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    Options are the right to exercise a contract or undertake a business activity. Financial options (as well as their underlying assets) are usually traded on exchanges. Real options involve assets or business opportunities often unique to a business, and decisions to undertake these types of projects are normally considered to be capital budgeting decisions (see Real Options Valuation).

    Here we look at financial options that are traded in financial markets. These options are very much like futures; however, future contracts require both parties to hold up their end of the deal - options do not. Options give one party the right, but not the obligation, to buy or sell a given quantity of an asset ("underlying asset") on (or perhaps before) a given date, at a price agree upon today.

    Call Option: A call option gives the holder of the option the right, but not the obligation,to buy a given quantity of some asset at some time in the future, at a price agreed upon today.

    Put Option: A put option gives the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at a price agreed upon today.

    Styles of Options

    European Options: European options are options that can be exercised only at the expiry date.

    American Options: American-style options are options that can be exercised up until and including the expiry date.

    Asian Options: Asian options, or average value options, are a more complex option where the payoff is determined by the average price of the underlying asset over a set period of time.

    LEAPS: Long-term equity anticipation securities are options with an expiration date usually over one year.

    Other Terminology

    Exercising the Option: Performing the contract by using the option to buy or sell the underlying asset.

    Strike Price or Exercise Price: The specified price written in the option contract that is agreed upon before at which the holder can buy or sell the underlying asset.

    Expiry Date: Self explanatory. This is the maturity date of the option. Some options can only be exercised at the expiry date, some can be exercised any time up until the expiry date.

    In-the-money: If the exercise price is less than the market price of the underlying asset, a call option is considered to be "in-the-money" (and vica versa for a put option).

    At-the-money: If the exercise price is equal to the market price of the underlying asset, both a call and put option are considered "at-the-money."

    Out-of-the-money: If the exercise price is more than the market price of the underlying asset, a call option is considered "out-of-the-money" (and vica versa for a put option).

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    BrainMass Categories within Options

    Black-Scholes Model

    Solutions: 135

    The Black-Scholes Model is an option pricing model based on the intuition behind the delta-hedging strategy. The discovery of the Black-Scholes model legitimized the trading of derivatives and has contributed significantly to their increased popularity.

    Binomial Option Pricing Model: Delta Hedging

    Solutions: 0

    Delta hedging is a binomial option pricing model that looks at the delta hedging strategies used by many major financial institutions to build portfolios and price options.

    Option Payoffs

    Solutions: 1

    In order to decide what type of securities should be purchased as part of a trading strategy, investors look at the payoffs that buying and selling different options will give them.

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    Convertible bonds or convertible debentures are bonds that have an option to be converted into a fixed number of common shares of the issuing company up until the date of maturity of the bond.

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    Solutions: 175

    Warrants are like options in that they give the holder the right but not the obligation to purchase an underlying asset. In this case, warrants give their holders the right to purchase a fixed number of shares of common stock directly from the issuing company at a fixed exercise price up until the expiry date.


    Upper and Lower Bounds of Options

    Solutions: 85

    Because options confer rights, but not obligations, to the party that holds the option, this party is willing to pay an

    Binomial Option Pricing Model: Risk-Neutral Valuation

    Solutions: 0

    In a risk-neutral wold, there exists the special case where the expected rate of return on any asset is simply the risk-free rate. This is because investors do not demand any additional return for additional risk. We use this special case for building a risk-neutral binomial option pricing model.

    Executive Stock Options

    Solutions: 29

    Executive compensation packages are typically made up of a mixture of components that include a base salary, benefits, long-term compensation, annual bonuses, retirement contributions, stock, and call options on the company's stock. Stock options can, and often do, make up the largest portion of an executive compensation package.

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