OPTIONS

The Skewed Contract

 CALL & PUT OPTION

AnOPTION is a right but not an obligation to

buy/sell an asset at a predetermined price
on or before a given date.
Theunderlying asset: stock, index, currency,
futures, commodity etc.
CALL OPTION
Right to buy an asset
PUT OPTION
Right to sell an asset
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 FEATURES OF OPTIONS

OPTION FEATURES
HOLDER WRITER
Who holds the right to exercise Who confers the right
WRITER/SELLER of the option is under obligation to perform.
HOLDER/BUYER has no such obligation.
Option Writer has to be paid a premium
EXERCISE/STRIKE PRICE MATURITY DATE
Price at which the right can be Time up to which the right can
exercised be exercised.
AMERICAN EUROPEAN
Exercised on or before maturity Exercised only on maturity

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PAY OFF CALL OPTION
Buyer Writer

Pay Off S<X -c +c

S>X SXc - (S X c)

c X
Spot Price, S

BUYER WRITER

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PAY OFF PUT OPTION
Buyer Writer
Pay Off S<X XSp - (X S p)
S>X p +p

BUYER WRITER

X p

Spot Price, S

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 OPTIONS vs. FORWARDS

Right but no obligation to Obligation to buy/sell at

buy/sell agreed price
Only writer is under Both the parties are under
obligation to perform obligation to perform
Upfront premium payable No upfront premium
Loss is limited to premium, if Protects down side but does
adverse movement but not retain upside potential.
unlimited gains Unlimited gains and losses are
possible
If American, flexibility of
timing of exercise exist Exercise must be done on fixed
date.
OTC as well as Exchange
Traded Only Over the Counter
product

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 OPTIONS vs. FUTURES
Same as the differences of options and forward.
Options can be exchange traded or tailor made, but futures are
always exchange traded
Counter party risk: Futures: None; in OTC options: Yes
Cost of hedging:
Options are most expensive,
Forwards are less expensive, and
Futures are least expensive.

Advantages:
Covers the economic exposure: If a company bidding for a
contract in foreign currency covers risk through forward and the
contract does not materialise it will have to honour the contract. If
covered through options only premium is lost. Covers contingent
exposures: Tender to enter contracts in foreign currency.

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 MONEYNESS OF OPTIONS
The option when upon exercise has the payoff that is
Positive IN THE MONEY (ITM)

For Call; S > X,

For Put; S < X
Zero AT THE MONEY (ATM)

When S = X for both Call and Put

Negative OUT OF THE MONEY (OTM)

For Call; S < X,

For Put; S > X

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 VALUE OF OPTIONS

Determination of option premium has been

major area of research. But there also exist
simple arbitrage based rule which explain a
lot about the option price behaviour,
though not exact pricing.
Theoption premium consists of two
components;
1. the intrinsic value, and
2. the time value
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 INTRINSIC AND TIME VALUE

Intrinsic
value is the money holder of option
gets upon exercise.
The
time value is the excess of actual value
over intrinsic value.
Timevalue refers to the chances that strike
price will be pierced before expiry of the
option contract.
Time value of an option
= Actual Price Intrinsic Value

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 BOUNDS TO CALL PRICE

Maximum value of the call option cannot exceed

the value of the asset itself on which the option is
bought, hence
cmax S
Theminimum value of call is given by spot price less
present value of exercise price.
cmin S Xe-rt
Time value of the option is greatest for ATM options.
American call is no expensive than an European
call.
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 BOUNDS TO CALL VALUE

Value of Call Option

Value
of Call
Value of Call Option
Upper Bound
Maximum value Time
Value
Lower
Bound

Intrinsic Value
X
Exercise Price Spot
Price
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 BOUNDS TO PUT VALUE

Maximum value of a put option cannot

exceed the present value of its exercise price.
pmax Xe-rt
The minimum value of put is given by present
value of exercise price less spot price.
pmin Xe-rt S
Sometimes, American put may be more
expensive than the European out.

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VALUE OF PUT OPTION

Value of the Put Option

Value of PUT Maximum Value, X

X S; the Minimum Value

Value of European Put

(PV of X S) Value of American Put

Exercise Price X Spot Price

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 ARBITRAGE BASED
RELATIONSHIPS
Call Option With Higher Strike Price Would Be
Priced Lower Than The One With Lower Strike
Price.
Difference in Call or Put Prices Cannot Exceed
the Difference in the Strike Prices
Call with Longer Time To Maturity Must be
Priced Higher Than the One with Shorter Time
to Maturity.
Higher the Exercise Price More Valuable is the
Put

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Difference in Call or Put Prices
Cannot Exceed the Difference in the
Strike Prices
Spot price = Rs 100
Strike price Call Price Strike price Call Price
X1 = Rs 80 c1 = Rs 25 X2 = Rs 85 c2 = Rs 19
Initial portfolio may be set up as to yield Rs 6:
Action Cash Flow (Rs)
Write Call with X = 80 25
Buy Call with X = 85 - 19
Net cash flow +6
The final position would always result in profit:
Price Condition Portfolio Status Profit
Spot < 80 Both call bought and call written are worthless Rs 6

80 < Spot < 85 Call sold is in the money by S 80,

Call bought is worthless Rs (S 80 + 6)
Always +ive
Spot > 85 Both call bought and call written exercised Rs 11
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 PUT CALL PARITY
Consider a portfolio of following securities:
1. Long on a share selling at S
2. Write a European call for X = 100 maturing at
time t and commanding a premium of c.
3. Buy a European put for X = 100 also maturing at
time t and selling at a premium of p.
INITIAL CASH FLOW -S+cp
INITIAL INVESMENT +S-c+p

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 PUT CALL PARITY
Portfolio Value at Maturity

Value of the Portfolio of Stock, Short Call and Long

Put at Expiration
Figures in Rs
Stock Price 0 50 75 100 125 150 200
Long Stock 0 50 75 100 125 150 200
Short Call at - - - - - 25 -50 -100
X = 100

Long Put at 100 50 25 - - - -

X = 100

Total Value of 100 100 100 100 100 100 100

the Portfolio

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 Put Call Parity
A Riskless Portfolio

Profit/Loss
End Value of Portfolio = X
Long Stock
Short Call

X Stock Price

Long Put

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 PUT CALL PARITY

Initial cost of the portfolio of long stock, short call and

long put
= Amount that can be borrowed at
risk free rate
= Present value of the bond maturing
to the exercise price
S-c+p = PV of X = X/(1+r)
= Xe-rt (for continuous compounding)

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 PUT CALL PARITY Contd.
If The Put Price Is Rs. 6 Figures in Rs
At t = 0 At t = 2 months
Action Cash flow Action Cash flow Arbitrage would
Buy the portfolio Sell the portfolio + 100.00 ensure that put
Buy stock - 100 call parity holds.
Write Call + 12
Buy Put - 6 - 94.00
Ifthe put call
Short Sell the bond + 98.04 Buy the bond - 100.00
and deliver parity does not
Net Cash flow + 4.04 0.00 hold it presents
IF THE PUT PRICE IS Rs. 11 Figures in Rs arbitrage
At t = 0 At t = 2 months opportunity by
Action Cash flow Action Cash flow forming portfolios
Sell the portfolio Buy the portfolio - 100.00 of call, put, bond
Sell stock +100 and stock.
Buy Call - 12
Write Put + 11 + 99.00
Buy the bond + 98.04 Sell the bond + 100.00
Net Cash flow + 0.96 0.00
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 PUT CALL PARITY Contd.

Put call parity also links the equity, bonds

and derivative markets for any inconsistent
returns in any of them, restoring the
balance amongst the three.
Put call parity also helps synthesise any of
the stock, call, put and bond, with the help
of other three.
c + X e-rt = p + S
Call option Bond maturing to X Put option Stock

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