Financial Management of Risks 441futures and for wards, option prices are a function of the value of an underlying
asset, thus they satisfy the definition of derivative. Unlike futures and for-
wards, however, options are assets that must be paid for initially. Recall that no
money changes hands initially as parties enter into for wards and futures. Op-
tions, though, are an asset that has to be bought for a price at the outset.
There are two kinds of options, call and puts. A call option is an asset that
gives the owner the right but not the obligation to buy some other underlying
asset, for a set price, on or up to a set date. For example, consider a call option
on Disney stock, that gives the owner the right to purchase one share of Dis-
ney stock for $70 per share, on or up to next June 15. (Actually, options are usu-
ally sold in blocks covering 100 shares. For expository purposes, however, we
will describe an option on only one single share.) The underlying asset would
be one share of Disney stock. The prespecified price, known as the “strike
price,” would be $70 per share. The expiration date would be June 15. The Dis-
ney option might cost $3 initially.
If on the expiration date, June 15, the market price of Disney stock stood
at $75, the call option owner would exercise the option, allowing him to buy a
share of Disney stock for $70. He could then turn around and sell the share for
$75 in the marketplace, realizing a terminal payoff from the option of $5. The
terminal payoff is $5, so the profit net of the $3 initial option price is $2.
Suppose, alternatively, that the market price of Disney stock on June 15
were $69. It would not be profitable to exercise the call option and thereby
purchase for $70 what is elsewhere available for $69. In such a case, the op-
tion owner would choose not to exercise, and the call would expire worthless.
It is the right not to execute the transaction that is the major difference be-
tween options and for wards. The long party in a for ward contract must buy
the goods upon expiration whether it is advantageous to do so or not. By con-
trast, a call option owner does not have to buy the underlying asset if he
chooses not to. At expiration, a call option should be exercised if and only if
the market price exceeds the strike price. When the market price is above
the strike price, the call option is said to be “in the money.” When the market
price is less than the strike price, the call is “out of the money.” When the
market price equals the strike price, the option is “at the money.” An option
that is out of the money, or even at the money, at expiration, will expire unex-
ercised and worthless.
An option’s payoff is defined as the maximum amount of money the op-
tion owner would receive at expiration, if she totally liquidated her position. If
the option expires out of the money, the payoff is zero. If the option expires in
the money, the payoff is the amount of money received from exercising the call
option, and then selling the stock in the open market. For example, if the strike
price is $70 and the terminal stock price is $60, the payoff would be zero, since
the option would be out of the money and should not be exercised. If the ter-
minal stock price were $80, the payoff would be $10, since the option should
be exercised, allowing the owner to buy the stock for $70, and then sell that
stock for $80 in the open market. Mathematically, the payoff is the maximum
of zero or the stock price minus the strike price.