Risk Management: Principles and Applications

Masters
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Finance & Accounting
Pages 10 (2510 words)
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Risk Management: Principles and Applications Options on stocks Options on stocks give their owner the right to purchase or trade shares of a particular stock, at a specified price. It is vital to compare the market price of the stock, with the exercise price of the option (Hull, 1997)…

Introduction

If the market price for the asset is greater than the strike price, it will be worth while for the holder to use the option. In this instance the option writer is forced to trade the asset to the option owner. The price at which a call is traded is called premium. In the case of calls, a higher stock price means that other things being equal; the option is more likely to be in the money on maturity. Therefore, a higher S is associated with a higher premium (Hull, 1997). Conversely, the higher the exercise price K, the lower is the premium. A higher exercise price makes it less likely that the option will be in the money on maturity. The time to maturity t has appositive effect on the option price: the greater t is, the more time the stock price has to climb above the exercise price. The volatility of the stock measured by the standard deviation of its returns ?, a;so has a positive influence on the call price. This due to the fact that call option holders are only concerned with the gain potential of their option, and this is greater the higher is the likelihood that the option will be beneficial on ripeness. Finally, the rate of interest, r has a positive influence on the call price. The greater the rate of interest r, the lower the strike value to be paid on maturity (e-rtK). The price of a call is given as C=S. N (d1) –K. e-rt. ...
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