The futures exchange may set limits on the amount by which future prices may change from one day to the next. The exchange may increase or reduce these limits in response to perceived changes in the price volatility of the contract.
11.4 OPTION CONTRACTS
11.4.1 CHARACTERISTICS OF OPTION CONTRACTS
Learning Objective 11.4.1 – Understand the characteristics of option contracts and the risks undertaken by each party
Options mainly come in two forms: Call options and Put options.
The holder of a call option has the right, but not the obligation, to purchase the underlying asset at a pre-specified price (called the 'strike price' or the 'exercise price') on, or up to a specific date (expiry date) in the future. The underlying asset could be an individual stock, stock index, currency, gold, or some other asset
Example 11.3
A November 21st call option on Intel with an exercise price of $85, gives the holder of the option the right but not the obligation to buy one share of Intel stock (from the seller or writer of the call option) for $85 on November 21st.
It would only be profitable for the holder to exercise the option on November 21st if the market price of Intel exceeds $85.
If an option is not exercised by the expiry day, the option expires worthless. If the option can be exercised at any time up to the expiry date, the call is said to be an 'American Style' option. If the option can be exercised only on the expiry day, it is said to be a 'European Style' option.
A put option gives the holder the right but not the obligation to sell the underlying asset to the put seller on the expiry date (if it is an European style put) or any time up to the expiry date (if it is an American style put) at the option's exercise price. Put options can be exercised profitably if the asset value declines below the exercise price.
Example
11.4
A November 21st put option on Intel with an exercise price of $85, entitles the holder to sell stock of Intel to the put writer for $85. It will be profitable for the put option holder to exercise his option if the market price of Intel declines to below $85.
The investor selling or writing an option charges a price for the option that he is granting to the buyer. This price at which the option trades is also called the option premium. An investor who has purchased an option need not wait until expiry to realize his profit, he can sell his option to another investor in the options market. Similarly, an investor who has sold an option can buy an option to offset his position. Options are traded on organized exchanges such as the Chicago Board Options Exchange (for stocks), the Philadelphia Exchange (for currencies). For other commodities and securities, options are traded in a number of other exchanges in the US and around the world. As with futures, it is the individual exchanges that define and standardize the options contracts, as well as setting the rules under which the options are traded.
The financial press carries market prices for options on a variety of underlying assets. The table below provides details for options trading on Intel stock at the Chicago Board Options Exchange (CBOE) as reported in the Wall Street Journal for three different exercise prices and three expiry months.
WSJ quotation - Options on Intel Stocks
Intel Strike Exp. Vol. Call
3 p.m. Vol. Put 3p.m. 80,25 75 Jan. 712 11 35 5,75 80,25 80 Oct. 2542 3,25 2360 7,125 80,25 85 Oct. 4986 1,375 354 7 1/8 80,25 85 Nov. 1630 3,5 197 8,75
The second column indicates the closing price of Intel stock - the underlying asset on which the option is written. Volume (Vol.) refers to the number of calls or puts traded on the previous day. The closing call and put premiums are shown in columns 5 and 7. The closing price for the January $75 strike call contract on Intel was $11 and the put for the same exercise price had a premium of $5.75. On the CBOE, each stock option contract is for the delivery of 100 shares, so an investor purchasing a call option would have to pay 100 × $11 = $1,100, while a put contract would cost 100 × $5.75 = $575.
The relationship between the exercises price and the market price of the underlying determines whether the option is profitable or not. The call option is said to be in the money if its exercise rice is lower than market price, at the money if the two prices are equal and, out of the money if the exercise price is higher than the market price of the underlying for put option the reverse is true.
11.5 SWAP CONTRACTS
A swap is a contractual agreement between two parties under which each agrees to make periodic payments on the basis of some underlying asset price or reference rate over a specified period of time. A swap based on interest rates is outlined in the next section.
11.5.1 INTEREST RATE SWAPS
Learning Objective 11.5.1 – Understand the characteristics and basic structure of an interest rate swap
A common form of swap is an interest rate swap in which one party makes a fixed interest rate payment while the other makes a floating rate payment - sometimes referred to as a fixed for floating swap. Market participants use interest rate swaps to transform one type of interest liability (such as a fixed rate liability) into another (such as a floating rate liability).
The following example shows the basic structure of an interest rate swap. Three participants are involved, AAA and BBB are corporations interested in entering into the swap agreement and they are brought together via an intermediary - the swap dealer. AAA prefers floating rate funding but has a relative advantage over BBB in the fixed rate market (spread of 2%), whereas BBB desires fixed rate funding but has a relative advantage over AAA in the floating rate market (spread of 1%). The swap dealer recognizes the opportunity for everyone to benefit by joining forces. AAA issues fixed rate bonds, while BBB issues floating rate bonds, each then agrees to assume the liability of the other- this is the swap.
Interest Rate Swap
AAA Prefers floating rate debt Can borrow floating at LIBOR + 1 Or can borrow fixed at 10%
AAA
BBB Prefers fixed rate debt Can borrow floating at LIBOR Or can borrow fixed at 12%