Investments, tenth edition

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   call  option  

  exercise or strike price  

  premium  

  put  option  

  in  the  money  

  out of the money  

  at  the  money  

  American  option  

  European  option  

  protective  put  

  covered  call  

  straddle  

  spread  

  collar  

  put-call  parity  theorem  

  warrant    

  KEY TERMS 

 Payoff to call investor

5 b

S

T

2 X if S

T

. X

0

if S

T

# X

 Payoff to put investor

5 b

0

if S

T

. X

X

2 S

T

if S

T

# X

  

Put-call parity: P 5 C 2 S

0

 1 PV(X ) 1 PV(Div)

 KEY EQUATIONS     

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710 

P A R T   V I

  Options, Futures, and Other Derivatives

which an investment in a foreign currency can be converted back into dollars. The right to 

translate a fixed amount of foreign currency into dollars at a given exchange rate is a sim-

ple foreign exchange option. Quantos are more interesting because the amount of currency 

that will be translated into dollars depends on the investment performance of the foreign 

security. Therefore, a quanto in effect provides a  random number  of options.  

  Digital Options 

 Digital options, also called binary or “bet” options, have fixed payoffs that depend on 

whether a condition is satisfied by the price of the underlying asset. For example, a digital 

call option might pay off a fixed amount of $100 if the stock price at maturity exceeds the 

exercise  price.     

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  C H A P T E R  

2 0

  Options Markets: Introduction

711

    1.  We said that options can be used either to scale up or reduce overall portfolio risk. What are some 

examples of risk-increasing and risk-reducing options strategies? Explain each.  

   2.  What are the trade-offs facing an investor who is considering buying a put option on an existing 

portfolio?    

    3.  What are the trade-offs facing an investor who is considering writing a call option on an existing 

portfolio?  

   4.  Why do you think the most actively traded options tend to be the ones that are near the money?     

    5.  Turn back to  Figure 20.1 , which lists prices of various IBM options. Use the data in the figure to 

calculate the payoff and the profits for investments in each of the following February expiration 

options, assuming that the stock price on the expiration date is $195.

a.   Call option,  X   5  $190.  

b.   Put option,  X   5  $190.  

c.   Call option,  X   5  $195.  

d.   Put option,  X   5  $195.  

e.   Call option,  X   5  $200.  

f.   Put option,  X   5  $200.     

   6.  Suppose you think FedEx stock is going to appreciate substantially in value in the next 6 months. 

Say the stock’s current price,  S  

0

 , is $100, and the call option expiring in 6 months has an exercise 

price,  X,  of $100 and is selling at a price,  C,  of $10. With $10,000 to invest, you are considering 

three alternatives.

     a.   Invest all $10,000 in the stock, buying 100 shares.  

    b.   Invest all $10,000 in 1,000 options (10 contracts).  

    c.   Buy 100 options (one contract) for $1,000, and invest the remaining $9,000 in a money market 

fund paying 4% in interest over 6 months (8% per year).    

 What is your rate of return for each alternative for the following four stock prices 6 months 

from now? Summarize your results in the table and diagram below.    

Basic

Intermediate