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Summary Managerial Finance, ISBN: 9781136008818 finance
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Concept of options and how this is different from American and European Options. Also giving the case how option is used in the real situation.
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MAC3702 EXAM PACK 2022
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Trusted Accounting & Tax Firm Newmarket, ON - Moaaz Sheikh CPA CA
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BUS 244Basic Options Concepts
Options characteristics
Option contracts are a type of derivative security.
While many options traded are standardised and traded over secondary markets such as a derivatives exchange (for
example the Sydney Futures Exchange), not all options may be exchanged. For instance, an option on a certain piece
of property that is created 'over-the-counter' will not be tradeable in secondary markets. This is usually because of
the uniqueness of the terms involved in such contracts.
Options that are standardised and exchanged in secondary markets are called exchange-traded options.
The strike price, otherwise known as the exercise price, is the price that the holder of the option may buy (for a call
option) or sell (for a put option) the underlying asset before or on the expiration date.
It is only in the case with call options that the strike price is the price above which the option is 'in-the-money'.
When the market price moves above the strike price for a call option, the holder has the choice of exercising the
option in order to buy the underlying asset at a price that is below the market price. In the case of a put option,
however, the option is only 'in-the-money' when the market price of the underlying asset moves below the strike
price rather than above.
The price of the option is affected by the strike price but is not equal to it. The price of the option is often known as
the option premium.
An American option allows the holder to exercise the transaction whenever they wish before the expiration date.
European options, on the other hand, only allow the holder to exercise on the expiration date. Therefore, the
American option is better because it provides more choice than a European option. This increased choice is desirable
because it allows the holder to take up opportunities that may not continue to exist on the expiration date. Thus If
two options have the same term to expiration, the same price, the same underlying asset, and are identical to each
other in all respects aside from the fact that one is American and one is European, the American option will always
be more desirable to hold.
The underlying asset of an option is the asset that is traded upon the exercise of the option. In the case of a call
option, the underlying asset is bought by the option holder when the option is exercised.
Since there are no rules on what the underlying asset is, the underlying asset may take on many forms (both financial
and non-financial). The following is a list of some of the more common forms:
shares
share indices (for example the S&P100 or ASX200)
gold
foreign currencies
agricultural commodities (such as corn)
interest rates
options (in exotic options).
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