITIONS IN THE OPTIONS MARKET There are two sides to every options contracts. On one side is the investor who has taken the long postion (i.e. bought the option). On the other side is the investor who has taken the short position (i.e. sold or written the option). The writer of an option receives cash up front, but has potential liabilities later. The writer’s profit or loss is the reverse of that of the purchaser of the option.The profit or loss depends on the option positions.There are four types of option positions: 1. Long position in call option When a trader believes that the price of a stock would appreciate, he/she can acquire the right to buy an option rather than just opting to purchase the stock. If the price of the stock moves above the exercise price by more than the premium, the trader earns a profit. Example: Profit from buying one European call option: option price = $5, strike price = $100.

2. Long position in put option When a trader believes that the price of a stock would depreciate, he/she can acquire the right to buy an option rather than just opting to sell the stock. If the price of the stock moves above the exercise price by more than the premium, the trader will not exercise the option. Example: Profit from buying a European put option: option price = $7, strike price = $70

3. Short position in Call option When a trader believes that the price of a stock would depreciate, he/she can sell the right to buy an option. In this case the profit is limited but the loss is unlimited. Example: Profit from writing one European call option: option price = $5, strike price = $100

4. Short position in Put option When a trader believes that the price of a stock would appreciate , he/she can sell a put option.This will give the trader an obligation to buy the stock from the put buyer. In this case the profit is limited but the loss is unlimited. Example: Profit from writing a European put option: option price = $7, strike price = $70

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