CHAPTER 16
OPTION CONTRACTS
16.1 An Overview of Option Markets and Contracts
16.1.1 Option Market Conventions
▪ Option contracts have been traded for centuries.
16.1.2 Price Quotations for Exchange-Traded Options
1. Equity Options
3. Foreign Currency Options (Exhibit 16.3)
16.2 The Fundamentals of Option Valuation
16.2.1 The Basic Approach
16.2.2 Improving Forecast Accuracy
2. Valuing in Other Subintervals (Exhibit 16.5)
16.2.3 The Binomial Option Pricing Model
1. Forecasting Price Changes (Exhibit 16.6)
16.2.4 The Black-Scholes Valuation Model
1. Properties of the Model (Exhibit 16.7)
– Current security price
2. An Example (Exhibits 16.8, 16.9)
16.2.5 Estimating Volatility (Exhibit 16.10)
▪ Historical: price movements
16.2.6 Problems with Black-Scholes Valuation
▪ Empirical studies showed that the Black-Scholes model overvalued out-of-the-money call
16.3 Option Valuation: Extensions (Exhibit 16.11)
16.3.2 Valuing Options on Dividend-Bearing Securities
16.4 Option Trading Strategies (Exhibit 16.12)
▪ Options are a leveraged alternative to making a direct investment in the asset on which the
16.4.1 Protective Put Options (Exhibits 16.13, 16.14)
16.4.3 STRADDLES, STRIPS, AND STRAPS (Exhibits 16.17, 16.18, 16.19)
16.4.5 Spreads (Exhibits 16.21, 16.22, 16.23)
16.5 Other Option Applications
16.5.1 Convertible bonds (Exhibits 16.26, 16.27)
▪ Can be viewed as a prepackaged portfolio containing two distinct securities: a regular bond
and an option to exchange the bond for a pre-specified number of shares of the issuing firm’s
16.5.2 Credit Default Swaps (Exhibit 16.28)
▪ A credit default swap (CDS) is better regarded as an option-like arrangement because it does