Finance Question

‫المملكة العربية السعودية‬
‫وزارة التعليم‬
‫الجامعة السعودية اإللكترونية‬
Kingdom of Saudi Arabia
Ministry of Education
Saudi Electronic University
College of Administrative and Financial Sciences
Assignment-1
FIN 405 – Financial Derivatives
Due Date: 28/09/2024 (End of Week-6) @ 23:59
Course Name: Financial Derivatives
Student’s Name:
Course Code: FIN 405
Student’s ID Number:
Semester: First
CRN:
Academic Year: 2024-2025
For Instructor’s Use only
Instructor’s Name: Dr Jyoti Agarwal
Students’ Grade: Marks Obtained / Out of 10 Level of Marks: High/Middle/Low
General Instructions – PLEASE READ THEM CAREFULLY
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The Assignment must be submitted on Blackboard (WORD format only) via
allocated folder.
Assignments submitted through email will not be accepted.
Students are advised to make their work clear and well presented; marks may be
reduced for poor presentation. This includes filling your information on the cover
page.
Students must mention question number clearly in their answer.
Late submission will NOT be accepted.
Avoid plagiarism, the work should be in your own words, copying from students
or other resources without proper referencing will result in ZERO marks. No
exceptions.
All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism).
Submissions without this cover page will NOT be accepted.
Assignment Questions: (Marks- 10)
Answer all the following Questions:
1. Identify and briefly discuss the various types of option transaction
costs? (250-300 words)
2.5 Marks
2. Explain why an option’s time value is greatest when the stock price is
near the exercise price and why it nearly disappears when the option is
deep- in -or out- of -the money. (250-300 words)
2.5 Marks
3. ABC Company stock currently priced at $ 80. One period later it can
go up by 25% or go down by 20%. The risk-free rate is 7 percent.
Calculate the current /theoretical value of the European call option if
the exercise/strike price is SAR 80?
(5 Marks)
Answers:
1
2
3
60
Chapter 2 Structure of Derivatives Markets
distinguish the trading a financial institution does for itself, in contrast to the tremendous trading it does for customers and its market-making activities.30
The OTC market works in a similar manner. A large number of financial institutions
play the role of market makers, being ready to take either side of a transaction, thereby
earning a bid–ask spread. When they enter into a transaction with an end user, they
almost immediately hedge the transaction by entering into an offsetting transaction in
either the underlying, another derivative, or a very closely related derivative. At one
time, an end user would have to talk to an OTC dealer to get a price quote, but now
there are electronic trading systems in which dealers can enter their quotes, which are
then accessible by end users. There are also some firms that engage in brokerage in the
OTC market, often matching up end users with unusual needs, such as complex customized transactions, with parties willing to take the opposite sides.
2-7 TRANSACTION COSTS
As with all financial market trading, derivatives trades generate certain transaction costs.
The costs depend on whether the trader is a member of the exchange, a nonmember
institutional investor, or a member of the public who is trading through a broker. This
section discusses the different types of transaction costs.
2-7a Floor Trading and Clearing Fees
Floor trading and clearing fees are the minimum charges assessed by the exchange, the
clearing corporation, and the clearing firms for providing their services. For trades that
go through a broker, these fees are included in the broker’s commission, as discussed in
the next section. For market makers, the fees are collected by the market maker’s clearing firm. The clearing firm enters into a contractual arrangement with a market maker to
clear trades for a fee usually stated on a per contract basis. The cost to a market maker is
usually less than $1.00 per transaction, though this amount can vary based on the volume of trades. In addition, market makers incur a number of fixed costs, such as the
personnel and infrastructure to operate their entities. For OTC market makers, these
types of costs are not incurred, but comparable, if not higher, costs are associated with
a firm’s trading operation and with processing these customized transactions.
2-7b Commissions
One of the main advantages of owning a seat on an exchange is that it lets one avoid
paying commissions on each trade. The market maker pays indirectly via the opportunity cost associated with the funds tied up in the seat price, through the labor involved
in trading, and by forgoing the earnings that would be realized in another line of work.
The savings in commissions, however, are quite substantial for high-volume traders.
For the public, discount brokers offer the lowest commission rates, but frequent or
large trades are sometimes necessary for taking advantage of discount brokers’ prices.
Also, a discount brokerage firm does not provide the advice and research that is available
from full-service brokers who charge higher commission rates. Options and futures commissions are fairly simple, usually based on a fixed minimum and a per contract charge.
Internet rates of less than $5, sometimes with a minimum of $10 to $15 per trade, are
available. Some brokers may set charges based on the total dollar size of the transaction,
and some offer discounts to more active customers. Futures commissions sometimes
cover both the opening and the offsetting transaction. These fees include the floor
30
Proprietary trading is also sometimes referred to as “prop trading.”
Chapter 2 Structure of Derivatives Markets
61
trading and clearing fees mentioned earlier. Very active traders can get large-volume discounts, such that they may pay less than $1.
When exercising a stock option, the investor must pay the commission for buying or
selling the stock. If an investor exercises a cash-settled derivative, the transaction entails
only a bookkeeping entry. Some brokerage firms do not charge for exercising a cash settlement option. When any type of option expires unexercised, there is normally no commission. For OTC options, commissions are not generally incurred, because the option
buyer or seller usually trades directly with the opposite party.
2-7c Bid–Ask Spreads
As noted earlier, the market maker’s spread is a significant transaction cost. Suppose the
market maker is quoting a bid price of €3 and an ask price of €3.25 on an option. An
investor who buys the option immediately incurs a cost of the bid–ask spread, or €0.25
points. That is, if the investor immediately sells the option, it would fetch only €3, the
bid price, and the investor would immediately incur a €0.25 point loss. This does not,
however, mean that the investor cannot make a profit. The option price may well
increase before the option is sold, but if the spread is constant, the bid price must
increase by at least the amount of the bid–ask spread before a profit can be made. A
similar point holds for futures and, indeed, for all financial trading.
It may appear that market makers can avoid the bid–ask spread transaction cost. This
is true in some cases. If, however, the market maker must buy or sell an option or
futures, there may be no public orders of the opposite position. In that case, the market
maker would have to trade with another market maker and thus would incur the cost of
the bid–ask spread. Also, market makers may need to hedge their transactions in other
markets and, thus, would incur bid–ask spreads in those markets.
In the OTC market, the buyer or seller trades directly with the opposite party. In
many cases, one of the parties is a financial institution that makes markets in whatever
derivatives its clients want. Thus, the client will probably face a bid–ask spread that
could be quite significant, but of course, the client is free to look for another dealer.
2-7d Delivery Costs
A futures or options trader who holds a position to delivery faces the potential for incurring a
substantial delivery cost. In the case of most financial instruments, this cost is rather small. For
commodities, however, it is necessary to arrange for the commodity’s physical transportation,
delivery, and storage. Although the proverbial story of the careless futures trader who woke up
to find thousands of pounds of pork bellies dumped on his front lawn certainly is an exaggeration, anyone holding a long position in the delivery month must be aware of the delivery
possibility. This no doubt explains part of the popularity of cash settlement contracts.
In forward markets, transactions are tailored to the needs of the parties. Consequently, the terms are usually set to keep delivery costs at a minimum. Cash settlement
is frequently used.
2-7e Other Transaction Costs
Derivatives transaction costs
include floor trading expenses,
clearing fees, commissions, bid–ask
spreads, delivery costs, and other
expenses.
Derivatives traders incur several other types of transaction costs. As previously noted, there may be margin requirements, which result in tying up
funds while the transaction is in place. There may also be costs involved in
hedging a derivatives position. For example, a dealer who sells a call option on
Apple stock might wish to hedge by buying Apple stock. That dealer would
then incur the transaction cost of a stock purchase, which would, at a minimum, consist of a bid–ask spread and potential commissions.
244
Part I Options
Recall that T1 is the shortest holding period, T2 is slightly longer, and
T represents holding all the way to expiration. The graph indicates that
the short holding period has the lowest range of profits. If the stock
price is low, the shortest holding period produces the smallest loss and
the longest holding period produces the largest loss. If the stock price is
high, the shortest holding period produces the smallest gain and the longest holding period produces the largest gain.
The logic behind these results is simple. First, recall that the low-exercise-price call
will always be worth more than the high-exercise-price call; however, their relative time
values will differ. An option’s time value is greatest when the stock price is near the exercise price. Therefore, when stock prices are high, the high-exercise-price call will have the
greater time value, and when they are low, the low-exercise-price call will have the
greater time value.
When we close out the spread prior to expiration, we can always expect the long call
to sell for more than the short call because the long call has the lower exercise price. The
excess of the long call’s price over the short call’s price will, however, decrease at high
stock prices. This is because the time value will be greater on the short call because the
stock price is closer to the exercise price. The long call will still sell for a higher price
because it has more intrinsic value, but the difference will be smaller at high stock prices.
Conversely, at low stock prices, the long call will have a greater time value because its
exercise price is closer to the stock price.
For a given stock price, the profit of
a call bull spread increases as
expiration approaches if the stock
price is on the high side and
decreases if the stock price is on the
low side.
MAKING THE CONNECTION
Spreads and Option Margin Requirements
Many option strategies are inherently risky, and option
traders face the risk of default from their trading counterparts. Exchange-traded options have the significant
advantage of an intermediary that manages credit risk,
typically some sort of clearinghouse. In return for the
mitigation of counterparty credit risk, clearinghouses
require option traders to post margin requirements.
In the past, the margin requirements were based on
the specific strategy followed by the trader. For complex positions where many risks are offset, the
strategy-based margin requirement would remain
very high. Now clearinghouses take a portfolio
approach and seek to measure market risk exposures
based on the cumulative portfolio risk exposure. The
net effect is that option margin positions are considerably lower than in the past.
For example, the margin requirements for a protective put strategy (long stock and long put) could result
in a decrease in the margin requirements dramatically.
The strategy-based approach would calculate margin
based on the 50 percent margin requirement for holding common stock and the 100 percent margin requirement for purchasing puts. We know, however, that
protective put buying sets a floor on the portfolio’s
losses; hence, the portfolio-based approach margin
requirement would be dramatically lower. In other
words, viewed separately, individual risks of these two
positions are quite large, but they have an offsetting, or
hedging, element that lowers their combined risks. Fortunately, margin requirements take the combined risk
into account.
As we consider numerous other complex option
strategies, such as spreads, collars, and other complex
combinations, it is important to know that there are
margin implications for the trader. An example of the
new portfolio margin requirements can be found on
the Chicago Board of Options Exchange website (currently www.cboe.com/Margin).
With the combination of lower margin requirements
for complex option positions along with an understanding that a call option can be viewed as a leveraged
position in stock, the option trader can achieve an
extremely high degree of implied leverage in a trading
position. Although leverage is beneficial if the position
moves in your favor, it can prove disastrous if the position moves against you.

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