Module 5

Option
What is an Option?
An option is a financial derivative that gives the buyer the right, but not the obligation, to buy
or sell an underlying asset at a predetermined price (strike price) on or before a specified
expiration date.
There are two main types of options:
 Call Option: The right to buy the underlying asset.
 Put Option: The right to sell the underlying asset.
2. Key Terms in Option Valuation
 Strike Price (Exercise Price): The price at which the holder can buy (call) or sell (put)
the underlying asset.
 Expiration Date: The last day on which the option can be exercised.
 Premium: The price paid by the buyer to the seller for the option.
 In-the-Money (ITM): When exercising the option would be profitable.
o For a call option, the underlying asset price is above the strike price.
o For a put option, the underlying asset price is below the strike price.
 Out-of-the-Money (OTM): When exercising the option would not be profitable.
o For a call option, the asset price is below the strike price.
o For a put option, the asset price is above the strike price.
3. Factors Affecting Option Value
The value of an option depends on several key factors, which are known as the "inputs" to
option pricing models:
 Underlying Asset Price: The current market price of the asset.
o Call options: Increase in value as the asset price rises.
o Put options: Increase in value as the asset price falls.
 Strike Price: The price at which the option can be exercised. Options are more
valuable the further they are in-the-money.
 Time to Expiration: More time until expiration generally increases an option’s value,
as there is more opportunity for the underlying asset to move in a favorable direction.
 Volatility: A measure of how much the price of the underlying asset fluctuates. Higher
volatility increases the potential for large price movements, thus increasing the value
of both call and put options.
  Risk-Free Interest Rate: A higher risk-free interest rate increases the value of call
options and decreases the value of put options (due to the time value of money).
 Dividends: For options on dividend-paying stocks, expected dividends can decrease
the price of call options and increase the price of put options, as the stock price
typically drops by the dividend amount when paid.
4. Option Valuation Models
Several models are used to estimate the fair value of an option. The most popular models are:
A. Black-Scholes Model
 Overview: The Black-Scholes model is used to price European-style options (which
can only be exercised at expiration). It assumes that the price of the underlying asset
follows a lognormal distribution and that there is no arbitrage.
 Formula

The Black–Scholes formula is used to calculate the price of a European call option:
𝐶=𝑁(𝑑1)×𝑆−𝑁(𝑑2)×𝑃𝑉(𝐾)

 Here are the parameters in the formula:

 S: The current price of the stock
 K: The exercise or strike price
 σ: The standard deviation of the stock's annual returns
 T: The time until the option expires, in years
 r: The annualized risk-free interest rate
 N(d): The standard normal cumulative distribution function
For a put option, the price is given by:
P=Xe−rTN(−d2)−S0N(−d1)
 Assumptions:
o The market is frictionless (no transaction costs, taxes).
o The risk-free interest rate and volatility are constant.
o European-style options are used.
B. Binomial Option Pricing Model
 Overview: This model evaluates options using a step-by-step approach over discrete
time intervals. It is particularly useful for valuing American-style options, which can
be exercised at any time before expiration.
  Process:
1. The model constructs a binomial tree of possible prices for the underlying
asset at different points in time.
2. At each node of the tree, the option price is calculated based on the probability
of the asset price moving up or down.
3. The final option value is derived by working backward from the expiration
date to the present.
Advantages:
o Handles American-style options.
o Can account for varying volatility and dividends.
C. Monte Carlo Simulation
 Overview: This method uses random sampling and simulation to estimate option
prices. It is useful for complex options where other models might struggle.
 Process:
o A large number of possible price paths for the underlying asset are simulated
using random inputs for asset price changes.
o The option price is then estimated by averaging the payoffs across all the
simulated paths, discounted to the present value.
5. Intrinsic Value vs. Time Value
 Intrinsic Value: The value if the option were exercised immediately
For a call option: Intrinsic Value=max(0,S0−X)
For a put option: Intrinsic Value=max(0,X−S0)
 Time Value: The additional value due to the possibility that the option will move
further in-the-money before expiration. The more time remaining, the greater the
time value.
6. Greeks in Option Valuation
The Greeks measure the sensitivity of an option’s price to various factors:
 Delta (Δ): Sensitivity of the option’s price to changes in the underlying asset's price.
o For calls, delta ranges from 0 to 1; for puts, it ranges from -1 to 0.
 Gamma (Γ): Sensitivity of delta to changes in the underlying asset’s price. Gamma
measures the curvature of the option’s price relative to the asset's price.
 Vega (ν): Sensitivity of the option’s price to changes in volatility.
 Theta (Θ): Sensitivity of the option’s price to time decay. It reflects how the option’s
value decreases as expiration approaches.
  Rho (ρ): Sensitivity of the option’s price to changes in the risk-free interest rate.
These are essential in managing option portfolios and understanding the behavior of option
prices under changing market conditions.
7. Practical Considerations in Option Valuation
 American vs. European Options: American options can be exercised anytime before
expiration, requiring more complex valuation methods (e.g., Binomial Model).
European options can only be exercised at expiration, and thus the Black-Scholes
model is appropriate.
 Dividends and Corporate Actions: When valuing options on dividend-paying
stocks, the impact of expected dividends should be factored into the pricing model.

Option Pricing:
The option price is in the form of premium paid on a contract. The rupee amount of the
premium is the price paid (debit) for an option when purchased or received (credit) for the
option when sold. The actual amount paid for a contract is quoted price times the number of
underlying shares, normally 100 shares, for each contract. The premium is determined by
buying and selling pressures in the auction type of market. The exercise or striking price is
the price to be paid or received for the underlying shares, when option is exercised.
Suppose, the exercise price of ACC is Rs. 250 for a call option and the actual market price is
Rs. 240, then the call is said to be out-of-the money. If on the other hand, the market price of
ACC is Rs. 260, which is above the exercise price (Rs. 250) then the option will have an
intrinsic value or real worth and the call is said to be in the money. The reverse is true in the
case of put options.
The premium for an option is almost always greater than the intrinsic value. This excess
value, namely, premium minus intrinsic value is called the time value which is the speculative
value of the premium paid on the option contract. This is what the buyer is willing to pay
above the real worth for the expectation of future profits based on the underlying share. It is
this time value which reflects the speculative element in option trading.
Factors explaining the premium of an option are as follows:
(a) Movements in exercise price relative to market price.
(b) Time remaining for expiration.
(c) Volatility of the underlying security.
(d) Market’s expectations for the underlying security.
(e) Quality and yield of the underlying security.
(f) Interest rates in general.
(g) Supply and demand position for the option.
The intrinsic value depends on the share price of the underlying security and the exercise
price of the option. This intrinsic value = actual share price — exercise price (call option).
The excess of the option premium over the intrinsic value is called the time value of option.
The time value depends on length of the time to maturity or expiration date and optimistic
expectations of a rise in price of the intrinsic security.
The time value of option thus depends on the speculative element and expectations of future.
The more risky the underlying share like Reliance, the more attractive is the option on it.
Such options will have a larger time value and the option price will rise with the risk on it,
and the volatility of the price of underlying security.
Among the other factors, influencing the option premium are the risk free rate of return, the
money market rate at which the investor can borrow and the general market risk and the risk
of the underlying security.
Take for example, TISCO, March 2000, 200 put @ Rs. 10. The expiration price is 200 and
the premium is Rs. 10 per contract of 100 shares. If the actual price is Rs. 210 the contract is
out of the money and if the price is Rs. 190, it is in the money. The premium of Rs. 10 will
vary depending upon the price of the underlying security and a host of other factors. If the
actual price is above say Rs. 180 then the option contract will have intrinsic worth and the
buyer may exercise his option to sell at Rs. 200 and after deduction of the premium paid Rs.
10 the buyer of the option gains Rs. 10 (200-190). If the market price of the underlying
security is the same as the exercise price, it is said to be trading At-the-Money.
Take the example of put option. TISCO 180 put @ Rs. 5 March 2000. The expiration price is
Rs. 180 and premium paid is Rs. 5/-, multiplied by 100 shares per contract, namely, Rs. 500.
If the actual price fell to less than Rs. 170 before the expiration, the buyer of the option may
exercise the right to sell as he will gain by selling at Rs. 180 instead of at say Rs. 170.
Depending upon whether the option is a call or put the premium will vary with the price.
Take the example of TISCO, namely, TISCO 200, and March 2000 is sold as call option at a
price of @ Rs. 10 for 100 shares. If you buy a contract, the minimum shares to be purchased
are 100 and to purchase a contract, one has to pay Rs. 10 ×100 = 1,000.
But the actual cash price of underlying securities if purchased will be Rs. 185 × 100 = 18,500
that time. If the investor is bullish and expects the rise in price much more than Rs. 10, he
will purchase the call option at Rs. 1,000. If the price of TISCO does rise at all, he will lose
only Rs. 1,000 but if it rises beyond Rs. 210, he will gain and the gain will depend on the
extent of the rise in TISCO price beyond Rs. 210, it’s the exercise price Rs. 200 plus
premium paid Rs. 10.
The terms used in options markets are as follows:
Writer of Options:
The uncovered options are called naked options. To cover calls pay the underlying security or
go long in a put of equal or higher premium maturity. To cover puts, go short in the
underlying security or go long in a put.
Normally option contracts are settled on the next day. If you exercise an option, settlement
takes place in T + 5 days. The OCC makes arrangements for the settlement of these contracts
in the U.S.A. The collection of margins and regulation of writing of contracts in options and
in their trading and related matters, including settlement and clearance are the responsibility
of the regulatory authority, namely, the Options Clearing Corporation, in the U.S.A.
Trading in Options:
The options market is an example of the derivative market. It is a hedge and leveraged
instrument. It provides needed diversification and duration adjustment in portfolio
management. The advantages of the market are many. It caters to the instinct of pure
speculation. It provides a hedge to the risk of the cash market. It lowers transactions costs and
enhances price discover)’ process.
It leads to increased liquidity, greater volumes and turnover and sophistication of the markets.
Arbitrage and hedge go together in the market, which leads to greater stability and
competition in the markets. Arbitrage is to buy in one market and sell on another market,
there by equalising the prices and returns. Hedging is covering up operations to reduce or
eliminate risk.
These derivative markets complement the cash markets and promotes sophistication of the
market structure and integration of the markets leading to the globalisation trend to move
faster. This market helps higher yields and efficient asset allocation.
These markets are all complementary and arbitrage brings about uniformity in pricing and
interest rates in each of sub-segments and segments.
There are three major categories of players other than investors, namely, write who write or
make the options as approved by the Exchange authorities, dealers who are wholesalers and
trade for themselves and traders who are retail agents of the customers.
The options have two varieties of trades, namely, calls and puts.
A call is a right to buy without any objection.
The following charts will explain the call options:
A right to sell is the put options.
An option contract can be represented diagrammatically as follows:
Types of options are two as shown below:

Pricing of options depends on the supply and demand as in any auction market. But basically
it depends on the intrinsic value of the underlying security or stock.
But in addition, there is also time value in many cases which depends on the following
factors:
(i) Stock Price
(ii) Time to Expiry of the Contract
(iii) Interest Rates Prevailing
(iv) Volatility of the Underlying Security
(v) Dividends Paid
(vi) Type of Option — say European or American Types of Option.
Price Changes:
The price of an option is the premium paid per 100 shares of the underlying security. The
purchase of an option involves the payment of the price per contract, of 100 shares,
multiplied by the number of such contracts purchased. In the event the price of the underlying
security goes against the option price, fixed at the time of writing the option, the loss to the
buyer is only the premium paid by the contracts purchased. The gain will be in the rise in
option price, depending on the price movements of the underlying security.
Thus, each contract of 100 shares will have a price, which varies with the price of the
underlying security and the unexpired time to maturity. The maturity of the option contract is
generally a 3 or 4 months and as the time goes on the price varies from day-to-day and even
minute to minute during trading time depending upon the demand and supply pressures.
The value of option has two components:
(a) Intrinsic value, based on the underlying security.
(b) Time value based on the time available before expiry.
Risks of Buying and Selling Options:
Depending on how options are used, investors can be subject to substantial risks or reduced
risks. Losing the entire amount spent to purchase a call option or a put option is not an
unusual event. Investors who write options are subject to the possibility of losing
substantially more than the premium received.
Option prices are volatile to the point that their relative values change by a multiple of the
change in the underlying stock. Thus, anything that can bring about a change in the price of
the underlying stock in a short period of time has the potential for producing great losses (or
profits) for the owner of a stock option.
If an option position is established in combination with another investment that is purchased
or is already owned, the result may be that an investor’s risk is reduced. For example, an
owner of 500 shares of TISCO may purchase five puts on this stock and guarantee a selling
price in the event that the market price of the stock declines.
Thus, the puts act as price insurance on the investment position. So is the case of call options.
Likewise, investors will frequently write calls on stocks that they own to generate additional
income. Because the stock is already owned by the writer, the required shares can be
delivered in case the option buyer exercises the call.
While options can be used in conjunction with other securities to reduce the overall risk of an
investment position, it is unlikely that this is the use to which most individual investors put
options. The speculative investor satisfying his urge may however prefer this derivative
market, which does not involve delivery.
Brokers and investment advisors frequently make the case that options expose investors to
less risk than an investment in the underlying common stock, because the potential losses are
smaller. This is true only for the rupee amount of the loss.
An investor stands to lose less on options only because less money is initially invested. From
this standpoint, the investor also generally stands to make less than would be the case if the
underlying stock was purchased. An investment in options is substantially riskier than an
investment in the underlying stock, unless this is combined with other investment or option
combinations.
The bottom line for investors is that stock options should be avoided by anyone who doesn’t
have a thorough understanding of the fundamentals and potential risks of these volatile
investments. The short-term nature of options frequently results in heavy trading and high
commissions and only intelligent traders should get into this trade.
Transactions in Options:
The index options are traded during the permitted time period on auction principles. Only
regular authorised members can trade in these options on their own account or on account of
their clients. There can be jobbers or specialists who deal with the authorised members as
market makers. In most developed markets as in Tokyo or New York, trading in options is
routed through the computer assisted order Routing and Execution System (CORES-O).
Contract Unit:
The contract multiplier can be fixed at 100, 1,000 or 10,000. In Tokyo the contract multiplier
is 10,000. If the contract is a three month call option priced at 30 and the underlying index is
2,480 and the exercise price 2,500. The actual price paid by the call buyer is 30 × 10,000 =
30,000 Yen.
The Exchange can set an upper or lower limit for the price fluctuation at say 60 to 120 points
depending upon the closing price of the previous day. The expiration cycle is 3 or 4 months in
Tokyo. The expiration dates are second Friday, which is the day prior to the second Friday of
the expiration month.
In Tokyo, there are five exercise prices for both call and put options. First a central exercise
price is set by rounding the current value of the index to the nearest 50 or 100. Then two
upper and lower exercise prices are set at 50 point intervals to bracket the central exercise
price. The Exchange may when necessary change the number of exercise prices and their
intervals.
Terms of Contracts:
(a) Underlying Security can be any index or marketable security.
(b) Term to expiration is one day to 9 months in the U.S. There are standard expiration dates
such as second Friday of every month.
(c) Exercise price is the current market price — normally standardised by OCC.
(d) Premium is negotiable.
The Options clearing corporation of the U.S. (OCC) has standardised the following
items in respect of Options:
(a) Exercise prices, based on the prices of underlying Securities.
(b) Expiration cycles and expiration dates of the options contracts.
(c) Trading pattern and trading times.
(d) There are both an initial or maintenance margin calculation and a minimum margin
calculation, standardised by the OCC.
Exercise Dates:
Exercise is the act of converting a call option into a purchase and a put option into a sale of
the underlying security. The holder has a right of such conversion but no obligation.
Normally options are not exercised but brought and sold through the auction system. The
premium is the price paid for the option. If the option is held upto the last day of trading, and
as the expiration date is the next day to the last day of trading it becomes worthless on the
day following the third Friday of the expiration month.
Regulation of options rests with the OCC. In U.S.A. the issuer or writer of options should be
a member of the OCC which provides the service of guarantor and middleman between the
issuer and the trader. In return the issuer has to keep margins in the form of underlying
securities with the OCC.
#### 1. **Definition of Derivatives**
A **derivative** is a financial instrument whose value is derived from an underlying asset,
index, or rate. Common underlying assets include stocks, bonds, commodities, currencies,
interest rates, and market indexes. Derivatives are primarily used for hedging risks or for
speculative purposes.
#### 2. **Types of Derivatives**
- **Futures**: Contracts to buy or sell an asset at a predetermined price on a specified future
date. Traded on exchanges (standardized contracts).
- **Forwards**: Customized contracts between two parties to buy or sell an asset at a
specific price on a future date. Traded over-the-counter (OTC).
- **Options**: Contracts that give the buyer the right, but not the obligation, to buy (call
option) or sell (put option) an asset at a set price before or on a specified date.
- **Swaps**: Contracts in which two parties agree to exchange cash flows or other financial
instruments. Common types are interest rate swaps and currency swaps.

#### 3. **Key Concepts**

- **Underlying Asset**: The financial instrument (e.g., stock, bond, commodity) upon which
a derivative's price is based.
- **Strike Price (Options)**: The fixed price at which the holder of an option can buy or sell
the underlying asset.
- **Expiry Date**: The date on which the derivative contract expires, after which it can no
longer be exercised.
- **Notional Amount**: The face value or amount underlying the derivative contract (for
swaps and other derivatives).
- **Premium (Options)**: The price paid for purchasing an option.

#### 4. **Uses of Derivatives**

- **Hedging**: Used to reduce or mitigate the risk of adverse price movements in the
underlying asset.
 - Example: A farmer uses a futures contract to lock in the price of wheat to avoid the risk
of falling prices.
- **Speculation**: Traders use derivatives to bet on the future price direction of an asset to
make profits.
- Example: A trader buys a call option on a stock anticipating that its price will rise.
- **Arbitrage**: Simultaneous buying and selling of assets in different markets to exploit
price differentials.

#### 5. **Valuation of Derivatives**

- **Options Pricing Models**:
- **Black-Scholes Model**: A popular model for pricing European-style options.
- **Binomial Model**: A model that evaluates the possible price changes of an underlying
asset over time.
- **Futures and Forwards Valuation**: Based on the cost-of-carry model, which includes
storage, financing, and convenience yield.
- **Swap Valuation**: Typically based on the net present value of expected future cash
flows.

#### 6. **Risks in Derivatives**

- **Market Risk**: Risk that the value of the derivative will change due to fluctuations in the
underlying asset's price.
- **Credit Risk (Counterparty Risk)**: Risk that one party will not fulfill their obligations.
- **Liquidity Risk**: Risk arising from the difficulty of entering or exiting a position due to
market conditions.
- **Leverage Risk**: Derivatives often involve leverage, amplifying both gains and losses.

#### 7. **Common Derivatives Markets**

- **Chicago Mercantile Exchange (CME)**: One of the largest futures and options
exchanges.
- **Intercontinental Exchange (ICE)**: Known for energy derivatives.
- **Over-the-Counter (OTC)**: Customized derivatives traded directly between parties,
typically with greater flexibility.

#### 8. **Regulation of Derivatives**

- **Dodd-Frank Act (U.S.)**: Introduced regulations for OTC derivatives post-2008
financial crisis to enhance transparency and reduce systemic risks.
- **Basel III (International)**: A global regulatory framework that sets standards for bank
capital requirements, including for derivatives exposures.

#### 9. **Real-World Examples of Derivatives**

- **Currency Swaps**: Used by companies to manage foreign exchange risks.
- **Commodity Futures**: Widely used by producers and consumers of commodities (e.g.,
oil, gold) to lock in prices.
- **Interest Rate Swaps**: Used by companies to manage exposure to fluctuating interest
rates.

#### 10. **Advantages and Disadvantages**

- **Advantages**:
- Risk management through hedging.
- Price discovery in markets like futures.
- Lower transaction costs compared to directly trading the underlying asset.

- **Disadvantages**:
- High leverage can lead to significant losses.
- Complex to understand and use properly.
- Potential for systemic risk (as seen in the 2008 financial crisis).