Options contracts Part A Flashcards

1
Q

What is an Option Contract

A

An option is a contract that gives the buyer the right, but not the obligation to buy or sell an asset at a predetermined price (exercise price) to the seller of the option:

In other words, the buyer (holder, or person in the long position) has a right to exercise (or to enforce the contract), but the seller (writer, or person in the short position) must comply with the buyer’s decision

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2
Q

why is an option a type of derivative security?

A

Options represent a claim on an underlying asset

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3
Q

An option contract normally specifies:

A
  1. a call or put option
  2. exercise or strike price
  3. maturity or expiration date
  4. specific asset underlying the option contract
  5. amount of the asset
  6. American or European in nature
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4
Q

an option contract normally specifies

call option or put option

distinguish between the two

A

Whether the option gives the buyer a right to buy the underlying asset (a call option) at the exercise price or a right to sell the underlying asset (a put option) at the exercise price;

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5
Q

an option contract normally specifies

exercise or strike price

A

X (i.e. the price at which the asset may be bought / sold by the option holder)

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6
Q

an option contract normally specifies

maturity or strike date

A

which is the terminating date of the option. The time to expiry is denoted T

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7
Q

an option contract normally specifies

the amount of the asset….

A

The amount of the asset that may be bought or sold under the option contract

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8
Q

call option

what does it give the holder?

A

It gives the holder (the person in the long position) the right but not the obligation to buy the asset underlying the contract;

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9
Q

call option

the writer of the option is

A

The writer of the option (the person in the short position) is obliged to sell the asset if the holder exercises their right to buy it under the option contract

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10
Q

call option

distinguish between a European and an American call option

A

If the option can only be exercised by the holder at expiry, it is known as a European call option.

If the option can be exercised by the holder at any time before expiry or at expiry, it is known as an American call option

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11
Q

put option

gives the holder

A

It gives the holder (the person in the long position) the right but not the obligation to sell the asset underlying the contract;

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12
Q

put option

the writer of the put option

A

the writer of the option (the person in the short position) is obliged to buy the asset if the holder exercises their right to sell it under the option contract

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13
Q

distinguish between American and European put options

A

If the option can only be exercised by the holder at expiry, it is known as a European put option.

If the option can be exercised by the holder at any time before expiry or at expiry, it is known as an American put option

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14
Q

when will call options be exercised?

A

When the price the holder can buy for in the spot market, S, is greater than the price they would pay for the asset under the option, X

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15
Q

when will put options be exercised?

A

When the price the holder can sell for in the spot market, S, is less than the price they would sell for the asset under the option, X

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16
Q

When the holder exercises a call option, the gain (payoff) the holder makes from the option can be expressed

Call Option

A

(ST-X) if ST>X, 0 otherwise (as the holder won’t exercise the option if STout of the money). In other words, the payoff is max (ST-X,0)

17
Q

When the holder exercises a put option, the gain (payoff) the holder makes from the option can be expressed

Put Option

A

(X-ST) if X>ST, 0 otherwise (as the holder won’t exercise the option if X because it is out of the money). In other words, the payoff is max (X-ST,0).

18
Q

payoff for the writer of the option or the person in the short position

call option

A

-(ST-X), or (X- ST), if ST>X, 0 otherwise (as the holder won’t exercise the option)

19
Q

payoff for the writer of the option or the person in the short position

Put Option

A

-(X-ST), or (ST-X) if X> ST, 0 otherwise (as the holder won’t exercise the option)

20
Q

what do payoff diagrams show?

A

the payoff for the holder is the exact opposite of the payoff for the writer of the option

21
Q

Payoff from a long position in a European call option

A
22
Q

pay off from a short position in a European Call option

A
23
Q

pay off from a long position in a European PUT option

A
24
Q

payoff from a short position in a European PUT option

A
25
Q

the holder of the option will only exercise the option if it benefits them this is when

A

holder of the option will only exercise the option if it benefits them (i.e. their minimum payoff is 0) and

the payoff for the writer is the exact opposite of the holder’s payoff (i.e. their maximum payoff is 0)