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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
Lesson # 44
Uses of Derivatives:
1. Risk Management:
Instead of wheat, imagine that your crop is equity securities: You want their value to grow
and generate capital gains. Your focus is more on investor demand than on supply. When
the country goes on the stock-buying binge, prices go up. When people get cold feet and
retreat from the market, prices go down. This market risk phenomenon is generally
analogous to the farmer's price risk. Similarly, someone holding bonds faces a potential for
a paper loss should interest rates unexpectedly. Derivative assets, especially interest rate
futures, can be used to reduce the interest rate risk.
2. Risk Transfer:
Derivatives are much more convenient (and less expensive) to use than security purchases
or sales each time the portfolio manger decides to alter market exposure. Futures and
options provide a means for risk to be transferred from one person to some other market
participant who, for a price is willing to bear it.
3. Financial Leverage:
Derivatives may provide financial leverage, which is one of the primary reasons some
speculators use them. As an example, an investor may feel that Ionics, Inc. (ION, NYSE), a
manufacturer of water treatment products, is an excellent take over candidate. If that
investor bought 100 shares of this stock at $29, the cost would be $2,900. As an alternative
the investor could speculate on takeover rumors using a single stock option selling for
perhaps $300. With this position, the investor would benefit from a sharp increase in the
stock price, but would have only a modest amount of money at risk. The worst that could
happen is that the investor would lose all $300. On the other hand, an investor who bought
the stock could lose much more than that if the stock plummeted.
4. Income Generation:
Some people use derivatives as a means of generating additional income from their
investment portfolio. Options are widely used for this purpose in the portfolios of
endowment funds, pension funds, and individual portfolios.
5. Financial Engineering:
Just as the chemist mixes compounds in the laboratory to produce something with known
characteristics, a financial engineer can mix financial assets in such a way that portfolio has
special characteristics. Derivative assets are the basic building blocks the engineer uses.
Some of the recent financial disasters involving derivatives occurred because the product
mix was the potentially volatile. Nitroglycerin can be use to treat heart disease, but masked
men of the Wild west also used it to blow up trains. Slight variations in the composition of
portfolio can result in drastically different characteristics.
Investment Analysis & Portfolio Management (FIN630)
What's next?
It is unlikely that we have seen the last of innovation in the derivative assets markets. Many
brilliant minds are searching for a better mousetrap in the areas of risk management and
income generation. As with much of scientific discovery, what is commonplace today
would have been a marvel just a few years ago. One thing that is certain is that these
products are the permanent features of the financial landscape. An informed investment
professional needs a basic understanding of their uses and potential risks.
The Origin of an Option:
Two parties are necessary to trade; if someone buys an option, someone else has to sell it.
Unlike more familiar securities such as shares of stock, there is no set number of put or call
options. In fact, the number in existence changes every day. Options can be destroyed. This
unusual fact is crucial to understanding the options market.
The first someone makes in a particular is called an opening transaction. When the option is
subsequently closed out with a second trade (or with expiration of the option), this latter
trade is called a closing transaction. Purchases and sales can be either type of transaction.
Buying something as an opening transaction is perhaps easier to understand than selling
something as an opening transaction. Returning to the football ticket example, the university
created the tickets and sold them; this was an opening transaction for the university. When
an option is sold as an opening transaction, it is called writing an option.
No matter what the owner of an option does, the writer of the option keeps the option
premium. The university keeps the $ 24 you paid for the two tickets whether you go the
game or not.
Options have an important characteristic called fungibility, meaning that, for a given
company, all options of the same type with the same expiration and striking prince are
identical. Just as a $1 bill is equivalent to any other $ bill, a Microsoft APR 90 call written
today is equivalent to a Microsoft APR 90 call written last month. Fungibility is particularly
important to the option writer. An investor who writes an option receives premium for doing
so. If market conditions changes a week later, the investor can buy an identical option and
close out the position. The investor pays for the option purchased, which may be more or
less than the amount received when the investor wrote the option. The important point is
that the option need not be repurchased from the specific person to whom it was sold,
because the options are fungible.
Which represent claims on an underlying common stock, are created by investors and sold
to other investors? The corporation whose common stock underlies these claims has no
direct interest in the transaction, being in no way responsible for the creating, terminating,
or executing put and call contracts.
Contracts giving the owner the Tight to buy or sell the underlying asset
Investment Analysis & Portfolio Management (FIN630)
An option to buy a stock at a sated price within a specified period of months
A call option gives the holder the right to buy (or "call away") 100 shares of a particular
common stock at a specified price any time prior to a specified expiration date. Investors
purchase calls if they expect the stock price to rise, because (lie price of the call and the
common stock will move together. Therefore, calls permit investors to speculate on a rise in
the price of the underlying common stock without buying the stock itself.
An option to sell a stock at a stated price within a specified period of months
A put option gives the buyer the right to sell (or "put away") 100 shares of a particular
common stock at a specified price prior to a specified expiration date. If exercised, the
shares are sold by the owner (buyer) of the put contract to a writer (seller) of this contract
who has been designated to take delivery of the shares and pay the specified price. Investors
purchase puts if they expect the stock price to foil, because the value of the put will rise as
the stock price declines. Therefore, puts allow investors to speculate on * decline in the
stock price without selling the common stock short.
Why Options Market?
An investor can always purchase shares of common stock if he or she is bullish about the
company's prospects or sell short if bearish. Why then should we create these indirect
claims on a stock as an alternative way to invest? Several reasons have been advanced, in-
cluding the following:
1. Puts and call expand the opportunity set available to investors, making available
risk-return combinations that would otherwise be impossible or that improve the-
risk-return characteristics of a portfolio. For example, an investor can; sell the stock
short and buy a call, thereby decreasing the risk on the short sale for the life of the
2. In the case of calls, an investor can control (for a short period) a claim on the
underlying common stock for a much smaller investment than required to buy the
stock itself. In the case of puts, an investor can duplicate a short sate without a
margin account and at a modest cost in relation to the value of the stock. The buyer's
maximum loss is known in advance. If an option expires worthless, the most the
buyer can lose is the cost (price) of the option.
3. Options provide leverage magnified percentage gains in relation to buying the stock;
furthermore, options can provide greater leverage than fully margined, stock
4. Using options on a market index such as the Standard & Poor's 500 Composite
Index (S&P 500), an investor can participate in market movements with a, single
trading decision.
Understanding Options:
To understand puts and calls, one must understand the terminology used in connection
with them. Our discussion here applies specifically to options on the organized exchanges
as reported daily in such sources as The Wall Street Journal.4 Important options terms
Investment Analysis & Portfolio Management (FIN630)
include the following:
1. Exercise (strike) price:
The exercise (strike) price is the per-share price at which the common stock may be
purchased (in the case of a call) or sold to a writer (in the case of a put). Most stocks in the
options market have options available at several different exercise prices, thereby providing
investors with a Choice. For stocks with prices greater than $25, the strike price changes in
increments of $5, whereas for those under $25, the increment is $2.50. As the stock price
changes, options with new exercise prices are added.
2. Expiration date:
The expiration date is the last date at which an option can be exercised. All puts and calls
are designated by the month of expiration. The options exchanges currently offer sequential
options and-other shorter term patterns. The expiration dates for options contracts vary from
stock to stock but do not exceed nine months.
3. Option premium:
The option premium is the price paid by. the option buyer to the writer (seller) of the option
whether put or call. The premium is stated on a per-share basis for options on organized
exchanges; and since the standard contract is for 100 snares, a $3 premium represents $300,
a $15 premium represents $1500, and so forth. Information on options premiums can be
found on The Wall Street Journal's "Listed Options Quotation" page. The most active
contracts for the day are reported along, with some individual equity options. Information
about index options is also available on this page.
The options page of The Wall Street Journal, as well as other sources, also carries the
information for long-term options known as long-term equity anticipation securities
(LEAPS), which were introduced in 1990. These long-term options, available on roughly
450 stocks and several indexes, trade on four U.S. exchanges. All LEAPS options for
stocks expire in January, and for indexes, December. Maturities extend out to about two
and one-half years.
LEAPS are typically more expensive than short-term options, but with a longer maturity,
they may cost less per share when calculated on a daily basis. Like short-term options, they
can be used to hedge-or speculate.
Standardized Options Characteristics:
All options have standardized expiration dates. For most options, it falls on the Saturday
following the third Friday designated months. Individual investors typically view the third
Friday of the month as the expiration date, because exchanges are closed to public trading
on Saturday.
Striking prices are established at multiples of 2 ˝ or $5 depending on the current stock
price. Stocks priced at $25 or below have the low multiple, while higher period stocks have
the $5 multiple. Shifts in the price of a stock result in the creation of new striking prices. As
a matter of policy there is always at least one striking price above and at least below the
current stock price.
Investment Analysis & Portfolio Management (FIN630)
Both puts and calls are based on 100 shares of the underlying security. As investor who
buys a call option on the stock of particular company is purchasing the right to buy 100
shares of stick. It is not possible to buy or sell odd lots of options.
The Premium:
The premium has two components: intrinsic value and time value. For a call option,
intrinsic value equals stock price minus striking price; for a put, intrinsic value equals
striking price minus stock price. In some respects, determining intrinsic value is the first
step in valuing an option. By convention, intrinsic value cannot be less than zero. Time
value is equal to the option premium minus the intrinsic value.
If an option has no intrinsic value, it is out-of-the-money, if it does have intrinsic value, it is
in-the-money. In special when an option's striking price is exactly equal to the price of
underlying security, the option is at-the-money.
Time value
How Options Work:
noted, a standard call' (put) contract gives the buyer the right to purchase (sell) 100
shares of a particular stock at a specified exercise price any time before the expiration date.
Both puts and calls are created by sellers who write a particular contract. Sellers (writers)
ate investors, either individuals or institutions, who seek to profit from their beliefs about
the underlying stock's likely price performance, just as the buyer does.
The buyer and the seller have opposite expectations about the likely performance of the
underlying stock, and therefore the performance of the option.
1. The call writer expects the price of the stock to remain roughly steady or perhaps
move down.
2. The call buyer expects the price of the stock to move upward relatively soon.
3. The put writer expects the price of the stock to remain roughly steady or perhaps
move up.
4. The put buyer expects the price of the stock to move down relatively soon.
The Options Exchanges:
Five option exchanges constitute the secondary market: the Chicago Board Options
Exchange (CBOE), the American, the Philadelphia, the Pacific, and the newer International
Securities Exchange (1SE) in New York. Traditionally, the first four exchanges controlled
the trading of U.S. options, each handling different options and competing very little. The
ISE began trading in May 2000, and now has a substantial share of U.S. trading volume in
options. This all-electronic market is extremely efficient, and has forced the other four
exchanges to handle all options. This competition has led to lower costs and narrower
spreads for customers, and quicker access to the market.
Investment Analysis & Portfolio Management (FIN630)
The options markets provide liquidity to investors, which is a very important requirement
for successful trading. Investors know that they can instruct their broker to buy or sell
whenever they desire at a price set by the forces of supply and demand. These exchanges
have made puts and call a success by standardizing the exercise date and exercise price of
The Clearing Corporation:
The options clearing corporation (OCC) performs a number of important functions that
contribute to the success of the secondary market for options. H functions as an
intermediary between the brokers representing the buyers and the writers. That is, once the
brokers representing the buyer and the seller negotiate the price on the floor of the
exchange, they no longer deal with each other but with the OCC.
Through their brokers, call writers contract with the OCC itself to deliver shares of
the particular stock, and buyers of calls actually receive the right to purchase the shares
from the 0CC Thus, the OCC becomes the buyer for every seller and the seller for every
buyer, guaranteeing that all contract obligations will be met. This prevents the problems
that could occur as buyers attempted to force writers to honor their obligations. The net
position of the OCC is zero, because the number of contracts purchased must equal the
number sold.
Investors wishing to exercise their options inform their brokers, who in turn inform the
OCC of the exercise. The OCC randomly selects a broker on whom it holds the same
written contract, and the broker randomly selects a customer who has written these options
to honor the contract. Writers chosen, in this manner are said to be assigned an obligation or
to have received an assignment notice. Once assigned, the writer cannot execute an
offsetting transaction to eliminate the obligation; .that is, a call writer who receives an
assignment must sell the underlying securities, and a put writer must purchase them.
One of the great advantages of a clearinghouse is that transactors in this market can easily
cancel their positions prior to assignment. Since the OCC maintains all the positions for
both buyers and sellers, it can cancel out the obligations of both call and put writers wishing
to terminate their position. With regard to puts and calls, margin refers to the collateral than
option writers provide their brokers to erasure fulfillment of the contract in case of exercise.
Options cannot be purchased on margin. Buyers must pay 100 percent of the purchase price.