An Introduction to the Bond Markets

7

Option Calculations

An option is an agreement whereby the purchaser of the option has the right, but not the obligation, to buy or sell from the writer (or seller) of the option a specified instrument at a specified price within a specified time period. The writer of the option grants the buyer this privilege for a sum of money called the ‘option price’ or ‘option premium’. The buyer of the option may exercise the option at the ‘strike price’ at or at any time up to the ‘expiry date’.

If the buyer can exercise the option at any time up to the expiry date of the option, it is called an ‘American option’. If the buyer can only exercise the option at the expiry date, it is called a ‘European option’. There is no geographical significance to the designations of American and European.

When the option grants the buyer the right to purchase the instrument from the writer, it is called a ‘call option’; when it grants the buyer a right to sell an instrument it is called a ‘put option’. These two basic types of options may then be combined together, possibly with other instruments, to form a variety of investment strategies. Such combinations are often called ‘exotic’ options.

A party to a call or a put option can thus:

• buy a call option;
• buy a put option;
• write (sell) a call option; or
• write a put option.

The financial implications of buying and writing (selling) put and call options are obviously different. If you buy an option the maximum you can lose is your initial stake, whereas ...