PS 303(d).

Dérivatives and Risk Management

UNIT III
Basics of Option Contract

Vasantha G, PhD
AIMIT, St. Aloysius College
Dr. Vasantha G
 FORWARDS
It is the simplest and oldest form of derivatives
It is an agreement between two parties to sell
or buy some asset or of that kind on a
specified future date at a specified rate
agreed at present.
There is no intermediary
Personalized contracts
 FORWARDS
Makes an Agreement

Accordingly the
Farmer agrees to sell
500 [Link] of Wheat at
Rs. 40/K.g After 3
Farmer months
Businessman
 FORWARDS
THREE MONTHS LATER

500 Kgs of Wheat

Pays 20,000 Rs.

 FUTURES
It is very similar to a forward contract.
It is an agreement between two parties to sell
or buy some asset or of that kind on a
specified future date at a specified rate
agreed at present.
There exists intermediary
Standardized contracts
 Futures

Contacts the
Contacts the
intermediary and
intermediary and
informs about his
ask for product
product

Interm
ediary
Farmer
Businessman
 Option Contracts
It is a contract that confers a right without an
obligation to the option buyer and an obligation to
the option seller to buy or sell an underlying asset at
a specified price on or before a specified future date.
The option holder enjoys the right to exercise the
option if it favors him on expiry/exercise date or not
to exercise if it unfavors.
Option seller has to obey what the option buyer does.
 Options
Makes an Option
Agreement

Accordingly the
Farmer agrees to sell
500 [Link] of Wheat at
Rs. 40/K.g After 3
Farmer buys the months
Businessman sells
option
the option
 OPTIONS

THREE MONTHS LATER THE SPOT

MARKET PRICE IS RS. 55/KG

The Farmer (Option Holder) Breaks

The Contract & Sells His Product in
The Open Market
Option Seller
Option Buyer/Holder
Differences between Option and Futures

FUTURES OPTIONS
Obligation to Both Buyer and Only on Seller of
perform Seller Option
Initial Payment None Premium
Pay off Linear Non-Linear
Types of Option
• A) Call Option
A)Stock Options
• B) Put Option
B) Index Options
C) Commodity Options
• A) American Option D)Currency Options
• B) European Option

• A) At-the-Money Option
• B) In-the- Money Option
• C) Out –of- the Money Option
 Terminology of Option
• Buyer or Holder- The person who has the right but not
obligation to buy or sell.
• Writer or Seller- The person who confers the right and
undertakes the obligation to perform.
• Premium- Upfront amount charged by the seller to the buyer.
This is also called as option price.
• Strike Price- This is the price pre-determined at the time of
buying/writing of option, at which the option can be exercised.
• Maturity/strike/expiry date: The time when the option can be
exercised.
 Call Option
• A Call option on a share (or any asset) is the right to buy
the share at an agreed price.
• It gives the option holder the right to buy the underlying
asset in the specified future date, at a price agreed today.
• The name call denotes, whenever the option holder calls
or asks the seller he has to sell his assets to the option
buyer.
• Call buyer will buy the underlying asset if the option is in-
the-money, that is only if it profitable to him.
Option Pay-offs (Moneyness)
• Refers to the relationship between the price of the underlying
asset and the exercise price.
• It describes the benefit the holder gets if he/she exercises the
option now.
• Three types of Moneyness- In-the-Money, At-the-Money and
Out-of-the-Money
• ITM-If exercised would result in a positive cash flow to the
holder.
• OTM- Result in cash outflows if exercised.
• ATM- Options would have no cash flows.
Option Pay-offs (Moneyness)- Example
• The share of Akruti Ltd ltd is selling at Rs. 110.
• John buys a three month call option at a
premium of Rs. 10.
• The exercise price is Rs. 120.
• What is John’s Pay off if the share price is Rs.
100, or Rs. 150?
Option Pay-offs (Moneyness)- Example
• In the above case what will be moneyness (pay-
off) of Mr John if the share price turns to be Rs
100, 115, 120, 125,130,135,140,145 or Rs. 150?
Pay-off Table
Share Prices in Premium
Market Paid Pay-off Net Pay off
100 -5 0 -5
105 -5 0 -5
110 -5 5 0
115 -5 10 5
120 -5 15 10
Pay- Off Chart

Net Pay off

12

10 10

6
5
4
Unlimited
2 Profit
0 0
100 105 110 115 120

-2

Limited Loss
-4
-5 -5
-6
 Pay-off Call option Seller
Share Prices in Premium
Market Received Pay-off Net Pay off
100 5 0 5
105 5 0 5
110 5 -5 0
115 5 -10 -5
120 5 -15 -10
 Pay-off Chart
Net Pay off
6
5 5

2 Limited Profit
0
Pay-off

0
95 100 105 110 115 120 125

-2

-4
-5
Un limited Loss
-6

-8

-10
-10

-12
 Formula

• Call Pay-off (Buyer) = Maximum of [Share Price – Exercise Price, 0]

• Call Pay-off = Maximum of [S– E, 0]

The pay off of call option seller is exactly opposite that of Call
option buyer. Whatever buyer gains, the seller losses and
whatever buyer losses the seller gains.
Therefore, the pay-off chart of Call option seller will be mirror image of
call option buyer
• Call Pay-off (Seller) = -Maximum of [Share Price – Exercise Price, 0]
• Call Pay-off = - Max [S– E, 0]
Exercise 1
• Mr. Jayaram has purchased a 3-month call option on a
company’s share with an exercise price of Rs. 510.
• Premium paid is Rs. 10
• The current price of the share is Rs. 500.
• Determine the value (Pay-off) of call option at
expiration if the share price turns out to be either Rs.
450, 460, 470, 480, 490, 500, 510, 520, 530,540 or 550?
• Prepare pay off table and chart of both Call Buyer and
Seller.
Exercise 2
• Sundar has sold a 6-month call option on a
company’s share with a exercise price of Rs.
1000.
• The current price of the share is Rs. 1000
• Premium received is Rs. 15
• Calculate the value of call option to Sundar at
maturity if the share price is Rs. 970, 980, 990,
1000, 1010, 1020 and 1030?
• Draw the pay-off chart.
Exercise
• Mr. Rohith expects that the price of a company’s share will rise in the
future. Therefore, he intends to buy one call option on share with an
premium of Rs. 20.
• The current market price of the share is Rs. 350. And the exercise
price is Rs. 360.
• What is the call option pay-off to Mr. Rohith if the possible share
prices on the expiration day is as follows; Rs. 330, 335, 338, 341, 356,
386, 392, 404 and 413.
• Also draw the pay-off graph. Further, calculate the pay-off of call
option seller and draw the pay-off chart.
 Put- Option
• Put Option is the option that confers the buyer of
the option, the right but not obligation to sell
certain underlying asset at a predetermined price
on or before a predetermined date.
• Put option buyer gets the right to sell the asset.
• Here the put seller has to purchase the assets if
he is asked to do so by the option buyer.
• Put option buyer is bearish about the market.
 Option Pay-offs- Put Option Buyer
• The share of XYZ ltd is selling at Rs. 104.
• Ramesh buys a three month put option at a
premium of Rs. 5.
• The exercise price is Rs. 105.
• What is Ramesh’s Pay off if the share price is Rs.
80, 85, 90, 95, 100, 105, 110, 115, or Rs. 120?
 Example 2- Put Option

• The share of ABC Ltd. is selling at Rs. 250.

• Suresh buys a three month put option at a premium
of Rs. 50.
• The exercise price is Rs. 255.
• What is Suresh’s Pay off if the share price is Rs. 200,
210, 220, 230, 240, 250, 260, 270, or Rs. 280?
• Draw the pay off table and chart of Mr Suresh
 Whatsapp Assignment
• Mr. Gireesh is bearish about the Sun Pharma Ltd shares.
• Hence he bought a put option from Mr. Prashanth with
exercise price of Rs. 215.
• He paid premium of Rs. 15 per share to acquire the options
contract.
• What will the profit/loss of Mr Gireesh and Prashanth on the
expiry day if the share price on that day turns to be Rs. 180,
or Rs. 185 or 190 or 200 or 210 or 215 or 220 or 225 or 230?
Plot the pay-offs of both the parties in a pay-off graph.
Exercise Problems
Exercise 1
• An investor buys a European put option on a share for Rs. 150. The
stock price is Rs. 2000 and strike price is Rs. 1800. Under what
circumstances does the investor make the profit. At what price will be
the option be exercised ? Draw a diagram showing the variations of
the investor’s profit with the stock price at the maturity of options?
Exercise 2
The stock of Reliance Industries in spot market is Rs1500 and two
month option contract is of Rs 1500. The price of the option is Rs. 20
per share. At what price the option will be at –the- money, out-of-
money and in-the-money if the option is both call as well as put
option?
Exercise 3
• Suppose that a European call option to buy a share for Rs. 3000 costs
Rs. 120 and it is held until maturity. Under what circumstances will
the holder of the option makes a profit? Under what circumstances
will the option be exercised?
Exercise 4
• The stock price of Infosys Ltd. in spot market Rs. 1400 and two month
call option strike price is 1450. The price of the call option is Rs. 50. At
what price the option will be in-the-money, at the money and out of
the money?
Exercise 5
• The stock price of X Ltd. stands at Rs. 120 in spot market. A put option
with strike price of Rs 130 are priced at Rs. 15.
• A) What is the intrinsic value of Options?
• B) If the share price falls to Rs. 50 by the expiry date, what would be
profit or loss for the holder and writer of the options?
Exercise 6
• A 3-month put option on Tata Steel with a strike price of Rs.
550 is selling for Rs. 60, while the share is trading ar Rs. 500.
Answer the following questions,
• A) What is the intrinsic worth of the put option?
• B) What is time value of put option?
• C) At what price of the asset would the put option holder
break-even?
Exercise 7 (2019 Final Exam)
• A call option enables purchaser of dollar for Rs. 75, while it is
quoted at Rs. 75.60 in spot market and the premium paid for
call option is Re.1.00. Calculate the intrinsic and time value
of the call option.
Exercise 8
• Find out the payoffs of the following positions on European
options on a stock whose price at maturity is Rs. 100.
• A) Long A call with an exercise price of Rs. 90
• B )Short A call with an exercise price of Rs. 80
• C) Long A put with an exercise price of Rs. 110
• D) Short A put with an exercise price of Rs. 110
• E) Long A call with an exercise price of Rs. 100
• F) Short A put with an exercise price of Rs. 100
Exercise 9
• Suppose Mr. Manoj owns 5000 shares worth Rs. 250 each. How can
put options be used to provide Manoj with insurance against a decline
in the value over the next 4 months?
Exercise 10
• Consider an investor who in August owns 1000 shares of IBM
corporation.
• The current share price is $ 55 per share. The investor is concerned
that the share price may decline sharply in the next two months and
wishes to protect himself.
• IBM put options are priced at $4 per shares.
• What could be investor’s strategy and show position if price of IBM
declined to $50 per share.
Exercise 11
• Mr. Robert wants to buy 1000 shares of Reliance Industries after a
month. He is of fear that price of reliance may increase in future (after
one month). He wants to hedge his risk. The current price of Reliance
is Rs. 2500 and call options are priced at Rs. 100 at strike price of Rs.
2600.
• a) How could Robert protect his position by entering in to into option
market?
• b) What will be profit/loss to Robert if Reliance spot after one month
is Rs. 3000 per share?
Exercise 12
• Radhika Krishnan has purchased a call option on a share at a premium
of Rs. 5. The current share price is Rs. 44 and the exercise price is Rs.
42. At maturity the share price may either increase to Rs. 45 or fall to
Rs. 43. Will Radhika exercise her option? Why?
Exercise 13
• Meena has purchased a 3-month put option on a company’s share
with an exercise price of Rs. 101. The current price of the share is Rs.
100. Determine the value of put option at expiration if the share price
turns out to be either Rs. 97 or Rs. 104. Draw a diagram to illustrate
your answer.
 Option Pricing
• Buying or selling an option comes with a price, called the option's
premium.
• To deal with option market, it is important to know how the options
are priced or valued.
• There are two reasons for it.
• First to see whether the existing options premiums are quoted in the
market are correct and
• Second, to identify profitable trading and arbitrage opportunities.
• Further, it is also useful to value non-exchange traded assets in the
market.
 Determinants of Option Price
• Factors influencing the option pricing:
• 1. Current Price of the Asset
• Higher the asset price higher the call option price.
• 2. Strike Price of the Option
• Lower the strike price, higher will be the option price and vice versa.
• 3. Time to expiration
• Longer the time to expiration, higher will be the option price.
• 4. Expected price volatility
• Higher the volatility, higher will be the option price.
• 5. Risk free interest rate
• Higher the short term interest rate, greater the option price.
• 6. Anticipated cash payment on the stock
 Determinants of Option Price
Factor Symbols Effect on Call Price Effect on Put Price

Current Price of the S Increase Decrease

Asset
Strike Price K Decrease Increase

Time to Expiration t Increase Increase

Price Volatility σ Increase Increase

Interest Rate (Short r Increase Decrease

Term)
Anticipated Cash c Decrease Increase
Payments
Black-Scholes Model of Option Pricing
• Was developed in 1973 by Fisher Black and Myron Scholes in 1973.
• Their pricing model completely revolutionized technical investing.
• Black and Scholes won the Nobel prize for their contribution in 1997.
• Black-Scholes is a pricing model used to determine the fair price or
theoretical value for a call or a put option.
• The quantum of speculation is more in case of stock market
derivatives, and hence proper pricing of options eliminates the
opportunity for any arbitrage.
• The Black-Scholes formula gives an estimate of the price according to
the European style option.
Factors Affecting Options prices in BS model
• Current price of stock
• Strike Price
• Time to expiration
• Volatility of stock price
• Risk free interest rate
• Dividend expected during life of the option
 Assumptions of BS Model
• Sufficient number of market participants (Perfect
competition)
• No transaction costs or insignificant transaction costs
• All trading profits are under same tax
• Risk free borrowing and lending
• No arbitrage opportunity
• No dividend
• Stocks follow Random Walk
BS Model Formula-Call Option

• Where
Example 1
• The current market price of a share is Rs. 64.
• The volatility of the share is measured as 25%. The risk-free rate is
currently 8% per annum.
• There is a call option as well as a put option on the share, expiring in 6
months with exercise price of Rs. 60.
• Calculate the price of the call option.
BS Model Formula- Put Option
•P

• Put call Parity method

Example 2 (MBA 2019)
• Calculate the price of the call option using B. S model.
Stock X Y
Spot Price 80 80
Exercise Price 70 80
Time to expiration 3 months 3 months
Risk free return 12% p.a 12% p.a
Standard deviation of stock 60% 60%
returns
Option pricing when there is dividend
• If a dividend is announced during the life of the options, then the spot
price of the underlying asset has to be adjusted with the present
value of the dividend.
• That means the dividend expected has to be discounted using the risk
free interest rate.
• Then the discounted value of dividend has to be deducted from the
current market price.
• Once this adjustment is done, we apply the basic BS formula to
calculate the option price.
Example 1
• Options are available in the market on a stock whose current market
price is Rs. 140. The options expire in 8 months. The exercise price of
the option is Rs. 130. The volatility of the stock price has been
ascertained as 32%. The risk-free interest rate is 8% per annum.
Calculate the call option and put option prices:
• A) When no dividends are expected during the option life
• B) When a dividend of Rs. 6 is expected to be received after 6 months
from now.
Binomial Option Pricing Model (BOPM)
Example- 1
• A share is currently selling for Rs. 120.
• There are two possible prices of the share after one year: Rs. 132 or
Rs. 105.
• Assume that the risk free rate of return is 9% per annum.
• What is value of one year call option (European) with an exercise
price of Rs. 125?
Example- 2
• The share of Ashok Enterprises is currently selling for Rs. 100.
• It is known that the share price will either turn to be Rs 108 or Rs. 90.
• The risk-free rate of return is 12% per annum.
• If you intend to buy a 3 month call option with an exercise price of Rs.
97, how much should you pay for buying the option today?
• Assume no arbitrage opportunity.
Option Valuation using risk neutral argument
Example 1
• A non dividend paying stock currently priced at Rs. 125 per share. It
can either go up by Rs. 25 or down by Rs. 25 in a year. Consider a 3
month call option, with strike price of Rs. 135. The continuously
compounded risk free rate is 8%. What is the option price? Use risk-
neutral argument.
Exercise 1
• The current market price of an equity share of Penchant Ltd is Rs. 420.
• Within a period of 3 months the maximum and minimum price of it is
expected to be Rs. 500 and Rs. 400 respectively.
• If the risk free rate of interest be 8% per annum what should be the
value of a 3 month call option under the no-arbitrage argument of
Binomial Tree.
Pricing of Put option under binomial model
• A stock whose cmp is Rs. 1000, is expected to go up to Rs. 1100 and
come down to Rs. 900 in next 6 months. The risk-free rate with CC is
8% pa. What is the put option price if the exercise price is Rs. 1000?
Verify your answer by using both no arbitrage argument and risk
neutral argument.