Mary offered to sell Mike several pieces of rare Chinese art at a very good pric
ID: 2749018 • Letter: M
Question
Mary offered to sell Mike several pieces of rare Chinese art at a very good price because they were duplicates in her own collection. Mike could not accept the offer at that time, but he did give Mary $500 in return for her promise to keep her offer open for three (3) weeks. Mike returned with the agreed-upon balance two weeks later to find that Mary already had sold the pieces she had offered to sell to him. Mary explained that she had been able to get a better price from another buyer. She offered to return Mike's $500 and insisted that this was all she was obligated to do. Is Mary right?
Explanation / Answer
No. Mary is not right. This deal is an example of a "call option", where buyer of the option has a right to buy the underlying asset at an agreed price on or before a particular date by paying a premium over the price of the asset. It further creates an obligation for the seller of the option to sell the underlying, if buyer wish to. For this obligation, the seller gets the premium over & above the price of the asset. In this example, below are the positions:
Underlying Asset: Pieces of rare Chinese art (Duplicate)
Premium: $500
Exercise Date: 3 weeks from the date of agreement.
Buyer : Mike (Right to buy)
Seller: Mary (Obligation to sell,if buyer wish to exercise the option)
In such options, if seller of the option is unable to deliver the underlying in case of option is excercised, the seller is supposed to pay some penalty over & above the premium received. So, in above case, Mike is supposed to get a lumpsum amount in the form of penalty over & above $500 paid by Mary.