Sunday, May 01, 2005

Tofu call options? Why not!

I had a student IM me about derivatives, I both sort of liked my response (yeah I am biased!) and also wanted to comply with Reg FD. So here you go: for derivatives, they are not easy to grasp...think of options like coupons for a product...when is the coupon valuable?

Consider the various variables that might affect the value of the coupon:
  • time to expiration--the longer, the more valuable
  • price on coupon--the lower, the more valuable
  • price of the product you are buying (technically, the difference between the coupon price and the market price)--the higher, the more valuable
  • the price variation of the product--the higher the variation, the more valuable the coupon

This last one (variation--or in finance-speak volatility) needs more development...

Suppose I give you two coupons each having a three month life. One is to buy tofu at 2.39 at any point in the next three months, the second coupon is to buy a gallon of gas at $2.39.

terminology: the tofu and gas are the underlying assets.

Q. Supposing you buy both gas and tofu equally often--(I do!)--which coupon is more valuable?

A. The gas coupon. Why? Since the price of gas is very volatile whereas tofu's price is very stable.

Think about it, I never remember seeing tofu selling for more than $2.39, whereas there is a pretty good chance that at some point over the next three months Gas will sell for more than $2.39.

What our option pricing models (for example Black Scholes) do is to calculate the valuation of the "coupon", really a call option--giving you the right, but not the obligation" to buy the underlying asset at an agreed price (the price on the coupon or the STRIKE price).

I hope this helps! I know it is a sort of stupid example, but I am a big believer is understanding things intuitively, and coupons are something we all have experience with, so ???

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