Financial Derivatives Overview

Underlying Instruments

• Financial instruments include bonds, stocks, currencies, indexes, and derivatives.
• Non-financial instruments include commodities (metals, grains, livestock, electricity, gas, oil) and weather-related derivatives.

Derivatives

• A derivative is a financial contract whose value derives from an underlying asset, executed at a future date.
• Types of derivatives: Options, Forwards/Futures, and Swaps.

Options

• Options are contracts that give the purchaser the right, but not the obligation, to buy/sell an underlying asset at a specific price before or at expiration.

Forwards/Futures

• Contracts obligating the exchange of goods at a predetermined future date and price.

Swaps

• Agreements where two parties exchange future cash flows from different financial instruments.

Speculation & Markets

• Speculating involves predicting market movements and taking action based on those beliefs.
• Spot market transactions involve immediate delivery of financial instruments.

Arbitrage

• Arbitrage profits occur when traders take advantage of price discrepancies in different markets.

Option Types

• American Option: Can be exercised any time before or on expiration.
• European Option: Can only be exercised on the expiration date.

Option Pricing

• Premium: The cost paid by the buyer to the seller for rights conferred by the option.
• Exercise Price (Strike Price): The price agreed for the execution of the option contract.
• Intrinsic Value: The current value of the option if exercised today, calculated differently for call and put options.

Market Efficiency

• Law of one price: The price of an identical asset should be the same across markets.
• Arbitrage indicates market inefficiencies.

Position Types

• Long Position: Taker of the option; expects price to rise.
• Short Position: Writer of the option; expects price to fall.

Call vs. Put Options

• Call Options: Right to buy; profitable if the asset price exceeds the strike price.
• Put Options: Right to sell; profitable if the asset price is below the strike price.

Market Indicators

• Open Interest: Total number of outstanding option contracts.
• Put/Call Ratio (PCR): Analyzes market sentiment—higher PCR indicates bearishness.

Intrinsic and Time Value

• The intrinsic value varies with the underlying asset's spot price relative to the strike price.
• Time value reflects the potential for value increase prior to expiration, higher for options with longer durations and greater volatility.

Option Boundaries

• Options cannot sell for less than zero.
• Maximum values differ between American and European options, with American options generally having higher potential due to early exercise privileges.

Earnings and Dividends

• Dividends affect the intrinsic value of options, making it advantageous to exercise before dividends are distributed.

Early Exercise

• American options provide the flexibility to exercise before expiration, unlike European options, which do not allow pre-expiration exercise.

These notes encompass critical aspects of derivatives, options, their pricing mechanisms, market behaviors, and the implications of dividends and early exercise.### Options Pricing and Characteristics

• Time Value: The value of options increases with more time to expiration, while less time decreases value.

• American vs. European Options:

  • American Puts are valued higher than European Puts due to the flexibility to exercise at any time before expiration.
  • American Calls are valued greater than or equal to European Calls.
  • Early exercise of American Puts is optimal only if stock prices drop sufficiently; dividends decrease the likelihood of early exercise.

Interest Rates Influence

• Call Options:

  • Call options allow investors to save capital by investing a smaller amount upfront, leaving the rest for other investments, like term deposits.
  • Example: Investing 1,000inacalloptionallows1,000 in a call option allows 1,000inacalloptionallows9,000 to be placed in a term deposit, potentially yielding more upon execution of the option.

• Put Options:

  • Puts offer the right to sell at a future date, essentially delaying a sale.
  • Higher interest rates decrease the value of put options as immediate sale offers better investment opportunities.

Volatility Effects

• Increased volatility raises the value of both Call and Put options.
  • Calls can yield higher profits if the market rises, but losses are capped.
  • Puts limit losses to the premium paid, making them valuable if anticipating price declines.

Put-Call Parity

• A crucial concept in options trading that relates the price of call and put options.
• It involves two portfolios:
  • Portfolio A contains a European Put option and a stock.
  • Portfolio B contains a European Call option and a bond at a risk-free rate.
• Payoffs of both portfolios are equivalent at expiration, maintaining parity:
  • When stock price (ST) is less than exercise price (X): Payoff equals X.
  • When ST is greater than X: Payoff equals ST.

Value Relationships

• For European options:
  • Value of a European Put: Call Option + Bond - Stock
  • Value of a European Call: Stock + Put Option - Bond
• American options can incorporate present value of dividends into their valuations.

Example Scenarios

• Example 1:

  • ANZ Call Options:
    • Cost: 0.52,SpotPrice:0.52, Spot Price: 0.52,SpotPrice:15.74, Expiration Time: 86/365, Exercise Price: $16.00.
  • ANZ Put Options:
    • Cost: 0.60,samespotpriceandexpiration,exerciseprice:0.60, same spot price and expiration, exercise price: 0.60,samespotpriceandexpiration,exerciseprice:16.00.
  • Higher put cost explained by it being "in the money" while the call is "out of the money."
  • Calculations validate that Put-Call Parity holds under given conditions.

• Example 2:

  • Demonstrating that "At the Money" call options will be worth more than “At the Money” put options when the spot price equals the exercise price.
  • Manipulation of put-call parity formula shows that call price equals put price plus the risk-free rate.