Page 78 - DCOM510_FINANCIAL_DERIVATIVES

Unit 5: Introduction to Options

` 200,000 from the hotel chain Notes
—` 120,000 to the farmer
—` 5,000 for the price of the option
` 75,000

Unfortunately, Ramesh do not have ` 120,000 to buy the property so Ramesh is left with
the second choice.
The second choice allows Ramesh to just sell the option directly to the hotel chain for a
handsome profit and then they can exercise the option and buy the land from the farmer.
If the option allows the holder to buy the property for ` 120,000 and the property is now
worth ` 200,000 then the option must be worth at least ` 80,000, which is exactly what the
hotel chain is willing to pay Ramesh for it. In this scenario Ramesh will still make ` 75,000.

` 80,000 from the hotel chain
—` 5,000 paid for the option
` 75,000 profit
In this example everyone is happy. The farmer got ` 20,000 more than he thought the land
was worth plus ` 5,000 for the option netting him a ` 25,000 profit. The hotel chain gets the
property for the price they were willing to pay and can now build a new hotel. Ramesh
made ` 75,000 on a limited risk investment of ` 5,000 because of his insight. This is the
same choice Ramesh will be making in the commodity and futures options markets he
trade. He will typically not exercise option and buy the underlying commodity because
then he will have to come up with the money for the margin on the futures position just as
he would have had to come up with the ` 120,000 to buy the property. Instead he would
sell the option in the market for profit. Had the hotel chain decided not to buy the property
then he would have had to let the option expire and would have lost the ` 5,000.
Now, let’s pretend the hotel chain knows that the land on which the hotel will be built is
only zoned for farming use and that the local government may not allow them to have it
rezoned for commercial property use. If it is not rezoned for hotel use the value will
drastically reduce since it can only be used as a farm again. This would drop it back to its
original value of ` 100,000 before all of these deals had happened. In order to protect
themselves and profit from the possible misfortune of this scenario the hotel chain
approaches a real estate investor and tells him they would like to buy a Put option from
them for ` 5,000. With this Put option the investor promises to allow the hotel chain to
“put” or sell the property to them for ` 150,000. As far as the investor knows the property
is worth ` 200,000 right now, so he is willing to receive ` 5,000 for this option’s possible
obligation to buy the property for ` 150,000 if the hotel so chooses to do so in the next 6
months before the option expires. A couple of months later the hotel chain finds out that
the local government will not allow the property to be rezoned, so they can no longer
build the hotel there. Therefore, they tell the investor they want to exercise their right to
sell him the property for ` 150,000. The investor is forced to pay ` 150,000 to the hotel chain
to own the property which means it cost him ` 145,000 because he received ` 5,000 a couple
of months ago for the option he sold. The hotel chain then limits their losses by selling a
property for ` 150,000 that was only worth ` 100,000 now that it can only be used as a farm.
By buying the option for ` 5,000, they were able to make ` 45,000 they would not have
been otherwise able to make.
` 150,000 from investor
—` 5,000 cost of option
Contd....

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