Chapter 16
Introduction to Options
Money is made by discounting the obvious and betting on the unexpected.
I introduce options as hedging instruments in the next chapter. It is instructive, therefore, to develop some basics on option valuation so that we can better understand how to formulate portfolio strategies using this very flexible set of securities. This chapter is not intended to substitute for a more comprehensive treatment of this important class of derivatives; for that, I would suggest a book such as John Hull's Options, Futures, and Other Derivatives or David Luenberger's Investment Science. I borrow liberally from both in the discussion that follows. Like futures, forwards, and swaps, options are derivative securities whose values are tied to the value of some underlying security. For that reason, I include a section on asset price dynamics—models of derivative securities are only as good as the models of the underlying price dynamic.
In general, options are contracts that give the holder the right but not necessarily the obligation to sell or purchase a security over some interval into the future for a price agreed upon today. The price is referred to as the strike price (K) and if the option can be exercised at any time over its life, then it is an American option. If, on the other hand, the option can be exercised at a single specific date, it is a European option. We will study European options.
There are two general types of options, calls and ...
