PART A - Describe the payoffs to the product, and discuss how different parameter values result in changes in the price of the option using the DerivaGem software.
A bond option gives the option holder the right, but not obligation, to buy or sell a bond to option writer/seller, for a pre-determined price on or before a given time in the future. There are two types of options: Call and Put options. A call option give the holder the right to buy a bond, and the payoff of a call option is Maximum（St – K，0）; while a put option give the holder the right to sell a bond and the payoff of a put option is Maximum(K – St，0). (Hull，2014)
In DerivaGem software, it can be seen that a call option price of European bond is 10.066 when strike price is 100, option life is 5, coupon rate is 8% and yield Volatility is 20%.
Firstly, it can be seen from DerivaGem software that increases Volatility from 20% to 40%, which results option price increased to 12.228, ceteris paribus.
It demonstrates that higher volatility results in higher option price. Volatility of a stock is a measure of uncertainty about the returns provided by the stock. When volatility is higher, the probability of option buyer to make high profit is higher and the risk of option seller is higher. In order to reduce the risk of option sellers, so option price will be higher. On the opposite, lower volatility, lower option price. (Hull，2014)
The second parameter is Strike Price. The strike price is the price at which the holders of option can buy/sell the underlying bond at the maturity date. Increases it from 100 to 105, which leads option price decreasing to 6.8747, ceteris paribus.
For call options, when th...
... middle of paper ...
...000- $3500= $10,500
Second one is without speculation: Net profit will be (40-35)*100=$500
In comparison, the profit with speculation is approximately up to 20 times than without speculation. However, options also may cause a huge loss of $3,500, which is the cost of options if the prices stay below $36. As a conclusion, if the investor bets right direction, then he/she can make big profits otherwise big losses. Speculation is a lot more risky than hedging.
Hull，J (2014). Fundamentals of Futures and Options Markets. 8th ed. London: Pearson. p210-215.
Hull，J (2012). Options，Futures，And Other Derivatives. 8th ed. Harlow: Pearson. p10-15.
Ross，S. (2015). How does a bond 's coupon interest rate affect its price?. Available:http://www.investopedia.com/ask/answers/111414/how-does-bonds-coupon-interest-rate-affect-its-price.asp. Last accessed 13th Mar 2016
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