Option Terminology

Options come in two flavors, puts and calls. The owner of a call option has the right, but not the obligation, to buy an underlying asset at a fixed price, called the strike price or exercise price, for a specified time. The owner of a put option has the right, but not the obligation, to sell an underlying asset at a fixed price for a specified time.

The act of buying or selling the underlying asset using the option contract is called exercising the option. Some options ("American" options) can be exercised anytime up to and including the expiration date (the last day); other options ("European" options) can be exercised only on the expiration date. Most options are American.

Because the buyer of a call option has the right to buy the underlying asset by paying the strike price, the seller of a call option is obligated to deliver the asset and accept the strike price if the option is exercised. Similarly, the buyer of the put option has the right to sell the underlying asset and receive the strike price. In this case, the seller of the put option must accept the asset and pay the strike price.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

23. Risk Management: An Introduction to Financial Engineering

© The McGraw-Hill Companies, 2002

CHAPTER 23 Risk Management: An Introduction to Financial Engineering

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