Financial Economics

Module V
Derivative Markets
Financial Derivatives
Financial derivatives are financial contracts whose value depends on the price of another
asset, called the underlying asset. These underlying assets may include stocks,
commodities such as gold or oil, currencies, or market indices. In simple terms, a
derivative does not have its own independent value; instead, its price changes according
to the value of the underlying asset. Because of this relationship, derivatives are widely
used in modern financial markets for different financial activities.
A simple example can explain this concept clearly. Suppose a farmer and a rice trader
make an agreement today that the trader will buy rice after three months at ₹50 per kg,
regardless of the market price at that time. If the market price becomes ₹60, the trader
benefits; if the price falls to ₹40, the farmer benefits. This type of agreement, where the
value depends on the price of rice, is similar to a financial derivative. In financial
markets, derivatives such as forwards, futures, options, and swaps are used to reduce risk,
speculate on price movements, and improve market efficiency.
A financial derivative is a contract that derives its value from the price movements of an
underlying asset. These instruments are widely used in financial markets for risk
management, speculation, and arbitrage.
Example:
If the price of crude oil increases, a derivative contract linked to crude oil will also
change in value.
Features of Financial Derivatives
1. Derived Value – The value depends on an underlying asset.
2. Contractual Agreement – It is based on an agreement between two parties.
3. Future Settlement – Most derivatives are settled at a future date.
4. Leverage – Investors can control large positions with relatively small capital.
 5. Risk Management Tool – Used for hedging against price fluctuations.
Types of Financial Derivatives
1. Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a
predetermined price on a specific future date.
Example:
A farmer agrees to sell wheat to a trader after 3 months at ₹2000 per quintal.
2. Futures Contracts
Futures are similar to forwards but are standardized contracts traded on organized
exchanges.
Example:
Stock index futures traded on stock exchanges like NSE.
3. Options
An option gives the right but not the obligation to buy or sell an asset at a
predetermined price.
Two types:
• Call Option – Right to buy
• Put Option – Right to sell
4. Swaps
A swap is an agreement between two parties to exchange cash flows in the future.
Example:
• Interest rate swaps
• Currency swaps
Uses of Financial Derivatives
Financial derivatives are widely used in financial markets for managing risk and
improving investment opportunities. The main uses of derivatives are:
 1. Hedging (Risk Management)
Derivatives help investors protect themselves from price fluctuations in assets such
as stocks, commodities, or currencies. For example, a farmer may use futures
contracts to lock in the price of crops and avoid losses due to falling prices.
2. Speculation
Traders use derivatives to predict future price movements and earn profits. By
using derivatives, investors can take positions in the market with a small initial
investment.
3. Arbitrage
Derivatives help traders take advantage of price differences of the same asset in
different markets. This helps in earning risk-free profit and maintaining price
balance in the market.
4. Price Discovery
Derivative markets help determine the future price of underlying assets based on
demand and supply conditions. This information is useful for investors and
producers.
5. Portfolio Management
Investors use derivatives to adjust and balance their investment portfolios. It helps
reduce risk and improve returns by managing exposure to different assets
Importance of Financial Derivatives
• Protect investors from market risks
• Increase market liquidity
• Help in efficient allocation of financial resources
• Provide opportunities for portfolio diversification
Example (Simple)
Suppose an investor expects the price of a stock to rise. Instead of buying the stock
directly, the investor buys a call option on that stock. If the price increases, the investor
can profit from the derivative contract.
 Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a fixed
price on a specific future date. The price is decided today, but the actual buying or selling
happens later. These contracts are usually made privately between two parties, so the
terms such as price, quantity, and delivery date can be customized according to their
needs.
For example, a farmer and a trader may agree today that the trader will buy wheat after
three months at ₹2000 per quintal. If the market price becomes ₹2200 after three months,
the trader benefits because he buys at the lower agreed price. If the price falls to ₹1800,
the farmer benefits because he can sell at the higher agreed price. Thus, a forward
contract helps both parties reduce the risk of future price changes.
Meaning of Forward Price
Forward price is the price that two parties agree today for buying or selling an asset at a
future date in a forward contract. Even though the transaction will happen later, the price
is fixed now.
In simple terms, the forward price is mainly based on the current market price (spot price)
of the asset and the cost of holding the asset until the future date, such as interest, storage,
or insurance. So, the forward price usually reflects what the asset might cost in the future
when these holding costs are considered.
Factors Determining Forward Price
The forward price is determined by the following factors:
1. Spot Price: The current market price of the underlying asset is called the spot price.
The forward price is based mainly on this price.
2. Time to Maturity: The time remaining until the contract expires affects the forward
price. A longer period usually increases the forward price because holding costs increase.
3. Risk-Free Interest Rate: If money is borrowed to buy the asset today, interest must be
paid. Therefore, the interest rate influences the forward price.
4. Cost of Carry: Cost of carry refers to the cost of holding an asset until the future
date, such as:
 • Storage cost
• Insurance cost
• Interest cost
These costs increase the forward price.
5. Income from the Asset: If the asset provides income (like dividends from stocks), it
reduces the forward price because the holder of the forward contract will not receive that
income.
Forward Price Formula
The basic formula for determining the forward price is:
𝐹 = 𝑆(1 + 𝑟)𝑡
Where:
• F = Forward price
• S = Current spot price
• r = Risk-free interest rate
• t = Time to maturity
If the asset provides income, the formula becomes:
𝐹 = 𝑆(1 + 𝑟)𝑡 − 𝐼
Where I represents income received during the period.
Example
Suppose:
• Current price of a stock (S) = ₹100
• Interest rate (r) = 10% per year
• Time (t) = 1 year
Forward price:
𝐹 = 100(1 + 0.10) = 110
So, the forward price of the asset after one year will be ₹110.
The forward price of a contract is determined based on the spot price, interest rate, time
to maturity, cost of carry, and income from the asset. Proper determination of forward
price helps maintain market efficiency and prevents arbitrage opportunities.

Futures Contract
A futures contract is an agreement to buy or sell an asset at a fixed price on a specific
future date. The price is decided today, but the actual transaction will happen later. Unlike
forward contracts, futures contracts are standardized and traded on organized exchanges,
which makes them more secure and transparent.
Futures contracts are commonly used for assets such as commodities (gold, oil, wheat),
currencies, stocks, and stock market indices. People use futures mainly to protect
themselves from price changes or to make profit from expected price movements. Since
these contracts are traded through exchanges and regulated by authorities, the risk of
default is lower compared to private agreements.
Meaning of Futures Contract
A futures contract is a legally binding agreement between two parties in which one
party agrees to buy and the other agrees to sell an asset at a fixed price on a future date.
Unlike forward contracts, futures contracts are standardized and traded on exchanges,
which reduces the risk of default.
Features of Futures Contracts
1. Standardization: Futures contracts have standardized terms such as quantity,
quality, and delivery date.
2. Exchange Trading: These contracts are traded on organized exchanges like stock
exchanges.
3. Margin Requirement: Both parties must deposit a margin amount as security
when entering into a futures contract.
4. Daily Settlement (Marking to Market): Profits and losses are settled daily based
on market price changes.
 5. Clearing House Guarantee: A clearing house acts as an intermediary and
guarantees the performance of the contract.
Types of Futures Contracts
1. Commodity Futures – Based on commodities like gold, oil, or wheat.
2. Currency Futures – Based on exchange rates between currencies.
3. Interest Rate Futures – Based on interest-bearing financial instruments.
4. Stock Index Futures – Based on stock market indices like NIFTY or SENSEX.
Uses of Futures Contracts
1. Hedging – Protects against price risk.
2. Speculation – Traders aim to profit from price changes.
3. Arbitrage – Taking advantage of price differences between markets.
Futures contracts play an important role in financial markets by helping investors
manage risk, improve price discovery, and increase market efficiency. They are
widely used by traders, investors, and businesses to protect against future price
fluctuations.

Difference Between Forward Contract and Futures Contract

Basis Forward Contract Futures Contract
Meaning A private agreement between two A standardized contract traded on
parties to buy or sell an asset at a an organized exchange to buy or
future date. sell an asset at a future date.
Trading Traded in over-the-counter (OTC) Traded on organized exchanges.
markets.
Standardization Terms are customized according Contracts are standardized by the
to the needs of the parties. exchange.
 Risk Higher default risk because there Lower risk because the clearing
is no clearing house guarantee. house guarantees the contract.
Margin Usually no margin requirement. Requires margin deposit from
Requirement both parties.
Settlement Settlement usually occurs only at Daily settlement (mark-to-
maturity. market) takes place.
Liquidity Less liquid because contracts are Highly liquid because they are
private. traded on exchanges.
Regulation Less regulated. Highly regulated by stock
exchanges.

Theories of future prices

Cost of Carry Model
The Cost of Carry Model is used to find the fair price of futures and forward contracts. It
explains that the futures price of an asset depends on the cost of holding the asset until
the future delivery date. In other words, the futures price is related to the current market
price of the asset and the cost involved in keeping the asset until the contract expires.
In simple terms, cost of carry includes all the costs and benefits of holding an asset for a
period of time. These costs may include interest, storage, and insurance, while benefits
may include income such as dividends. Therefore, the futures price is usually calculated
by considering the spot price of the asset plus the cost of carrying the asset until the
delivery date.
Meaning of Cost of Carry
The cost of carry is the net cost incurred for holding an asset until the maturity of the
futures contract.
It includes:
• Interest cost of investing money
 • Storage cost
• Insurance cost
• Other carrying charges
It may also include income received from the asset, such as dividends.
Cost of Carry Model
According to this model, the futures price is determined by adding the cost of carrying
the asset to the current spot price.
Formula
𝐹 =𝑆+𝐶
Where:
• F = Futures price
• S = Spot price (current market price)
• C = Cost of carry
Example: Suppose the current spot price of gold (S) is ₹50,000. The cost of holding the
gold for three months (interest, storage, insurance, etc.) is ₹2,000. According to the Cost
of Carry Model, the futures price is calculated by adding the cost of carry to the spot
price.
Using the formula F = S + C
𝐹 = 50,000 + 2,000 = 52,000
So, the futures price of gold will be ₹52,000. This means the agreed price in the futures
contract for delivery after three months would be ₹52,000.
Extended Formula
If interest rate is considered:
𝐹 = 𝑆(1 + 𝑟)𝑡
Where:
• F = Futures price
 • S = Spot price
• r = Risk-free interest rate
• t = Time to maturity
When Asset Provides Income
If the asset provides income (like dividends), the formula becomes:
𝐹 = 𝑆(1 + 𝑟)𝑡 − 𝐼
Where:
• I = Income received from the asset.
Components of Cost of Carry
1. Interest Cost – Interest paid for funds used to purchase the asset.
2. Storage Cost – Cost of storing commodities.
3. Insurance Cost – Cost of insuring the asset.
4. Income from Asset – Dividends or returns received while holding the asset.
Example
Suppose:
• Spot price of gold = ₹50,000
• Interest rate = 10% per year
• Time = 1 year
Then,
𝐹 = 50000(1 + 0.10)
𝐹 = 55,000
So the futures price will be ₹55,000.
The Cost of Carry Model helps determine the fair value of futures contracts by
considering the spot price, interest rate, time to maturity, and carrying costs. It ensures
that there are no arbitrage opportunities in the market.
 Expectation Model
The Expectation Model is a theory used to determine the price of futures contracts.
According to this model, the futures price of an asset is based on what people in the
market expect the asset’s price will be in the future. In other words, the futures price
reflects the market’s expectation about the future spot price of the asset.
For example, if investors believe that the price of gold will increase to ₹65,000 after three
months, the futures price will move close to that expected price. Thus, according to the
expectation model, the futures price mainly depends on the expectations of investors
about future market prices.
Meaning of Expectation Model
The Expectation Model states that the futures price is equal to the expected future spot
price of the underlying asset.
If investors expect the price of an asset to increase in the future, the futures price will be
higher. If they expect the price to fall, the futures price will be lower.
2. Formula of Expectation Model
𝐹𝑡 = 𝐸(𝑆𝑇 )
Where:
• Fₜ = Futures price at time t
• E(Sₜ) = Expected spot price at maturity (future date)
This means the futures price is determined by the expected future value of the asset.
Assumptions of Expectation Model
1. Investors are rational and make decisions based on expectations of future prices.
2. There are no carrying costs like storage or interest costs.
3. Market participants have equal access to information.
4. Futures prices reflect the collective expectations of all investors.
Example
Suppose the current price of a stock is ₹100, and investors expect that the price will
increase to ₹120 after three months.
According to the expectation model, the futures price will be approximately ₹120,
because it reflects the expected future price.
Importance of Expectation Model
• Helps explain how futures prices are formed.
• Reflects market expectations about future prices.
• Useful for investors and traders in predicting price movements.
The Expectation Model suggests that the futures price is determined by the expected
future spot price of the asset. It emphasizes the role of market expectations and investor
beliefs in determining futures prices.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a financial model used to determine the
expected return on an investment based on its risk compared to the overall market. It
explains the relationship between risk and expected return of a security.
CAPM helps investors decide whether a security is fairly priced and whether it should be
included in their investment portfolio.
Meaning of CAPM
The Capital Asset Pricing Model states that the expected return on a security depends
on:
• The risk-free rate of return
• The market return
• The systematic risk (Beta) of the security
It measures how much return an investor should expect for taking additional risk.
CAPM Formula
𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 (𝑅𝑚 − 𝑅𝑓 )

Where:
• E(Rᵢ) = Expected return of the security
• R_f = Risk-free rate of return
• βᵢ (Beta) = Measure of systematic risk of the security
• R_m = Expected return of the market
• (R_m − R_f) = Market risk premium
Components of CAPM
1. Risk-Free Rate (Rf)
The return on a risk-free investment such as government treasury securities.
2. Market Return (Rm)
The average return expected from the market portfolio.
3. Beta (β)
Beta measures the sensitivity of a security's return to changes in the market.
• β = 1 → Risk equal to market
• β > 1 → Higher risk than market
• β < 1 → Lower risk than market
4. Market Risk Premium
It is the extra return investors expect for taking market risk.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = (𝑅𝑚 − 𝑅𝑓 )

Example Suppose:
• Risk-free rate = 5%
• Market return = 12%
• Beta of a stock = 1.5
Using CAPM:
𝐸(𝑅𝑖 ) = 5 + 1.5(12 − 5)
𝐸(𝑅𝑖 ) = 5 + 1.5(7)
𝐸(𝑅𝑖 ) = 5 + 10.5 = 15.5%
So, the expected return of the stock is 15.5%.
Importance of CAPM
• Helps estimate the required rate of return for investors
• Assists in investment decision making
• Useful in portfolio management
• Helps evaluate whether a stock is overvalued or undervalued
The Capital Asset Pricing Model is an important tool in financial management that
explains the relationship between risk and expected return. It helps investors make
better investment decisions by considering the level of risk involved.

Relation between Spot and Futures Prices

The spot price is the current market price of an asset for immediate delivery, while the
futures price is the agreed price at which the asset will be bought or sold on a future
date. There is a close relationship between spot prices and futures prices because both
depend on the same underlying asset.
Basis Spot Price Futures Price
Price of an asset for Price agreed today for buying
Meaning immediate delivery in the or selling the asset at a future
market. date.
Time of Transaction takes place Transaction takes place on a
Transaction immediately. future specified date.
 Occurs in the futures market
Market Occurs in the spot market.
(exchange).
Determined by spot price, cost
Price Determined by current
of carry, and market
Determination demand and supply.
expectations.
Asset is delivered Asset is delivered at the
Delivery
immediately. contract maturity date.
Usually higher than spot price
Current market price of the
Price Relationship due to carrying costs (interest,
asset.
storage, insurance).

Hedging in Futures
Hedging in futures means using futures contracts to protect against the risk of price
changes in the market. Producers, traders, and investors use this method to avoid losses
when prices move unfavorably. By entering into a futures contract, they can fix the price
of an asset today for a transaction that will happen in the future.
In simple terms, hedging helps reduce uncertainty about future prices. For example, a
farmer expecting to sell wheat after three months may sell a futures contract now at a
fixed price. If the market price falls later, the farmer will not suffer a loss because the
selling price was already fixed through the futures contract. Thus, hedging helps reduce
risk and provide price stability.
Meaning of Hedging
Hedging is the process of taking a position in the futures market that is opposite to the
position in the spot market in order to reduce the risk of price changes.
For example, if a trader expects the price of a commodity to fall in the future, they can
sell futures contracts to protect against losses.
Types of Hedging in Futures
1. Long Hedge: A long hedge is used when an investor plans to buy an asset in the
future and wants protection against a possible increase in price.
Example:
A company that needs raw materials after three months buys a futures contract to avoid
the risk of price increase.
2. Short Hedge: A short hedge is used when a person plans to sell an asset in the
future and wants protection against a possible fall in price.
Example:
A farmer expecting to sell wheat after three months sells a futures contract to lock in the
price.
Advantages of Hedging
1. Reduces price risk in the market.
2. Provides price stability for producers and consumers.
3. Helps in financial planning and budgeting.
4. Protects against unexpected market fluctuations.
Example of Hedging
Suppose a farmer expects to harvest wheat in three months and fears that the price may
fall.
• Current price of wheat = ₹2000 per quintal
• The farmer sells a futures contract at ₹2000.
If the market price falls to ₹1800, the farmer's loss in the spot market is offset by profit in
the futures market.

Options
An option is a financial derivative contract that gives the buyer the right, but not the
obligation, to buy or sell an asset at a fixed price on or before a specific future date. The
price agreed in the contract is called the exercise price or strike price. This means the
buyer can choose whether to complete the transaction or not.
In simple terms, an option gives a person the choice to buy or sell an asset in the future at
a fixed price. If the market price becomes favorable, the buyer can use the option and
make a profit. If the price is not favorable, the buyer can simply ignore the contract and
avoid further loss, except for the premium paid for the option.
1. Types of Options
There are two main types of options:
1. Call Option
A call option gives the holder the right to buy an underlying asset at a fixed price within a
certain period of time. Investors usually buy a call option when they expect the price of
the asset to increase in the future.
For example, if a trader believes that the price of a stock will rise, they may buy a call
option so they can purchase the stock later at the fixed price agreed in the contract. If
the market price increases, the trader can buy the stock at the lower strike price and make
a profit.
2. Put Option
A put option gives the holder the right to sell an underlying asset at a predetermined price
within a specific period of time. Investors usually buy a put option when they expect the
price of the asset to fall in the future.
For example, if an investor thinks that the price of a stock will decrease, they may buy a
put option so they can sell the stock later at a higher fixed price agreed in the contract. If
the market price falls, the investor can still sell the stock at the higher strike price and
make a profit.
Value of an Option
The value of an option is the price paid by the buyer to obtain the option contract. This
price is called the option premium. It represents the amount an investor pays for the
right to buy or sell an asset at a fixed price in the future.
1. Intrinsic Value: Intrinsic value is the actual value of the option if it is exercised
immediately.
For a call option:
 𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 = 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒 − 𝑆𝑡𝑟𝑖𝑘𝑒 𝑃𝑟𝑖𝑐𝑒
For a put option:
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 = 𝑆𝑡𝑟𝑖𝑘𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑆𝑝𝑜𝑡 𝑃𝑟𝑖𝑐𝑒
2. Time Value: Time value is the additional value of the option due to the time remaining
until expiration. The more time remaining, the greater the chance of favorable price
movement.
𝑂𝑝𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 = 𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 + 𝑇𝑖𝑚𝑒 𝑉𝑎𝑙𝑢𝑒
Factors Affecting Option Value
1. Current price of the underlying asset
2. Strike price of the option
3. Time to expiration
4. Volatility of the asset price
5. Interest rates
Options are important financial derivatives that provide flexibility to investors. By using
call and put options, investors can manage risk, speculate on price movements, and
improve their investment strategies.

Pay-Offs from Buying and Selling of Options

The pay-off of an option refers to the profit or loss that an investor gets from an option
contract at the time of expiry. It depends on the difference between the market price of
the underlying asset and the strike price (exercise price) mentioned in the option contract.
In simple terms, if the market price moves in a favorable direction, the investor can make
a profit from the option. If the market price moves in an unfavorable direction, the
investor may incur a loss or let the option expire without using it. Thus, the pay-off
shows the final financial result of buying or selling an option.
There are four main option positions:
1. Buying a Call Option
 2. Selling a Call Option
3. Buying a Put Option
4. Selling a Put Option
1. Pay-off from Buying a Call Option
A call option buyer has the right to buy the asset at the strike price.
• If the market price is higher than the strike price, the buyer makes a profit.
• If the market price is lower than the strike price, the buyer lets the option expire
and only loses the premium.
Pay-off Formula
𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑀𝑎𝑥(0, 𝑆 − 𝐾) − 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
Where:
• S = Market price of the asset
• K = Strike price
2. Pay-off from Selling a Call Option
A call option seller (writer) has the obligation to sell the asset if the buyer exercises the
option.
• Profit is limited to the premium received.
• Loss can be unlimited if the market price rises sharply.
Pay-off Formula
𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 − 𝑀𝑎𝑥(0, 𝑆 − 𝐾)
3. Pay-off from Buying a Put Option
A put option buyer has the right to sell the asset at the strike price.
• Profit occurs when the market price falls below the strike price.
• Maximum loss is the premium paid.
Pay-off Formula
 𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑀𝑎𝑥(0, 𝐾 − 𝑆) − 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
4. Pay-off from Selling a Put Option
A put option seller must buy the asset if the buyer exercises the option.
• Maximum profit is the premium received.
• Loss occurs when the market price falls below the strike price.
Pay-off Formula
𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 − 𝑀𝑎𝑥(0, 𝐾 − 𝑆)

Put–Call Parity Theorem

The Put–Call Parity Theorem is an important concept in option pricing that explains the
relationship between the prices of European call options and European put options with
the same strike price and expiration date. It shows that the prices of these options are
connected to the price of the underlying asset, and they must follow a certain balance in
the market.
In simple terms, the theorem states that the value of a call option and a put option must
maintain a specific relationship with the price of the underlying asset. If this relationship
is not maintained, investors could take advantage of the price difference and earn risk-
free profit through arbitrage. Therefore, put–call parity helps maintain price balance and
efficiency in the options market.
2. Formula of Put–Call Parity
The standard formula is:
𝐶 + 𝑃𝑉(𝐾) = 𝑃 + 𝑆
Where:
• C = Price of the call option
• P = Price of the put option
• S = Current price of the underlying asset (spot price)
• PV(K) = Present value of the strike price
 • K = Strike price
Another common form is:
𝐶 − 𝑃 = 𝑆 − 𝑃𝑉(𝐾)
Explanation
The theorem says that:
• Buying a call option and investing the present value of the strike price
gives the same result as
• Buying a put option and purchasing the underlying asset.
Therefore, the prices of calls and puts must maintain this balance in the market.
Example
Suppose:
• Current stock price (S) = ₹100
• Strike price (K) = ₹100
• Call option price (C) = ₹12
• Put option price (P) = ₹7
• Present value of strike price = ₹95
Check parity:
𝐶 + 𝑃𝑉(𝐾) = 12 + 95 = 107
𝑃 + 𝑆 = 7 + 100 = 107

Since both sides are equal, Put–Call parity holds.

Importance of Put–Call Parity
1. Helps determine the fair value of options.
2. Prevents arbitrage opportunities in the market.
 3. Shows the relationship between call options, put options, and underlying
assets.
4. Useful for options pricing and trading strategies.
The Put–Call Parity Theorem establishes a theoretical relationship between call and put
option prices. It ensures market efficiency by maintaining balance between option prices
and preventing risk-free arbitrage opportunities.

Binomial Option Pricing Model (BOPM)

The Binomial Option Pricing Model (BOPM) is a method used to calculate the value of
an option by considering possible future movements in the price of the underlying asset.
According to this model, the price of the asset can move in two directions over a period
of time: it can either go up or go down.
This model was developed by Cox, Ross, and Rubinstein in 1979. It helps investors
estimate the value of an option by analyzing these possible price movements step by step,
making it easier to understand how the option price may change in the future.
Meaning of Binomial Option Pricing Model
The Binomial Option Pricing Model determines the price of an option by creating a
binomial tree that represents different possible prices of the underlying asset over time.
At each stage, the price of the asset can either:
• Increase (Up movement)
• Decrease (Down movement)
Using these possibilities, the value of the option is calculated step by step.
Assumptions of BOPM
1. The price of the underlying asset can move in two directions (up or down) in each
time period.
2. Markets are efficient and free of arbitrage opportunities.
3. The risk-free interest rate is constant.
 4. There are no transaction costs or taxes.
5. The model works over discrete time intervals.
Steps in the Binomial Model
1. Determine the current price of the asset.
2. Estimate the upward and downward movement in price.
3. Construct a binomial tree showing possible future prices.
4. Calculate the option pay-off at expiration.
5. Discount the pay-off back to the present value using the risk-free interest rate.
Simple Example
Suppose:
• Current stock price = ₹100
• In the next period, price may rise to ₹120 or fall to ₹80.
• Strike price = ₹100
If it rises to ₹120:
Call option payoff =
120 − 100 = 20
If it falls to ₹80:
Call option payoff =
0
Using probabilities and discounting, the present value of the option is calculated.
Advantages of BOPM
1. Easy to understand and flexible.
2. Can handle American options (options that can be exercised before expiry).
3. Shows price movements step by step.
 4. Useful for complex option pricing problems.
The Binomial Option Pricing Model is a widely used method for valuing options by
considering possible future price movements of the underlying asset. It provides a simple
and effective framework for understanding option pricing and risk management.

Black–Scholes Option Pricing Model

The Black–Scholes Option Pricing Model is a mathematical method used to determine
the fair price of European call and put options. It was developed by Fischer Black and
Myron Scholes in 1973, and later improved with contributions from Robert Merton.
This model is widely used in financial markets to calculate the theoretical value of
options. It considers factors such as the current price of the asset, strike price, time to
maturity, risk-free interest rate, and volatility of the asset price to estimate the correct
value of an option.
Meaning of Black–Scholes Model
The Black–Scholes Model provides a formula for calculating the price of an option based
on factors such as the current stock price, strike price, time to maturity, interest rate, and
volatility of the stock.
It assumes that the stock price follows a lognormal distribution and markets are efficient.
2. Black–Scholes Formula (Call Option)
𝐶 = 𝑆0 𝑁(𝑑1 ) − 𝐾𝑒 −𝑟𝑡 𝑁(𝑑2 )
Where:
• C = Price of the call option
• S₀ = Current price of the underlying asset
• K = Strike price
• r = Risk-free interest rate
• t = Time to maturity
• N(d₁), N(d₂) = Standard normal distribution values
 ln⁡(𝑆0 /𝐾) + (𝑟 + 𝜎 2 /2)𝑡
𝑑1 =
𝜎 √𝑡
𝑑2 = 𝑑1 − 𝜎√𝑡
Where:
• σ (sigma) = Volatility of the stock price
Factors Affecting Option Price
According to the Black–Scholes model, the price of an option depends on:
1. Current price of the underlying asset
2. Strike price of the option
3. Time to expiration
4. Risk-free interest rate
5. Volatility of the asset price
Assumptions of the Model
1. Markets are efficient with no arbitrage opportunities.
2. There are no transaction costs or taxes.
3. The risk-free interest rate is constant.
4. The underlying asset does not pay dividends.
5. Stock prices follow a lognormal distribution.
Importance of Black–Scholes Model
1. Helps determine the fair value of options.
2. Widely used in financial markets and derivative trading.
3. Helps investors evaluate investment opportunities.
4. Improves risk management and pricing accuracy.
The Black–Scholes Option Pricing Model is one of the most important models in
financial economics. It provides a scientific method to calculate option prices and is
widely used by traders, investors, and financial institutions in modern financial markets.