Lecture 9 – The final one
Options Contract
FINS1612 Capital Markets & Institutions
Lecturer –
Copyright By PowCoder代写 加微信 powcoder
Summer Term , 2022
Course schedule and final exam preparation
• Our course includes 9 lectures and tutorials in a standard term, and summer has no
exception. Therefore, lecture/tutorial 9 will be our final class.
• I will finish all my teaching duties for this summer term after Tuesday, but I will still run Lecture 10 as an extra consultation session for you. Feel free to attend it if you want to ask me questions.
Option contract
A. Major risks in business operation
B. Option contracts
• Call vs Put option
C. Call option payoff and Put option payoff
D. Option pricing and trading strategies
• Factors affecting option pricing
• Option trading strategies
Lecture Content
A. Major risks in business operation
• Let’s do a quick summary before starting today’s topic. There are three key areas in finance (debt, equity, and derivatives), and we have covered the following content:
1. banking system (how a commercial bank borrows and lends money, the capital requirement under Basel agreement)
2. debt market (how a corporation borrows short-term and long-term funds)
3. interest rate determination (yield curve, theories used to explain the yield curve)
4. Foreign currency (bid and offer price, FX cross-rate, spot and forward FX rate)
5. Equity market (Securities exchange, investing in share market, taxation issue, etc.)
• Companies will participate in various forms of investments, and they need to be engaged in transactions that will occur later.
• For example, CBA may want to buy USD 1 million in March 2022, Westpac may intend to sell $2 million worth of Facebook shares in Jan 2023. How will they manage risks
associated with trading in the debt, equity and FX market?
• Risk is any uncertainties or unexpected changes, and companies are exposed to different types of risks. Therefore, when you become a finance manager in the future, you need to identify factors that affect these risks.
• Interest rate risk – a change in the interest rate will change a firm’s investment return and borrowing cost, resulting in a difference in its earnings and cash flow position. Also, we learnt from the last lecture that the present value of a company’s future dividends would determine its current share price, so the interest rate change also influences its share market performance.
• Liquidity risk – the cash flow issues faced by a company. For example, we discussed the matching principle where long-term assets should be funded with long-term liabilities. When a company holds non-current assets, it needs to wait for a longer period to receive the invested amount back and may not be able to sell them to another party in the market very quickly. So if it borrows short-term liability to fund
this asset purchase, it may encounter a cash-flow crisis since it will need to repay its
debt soon.
• Credit risk – the possibility of not receiving our money back. It’s a significant risk for banks. Banks lend money to millions of consumers, and there is always a portion of these borrowers who will fail to make all repayments.
• To eliminate this risk, banks diversify their lending portfolio by giving loans to different industries. In addition, they have established credit checking departments responsible for assessing the creditability of their customers.
• For non-bank companies, the possibility of not collecting account receivables from clients will be their credit risk.
• Foreign currency risk – most Australian companies have business overseas, so the fluctuation in the value of AUD will impact their profitability.
• When a company buys products from another country, the product price will be denominated in the foreign country’s currency. However, suppose the foreign currency would appreciate/depreciate against the domestic currency. In that case, the company will need to pay a different amount payment in its domestic currency to meet the contracted price.
• Inflation risk – higher inflation will eat everyone’s money, implying an increase in the price of goods and a decrease in our purchasing power.
• For example, in Jan 2022, Justin purchased an Australian government bond with a $1,000 face value and 3% annual coupon rate.
• If the annual inflation is 1.5%, then the $30 yearly coupon payment ($1,000 * 3%) for 2022 will only have an actual value of $15.
• But if the annual inflation increases to 2%, then the actual value of the annual coupon payment will only be $10.
• To eliminate this risk, we added an inflation premium into the interest rate. For example, if the inflation is 1.5%, the Australian government will increase the government bond’s coupon by 1.5%. We call it the Treasury Indexed Bonds.
• In Jan 2022, Turkey is experiencing extremely high inflation – 20% inflation in
general and a 60% increase in the price for daily dairy products (eggs, cheese,
milk, etc.). The higher inflation has resulted in a sharp depreciation in Turkey’s
currency, worsening its economy.
• Capital risk – The Basel III agreement required all depository-taking institutions, such as commercial banks, to hold enough capital to cover their unexpected operation losses. If a bank makes an extra risky investment, it will have a higher level of risk, increasing its risk-weighted asset value. As a result, it must hold more capital to meet the minimum requirement set out by the Basel agreement.
• Capital risk refers to the situation where a bank doesn’t have enough capital.
• – a country’s possibility of not repaying its debt. For example, if a country’s currency suddenly depreciates by a large percentage, its central bank or government may fail to repay its global debt.
• We call the US treasury bond the safest asset globally because they never defaulted in history. Unfortunately, the US government had some trouble repaying its existing bondholders last October (2021), but they have resolved the issue by borrowing new money to repay their old debts.
• After we have covered all key risk categories, we need to develop an efficient risk management process. One of the widely used models is listed as follows:
• Identify risk exposure
• Analyze the impact of the risk exposure
• Assess the attitude of the organization to each risk exposure
• Select appropriate risk management strategy and tool
• Risk control policy and implement the risk management strategy • Ongoing review and monitor
• For selecting appropriate risk management strategies and tools, most companies choose to use derivatives to manage their risks.
• Companies can issue debt and equity securities to obtain funds from the market, and they use the derivative to manage their risk exposures.
• Derivative is a financial contract used between two or more parties to hedge a trading position that will occur later.
• The four main categories of the derivative are futures, forwards, options, and swaps.
• The most common underlying assets for derivatives are ordinary shares, bonds, FX, and
commodities.
• A future contract is an agreement to trade (buy or sell) a specified commodity or
financial assets at a specified date at a price predetermined today. For example, if I want to buy Tesla shares in May 2022, I can buy a futures contract based on Tesla shares. This contract gives me the right to buy a certain quantity of Tesla shares at a specified price in May.
• A forward contract is very similar to a future. The significant difference is that futures are exchange-traded, but the forward contract is not.
B. Option contracts
• An option contract gives the option buyer the right, but not the obligation, to buy or sell a specified commodity or financial securities at a specified price (exercise or strike price) on or before a specified date.
• Options are traded on a securities exchange so that all investors can trade them via most online trading platforms.
• Options can also be traded over-the-counter (not on a security exchange), where two parties negotiate an option contract for their transactions.
• European-type option – the buyer of this option can exercise it only on the maturity date (the specified date)
• American-type option – the buyer of this option can exercise it anytime on or before the maturity date (the specified date). 10
• Exchange traded options
• Standard contact sizes, standard exercise dates, standard underlying assets, standard
margin rules.
• For example, most Apple share options on security exchanges have the same expiry
date (20 Feb or 20 March 2022) and a standardized exercise price (a multiple of 5, such
as $175, $180, $190, etc.)
• Exchange clearing house is the counterparty to the option buyer and to the option
seller (buyer and seller can act independently of each other)
• Over-the-Counter (OTC) traded options
• Provided by commercial banks and investment banks to their clients
• Customized contract sizes, customized exercise dates, the margin may not be required,
underlying assets that are not well covered in the exchange-traded market, etc
• Main products are interest rate-related and FX-related options associated with
importing, exporting, borrowing and investing
• Now, let’s get to know some of the major Exchanges for trading options.
• In Australia, options are traded on ASX. The Sydney Future Exchange in Australia was the
primary derivative exchange, but it merged with ASX in 2006.
• In the US,
1. Chicago Board of Trade (one of the oldest futures and options exchange in the world. In 2007, it merged with CME)
2. CME (Chicago Mercantile Exchange, another largest financial derivatives exchange)
• In China, Shanghai Stock Exchange (the 3rd largest exchange by market capitalisation in the
world, but not entirely open to foreign investors yet)
• In the UK, the London Stock Exchange (established in 1801, making it one of the oldest
exchanges in the world)
• Call option gives buyers a right to buy a specified asset at an exercise price on or before a specified date.
• For example, if you buy a Call option, you are the buyer of this call option, and you now have a right to use this call option to buy the specified asset at the exercise price on or before a specified date.
• Put option gives buyers a right to sell a specified asset at an exercise price on or before a specified date.
• For example, if you buy a put option, you are the buyer of this put option, and you now have a right to use this put option to sell the specified asset at the exercise price on or before a specified date.
• Just like any other thing, an option is a financial contract, so it has a trading price, known as the option premium.
• When we buy an option contract, we must pay the price to the seller of this option.
• When we sell an option contract to another party, we will charge the buyer the price.
• Assume that you want to buy a Tesla call option from investor A. The call option has a $970 per share exercise price and will expire on 23 March 2022. The current market price of this option is $23 per share.
• Option Premium = $23 per share, and it’s how much you need to spend on buying this option contract from investor A.
• After you purchased this call option, you now have a right to use this call option to buy
Tesla shares at $970 each from investor A (the seller of this call option) anytime before
23 March 2022 (assume it’s an American-type option).
• Here we go one more time, but let’s use a put option as an example.
• Assume that you want to buy a Tesla put option from investor A. The put option has a $970 per share exercise price and will expire on 23 March 2022. The current market price of this option is $23 per share.
• Option Premium = $23 per share, and it’s how much you need to spend on buying this put option contract from investor A.
• After you purchased this put option, you now have a right to use this put option to sell Tesla shares at $970 each to investor A (the seller of this put option) anytime before 23 March 2022 (assume it’s an American-type option).
• After the two examples, you should know the difference between a call and put option. Now, let’s discuss the difference between the buyer and seller of an option contract.
• As you may be aware, the buyer of an option contract only has a right without any obligation. In other words, if you buy the Tesla call/put option,
1. You, of course, can choose to exercise it before the option’s expiry date. For example, you have a right to buy or sell the Tesla shares at the exercise price.
2. Alternatively, you can do nothing if you think the option is useless due to the market volatility. For example, the Tesla share price may be more attractive in real life, so you have no incentives to exercise the option contract.
• But what if you sell an option contract to others? From investor A’s perspective, he must trade Tesla shares with you at the exercise price if you (the buyer of the option) decides
to exercise the option.
• Let’s do a quick summary before we move on to the option payoff.
What right do you get
Call option is the right to buy the underlying at the exercise price
Put option is the right to sell the underlying at the exercise price
American option can be exercised any time before exercise date European option can only be exercised on the exercise date
When to exercise
C. Call Option Payoff
• When you buy a call option, you have a right to use it to buy a specified asset at the
exercise price. So on and before the option’s expiry (maturity) date, this call option is
• In the Money, if market asset price > the exercise price
• Out of The Money, if market asset price < the exercise price
• Option payoff = your final profit/loss from trading an option contract, so we also need to consider the option premium
• If you buy a call option, you need to pay the option premium to the seller, so it’s your purchase cost
• If you sell a call option, you will receive the option premium from the buyer, and it’s your revenue
• Long a Call option – you buy a call option, so you are the buyer of this option contract.
• In Jan 2022, you buy a Tesla call option from investor A. The call option has a $970 per share exercise price and will expire on 23 March 2022. The current market price of this option is $23 per share.
• After you bought (long) this call option, you will have a right, but no obligation, to use it to buy Tesla shares at $970 each from investor A.
Payoff diagram for you
When market share price > $970
Your profit = (market share price – $970) – $23
Break-even ($0 profit) when market share price = $993 When the market share price < $970, you will not
exercise this call option, and your loss = $23 19
Market share price
• Short a Call option – you sell a call option, so you are the seller of this option contract.
• From investor A’s perspective, after he sold (short) this call option to you,
• if you decide to use the call option to buy Tesla shares at $970 per share from him, he must sell shares at $970 per share to you.
Investor A sold the call option to you, so he will receive the option premium ($23) as his income.
When market share price > $970
A’s profit/loss = $23 + ($970 – market share price)
Market share price
Payoff diagram for investor A
Break even ($0 profit) when market share price = $993
When market share price < $970, you will not exercise
this call option, and investor A’s profit = $23
C. Put Option Payoff
• Now, let’s talk about the put option payoff, and we know that Option payoff = your final
profit/loss from trading an option contract.
• When you buy a put option, you have a right to use it to sell a specified asset at the
exercise price. So on or before the option’s expiry date, this put option is
• In the Money, if market asset price < the exercise price
• Out of The Money, if market asset price > the exercise price
• Long a put option – you buy a put option, so you are the buyer of this option contract.
• In Jan 2022, you buy a Tesla put option from investor A. The option has a $970 per share exercise price and will expire on 23 March 2022. The current market price of this put option is $23 per share.
• After you bought (long) this put option, you will have a right, but no obligation, to use it to sell Tesla shares at $970 each to investor A.
Payoff diagram for you
When market share price < $970
Your profit = ($970 – market share price) – $23
Market $970
Break-even ($0 profit) when market share price = $947 share price
When the market share price > $970, you will not exercise this put option, and Your loss = $23 22
• Short a Put option – you sell a put option, so you are the seller of this option contract.
• From investor A’s perspective, after he sold (short) this put option to you,
• if you decide to use the put option to sell Tesla shares at $970 per share to him, he must buy at $970 per share from you.
Payoff diagram for investor A
Investor A sold the put option to you, so he will receive the option premium ($23) as his income.
When market share price < $970
A’s profit/loss = $23 + (market share price – $970)
Break-even ($0 profit) when market share price = $947 When the market share price > $970, you will not
exercise this put option, and investor A’s profit = $23 23
$970 Market share price
Lecture practice activity 1
You purchased a Share A call option with a exercise price of $19 per share. The option premium is $1.7 per share. What would be your payoff if share A’s market price is $21? Should you exercise this call option?
D. Option pricing and trading strategies
Everything has a price. In Jan 2022,
• a big Mac costs us around $6,
• a pack of 20 Chicken Nuggets is around $10,
• a pack of dozen doughnuts from is $24
• an iPhone costs us around $2,000.
Option contracts also have a trading price, and it’s known as the option’s premium.
There are four key factors that will impact the option premium
• Intrinsic value
• Time value
• Price volatility of the underlying asset
• Interest rates
Factor 1 – intrinsic Value
• The intrinsic value determines how in-the-money an option contract it, and it measures the
relationship between the market asset price (S) and its exercise price (X).
• For a call option
• It has some value (in the money) when S > X, so its intrinsic value = S – X
• It has no value (out of the money) when S < X, so its intrinsic value = 0
• Let’s use the Tesla call option with an exercise price of $970.
• If Tesla’s market price is $1,000, the option’s intrinsic value = $1,000 – $970 = $30
is $900, the option’s intrinsic value = $0
• A greater intrinsic value will make the call option more valuable, increasing its premium.
• S = market asset price and X = option’s exercise price
• For a put option
• It has some value (in the money) when S < X, so its intrinsic value = X – S
• It has no value (out of the money) when S > X, so its intrinsic value = 0
• Again, let’s use the Tesla put option with an exercise price of $970.
• If Tesla’s market price is $900, the option’s intrinsic value = $970 – $900 = $70
is $1,000, the option’s intrinsic value = $0
• A greater intrinsic value will make the put option more valuable, increasing its premium.
• Intrinsic value measures the profit as determined by the difference between the option’s
exercise price and market asset price, and so its minimum value is 0 and can’t be negative. 27
Factor 2 – Time Value
• Both call and put options give the option’s buyer a right, but no obligation, to trade (buy
or sell) a specified asset at the exercise price on or before the maturity date.
• If the option’s maturity is far away, let’s say Jan 2023, the market asset price will
experience more volatility, giving the option more chances to be in the money.
• If the option’s maturity is due soon, let’s say Feb 2022, the market asset price will have