Options

Options

1. Gives the buyer the right but not the obligation to buy or sell an asset an agreed price at or before an agreed future date. The buyer pays a premium. Can be OTC or traded contracts. OCT can be tailored to buyer needs whereas an ET is standardised. The seller bears more risk that the buyer which is compensated by the premium.

   • Types: * Options written on physical commodities *Options on IRSs *Options on IR *Options on Foreign Exchange

2. LONG CALL; The buyer has the right but not the obligation to buy. SHORT CALL: The seller or writer of the call has the obligation but not the right to sell the commodity. LONG PUT: The buyer has the right but not the obligation to sell. SHORT PUT: The seller has the obligation but not the right to buy

3. PRICING: 1. Intrinsic Value: Represent the difference between the forward price and the option exercise price. 2. Time Value: Is the remaining premium in excess of intrinsic value before expiration

   • KEY DETERMINANTS IN PRICE: * Spot Price * Strike Price * Time to expiry * Volatility * Domestic and foreign interest rates

4. Hedging Using Options

   • Companies can adjust their underlying exposure by using options to limit downside risk while still allowing the company to benefit from favourable price movements

5. Determinants of Options Premiums

   • Black-Scholes-Merton option pricing model: *Spot price of the underlying asset * Excercise price * time to maturity * Risk-Free rate of return *Expected volatility of the underlying asset

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