Chapter 20: investment Analysis & Fund Managemnet

Investment Analysis And portfolio Management

1. Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 22

2. Chapter 22
Option Contracts
Questions to be answered:
•How are options traded on exchanges and in OTC
markets?
•How are options for stock, stock indexes, foreign
currency, and futures contracts quoted in the
financial press?
•How can investors use option contracts to hedge
an existing risk exposure?

3. Chapter 22
Option Contracts
•What are the three steps in establishing the
fundamental “no arbitrage” value of an option
contract?
•What is the binomial (or two-state) option pricing
model and in what ways is it an extension of the
basic valuation approach?
•What is the Black-Scholes option pricing model
and how does it extend the binomial valuation
approach?

4. Chapter 22
Option Contracts
•What is the relationship between the Black-
Scholes and the put-call parity valuation models?
•How does the payment of a dividend by the
underlying asset impact the value of an option?
•How can models for valuing stock options be
adapted to other underlying assets, such as stock
indexes, foreign currency, or futures contracts?

5. Chapter 22
Option Contracts
•How do American- and European-style options
differ from one another?
•What is implied volatility and what is its role in
the contract valuation process?

6. Chapter 22
Option Contracts
•How do investors use options with the underlying
security or in combination with one another to
create payoff structures tailored to a particular
need or view of future market conditions?
•What differentiates a spread from a straddle, a
strangle, or a range forward?

7. Derivatives
•Forwards
–fix the price or rate of an underlying asset
•Options
–allow holders to decide at a later date whether
such fixing is in their best interest

8. Option Market Conventions
•Option contracts have been traded for centuries
•Customized options traded on OTC market
•In April 1973, standardized options began
trading on the Chicago Board Option Exchange
•Options Clearing Corporation (OCC) acts as
guarantor of each CBOE -traded options

9. Price Quotations for
Exchange-Traded Options
•Equity options
–CBOE, AMEX, PHLX, PSE
–typical contract for 100 shares
–require secondary transaction if exercised
–time premium affects pricing

10. Price Quotations for
Exchange-Traded Options
•Stock index options
–only settle in cash
•Foreign currency options
–allow sale or purchase of a set amount of non-USD
currency at a fixed exchange rate
–quotes in USD
•Options on futures contracts
–Give the right, but not the obligation, to enter into a
futures contract on an underlying security or
commodity at a later date at a predetermined price

11. The Fundamentals of Option Valuation
•Risk reduction tools when used as a hedge
•Forecasting the volatility of future asset prices
–direction and magnitude
•Hedge ratio is based on the range of possible
option outcomes related to the range of possible
stock outcomes
•Risk-free hedge buys one share of stock and sells
call options to neutralize risk
•Hedge portfolio should grow at the risk-free rate

12. The Binomial Option Pricing Model
•Two-state option pricing model
–up movement or down movement
–forecast stock price changes from one subperiod to
the next
•up change
•down change
•number of subperiods
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14. The Black-Scholes Valuation Model
•Continuous changes rather than discrete
•Geometric Brownian motion
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15. The Black-Scholes Valuation Model
Value is a function of five variables:
1. Current security price
2. Exercise price
3. Time to expiration
4. Risk-free rate
5. Security price volatility
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16. Estimating Volatility
•Mean and standard deviation of a series of price
relatives
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17. Problems With
Black-Scholes Valuation
•Stock prices do not change continuously
•Arbitrageable differences between option values
and prices (due to brokerage fees, bid-ask
spreads, and inflexible position sizes)
•Risk-free rate and volatility levels do not remain
constant until the expiration date

18. Problems With
Black-Scholes Valuation
•Empirical studies showed that the Black-
Scholes model overvalued out-of-the-
money call options and undervalued in-the-
money contracts
•Any violation of the assumptions upon
which the Black-Scholes model is based
could lead to a misevaluation of the option
contract

19. Option Valuation:
Extensions and Advanced Topics
•Valuing European-style put options
•Valuing options on dividend-bearing
securities
•Valuing American-style options
•Stock index options
•Foreign currency options
•Futures options

20. Option Trading Strategies
•Options are a leveraged alternative to
making a direct investment in the asset on
which the contract is based
•Put options could be used in conjunction
with an existing portfolio to limit the
portfolio’s loss potential

21. Option Trading Strategies
•Protective put options
•Covered call options
•Straddles, strips, and straps
•Strangle
•Chooser options
•Spreads
•Range forwards

22. The Internet
Investments Online
http://www.cboe.com/
http://www.optionmax.com
http://www.finance.wat.ch/cbt/options
http://www.coveredcall.com

23. End of Chapter 22
–Option Contracts

24. Future topics
Chapter 23
•Swap Contracts, Convertible Securities, and
Other Embedded Derivatives