Questions and Answers
What does a high Put/Call Ratio (PCR) indicate about market sentiment?
Which statement correctly describes the intrinsic value of an out of the money European Put option?
How does the time value of an option vary in relation to its time to expiration?
At expiration, the maximum value of an American Put option is determined by which of the following?
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What happens to the option value as the time to expiration decreases?
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What condition defines an option as being 'in the money' for a call option?
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Which situation describes a short position in a put option?
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What does the term 'premium' refer to in options trading?
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How is open interest in options defined?
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Which of the following statements accurately describes a long position on a call option?
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Which of the following statements accurately describes a derivative?
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What best distinguishes a futures contract from an options contract?
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What is the primary purpose of arbitrage in financial markets?
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In what way do over-the-counter (OTC) markets differ from exchange-listed markets?
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Which of the following statements regarding American options is true?
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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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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.