This document summarizes information about financial derivatives, with a focus on options. It defines key terms like forwards, futures, swaps, and provides details on call and put options. It explains how options work, including factors that influence pricing and examples of trading options on exchanges. The document also discusses an example where some option traders profited from their positions before an announcement that News Corp was offering to buy Dow Jones & Co. for $60 per share, sending the stock price up 50%. It concludes with some option strategies and examples of financial engineering techniques.

1. Financial Derivatives
A focus on Options
By: Wayne Horak
Vincent Wedelich
Financial Management HBU
Professor: Dr. Allen Yan
Presentation Project
May 10, 2007

2. Financial Derivatives
A focus on Options

3. Financial Derivatives
 Forwards and Futures
 Swaps
 Black and Scholes model.
 What is an option?
 How to purchase or sell options on the open market.
 News Corp speculators make a huge profit on the
upcoming news that News Corp was being offered
$60.00 per share.
 How to mitigate risk by adding options to your
portfolio. Financial Engineering.

4. Financial Derivatives
 Financial derivatives are investments whose present
value today or at some future date is derived.
 It is derived entirely from the value of other assets,
 The other asset is the underlying asset.

5. Forwards and Futures
 Represents the obligation to buy (sell) a security or
commodity at a pre-specified price, known as the
forward price, at some future date
 The most important financial forward market is the
inter-bank forward market for currencies, particularly
dollars for yen and dollars for Euros.
 Obligation for both a contract to exchange an asset
in the future at a specified price

6. Swaps
 Swaps are sometimes called, to periodically
exchange the cash flow of one security for the cash
flow of another.
 The last date of exchange determines the swap
maturity.
 An agreement to exchange a series of cash flows at
specified prices and times.

7. Options
 Gives their buyers the right,
 but not the obligation,
 To buy (call option) or sell (sell option) an underlying
security at a pre-specified price, known as the strike
price.

8. Black and Scholes
 A major break through occurred in the valuation of
derivatives when two finance professors at MIT,
 Black and Scholes, came out with a formula that
related the price of a call option to the price of the
stock to which the option applies.

9. Black and Scholes
 “The Black-Scholes Option Pricing Model (OPM),
developed in 1973, helped give rise to the rapid
growth in options trading.
 This model, which has even been programmed into
some hand-held and web-based calculators, is
widely used by options traders”. (Brigham 2007 p
295)

10. Basics: What is an option?
 Options are types of derivative contracts, including
call options and put options,
 The future payoffs to the buyer and seller of the
contract are determined by the price of another
security.

11. Basics: How do options work?
 A call option is an agreement in which the holder has the
right (but not the obligation) to exercise by buying an
asset at the strike price on or before a future date.
 A put option is an agreement in which the holder has the
right (but not the obligation) to exercise by selling an
asset at the strike price on or before a future date.
 The seller has the obligation to honor the terms of the
contract.

12.  Buying a call option - This is a graphical interpretation of
the payoffs and profits generated by a call option as seen
by the buyer. A higher stock price means a higher profit.
Eventually, the price of the underlying security will be high
enough to fully compensate for the price of the option.

13.  Writing a call option - This is a graphical interpretation
of the payoffs and profits generated by a call option as
seen by the writer of the option. Profit is maximized
when the strike price exceeds the price of the underlying
security, because the option expires worthless and the
writer keeps the premium.

14. Example of a call option on a stock
 Buy a call: buyer expects that the price may go up.
Pays a premium that buyer will never get back.
Buyer has the right to exercise the option at the
strike price.
 Write a call: writer receives the premium. if buyer
decides to exercise the option, writer has to sell the
stock at the strike price.

15. Basics: How Do Options Work?
 Since the option gives the holder a right and the
seller an obligation, the buyer pays the option
premium to the seller.
 Traders in exchange-traded options do not usually
interact directly, but through a clearing house.
 The clearing house guarantees that an assigned
seller will fulfill his obligation if the option is
exercised.

16. Five Principal Factors Influencing
Option Valuation
1. The price of the underlying security in relation to.
2. The strike price.
3. The cumulative cost required to hold a position in
the security (including interest + dividends).
4. The time to expiration.
5. The estimate of the future volatility of the security's
price. (Least known factor)

17. Trading Options
 The most common way to trade stock options is
trading standardized options contracts that are listed
by various futures and options exchanges.
 Currently there are six exchanges in the United
States that list standardized options contracts based
on underlying stocks.

18. Trading Options
 Options Exchanges.
– Philadelphia Stock Exchange (PHLX)
– American Stock Exchange (AMEX),
– NYSE in New York City
– Chicago Board Options Exchange (CBOE)
– International Securities Exchange (ISE)
– Boston Options Exchange (BOX)

19. Over-The-Counter Contracts
 Options contracts that are not traded on exchanges,
but between two independent parties.
 At least one of those parties is usually a large
financial institution with a balance sheet big enough
to underwrite such a contract.

20.  Stock investors were surprised by word that News
Corp was interested in buying Dow Jones & Co.
 Some option buyers had positioned themselves for big
gains in the shares.
 Tuesday May 1, Dow Jones & Co. acknowledged that
it was considering a proposal from News Corp to buy
the company for $60 a share.
 This sent the stock up more than 50%.
News Corp.’s interest in Dow Jones & Co.

21.  Many option traders built they position by trading in
options that would profit most from a jump in Dow
Jones shares.
 Most of this activity occurred on Monday April 30
which was far more heavier than usual.
News Corp.’s interest in Dow Jones & Co.

22.  More than 4,300 call options on Dow Jones
changed hands, nearly half of the volume of calls
traded during the whole month of April.
 The Dow Jones stock closed at $36.33 on Monday
April 30 and spiked 50% closing at $54.46 on
Tuesday.
News Corp.’s interest in Dow Jones & Co.

23. News Corp.’s interest in Dow Jones & Co.
 Prior to May 1, call options picked up generally in April,
and was particularly heavy on the 17th
and 25th
of the
month.
 Including Monday April 30, 10,000 call options on Dow
Jones &Co changed hands.
 This is compared to 7,000 call options during the entire
first quarter.
 This has many option traders crying foul.

24. Option strategies
Financial engineering
– Options can be mixed in various ways to create an
unlimited number of payoff profiles.
Examples of Financial Engineering
– Buy a stock and a put
– Buy a call with one strike price and sell a call with
another
– Buy a call and a put with the same strike price

31. References:
– Financial Management Theory and Practice Eugene F.
Brigham and Michael C. Ehrhardt Edition 11e 2007
– Forbes .com, Associated Press. May 1,2007
– MIT SLOAN SCHOOL OF MANAGEMENT
– Wall Street Journal, May 1, 2007 New Corp.
– Wikipedia. Option (Financial)

32. Questions?