Chapter 20

True/False questions
1.

F Option contracts protect a hedger against potential losses but prevent the hedger making a

profit from favourable price movements.

2.

T The strike price is the price at which an option can be exercised by the option buyer at a

future date.
3.

F A put option gives the buyer of the option the right to buy the specified asset at the

predetermined exercise price.

4.

F A European-type option may be exercised by the holder of the option at any time up to, and

including, the expiry date.

5.

T A collar is an options strategy that combines the simultaneous buying and selling of a cap

and a floor in order to minimise the net cost of an interest rate risk cover.
6.

F A long-call party would not exercise a call option with an exercise price of $8.00 and a

premium of $1.00 if the current price of the underlying asset is $8.90 on the exercise date.
7.

F The short-call party to a call option with an exercise price of $12.00 and a premium of

$2.00, where the current price of the underlying asset is $13.80 on the exercise date, would make a
loss of $0.20.
8.

F A put option buyer will exercise the option with an exercise price of $10.00 and a premium

of $1.50 if the current price of the underlying physical market asset is $11.30 on the exercise date.
9.

F The seller of a put option will make a profit of $0.20 if an option has an exercise price of

$10.00 and a premium of $1.50 and the current price of the underlying physical market asset is
$11.30 on the exercise date.
10.

F One of the advantages for both buyers and sellers of options is that, while the potential

losses are limited, the potential profits are unlimited.

11.

T The writer of a call option on a particular asset is said to have written a covered option if

the writer owns sufficient of the underlying asset to meet the requirements of the option contract
should it be exercised.
12.

T Naked short selling using option contracts has been banned in Australia as a result of the

so-called sub-prime credit crisis.

13.

T A LEPO is a deliverable European-type option normally based on a parcel of 100 shares

listed on the ASX.

14.

F An in-the-money option is one where the exercise price is equal to the current price of the

underlying asset in the physical market.

15.

T All other relevant variables being constant, the longer the time to the expiration of an

option, the greater the value of the option.

16.

T All other relevant variables being constant, the greater the price volatility of the underlying

asset, the more valuable is an option.

17.

F There is a positive relationship between the value of a put option and the rate of interest, all

other relevant variables being constant.

18.

T If you are to acquire an asset in the future, and you expect the asset price to rise, the

purchase of a call option would provide some protection against the expected price rise.
19.

T One way of profiting from an expected fall in the price of an asset that you own is to write

a call option on the asset.

20.

T Speculators who believe that the price of an asset is going to become highly volatile in the

near future could position themselves to profit from a price rise, or fall, by simultaneously buying a
call option and a put option on the asset.

Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For example, an undergraduate student may only be required to briefly introduce
points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.
1. Describe the characteristics of a call option and a put option, and define the premium and
the strike price, or exercise price, from the perspective of both the buyer and the writer of
these contracts. (LO 20.1)

Option contractgives the buyer of the option the right, but not the obligation, to buy or sell a
specific asset on a specified date at a price determined today.

Call optiongive the buyer of the option the right to buy under the terms of the option contract.

Put optiongives the option buyer the right to sell under the terms of the contract.

Premiumin order to receive the right to buy or sell (without the obligation), the buyer of the
option will pay a premium amount to the writer of the option. The premium represents the

maximum potential income the writer can earn for the commitment to the contract. Note: if the
price moves against the writer, they will begin to lose the premium. If this continues the writer
may potentially make a loss on the contract.

Exercise pricesometimes referred to as the strike price; the price specified in the option
contract at which the option buyer can buy or sell.

2. A company has a debt facility that will need to be refinanced in three months time. It is
concerned that interest rates may change in that time, but is uncertain whether they will rise
or fall. The company is considering using an option contract to manage the risk exposure.
What are the advantages and disadvantages of using an option contract strategy to manage an
interest rate risk exposure? In your answer, consider the nature of an option contract within
the context of exchange-traded option contracts and over-the-counter option contracts. (LO
20.1)

An options contract gives the buyer the right, but not the obligation, to buy or sell.

If rates rise the option contract provides protection to the borrower, however, if interest rates fall,
the borrower is able to take advantage of the lower rate by not exercising the contract and
allowing the option to lapse.

The borrower needs to consider the opportunity costs and cash flow implications of an option
contract; that is, the premium will need to be paid up-front.

An exchange traded option contract is a standardized contract offered through a formal exchange
such as the ASX. In this case, the contact terms may not exactly match the risk exposure of the
company. If the contract is in-the-money then it is possible to sell the contract through the
exchange.

An over-the-counter contract is not standardized and therefore can be tailored to meet the
specific risk management needs of a risk manager. However, there is not a liquid market.

3. (a) Explain the differences between American-type options and European-type options.

An American [type] option is an option that can be exercised by the holder any time between its
origination and expiration.

A European [type] option gives the option buyer the right to buy or sell at the exercise price only
at a specified date or dates.

(b) What are the advantages of each option contract for both the buyer and the seller of a
contract?

The American type option is a much more flexible product; for example, the holder of an
American type option to buy Westpac Banking Corporation shares at $20.35 may exercise the
right to buy at any time during the life of the option, particularly if Westpac shares are trading in
the market above the $20.35 exercise price.

Exchange traded option contracts are often American type options.

The European type option is relatively cheaper in that a lower premium is payable; for example,
the buyer of a put option to sell BHP Billiton shares at $30.00 will hold the option to exercise
that right on the expiration date specified in the option contract.

This lower cost type of option may be attractive to risk managers who have a specific date
related risk to hedge.

(c) Discuss the effect of each option type on the pricing of the premium. (LO 20.1)

The buyer of an American type of option will be required to pay a higher premium than would
otherwise be payable for the same European type option. The higher premium on the American
type option, or the lower premium on the European type option, reflects the relevant risk
relationships.

The writer of the American type option will be compensated for providing a much more flexible
risk management product.

4. Suncorp Group shares currently trade at $6.98. An investor enters into a long call option on
Suncorp Group with an exercise price of $8.05 per share in two months, and a premium of
$0.15 per share.
(a) Calculate the break-even price for the short call position.

The short call position is held by the writer of the option. The writer of the option receives the
$0.15 premium. The break-even for the writer is the exercise price plus the premium.

That is, $8.05 + $0.15 = $8.20

(b) Draw a fully labelled diagram of the long call and short call positions.

(a)Buyerofoption
Profit

(b)Sellerofoption
Profit
Breakeven

Breakeven

+$0.15
Premium
0

$0.15

Loss

$8.05
$8.20

Market
price

$8.20
$8.05

Premium

Exercise
price

Loss

Exercise
price

(c) At what minimum stock price will the option buyer exercise the option on the expiration
date? (LO 20.2)

The option buyer will exercise the option when the share price in the stock market is above $8.05

While the share price is between $8.05 and $8.20, the buyer will exercise the option in order to
recover some of the premium already paid.

5. Wesfarmers shares currently trade at $29.66. A funds manager is holding a large number of
Wesfarmers shares in an investment portfolio and wishes to protect the value of the
investment. The manager buys a long put option with an exercise price of $29.45 per share and
pays a premium of $1.20 per share.
(a) By entering into this options strategy, explain whether the funds manager will exercise the
option if the spot price is above or below the exercise price.

The funds manager has bought the right to sell Wesfarmers shares at $24.95

The manager will exercise the option if the share price is below the option exercise price of
$24.95

(b) Calculate the break-even price for the long put position.

The break-even point for the buyer of the option (long put) is the exercise price less the
premium; that is: $24.95 - $1.20 = $23.75

Note: the option holder will exercise the option when the share price is between $23.75 and
$24.95 as he/she will be able to offset the cost of at least part of the premium that has already
been paid. If the share price falls below $23.75 the option holder will be in-the-money.

(c) Draw a fully labelled diagram of the long put and the short put positions. (LO 20.2)
(a)Buyerofoption
Profit

(b)Sellerofoption
Profit

Breakeven

Breakeven

+$1.20
Premium
$23.75

$1.20

$24.95

Market
price

$24.95
$23.75

Premium

Loss

Exercise
price

Loss

Exercise
price

6. A speculator has written an option on the shares of Newcrest Mining.

(a) Discuss the differences between a covered option and a naked option.

With an exchange-traded option, the writer is currently required by the market regulator to write
a covered option.

Previously, a writer of an option who did not have cover was said to have written a naked option.

In response to the financial turmoil experienced in the global financial markets in 2008, most
major financial market regulators have banned naked short-selling, plus the covered short-selling
of certain listed stocks (generally shares of financial institutions). These bans will be reviewed
from time to time.

The current regulatory position can be found on each regulator's website, for example, in
Australia at www.asic.gov.au or www.asx.com.au.

(b) What requirements will be applied by an options exchange to ensure that the option writer
can meet the contract obligations? (LO 20.2)

The potential loss that may be incurred by the writer of an option contract could extend well
beyond the amount of the premium received.

An option is covered when there is a guarantee that the writer of the option can complete the
contract.

The writer of a call option would be considered to have written a covered call option if the writer
owned sufficient of the underlying asset to meet the requirements of the option contract in the
event that it is exercised; for example, if the call option gave the right to the option-holder to buy
shares in BHP Billiton Limited, the option would be covered if the writer held enough of those
shares to meet the requirements under the option.

Under an alternative arrangement, an option-writer would be covered if a third party, such as a

securities custodian, provided a guarantee that the option-writer could borrow the underlying
security on or before the options contract settlement date.

Transparency and reporting requirements have been tightened with a requirement that covered
short selling positions must be notified to the ASX. Naked short-selling is not permitted.

7. (a) Options exchanges tend to specialise in certain option contracts. Discuss this statement
within the context of the international options markets.

Globalisation of the financial markets, coupled with the use of electronic communication and
product delivery systems means that options trading can take place 24-hours a day around the
globe. The tyranny of distance is no longer a constraint on trading.

Price with the markets is directly influenced by the level of liquidity in the market. Highly liquid
markets tend to have lower costs and tighter margins, and therefore become more competitive.

Exchanges now tend to specialise in options products in which they have strength and liquidity

The strong options contracts are typically based on underlying local physical market
commodities and financial instruments; for example, in Australia options contracts offered by the
ASX are based on shares listed on the Australian exchange.

(b) Option contracts may be traded by open outcry or through electronic trading systems.
Briefly explain each of these methods used for trading option contracts. (LO 20.3)

Open outcry occurs on the floor of the exchange. Clients will contact their brokers who will
forward the orders directly to traders on the floor of the exchange. The trader will use a
combination of voice and hand-signals to try and execute the order with another trader on the
floor. To an observer, floor trading looks very colourful and noisy, but it may be argued that it is
less efficient than electronic trading.

The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) are both
open outcry exchanges.

Electronic trading uses sophisticated communication and computer-based trading and settlement
systems. Clients contact their broker who enters the order directly into the exchanges electronic
trading system. The system automatically matches buy and sell orders and provides the
information to the clearing-house.

The clearing-house uses its settlement system to accept margin calls, record contracts and
facilitate delivery as required.

The Australian Stock Exchange (ASX), including the Sydney Futures Exchange (SFE) is an
example of an electronic exchange.

Electronic systems would appear to be more efficient in the conduct of trades and also allow
price information to be more quickly provided to the market.

8. Option categories available through the ASX include equity options, LEPOs and warrants.
Briefly discuss the structure and features of each of these option categories. (LO 20.3)
Equity options:

Equity options are issued based on the ordinary shares of specified companies listed on the ASX.

For each company share option, there are usually three or more contracts traded with the same
expiration date, but with the options distinguished by different exercise prices. Also there are
numerous options on the particular share, with the options being distinguished by the expiration
date.

Contract expiry dates, at issue, typically range from six months out to three years.

The clearing-house maintains a system of deposits, maintenance margins, and a share scrip
depository.

The writer must write covered options, where scrip is deposited with the clearing house, or must
be cash covered by meeting deposit and maintenance margin requirements.

If an option is exercised, settlement occurs at the delivery of the underlying shares by the option
writer.

Low exercise price options:

A LEPO is a highly leveraged option on individual stocks, with an exercise price of between one
and 10 cents, and a premium that is therefore comparable to the price of the underlying stock.
This means that they behave much like individual share futures and, like futures, they can be
traded on a margin.

The LEPO is a deliverable contract, with a European-type expiry, that is, it can be exercised only
on the last trading day. Each contract normally covers 1000 shares. If the holder elects to
exercise at expiry, it will take delivery of those 1000 shares from the writer at the exercise price.

LEPO contracts are currently available over a range of high-liquidity stocks listed on the ASX.

While the premium of a LEPO is similar to the current market price of the underlying listed
shares, the cost is usually lower than the share price because the holder of a LEPO is not entitled
to receive dividend payments associated with the shares. This makes the LEPO attractive to
foreign investors who typically are unable to take advantage of franking tax credits that may be
attached to Australian company dividend payments.

Warrants:

A warrant is simply an options contract.

The warrant conveys a right to the buyer, or holder, of the warrant, but the holder is not obliged
to exercise the warrant.

Exchange traded warrants are mainly issued as financial products principally designed for
investment and the management of an exposure to price movements in the markets.

On the ASX, these warrants are not issued by the underlying companies, but by financial
institutions as investment and financial risk management products. Warrants issued and traded
through the ASX may be American-type or European-type contracts. They are traded on CLICK
XT/ITS, the ASXs electronic trading system.

The buyer of a warrant will pay a premium for the right to exercise the warrant.

Settlement of contracts occurs through the ASX options clearing house.

9. Discuss the relationship between the exercise price of an option, the current market price of
the underlying asset and the intrinsic value of the option. In your answer explain the money
position of an option. (LO 20.4)

The relationship between the current market price of the underlying asset and the exercise price
of an option determines whether or not the option actually has a value if the option was exercised
immediately. This value is referred to as the intrinsic value of the option.

If an option could be exercised immediately and a profit made, the price that would be paid to
buy such an option should be equal to the intrinsic value of the option.

The greater the intrinsic value of the option, the higher is the value of the option, that is, the
larger the premium.

The relationship between the price of an asset and the option exercise price determines whether
an option is in-the-money or not. An option is in-the-money if it can be exercised at a profit, that
is, if it has a positive intrinsic value.

If the exercise price is equal to the price of the asset in the physical market, the option is said to
be at-the-money.

In the situation where an option would not be exercised, the option is described as being out-ofthe-money.

10. Within the context of the pricing of an option, explain the relationship between:
(a) the volatility of the price of the underlying asset and the value of an option

The higher the volatility of the price of the asset the greater is the chance that the holder of the
option will be able to exercise for a larger profit. Thus, on average, the value of an option is
higher for an asset that demonstrates a higher price volatility compared with one that displays a
low volatility.

The relationship of volatility and the value of the option is also impacted by the type of option. It
is to be expected that a European option that exhibits the same level of volatility over the
contract period as an American option will have less value.

(b) the time to the expiration date and the value of an option. (LO 20.4)

Options possess time value. It is the time value of an option that, in part, explains why options
most frequently are valued at a premium greater than the intrinsic value.

The reason the expiration date is important in determining the options premium is to be found in
the fundamental nature of an option.

The option gives the holder the future chance to make a profit by exercising the contract under
favourable conditions.

On the assumption that the price of the underlying asset will fluctuate in the future, the longer
the time until expiration the greater is the chance that the option will be able to be exercised at a
profit; for example, if the exercise price for a call option is currently above the spot price, the
longer the time to expiry the greater is the chance that the spot price will move above the
exercise price.

It must be acknowledged also that the longer the time to expiry the greater is the risk that the
spot price may move adversely. In that situation, however, the loss sustained by the holder of the
call option would be limited to the premium paid.

What is important in valuing the option is that the longer the time to expiry the greater is the
probability of there being a favourable spot price movement.

11. A company knows that it will need to borrow $500 000 in six months time and is concerned
that interest rates may rise before that date. The company wishes to protect itself against a rise
in interest rates and decides to use an options collar strategy. Explain how a collar strategy is
structured and why the company might consider this type of strategy. (LO 20.5)

A collar is an interest rate risk management strategy using a combination of an options cap and
an options floor. Caps, floors and collars are over-the-counter options that are negotiated
between a financial intermediary and a borrower. A cap is a strategy that may be adopted by a
company that wishes to place an upper limit on the interest rate payable on a future borrowing
commitment.

The borrower would pay a premium to buy the cap.

At the same time, the company may sell an option contract that places a minimum limit, or floor,
on how low the interest rate payable may fall. The borrower would receive the premium for
writing the floor.

The combination of a cap and floor is called a collar. This strategy is designed to lower the
overall cost of the cover; the premium paid for the cap is offset by the premium received for the
floor.

The success of this strategy will depend upon the forecast direction and volatility of future
interest rates; for example, if interest rates in the market are generally expected to rise over the

contract period, the cost of the cap premium will be higher than the premium received from the
sale of the floor, therefore, the premium offset of a cap and a floor of the same contract period
will not usually be equal.
Borrowinghedgecollaroptionstrategy
Costof
borrowing
8.00%

Interestratecappayoptionpremium

Collar

7.00%

Interestratefloorreceiveoptionpremium

12. An investor has a quite bullish view that prices in the share market will rise, but is
concerned that there is still some risk that prices might fall. Draw and explain the relevant
profit profiles for a call bull spread strategy for (a) the holder of a call option, (b) the writer of
a call option, and (c) the long call plus short call. (LO 20.5)

The investor will position the option strategy so that if the asset price rises a profit would be
made, but at the same time, they gain some protection in the low probability situation that prices
might fall. One way of achieving this would be to simultaneously buy and sell call options.

The purchase of the call option provides the potential profit if the share market rises.

The premium paid on the purchase of the call option may be high since there is an expectation
that the market will rise.

One way of recouping some of the cost of the option would be to simultaneously write a call
option and thus earn a premium.

The short call would be written at an exercise price higher than that for the long call option.

The profit profile for the combined short put and long call strategy follows.

StrategyCall bull spread: quite bullish, with some risk of a price fall
Profit

(a)Holderofacalloption
Exerciseprice

Marketprice
Premium

Loss

(b)Writerofacalloption
Profit
Exerciseprice
Premium
Marketprice

Loss

(c)Longcall+shortcall
Profit
Price
expectations

Marketprice
Net
Premium

Loss

13. (a) In what circumstances might an investor consider a vertical bear spread option
strategy?

When there is a strong expectation that asset prices will fall; for example, a confident
forecast that the share market will experience a downturn.

(b) Discuss the construction of the strategy and draw the relevant profit profiles. (LO 20.5)

The first part of this combination options strategy is to buy a put option; pay a premium
and simultaneously write a call option with an exercise price higher than that for the long
put: a premium is earned.

The advantage from writing the short call is that the premium would go some way
towards reducing the cost of acquiring the long put.

At the same time, the writing of the call exposes the writer to potentially unlimited losses
if the price of the asset unexpectedly rises.

Strategyvery bearish about asset price (vertical bear spread):

Profit

Holderofaputoption
Exerciseprice

Marketprice
Premium

Loss
Profit

Writerofacalloption
Exerciseprice

Premium

Marketprice

Loss
Profit

Longput+shortcall
Priceexpectations

Marketprice
Net
premium

Loss

In a situation where the on-balance expectation is bearish, but there is considered to be a

reasonable risk that the asset price may rise, the vertical bear spread would not be
favoured.

14. There is an expectation of increasing price volatility in the market due to the lingering
effects of the GFC, problems with the world economy and concerns about sovereign debt.

Design an options strategy that will enable a profit to be locked in, regardless of the future
direction of asset prices. (LO 20.5)

Situations may arise when the price of the asset is expected to become more volatile, but without
an obvious trend emerging.

What is needed is a combination strategy that will allow a profit to be made regardless of
whether the asset price rises or falls.

To profit from a price rise, a call option would be bought; to profit from a price fall, a put option
would be bought. The simultaneous purchase of a long call and a long put, with a common
exercise price, is referred to as a long straddle.

Expectation of increased price volatility: long straddle

Profit

Holderofacalloption

Exerciseprice

Marketprice
Premium

Loss

Profit

Holderofaputoption

Exerciseprice
Marketprice
Premium

Loss

Profit

Longcall+longput
Priceexpectations

Marketprice
Net(double)
premium

Loss

If the net double premium is considered to be too expensive, a variation on the long straddle
may be put in place.

Rather than buying the call and put options with an identical exercise price, the two options
could be purchased with out-of-the-money exercise prices.

This strategy is referred to as a long strangle.

The long strangle would be particularly appropriate when the expectations of increased volatility,
without trend, are tempered by a view that the asset price may continue to stagnate for some time
around price A. If the price does stagnate, the loss sustained by the individual would be the
double premium. This is clearly less for the long strangle than it is for the long straddle.

Expectation of increased price volatility: long strangle

Profit

Holderofacalloption
Exerciseprice

A
Premium

Marketprice

Loss
Profit

Holderofaputoption

Exerciseprice

Marketprice
Premium

Loss
Profit

Longput+longput
Priceexpectations

A
Net(double)
premium

Loss

Marketprice

15. A corporate treasurer is concerned at the high cost of the premium associated with
establishing an options strategy. The companys bank suggests that the use of a barrier knockout option to protect against a rise in the spot exchange rate might be a cheaper alternative
strategy.
(a) Explain how a barrier knock-out option is structured.

The barrier option is suited to the management of foreign exchange risk exposures and includes
both knock-out and knock-in options.

The knock-out option is extinguished if a specified spot exchange rate barrier is breached. The
barrier rate can be set above or below the current spot rate. Because the barrier limits the
exposure of the option writer the premium is not as high as with a straight option.

The knock-out nature of the barrier option is shown in the following figure. In the figure, while
the specified spot exchange rate remains below the barrier rate the option remains in existence.

If the spot exchange rate moves above the barrier rate before the expiration date, the option
ceases to exist.

(b) Draw a fully labelled diagram showing the strategy.

Barrier optionFX knock-out option
SpotFXrate

Barrierrate
Knockouttriggerpoint
Time

(c) Using what you know about barrier knock-out options, briefly explain how these
securities might contribute to the volatility of market prices. (LO 20.5)

Simply, barrier knock-out and knock-in options might encourage traders to attempt to
knock-out particular options by pushing prices through particular critical levels.