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Notes On Options Theory, Financial Derivatives

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Options Theory, Financial Derivatives, Notes

Mahafrin F / Dubai

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  1. Options Q l. Explain the term options. Ans. 1. Meaning: Option is a derivative instrument that gives the holder a right, without any obligation to perform. Thus, Option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions. Options are deferred settlement contracts. 2. Parties: The parties to an Options Contract are- a) Holder (Buyer): One who buys the right. b) Writer (Seller): One who sells the right. 3. Nature Of right: Option gives the holder a right to- a) Activity: Buy or sell an asset. b) Consideration: At an agreed price (called as Exercise Price or Strike price, i.e. the price at which the option can be exercised). C) Time Limit: On or before a specified period of time. 4. Advantage: Options enable the hedger, to take advantage of the favorable movement in price of the underlying asset. 5. Types Of options: a) Based on nature of activity Call o tion Option which gives the holder the right to BUY an asset, but not an obli ation to bu . Call option will be exercised only when the Exercise Price is lower than the Market Price. [Only then it will be advantageous to the Holder] Seller/ writer is under an obligation to sell the underlying asset if the buyer exercises his o tion to bu the shares/ stock. b) Based on exercising the option: American o tion Option under which the holder can exercise his ri htat an time before exi date. Puto tion Option which gives the holder the right to SELL an asset, but not an obli ation to sell. Put option will be exercised only when the Exercise Price is higher than the Market Price. [Only then it will be advantageous to the Holder] Seller/ writer is under an obligation to buy the underlying asset if the buyer exercises his o tion to sell his shares/ stock. Euro ean o tion Option under which holder can exercise his ri ht onl on the exi date.
  2. 6. Option premium: option premium is the consideration for the Writer of the option, for assuming or taking up the liability to perform. It is the price to be paid by the Holder, irrespective of whether the option is exercised or not. Q2. Explain Call and Put Option with reference to debentures. Ans. 1. Call Option= Right to issuer: Call option empowers the issuer of the debenture, to pay back the amount earlier to the redemption date at a pre-determined price (Strike/ Exercise Price) within the specified period, i.e. right to issuer to redeem at an earlier date for an agreed price. 2. Put Option= Right to Debenture- holder: Put option gives the right to investors to demand back the money earlier to the redemption date at a pre- determined price (strike price) within the specified period, i.e. right to the debenture- holder to redeem at an earlier date for an agreed price. 3. Benefits: a) To debenture-holders: debenture- holders can get back the money and invest it in other avenues. b) To the issuer: when the company has surplus funds, but no re-investment opportunity, it can redeem the debentures, thereby reducing the financing cost. It will also increase the wealth of the equity shareholders. c) To the instruments: instrument becomes more investor- friendly, and it ensures liquidity in the debentures market. Q3. Explain the terms used in relation to Options Contract. Ans. 1.Strike price/ exercise price: a) Price at option can be exercised: Strike price/ exercise price is the price at which the option can be exercised i.e. the price at which the underlying asset can be bought or sold on the expiry date (European option)n or before the expiry date (in case of American option). b) Exchange fixed: strike price/ exercise price is fixed by the stock exchange, and not by the writer or holder of an option. c) Series Of prices: the stock exchange fixes a series of prices spaced at appropriate price intervals for an underlying asset. An investor can choose his preferred strike price from a such a range of prices. Example: strike price for December 2007 options contract on shares of Wipro expiring on 27.12.2007 will be - 1900, Rs.1925, Rs.1950, Rs.195, Rs.2000 etc. An investor can choose to buy an option with an exercise price of Rs. 1900, while another might choose Rs. 1950. 2. Option premium a) Price Of the option:
  3. Premium is the price at which the options contract for an asset with a given expiry date and strike price is traded. It is paid by the buyer to the writer/ seller of the option. b) Income to writer: the writer keeps the premium whether or not the option is exercised. It is the consideration paid to the writer/ seller for undertaking to deliver/ buy the underlying security, if the option is exercised. c) Market determined: Option premium is market determined, i.e. based on the demand for the options with a given strike price. d) Factors: premium payable on an options contract depends upon various factors like strike price, expiry date etc. e) Components: Option premium consists of two components- i) Intrinsic value; and ii) time value 3. Expiry date: a) Meaning: it is the last day (in the case of American style) or the only day (in the case of European style) on which an option may be exercised. b) Defines the options contract: Generally, options contract on any security is traded based on its strike price and the expiry date. Example: In November 2007, the following options on Wipro shares can be traded- • 2007 December Wipro series of options contract with strike prices of Rs.1900, Rs.1925, Rs.1950, Rs.1975, Rs.2000 etc. • 2008 January Wipro series of options contract with strike prices Rs. 1950, Rs.1975, Rs.2000, Rs.2025, Rs.2050 etc. 4. Contract size: a) Meaning: contract size is the number of units of the underlying asset covered by an options contract. Example: 100 shares of Wipro, 200 Kgs of Wheat, etc. b) Exchange fixed: contract size is fixed by the exchange. Q4. When will an option- holder exercise his option? What is "In-the-Money", and "Out-the- Money", with reference to Options? Ans. 1. Meaning: These terms describe the position of options contract from the trader's perspective (both Buyer and Seller of an option). a) In the money: It is a situation, when exercising the option would be advantageous and result in gain or profit to the option holder. b) At the money: Exercise of option in this position, would neither result in a gain or loss to the option holder. At this stage the Current Market Price (CMP) and the Exercise Price (EP) are equal.
  4. c) Out of money: Exercise of option in this situation would result in a loss to the option holder. 2. Call Option and Put option: An option- holder will exercise his option, only when it is advantageous to exercise it, based on the Strike Price and the Market Price on the date of expiry. Action on options are as follows based on the market price on the date of expiry- Situation CMP EP CMP> EP Position Out of money At the money In the money Call Option Action Lapse. Buying at EP will not be advantageous. Do not exercise the option. Indifference point. Exercise. Buying at EP would be advantageous. Exercise the option. Position In the money At the money Out the money Put Option Action Exercise. Selling at EP would be advantageous. Exercise the option. Indifference point. Lapse. Selling at EP will not be advantageous. Do not exercise the option. Note: CMP =Current Market Price on Exercise/ Expiry Date; EP= Exercise Price Q5. What are the factors that determine the premium payable on an option? Ans. He factors on which the level of premium depend are- l. Exercise Price: Exercise Price or Strike Price refers to the price at which the contract is agreed upon. When buying an option, an investor can choose from a set of Strike Prices, for which Options can be bought/ sold. Based on Strike Price chosen, the Option Premium will vary as follows- Exercise Price High Low Call O tion Premium is- LOW. As the Exercise Price goes up, the value of Option (i.e. CMP Lees EP) goes down. Therefore, it becomes less valuable. HIGH. As the Exercise Price oes down, the value Put O tion Premium is- HIGH. As the Exercise Price goes up, the value of the Option (i.e. EP Less CMP) goes up. Therefore, it becomes more valuable. The value of obligation to perform is also high from holder's rs ective. LOW. As the Exercise Price oes u , the value of o tion
  5. of Option (i.e. CMP Less EP) goes up. Therefore, it becomes more valuable. Value of obligation to perform is also high from holder's rs ective. (i.e. EP Less CMP) goes down. Therefore, it becomes less valuable. 2. 3. 4. 5. 6. a) b) Current price of the underlying asset: Other things remaining constant, f the current market price of the asset goes up, value of the call option increases (since the possibility of exercising the call also increases) and put option decreases. If the Current Market Price decreases, value of put option increases (as the possibility of exercising the put option also increases), value of and call option decreases. Maturity or expiry date: Longer the time to maturity, higher the period of uncertainty, and hence higher the Option Premium. Therefore, an option with 3 months to maturity will have higher premium than an option with I month to maturity. Volatility of stock prices: Volatility of stock price in the spot market (Cash Market) also contributes to premium. Higher volatility would mean a prices hitting the extremes, and the buyer of option would exercise his option, which would result in a higher obligation on the part of the seller of the option. Therefore, the values of both calls and puts increase as volatility increases. Greater the volatility, higher will be the premium, and vice-versa. Interest rate movement: As interest rates increases, the expected return required by the investors on the stock also increases. Therefore, the present value of the future returns decreases. If the interest rate decreases, the expectations also go down. Market factors: Liquidity in the market i.e. extent of money available for investment. Dividend expectations i.e. if a large dividend is expected from a stock, the call option will be priced less, since dividend when declared and distributed, the prices will fall down. When cash market prices fall, the value of a call option also goes down. Q6. Explain the terms "Intrinsic value of an option" and "Time value Of an option" Ans. 1. Intrinsic value: a) Intrinsic value is the value that an option would fetch if it is exercised today (i.e. before the expiry date). This is more relevant for American Option, which can be exercised any time before the expiry date. b) Intrinsic value = Difference between the Option's Exercise Price and the underlying asset's Current Market Price. tions Call Option Put Option Intrinsic value [Maximum of (CMP - EP), [Maximum of (EP - CMP), 01
  6. Note: the Minimum Intrinsic Value of any option will be Zero and not loss, since an option would not be exercised, if it were not advantageous. c) Example: if an option on shares of A Ltd with an exercise price of Rs.500, and period to expiry of 50 days, is quoted at Rs.475 on ()7.07.2007, the intrinsic value for Put Option and Call Option would be as follows- tions Call Option Put Option 2. Time Value: Com utation [Maximum of (Rs.500- Rs.475), 01 [Maximum of (Rs.475- Rs.500 0 Intrinsic value Rs.25 a) It is the Risk Premium that the writer of an option requires to sell the right to the holder. It is also known as "Extrinsic Value". It is the value of premium over and above the Intrinsic Value. b) Mathematically it is maximum of [(Premium Less Intrinsic Value), O] c) Example: option (both Call and Put) on shares of A Ltd with an exercise price of Rs.500, and period to expiry of 50 days, is priced at Rs.40. The ruling Market Price as on 07.07.2007 is Rs.470. For Call Option: Intrinsic Value= Maximum of [(CMP — EP), O] = Maximum of [(Rs.500- Rs.470), 0] = Rs.30 Time Value= Maximum of [(Premium — Intrinsic Value), 0] = Maximum of [(Rs.40- 30, O] = Rs. 10 For Put Option: Intrinsic Value = Maximum of [(EP — CMP), O] = Maximum of [(Rs.470- Rs.500), 0] = Rs.O Time Value= Maximum of [(Premium — Intrinsic Value), O] = Maximum of [(Rs.40- Rs.(), O] = Rs.40 3. Significance: Intrinsic Value and Time Value of an option are primary determinants of the Option's Price. Q7. What are covered options and naked options? Explain. Ans. 1. Covered Option: it is an option that is combined with an offsetting position in the underlying stock. Covered Option implies that, in case of Call Options, the Seller has the underlying stock in their possession, which can be transferred at the time of expiry, in case of Put Option, the Seller has sold the shares in the Cash Market. a) Covered Calls: • Here the Seller/ Writer of a Call Option owns the underlying stock.
  7. b) 2. a) b) • If the option is exercised by the Option Holder, the Seller would simply deliver the stock he already owns, and receives the sale price of the stock equal to the Strike Price. Covered Puts: Here the Seller/ Writer of a Put Option has sold the stock in the Cash Market (obtained under Stock Lending Scheme or his own stock) If the option is exercised by the Option Holder, the seller would buy the stock and at the Exercise Price, and delivers it back to the person from whom he had borrowed the Stock under Stock Lending Scheme. If he had sold his own stock earlier, his portfolio would once again include the stock bought under the Put Option. Naked Options: it is an option that is not combined with an offsetting position in the underlying stock. When the investor (writer of a Call and writer of a Put), does not have any stock in his hand or is not short (sell position) in the cash market, at the time of entering into options contract, it is called Uncovered Options. Uncovered Calls: Here the Seller/ Writer of the Call Option, does not own the underlying stock. If the price of the underlying asset rises, the Call Writer has no protection, and would be required to buy in the open market, and deliver the asset to the Option Holder. If the Call Writer does not own the stock, and the option is exercised, the potential loss on his head is unlimited. Uncovered Puts: Here the Writer/ Seller of the Put Option, does not sell the underlying asset in the Cash Market (either his own stock or borrowed under Stock Lending). If the price of the underlying asset falls, the Put Writer will not have any protection but to buy the stock at a very high price.

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