Introduction to Derivatives and Instruments

Questions and Answers

What does a high Put/Call Ratio (PCR) indicate about market sentiment?

It reflects that market volatility is expected to decrease.

It suggests a bearish market with falling prices. (correct)

It shows there is indecision among investors about market direction.

It indicates a bullish market with rising prices.

Which statement correctly describes the intrinsic value of an out of the money European Put option?

It is greater than the present value of the exercise price.

It is equal to the difference between the exercise price and the spot price.

It is zero as it cannot be executed profitably. (correct)

It is equal to the present value of the exercise price.

How does the time value of an option vary in relation to its time to expiration?

It decreases as the time to expiration lengthens.

It is generally higher for options with longer times until expiration. (correct)

It is maximized when the option is deep in the money.

It increases as the option approaches expiration.

At expiration, the maximum value of an American Put option is determined by which of the following?

The difference between the exercise price and the spot price. Signup and view all the answers

What happens to the option value as the time to expiration decreases?

The option value generally decreases due to the time value of money. Signup and view all the answers

What condition defines an option as being 'in the money' for a call option?

The spot price is higher than the exercise price. Signup and view all the answers

Which situation describes a short position in a put option?

You expect the asset's price to rise above the strike price. Signup and view all the answers

What does the term 'premium' refer to in options trading?

The cost incurred by the buyer to purchase an option. Signup and view all the answers

How is open interest in options defined?

The total number of option contracts that remain unexercised. Signup and view all the answers

Which of the following statements accurately describes a long position on a call option?

You expect the price of the stock to rise above the strike price. Signup and view all the answers

Which of the following statements accurately describes a derivative?

A derivative is a contract that derives its value from the performance of underlying financial or non-financial instruments. Signup and view all the answers

What best distinguishes a futures contract from an options contract?

A futures contract obligates both parties to transact specific quantities at a set price, while an options contract provides the right but not the obligation. Signup and view all the answers

What is the primary purpose of arbitrage in financial markets?

To profit from price discrepancies of the same asset across different markets. Signup and view all the answers

In what way do over-the-counter (OTC) markets differ from exchange-listed markets?

OTC markets operate based on customizable contracts, whereas exchange-listed markets have standardized trading conditions. Signup and view all the answers

Which of the following statements regarding American options is true?

American options give the holder the right to buy or sell at any time before the expiration date. Signup and view all the answers

Study Notes

Underlying Instruments

Financial instruments include bonds, stocks, currencies, indexes, and other derivatives.
Non-financial instruments encompass commodities like metals, grains, livestock, electricity, gas, and oil, as well as weather derivatives.

Derivatives

A derivative derives its value from another financial instrument's price and involves a contract between two parties, with terms set today and delivery at a future date.
Main types of derivatives: options, forwards/futures, swaps.

Options

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price before or at expiration.
American Options can be exercised any time up to expiration, while European Options can only be exercised at expiration.

Forwards and Futures

Forwards and futures are contracts obligating two parties to exchange assets at a future date for a specific price.

Swaps

Swaps involve two parties exchanging future cash flows from different financial instruments, essentially a chain of futures.

Market Types

Spot Market: Immediate delivery of financial instruments.
Exchange Listed Markets: Regulated markets with defined position and order limits.
Over-the-Counter Markets: Customized contracts without restrictions.

Arbitrage

Arbitrage involves profiting from price discrepancies of the same asset in different markets.
The Law of One Price indicates price equality for the same asset in different markets.

Market Positions

Long Position (Taker): Buyer of the option; expects the stock price to rise.
Short Position (Writer): Seller of the option; expects the stock price to stay below the strike price.

Call and Put Options

Call Options: Right to buy the underlying asset.
Put Options: Right to sell the underlying asset.
Positions can be long (buy) or short (sell), depending on expectations of price movements.

Intrinsic Value

For Call Options: Intrinsic value is the difference between the spot and exercise prices (max(0, Spot Price - Strike Price)).
For Put Options: Intrinsic value is the difference between the exercise and spot prices (max(0, Strike Price - Spot Price)).

Open Interest & Put/Call Ratio

Open Interest: Number of outstanding option contracts; higher indicates more interest in particular options.
Put/Call Ratio (PCR): Indicates market sentiment; high PCR (>1) suggests bearishness, while low PCR indicates bullishness.

Time Value

Time Value represents the potential for future price increases; premium of an option comprises intrinsic and time value.
Longer time until expiration typically results in higher premium due to increased uncertainty.

Option Boundaries

Call Options have a minimum value of max(0, Spot Price - Exercise Price) for American Options.
Put Options have a minimum value of max(0, Exercise Price - Spot Price) for American Options.

Pricing Factors

Call Options premiums depend on exercise price, current spot price, volatility, time to expiration, and interest rates.
Put Options premiums similarly depend on these factors but inversely correlate with exercise prices.

Dividends and Early Exercise

Dividends impact option values; call options may be exercised early before a dividend payment to capture value.
American Options allow early exercise, primarily benefiting from the timing of dividend announcements.

Summary of Call and Put Options

Call Options:
- In the money (ITM) when spot price exceeds strike price.
- Out of money (OTM) when spot price is below strike price.
Put Options:
- ITM when spot price is below strike price.
- OTM when spot price is above strike price.

Example Evaluation

Call and put options have varying premiums based on their exercise prices; lower exercise prices for calls and higher for puts lead to increased premiums due to better profitability prospects.### Time Value and Options
Time value affects option pricing: longer expiration yields higher value, while shorter expiration leads to lower value.
American Puts are generally worth more than European Puts due to early exercise options.
American Calls are equally or more valuable than European Calls, as they too allow early exercise.
Early exercise of American Puts becomes less likely when stock dividends are high, as exercising forfeits future dividends.

Interest Rates and Options

Call options provide financial leverage: less initial investment compared to buying the stock outright allows funds to be allocated to interest-earning investments.
Delaying the sale of a stock through a put option means potential lost interest earnings from immediate sales due to high interest rates.
Higher market interest rates diminish the value of put options as they incentivize immediate selling and investing in higher rates.

Volatility's Impact on Options

Increased volatility enhances the value of Call options, offering the potential for higher profits when the market rises.
Conversely, higher volatility also increases Put options' value as it limits losses to the premium paid, while allowing for gains from price drops.

Put-Call Parity

Put-Call Parity is a key principle to determine price relationships between puts and calls.
Two portfolios analyzed: Portfolio A (European Put + Stock) and Portfolio B (European Call + Bond).
Pay-offs for both portfolios equalize under various market conditions, confirming the relationship that PV(Stock) + Put = Call + PV(Bond).

European Options Pricing

The pricing relationship for European options:
- Value of a European Put = Call Option + Bond - Stock
- Value of a Call Option = Stock + Put Option - Bond

American Options Considerations

American options can incorporate present value adjustments for dividends, affecting their pricing dynamics.

Example Analysis: ANZ Options

Call option for ANZ has a cost of $0.52, spot price of $15.74, and exercise price of $16.00.
Put option for ANZ costs $0.60, also with a spot price of $15.74 and exercise price of $16.00.
The Put costs more than the Call because it is "in the money" while the Call is "out of the money".
Example confirms that Put-Call Parity holds since the values align when calculated.

Illustrating Call and Put Value Comparison

An "At the money call option" should be priced higher than an "At the money put" due to risk-free returns.
Rearranging pricing formulas shows: as spot price equals exercise price (S = X), Call Price will always equal Put Price plus the risk-free rate.

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Description

Explore the essential concepts of financial and non-financial instruments, focusing on derivatives such as contracts based on bonds, stocks, and commodities. This quiz delves into the characteristics and workings of the derivative market, making it a crucial resource for understanding these financial instruments.