Derivatives Essay

619 Words Nov 16th, 2011 3 Pages
Workshop 7

8-1 An option is a contract giving the buyer the right but not the obligation to buy or sell a given amount of foreign exchange at a fixed price for a specified time period. A future is an exchange-traded contract calling for future delivery of a standard amount of foreign currency at a fixed time, place, and price. The essence of the difference is that an option leaves the buyer with the choice of exercising or not exercising. The future requires a mandatory delivery. The future is a standardized exchange-traded contract often used as an alternative to a forward foreign exchange agreement. 8-5 A put on pounds sterling is a contract giving the owner (buyer) the right but not the obligation to sell
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This is somewhat equivalent of having sold (call option writer) or bought (put option writer) at a price better than current market, only to have the market price move even further in a beneficial direction. If the option writer does not own the underlying shares, the option is written “naked.” Only in this instance can the cash loss to the option writer be a very large amount. 8-10 a. Intrinsic value for a call option is the amount of gain that would be made today if the option were exercised today and the underlying shares sold immediately. For a put, intrinsic value is the amount of gain that would be made if the underlying shares were purchased today and delivered immediately against the option. Intrinsic value can be zero, as when the option is not worth exercising today. However, if a gain could be made by exercising the option today, the intrinsic value is positive because intrinsic value can never be less than what can be gained from an immediate exercise of the option. Note that gain is not the same as net profit because in all cases the option buyer has already paid the premium. b. Time value of an option is related to what one will pay above intrinsic value because of the chance that between today and the maturity of the option intrinsic value will become positive (option with no intrinsic value) or greater than today (option having some positive intrinsic value today). In effect,

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