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Master Class: Derivative Products: Options on shares, stocks, currencies and equities

Stock Options

The contract gives the holder the right to buy or sell a given number of shares at the exercise price.

Foreign Currency Options

These contracts give the holder the right to buy or sell a foreign currency denominated amount. They are usually traded on the over-the-counter market.

A call option would give the holder the right to buy a specified amount of foreign currency at a predetermined exchange rate expressed as local currency per unit of foreign currency. For example if the holder may have the right to buy EUR 100,000 for EUR 1.34 per USD. If the exchange rate rose to 1.35 and if the holder exercised the option the payoff (before accounting for the upfront cost of the option) would be USD 1,000 = 100,000 × (1.35-1.34).

Index Options

The contract gives the holder the right to buy or sell a multiple (M) of the index value at the exercise price. The index value used is the one at the end of the day in which option is exercised. This is a cash settlement contract and does not require delivery of the portfolio underlying the index on the exercise date. Usually these are exchange traded.

When a call option is exercised the holder will receive (S-K) × M in cash, where S is the value of the index, K is the strike price and M is a multiple of the index.

When a put option is exercised the holder will receive (K-S) × M in cash.

Futures Options

This is an option on a futures contract. It gives the holder the right to enter into a futures contract at a specified futures price by a certain date. Futures options tend to be American options.

A call option gives the holder the right to a long position in the underlying futures contract plus a payoff equal to the difference between the futures price and the strike price.

A put option gives the holder the right to a short position in the underlying futures contract plus a payoff equal to the difference between the strike price and the futures price.

The expiration date mentioned in a futures option pertains to the delivery date of the underlying futures contract. The option will expire on this date or may be a few days before this date.

Most common futures options are options of Treasury bond futures, Treasury note future and Euro dollar futures.

Warrants

This is an option issued by a company that permits the owner to purchase a certain number of common stock for a specified price. Warrants are usually issued when the company issues bonds to encourage investors to purchase the bonds. They tend to have a long time to maturity and some may even be perpetual. The exercise price of the warrant is usually set higher that the market price at the time they are issued and tend to increase with time. Some warrants are detachable from the underlying instrument and can be traded on organized exchanges. Others can only be exercised by the bond holder and are called non-detachable warrants.

Employee Stock Options

These are call options offered to company employees, primarily its executives as an incentive to work for the interests of the company. Other features include:

  • Usually the strike price equals the market price at issue, i.e. the options are at-the-money when they are issued
  • Long tenors, between 10-15 years
  • Vesting period during which options cannot be exercised. Also, if the employee leaves the job during this time he will not be able to exercise the option in future
  • The options cannot be sold. Therefore the only way that employees can realize a cash benefit is to exercise the option and then sell the shares.
  • When the option is exercised the company issues new shares which are then sold to the employee at the strike price

Convertibles

The holder of a convertible bond has the right to convert the bond to equity (common stock) of the issuer at predetermined dates and for a predefined conversion ratio.

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