Options an Introduction-derivatives

admin — Tue, 26 May 2009 00:40:48 +0000

Options are classic examples of derivatives that can be used to increase or reduce risk exposure. An option is a contract that gives its owner the right to buy or sell some asset for a fixed price at some future date or dates.

Puts: A bearish type of options contract that gives the buyer the right, but not the obligation, to sell, or put, a specific asset (stock, index, or futures contract) at a specific price for a predetermined period of time.

A put option confers the right to sell an asset for a fixed price at some future date.

Calls: A bullish type of options contract that gives the buyer the right, but not the obligation, to buy, or call, a specific asset (stock, index, or futures contract) at a specific price for a predetermined period of time.

A call option gives its owner the right to buy some underlying asset for a fixed price at some future time.

when discussing an option, the contract can be described using four factors:

1. The name of the underlying stock (or future, index, exchange-traded fund, etc.).

2. The expiration date.

3. The strike price.

4. Whether it is a put or call.

The owner of the option has the right – but not the obligation – to buy (or sell) the asset. In contrast, under a forward contract one party is obliged to buy (or sell) the asset. Options can be based on a wide range of underlying assets. The asset could be a financial security such as a common stock or a bond. The underlying asset need not be a financial asset: it could be a Picasso painting or a rare bottle of Chateau Margaux. The terms of the option contract specify the underlying asset, the duration of the contract and the price to be paid for the asset. In option jargon, the fixed price agreed upon for buying the asset is called the exercise price or the strike price. The act of buying or selling the asset is known as exercising the option. The simplest type of option is a “European” option, which can only be exercised at the end of the contract period. On the other hand, an “American” option can be exercised at any time during the contract period.

Example: Put options provide protection in case the price of the underlying asset falls. WS Corp could use put options on gold to lock in a floor price. For example, suppose the current gold price isUS$880 an ounce and WS decides it wants to have a guaranteed floor price of US$885 per ounce in one year’s time. The company could buy one-year maturity put options with a strike price of US$885 an ounce. If the price of gold in one year’s time is below US$885, Sperrin has the right to sell its gold for a fixed price of US$885 per ounce. For example, if gold dropped to US$850 per ounce WS has the right under the put option to sell the gold for US$885 per ounce and the option is then worth US$35 per ounce. However, if the price were to rise to US$960, Sperrin can make more money by selling its gold at the prevailing market price and would not exercise the option. In this case, the option would not have any value at maturity. The put option gives WS protection against a fall in the price of gold below US$885 while still allowing the gold company to benefit from price increases. In this respect the put option differs from the forward contract. Under a forward contract, the firm still has price protection on the downside but it gives up the benefits of price increases because it has to sell the gold (at a loss) for the contract price.

Financial Derivatives Introduction

admin — Tue, 26 May 2009 00:39:28 +0000

A derivative is a contract that is used to transfer risk. There are many different underlying risks, ranging from fluctuations in energy prices to weather risks. Most derivatives, however, are based on financial securities such as common stocks, bonds and foreign exchange instruments.

The term derivative describes a new type of asset whose value is derived from the more familiar markets. That is to say that the centuries-old markets of stocks, bonds, and commodities have

given birth to a whole new asset class that is derived from them.

Derivatives always depend on their underlying parent markets to support them. Sort of like that black sheep brother-in-law who’s been staying at your parents’ house. Derivatives are similarly dependent on their underlying parent markets, but they never mooch beer money or run up the phone bill. The most basic derivatives are options, forwards, and futures.

Financial derivatives such as options, futures, forwards, and swaps inherit their value directly from their parents. In fact, a financial derivative would not have a price at all if the parent ceased to exist (stopped trading). The parents are the three basic financial groups that we are already quite familiar with: stocks, bonds, and commodities.

Three Basic Spot Markets (not Derivatives)

1. Stocks

2. Bonds

3. Commodities

Three Basic Derivative Markets

1. Forwards

2. Futures

3. Options

Market Analysis Blog » Derivatives

Options an Introduction-derivatives

Financial Derivatives Introduction