Risk MGMT Mod 4 &amp 5

RISK MANAGEMENT USING
OPTIONS
AN OPTION IS A PARTICULAR TYPE OF A
CONTRACT BETWEEN TWO PARTIES WHERE
ONE PERSON GIVES THE OTHER THE RIGHT TO
BUY OR SELL A SPECIFIC PRICE WITHIN A
SPECIFIC TIME PERIOD. THE OPTION IS A
SPECIFIC DERIVATIVE INSTRUMENT UNDER
WHICH ONE PARTY GETS THE RIGHT BUT NO
OBLIGATION TO BUY /SELL A SPECIFIC
QUANTITY OF AN ASSET AT AN AGREED PRICE
ON OR BEFORE A PARTICULAR DATE.
11 July 2013 PROF. D.GOPINATH 1

RISK MANAGEMENT USING
OPTIONS
THE BUYER WILL EXERCISE THE OPTION
ONLY WHEN HE EXPECTS TO GAIN. IN
CASE OF LOSSES HE WILL NOT EXERCISE
THE OPTION.NOWADAYS OPTIONS ARE
TRADED ON A VARIETY OF INSTRUMENT
LIKE COMMODITIES,FINANCIAL ASSETS,
TREASURY BILLS, STOCKS, STOCK INDEX
FOODGRAINS,PETROLEUM,METALS ETC.

OPTIONS TERMINOLOGIES
1.PARTIES IN A OPTION DEAL:
WE HAVE TWO PARTIES THE BUYER (HOL-
DER) AND SELLER (WRITER). THE WRIT-
ER GRANTS THE BUYER THE A RIGHT TO
BUY OR SELL A PARTICULAR ASSET IN
EXCHANGE FOR A CERTAIN SUM OF MO-
NEY FOR THE OBLIGATION TAKEN BY
HIM IN THE OPTION CONTRACT.

OPTION TERMINOLOGIES
2. EXERCISE PRICE:-
THE PRICE AT WHICH THE UNDERLYING
ASSET MAY BE SOLD OR PURCHASED BY
THE OPTION BUYER FROM THE OPTION
WRITER IS CALLED AS EXERCISE OR
STRIKE PRICE.AT THIS PRICE THE BUYER
CAN EXERCISE HIS OPTION.

3. EXPIRATION DATE AND EXERCISE DATE:
THE DATE ON WHICH AN OPTION CONTR-
ACT EXPIRES IS CALLED AS EXPIRATION
DATE OR MATURITY DATE. THE OPTION
HOLDER HAS THE RIGHT TO EXERCISE
HIS OPTION ON ANY DATE BEFORE THE
EXPIRATION DATE.EXERCISE DATE IS
DATE UPON WHICH THE OPTION IS
ACTUALLY EXERCISED.

4. OPTION PREMIUM:- THE PRICE AT WHI-
CH THE OPTION HOLDER BUYS THE
RIGHTFROM THE OPTION WRITER IS
CALLED AS OPTION PREMIUM /PRICE.
THIS IS THE CONSIDERATION PAID BY
THE BUYER TO THE SELLER AND IT REM-
AINED WITH THE SELLER WHETHER THE
OPTION IS EXERCISED OR NOT.THIS IS
FIXED AND PAID AT THE TIME OF
WRITING THE OPTION DEAL.
5.OPTION „IN‟, „OUT‟ AND AT THE MONEY:-
WHEN THE UNDERLYING FUTURES PRICE IS
GREATER THAN THE STRIKE PRICE/ EXERCISE
PRICE,THE OPTION IS IN THE MONEY,AND THE
FUTURES PRICE IS LESSER THAN THE STRIKE
PRICE IT WILL BE CALLED AS OUT OF MONEY
CALL OPTION,AND IF THE FUTURES PRICE IS
EQUAL TO THE STRIKE PRICE IT IS AT THE
MONEY.

PAY OFF PROFILE OF OPTION
CALL OPT PUT OPT

IN THE MONEY FUT> STR FUT< STR
AT THE MONEY FUT=STR FUT=STR
OUT OF MONEY FUT < STR FUT>STR

6. THE BREAK EVEN PRICE:-
IT IS THAT PRICE OF THE STOCK WHERE THE
GAIN ON THE OPTION IS JUST EQU-AL TO THE
OPTION PREMIUM. THE BRE-AK EVEN PRICE
LEVEL IS DETERMINED BY ADDING THE STRIKE
PRICE AND THE PREMIUM PAID TOGETHER.
SINCE THERE IS ZERO SUM GAME THE PROFIT
FROM SELLING A CALL IS THE MIRROR IMAGE
OF THE PROFIT FROM BUYING THE CALL.

TYPES OF OPTIONS
OPTIONS CAN BE CLASSIFIED INTO:-
1. CALL AND PUT OPTIONS.

2. AMERICAN AND EUROPEAN OPTIONS.
3. EXCHANGE TRADED AND OTC-TRADED
OPTIONS.

TYPES OF OPTIONS
CALL AND PUT OPTIONS:-
WHEN AN OPTION GRANTS THE BUYER
THE RIGHT TO PURCHASE THE UNDERLY
-ING ASSET FROM THE WRITER (SELLER)
A PARTICULAR QUANTITY AT A SPECIF-
IED PRICE WITHIN A SPECIFIED EXPIRA-
TION DATE IT IS CALLED “CALL OPTION”.
THE CALL OPTION HOLDER PAYS THE
PREMIUM TO THE WRITER.

TYPES OF OPTIONS
A PUT OPTION IS AN OPTION WHERE THE
OPTION BUYER HAS THE RIGHT TO SELL THE
UNDERLYING ASSET TO THE WRIT-ER AT A
SPECIFIED PRICE AT OR PRIOR TO THE
OPTION „S MATURITY DATE. IT IS ALSO
CALLED SIMPLY AS „PUT”. SO IF WE BUY A PUT
OPTION TO ON SBI STO-CK WE HAVE GAINED
THE RIGHT TO SELL THE SHARES OF SBI TO
THE WRITER AT A SPECIFIED PRICE ON OR
BEFORE THE EXPIRATION DATE.

TYPES OF OPTIONS-ON THE BASIS
OF TIMING
A EUROPEAN OPTION CAN BE EXERCISED
ONLY AT THE EXPIRATION DATE WHERE-
AS THE AMERICAN OPTION CAN BE
EXERCISED AT ANY TIME UP TO AND
INCLUDING THE EXPIRATION DATE.
MOST OF THE OPTIONS DEALT ARE
AMERICAN UNTIL ACTUALLY CLARIFIED
AS EUROPEAN.THE NAMES ARE MERELY
CONVENTIONAL NOT GEOGRAPHIC.
TYPES OF OPTIONS
EX CHANGE TRADED OPTION CONTRACTS
ARE STANDARDISED AND ARE TRADED
ON THE RECOGNIZED EXCHANGES.OTC
OPTIONS ARE TAILORMADE AGREEMENT
SOLD DIRECTLY BY THE DEALER.THE
TERMS AND CONDITIONS OF THESE
CONTRACTS ARE NEGOTIATED BY THE
PARTIES TO THE CONTRACT.

DIFFERENCES - EXCHANGE
TRADED AND OTC OPTIONS
1. EXCHANGE TRADED ARE STANDARDISED AND
TRADED ON RECOGNISED STOCK EXCHAN-
GES. OTC OPTIONS ARE WRITTEN ON THE
COUNTERS OF COMMERCIAL & INVESTMENT
BANKERS.
2. EXCHANGE TRADED OPTIONS HAVE CERTAIN
SPECIFIED NORMS RELATING TO QUANTITY,
QUALITY, DATES ETC. UNDER OTC, NORMS
ARE NEGOTIATED AND MUTUALLY
DETERMINED BY BUYERS AND SELLERS .
DIFFERENCES-EXCHANGE TRADED
AND OTC OPTIONS.
3.BEING STANDARDISED IN NATURE AN
OPTION CONTRACT TRADED THROUGH
THE RECOGNIZED EXCHANGE HAS UNIF-
ORM UNDERLYING ASSET,LIMITED NO OF
STRIKE PRICES LTD EXPIRATION DATES
ETC.BUT IN CASE OF OPTIONS THROUGH
OTC THE CONTRACTS ARE TAILOR MADE
AS PER THE REQUIREMENTS OF THE
BUYERS AND SELLERS.
AND OTC OPTIONS.
4.EXCHANGE TRADED OPTIONS ARE PERF-
ORMED AND CLEARED THROUGH A
CLEARING HOUSE WHICH ACTS AS A
THIRD PARTY. SO RISK OF DEFAULT IS
ELIMINATED.BUT IN OTC TRADED
CONTRACTS THE RISK OF DEFAULT IS
HIGHER AS THERE ARE ONLY TWO PART-
IES AND IF THE OPTION WRITER DEFAU-
LTS THERE IS NO GUARANTEE.
DIFFERENCE-EXCHANGE TRADED
AND OTC OPTIONS.
5.ON BUYING A OPTIONS CONTRACT FROM A
EXCHANGE THE OBLIGATION CAN BE
FULFILLED AS FOLLOWS:
a) THE BUYER MAY NOT EXERCISE THE
OPTION.HE MAY ALLOW IT TO EXPIRE.
b) IN THE CASE OF AN AMERICAN OPTION HE
MAY EXERCISE HIS OPTION ON OR BEFORE
THE EXPIRATION DATE, LETTING THE SELLER
ADHERE TO CONTRACT AND KEEP THE
PREMIUM.

AND OTC OPTIONS.
c) EITHER OF THE PARTIES CAN EXECUTE
AN OFFSETTING TRANSACTION TO
ELIMINATE THE FUTURE OBLIGATION.
BUT UNDER AN OTC OPTION NO SUCH
FACILITIES EXIST THEY ARE TAILOR
MADE AND UNSTANDARDISED IN
NATURE.SO THE QUESTION OF OFFSET-
TING DOES NOT EXIST.

DIFFERENCES –EXCHANGE AND
OTC TRADED OPTIONS.
6.UNDER THE WRITERS ARE EXPECTED TO
DEPOSIT MARGINS AS THEY ARE EXPOS-
ED TO CONSIDERABLE RISK. UNDER OTC
NO SUCH MARGINS EXIST.
7. UNDER THE EXCHANGE TRADED OPTIO-
NS TRANSACTIONS COST ARE LOWER
BUT THE OTC OPTIONS DEPEND UPON
THE CREDITWORTHINESS OF THE BUYER

AND OTC OPTIONS.
8. IN OTC TRADED OPTIONS MARKET, LAR-
GE INVESTMENT BANKING FIRMS AND
COMMERCIAL BANKS NORMALLY OPERA-
TE AS PRINCIPALS AS WELL AS BROKERS.
THAT IS WHY THEY ARE LESS LIQUID IN
COMPARISON TO THE EXCHANGE
TRADED OPTIONS. FURTHER THEY TAKE
THEM AS PART OF AN ASSET –LIABILITY
MANAGEMENT IN WHICH THEY INTEND
TO HOLD THEM TO EXPIRATION.
DISTINCTION-OPTIONS AND
FUTURES
1.UNDER OPTIONS ONE PARTY (BUYER) IS
NOT OBLIGATED TO TRANSACT THE
CONTRACT AT A LATER DATE,ONLY THE
SELLER IS UNDER THE OBLIGATION TO
PERFORM THE OPTION CONTRACT AND
ONLY IF THE BUYER DESIRES.UNDER
FUTURES BOTH THE PARTIES ARE UNDER
THE OBLIGATION TO PERFORM THE
CONTRACT.
FUTURES
2.UNDER THE OPTIONS THE BUYER OF THE
OPTION HAS TO PAY THE OPTION
PREMIUM TO THE SELLER AND THIS IS
FORFEITED IRRESPECTIVE OF COMPLET-
ION OF THE CONTRACT.IN FUTURES NO
CASH IS TRANSFERRED TO EITHER
PARTY.

FUTURES
3.UNDER FUTURES CONTRACT THE BUYER
OF THE CONTRACT REALIZES THE GAIN
IN CASH WHEN THE PRICE OF THE FUTU-
RES CONTRACT INCREASES AND LOSSES
IN CASE OF FALL IN THE PRICES.UNDER
OPTIONS SUCH SYMMETRIC RISK/REW-
ARD RELATIONSHIP DOES NOT ARISE.
THE MOST THE BUYER CAN LOOSE IS
THE OPTION PREMIUM.
FUTURES
4.OPTIONS CONTRACTS ARE BROUGHT
INTO EXISTENCE BY BEING TRADED,IF
NONE IS TRADED NONE EXISTS,ALSO
THERE IS NO LIMIT ON NUMBER OF
OPTION CONTRACTS THAT CAN BE IN
EXISTENCE AT ANY TIME.HOWEVER IN
CASE OF FUTURE CONTRACT THERE IS A
PROCESS OF CLOSING OUT POSITION
WHICH CAUSES CONTRACTS TO CEASE.
OPTIONS VALUATION
1. INTRINSIC VALUE :- IT IS THE GAIN TO
THE HOLDER OF AN OPTION ON IMMED-
IATE EXERCISE. SINCE THE INVESTOR
CANNOT EXERCISE THE OPTION BEFORE
MATURITY IN EUROPEAN OPTION, SO
THE VALUE IS ONLY NOTIONAL. UNDER
THE AMERICAN OPTION IT CAN BE
EXERCISED AT ANY TIME BEFORE THE
EXPIRATION DATE.
OPTIONS VALUATION
THAT MEANS THIS VALUE FOR A CALL IS
NOTHING MORE THAN THE DIFFERENCE
BETWEEN THE MARKET PRICE AND STRIKE
PRICE OF THE UNDERLYING ASSET.
FOR A CALL OPTION:- MAX {(St –X),0} WHERE St
IS CURRENT STOCK PRICE, X IS STRIKE PRICE
OF THE ASSET.IF St > X IT IS POSITIVE
INTRINSIC VALUE.IT CANNOT BE –ve AS BUYER
WILL NOT EXERCISE THE OPTION.SO THE
VALUE CANNOT FALL BELOW ZERO.
OPTIONS VALUATION
FOR A PUT OPTION:-
INTRINSIC VALUE IS:-

MAX{(X –St),0}
IF X>St THE VALUE IS +VE, X=St THE
VALUE IS ZERO .

OPTIONS VALUATION
2. TIME VALUE OF THE OPTION:-
THE VALUE OF AN AMERICAN OPTION AT
ANY TIME PRIOR TO EXPIRATION ,MUST
BE AT LEAST TO ITS INRINSIC VALUE. IN
GENERAL IT WILL BE LARGER.THIS IS
BECAUSE THERE IS A POSSIBILITY THAT
THE STOCK PRICE WILL MOVE FURTHER
IN FAVOUR OF THE OPTION HOLDER.

TIME VALUE OF AN OPTION
THE DIFFERENCE BETWEEN THE VALUE OF AN
OPTION AT THE PARTICULAR TIME t AND ITS
INTRINSIC VALUE AT THE TIME IS CALLED THE
TIME VALUE OF AN OPTION. THIS DOES NOT
HOLD GOOD TO A EUROPEAN OPTION. MAJOR
FACTORS THAT INFLUENCE THE TIME VALUE
ARE THE EXPECTED VOLATILITY OF THE STOCK
PRICE, LENGTH OF THE PERIOD TO EXPIRY,
THE EXTENT TO WHICH THE OPTION IS IN OR
OUT OF MONEY.

TIME VALUE OF OPTION
IT IS OBSERVED THAT OUT OF MONEY OPTIONS
HAVE LESS TIME VALUE THAN AT THE MONEY
OPTIONS SINCE THE STOCK PRICE HAS
FURTHER TO MOVE BEFORE INTRINSIC VALUE
IS ACQUIRED. SIMILARLY IN THE MONEY
OPTIONS HAVE LESS TIME VALUE THAN AT
THE MONEY OPTIONS REASON BEING THAT
THEIR PRICES CONTAIN INTRINSIC VALUE
WHICH IS VULNERABLE TO FALL IN STOCK
PRICE.FURTHER THE MORE TIME REMAINS
UNTIL EXPIRY THE HIGHER THE TIMEVALUE
TENDS TO BE.

OPTION POSITIONS
IN EVERY OPTION CONTRACT THERE ARE
TWO SIDES:- 1. THE INVESTOR WHO
TAKES THE LONG POSITION ( i.e. he has
purchased the option) 2. OPPOSITE TO
THIS IS THE INVESTOR WHO TAKES THE
SHORT POSITION (i.e. he has sold or writ-
ten the option). SO IF ONE TAKES LONG
POSITION THEN THE OTHER SHORT.
THERE ARE 4 TYPES OF OPTIONS:-

TYPES OF OPTIONS.
1.A LONG POSITION IN A CALL OPTION.
2.A LONG POSITION IN A PUT OPTION.
3.A SHORT POSITION IN A CALL OPTION.
4.A SHORT POSITION IN A PUT OPTION.
NAKED (UNCOVERED):- THESE ARE OPTIONS
WHICH DO NOT HAVE OFFSETTING POSITIONS
AND ARE MORE RISKY. WHERE THE WRITER H-
AS A CORRESPONDING OFFSETTING POSITION
IN THE ASSET IT IS A COVERED OPTION.

NAKED AND COVERED OPTIONS
WRITING A SIMPLE UNCOVERED CALL OPTION
INDICATES TOWARD EXPOSURE OF THE
OPTION WRITER TO UNLIMITED POTENTIAL
LOSSES. THE AIM IS TO EARN PREMIUM.IN
PERIOD OF STABLE/FALLING PRICES CALL
OPTIONS WRITING MAY RESULT IN ATTRACT-
IVE PROFITS BY CAPTURING THE TIME VALUE
OF AN OPTION.WRITING AN UNCOVERED OPTI-
ON SHOWS THE INVESTOR TOLERENCE FOR
RISK.

COVERED/UNCOVERED OPTIONS
A COVERED OPTION POSITION INVOLVES
THE PURCHASE OR SALE OF AN OPTION
IN COMBINATION WITH AN OFFSETTING
(OR OPPOSITE) POSITION IN THE ASSET
WHICH UNDERLIES THE OPTION.THE
WRITER OF AN CALL OPTION INCURS
LOSSES WHEN STOCK PRICES RISE AND
PUT WRITERS INCUR LOSSES WHEN THE
PRICES FALL.
COVERED/UNCOVERED OPTIONS
IN SUCH A SITUATION THE WRITER CAN
COVER THE SHORT PUT WITH A SHORT
POSITION AND SHORT CALL WITH A
LONG POSITION IN THE UNDERLYING
ASSET.THIS CAN BE STATED AS:-
COVERED CALL SALE=SHORT CALL +LONG
FUTURES.
COVERED PUT SALE= SHORT PUT+SHORT
FUTURES.

SYNTHETIC FUTURES AND
OPTIONS
SYNTHETIC FUTURES POSITIONS ARE CRE-
ATED BY COMBINING TWO OPTIONS
POSITIONS SUCH THAT THE RESULTING
PAY OFF REMAINS SAME OR NEARLY
SAME AS THAT OF AN OUTRIGHT FUTU-
RES POSITION.SYNTHETIC LONG POSITI-
ON IS CREATED BY COMBINING LONG
CALL OPTION WITH SHORT PUT OPTION
HAVING THE SAME STRIKE PRICE.
SYNTHETIC FUTURES AND
OPTIONS
SYNTHETIC SHORT FUTURES IS CREATED BY
COMBINING LONG PUT WITH SHORT CALL
OPTION HAVING THE SAME STRIKE
PRICE.THEREFORE:-
SYN LONG FUTURES=LONG CALL +SHORT PUT.
SYN SHORT FUTURES= LONG PUT + SHORT
CALL.
SIMILARLY WE HAVE SYNTHETIC OPTIONS.

THE UNDERLYING ASSETS IN
EXCHANGE TRADED OPTIONS
VARIOUS ASSETS WHICH ARE ACTIVELY
TRADED ON THE RECOGNIZED EXCHAN-
GES ARE STOCK,STOCK INDICES, FOREI-
GN CURRENCIES AND FUTURES CONTRA-
CTS.
1.STOCK OPTIONS:- OPTIONS ON INDIVID-
UAL SHARES OF COMMON STOCK HAVE
BEEN TRADED FOR MANY YEARS.

STOCK OPTIONS
STOCK OPTIONS ON A NUMBER OF OVER THE
COUNTER STOCKS ARE ALSO AVAILABLE.WHILE
THE STRIKE PRICES ARE NOT BECAUSE OF
CASH DIVIDENDS PAID TO COMMON STOCK
HOLDERS THE STRIKE PRICE IS ADJUSTED TO
STOCK SPLITS,STOCK DIVIDENDS, REORGANIS-
ATIONS ETC,WHICH AFFECT THE VALUE OF
THE UNDERLYING STOCK.STOCK OPTIONS ARE
MOST POPULAR ASSETS TRADED ALL OVER
THE WORLD.

FOREIGN CURRENCY OPTIONS.
THIS IS ANOTHER IMPORTANT ASSET TRA-
DED ON VARIOUS STOCK EXCHANGES.
MAJOR CURRENCIES TRADED ARE US$,
AUS $,BRITISH POUND,CAN $,GER
MARK,FRENCH FRANC,JAP YEN,SWISS FR.
THE SIZE OF THE CONTRACT DIFFERS
FROM CURRENCY TO CURRENCY. WE
SHALL SEE THESE UNDER CURRENCY
OPTIONS.
INDEX OPTIONS
MANY DIFFERENT INDEX OPTIONS ARE
CURRENTLY TRADED ON DIFFERENT
EXCHANGES. IN INDIA TRADING IS
UNDERTAKEN ON NSE,AND BSE. LIKE
STOCK OPTION, INDEX OPTION‟S STRIKE
PRICE IS THE INDEX VALUE AT WHICH
THE BUYER OF THE OPTION CAN BUY
AND SELL THE UNDERLYING STOCK
INDEX.
INDEX OPTIONS
THE STRIKE INDEX IS CONVERTED INTO
DOLLAR(RUPEE) VALUE BY MULTIPLYING
THE STRIKE INDEX BY THE MULTIPLE
FOR THE CONTRACT.IF THE BUYER OF
THE STOCK INDEX OPTION INTENDS TO
EXERCISE THE OPTION THEN THE STOCK
MUST BE DELIVERED.IT WOULD BE
COMPLICTED TO SETTLE A STOCK INDEX
OPTION BY DELIVERING ALL STOCKS
THAT MAKE UP THE INDEX.
INDEX OPTIONS
SO INDEX OPTIONS ARE CASH SETTLEME-
NT CONTRACTS. IF THE OPTION IS
EXERCISED THE EXCHANGE ASSIGNED
OPTION WRITER PAYS CASH TO THE
OPTION BUYER AND THERE WILL BE NO
DELIVERY OF ANY SHARE. THE MONEY
VALUE OF THE STOCK INDEX UNDERLY-
ING AN INDEX OPTION IS EQUAL TO THE
CURRENT CASH INDEX VALUE MULTIPLI-
ED BY CONTRACTS MULTIPLE.
INDEX OPTIONS
RUPEE VALUE OF THE UNDERLYING INDEX
= CASH INDEX VALUE*CONTRACT
MULTIPLES.
FOR EXAMPLE:- THE CONTRACT MULTIPLE
FOR THE S&P 100 IS $100. ASSUME THAT
CASH INDEX VALUE FOR THE S&P 100 IS
750 THEN THE DOLLAR VALUE OF S&P
100 CONTRACTS IS 750*100 = $75,000

ELEMENTARY INVESTMENT
STRATEGIES
THE USE OF OPTIONS ENABLES AN INVES-
TOR TO ACHIEVE UNIQUE RISK-RETURN
PATTERNS WHICH CANNOT BE ACHIEVED
BY TAKING INVESTMENT POSITIONS ON-
LY IN THE UNDERLYING ASSETS.THIS IS
IN FACT THE ECONOMIC RATIONALE FOR
THE EXISTENCE OF OPTIONS.THE TWO
INVESTMENT STRATEGIES WELL KNOWN
ARE LONG AND SHORT POSITION.
INVESTMENT STRATEGIES
1. LONG POSITION:- A POSITION CREATED
BY A PERSON BY BUYING AN ASSET
WITHOUT TAKING ANY OFF SETTING
POSITION. THE ABOVE BUYER WILL GAIN
WHEN THE PRICE RISES AND LOSE DUE
TO THE FALL IN PRICE.ON THE OTHER
HAND IF THE STOCK PRICE REMAINS
UNCHANGED OR DECLINES THE INVEST-
OR MAKES NO PROFIT OR INCURS A
LOSS (IGNORING TRANSACTION COSTS)
2. SHORT POSITION:-
A SHORT POSITION INVOLVES SELLING
THE ASSET FIRST (WITHOUT ACTUALLY
OWNING IT) AND BUYING IT BACK
LATER.THE INVESTOR WHO SHORT
SELLS HOPES THAT THE PRICE WILL
DECLINE DURING THE TIME HE IS
SHORT.

LONG CALL:-
LONG CALL REFERS TO THE PURCHASE OF
A CALL. THE SIMILARITY BETWEEN THE
LONG POSITION IN THE UNDERLYING
ASSET AND LONG CALL POSITION IS
THAT THE INVESTOR CONCERNED MUST
BE BULLISH ON THE UNDERLYING ASSET.

SHORT CALL:-
THE STRATEGY INVOLVES WRITING A CALL
WITHOUT OWNING THE UNDERLYING
ASSET. THE CALL WRITER MAKES A
PROFIT IF THE OPTION EXPIRES
WORTHLESS ON THE EXPIRATION DATE.

LONG PUT:-
THIS STRATEGY INVOLVES BUYING A PUT-
RIGHT TO SELL THE UNDERLYING ASSET
AT A SPECIFIED PRICE. THE PUT BUYER
ANTICIPATES A DECLINE IN THE PRICE
OF AN UNDERLY-ING ASSET.

SHORT PUT:-
THIS IS A STRATEGY OF WRITING A PUT. IN
CONTRAST TO THE PUT BUYER THE PUT
WRITER IS BULLISH ON THE UNDERLYING
ASSET AND EARNS AN INCOME (IN THE FORM
OF PUT PREMIUM) BY SPECULATING ON HIS
PREDICTION. HE IS ALSO PREPARED TO
ACCEPT OWNERSHIP SHOULD THE PUT OWNER
DECIDE TO EXERCISE.

CAPS,FLOORS AND COLLARS
CAPS (interest rate caps):- A CAP IS A
SERIES OF INTEREST RATE OPTIONS,
WHICH GUARANTEES A FIXED RATE
PAYABLE ON A BORROWING OVER A
SPECIFIC TIME PERIOD AT SPECIFIC
FUTURE DATES. IF INTEREST RATES RISE
ABOVE THE AGREED CAP RATE THEN THE
SELLER PAYS THE DIFFERENCE BETWEEN
THE CAP RATE AND THE INTEREST RATE
TO THE PURCHASER.
A CAP IS USUALLY BOUGHT TO HEDGE
AGAINST A RISE IN INTEREST RATE AND
YET IS NOT A PART OF THE LOAN AGRE-
EMENT AND MAY BE BOUGHT FROM A
COMPLETELY DIFFERENT BANK/WRITER.
IN A CAP USUALLY AN UPFRONT FEE IS
TO BE PAID TO THE BANK/WRITER.THE
CAP GUARANTEES THAT THE RATE
CHARGED ON A LOAN WILL NEVER
EXCEED THE CURRENT EXISTING RATES.
FLOORS:- A FLOOR IS AN AGREEMENT
WHERE THE SELLER AGREES TO COMPE-
NSATE THE BUYER IF INTEREST RATES
FALL BELOW THE AGREED UPTO A ON
FLOOR RATE. IT IS SIMILAR TO A CAP
BUT ENSURES THAT IF THE INTEREST
RATE FALLS BELOW A CERTAIN AGREED
FLOOR LIMIT INTEREST RATE WILL BE
PAID.
CAPS, FLOORS AND COLLARS
COLLARS:-
A COLLAR IS A COMBINATION OF A CAP
AND A FLOOR WHERE YOU SELL A FLOOR
AT A LOWER STRIKE RATE AND BUY A
CAP AT A HIGHER STRIKE RATE. THUS
THEY PROVIDE PROTECTION AGAINST A
RISE IN INTEREST RATES AND SOME
BENEFIT FROM A FALL IN INTEREST
RATES.

STRADDLE
A STRADDLE INVOLVES A CALL AND A PUT
OPTION WITH THE SAME EXERCISE
PRICE AND THE SAME EXPIRATION DATE.
A STRADDLE BUYER BUYS A CALL AND A
PUT OPTION AND THE SELLER SELLS A
CALL AND A PUT OPTION AT THE SAME
EXERCISE PRICE AND THE SAME EXPIRA-
TION DATE. THE MAXIMUM LOSS
ASSOCIATED WITH THE LONG STRADDLE
IS THE PREMIUM PAID /COST OF OPTION
STRADDLE
PROFIT POTENTIAL IS UNLIMITED WHEN
THE PRICES OF THE UNDERLYING ASSET
RISE SIGNIFICANTLY AND LIMITED
WHEN IT FALLS SIGNIFICANTLY.IT IS A
CASE WHEN INVESTOR PURCHASING A
STRADDLE MAKES PROFIT AT PRICES
WHICH ARE SIGNIFICANTLY LOWER/
HIGHER THAN THE PREVAILING MARKET
PRICE.
STRADDLE
THIS STRATEGY WILL APPEAL TO AN
INVESTOR WHO WANTS TO TAKE A
POSITION IN AN UNDERLYING ASSET
THAT IS VOLATILE BUT DOES NOT HAVE
A CLUE WHETHER IT WILL RISE OR FALL
IN THE SHORT RUN.THE INVESTOR
HOWEVER ONLY ANTICIPATES A SHARP
MOVEMENT IN THE PRICE OF THE ASSET.

STRADDLE
THE GRAPH HAS BEEN DRAWN CONNECT-
ING THE DAILY HIGH-LOW PRICES.THE
TRIANGULAR FORMATION REVEALS THAT
THERE HAS TO BE A BREAK OUT EITHER
UPWARDS OR DOWNWARDS.IT IS DIFFI-
CULT TO PREDICT THE DIRECTION IN
WHICH THE STOCK WILL MOVE BECAUSE
THE SUCCESSIVE TOPS ARE LOWER
THAN THE PRECEDING TOPS WHICH IS A
BEARISH SIGNAL.
STRADDLE
ALSO THE SUCCESSIVE LOWS ARE HIGHER
THAN THE PRECEDING LOWS WHICH IS A
BULLISH SIGNAL.IF THE INVESTOR
KNOWS THAT THE STOCK IS A VOLATILE
ZTOCK HE CAN PROFIT FROM THIS
SCENARIO BY BUYING A STRADDLE ON
THE STOCK.OBVIOUSLY THE WRITER OF
A STRADDLE ANTICIPATES NO MAJOR
FLUCTUATION IN THE PRICES OF ASSETS
STRANGLE
IT IS A COMBINATION OF A CALL AND A
PUT WITH THE SAME EXPIRATION DATE
AND DIFFERENT STRIKE PRICES. IF THE
STRIKE PRICES OF THE CALL AND THE
PUT OPTIONS ARE X1 AMD X2 THEN A
STRANGLE IS CHOSN IN SUCH A WAY
THAT X1>X2. ASSUME THAT WE BUY A
CALL AND PUT OPTION ON A PARTICU-
LAR STOCK WITH STIKE PRICES $35 &
$30.
STRANGLE
LET THE COST OF CALL AND PUT OPTION
BE $3 AND $ 5 RESPECTIVELY.OUR
INITIAL OUTFOW IS $8. IF WE HAVETO
BENEFIT THE TOTAL PAYOFF SHOULD
EXCEED $8.WE WILL EXERCISE THE CALL
OPTION ONLY WHEN THE PRICE OF THE
STOCK AT EXPIRATION GOES ABOVE
$38.SIMILARLY PUT OPTION ONLY IF
PRICE IS BELOW $25.
STRANGLE
TO BREAK EVEN THE STOCK‟S PRICE AT
EXPIRATION SHOULD BE BELOW $22 0R
ABOVE $43. IF THE PRICE FALLS BETWE-
EN $22 AND $43 THEN WE DO NOT
BENEFIT FROM THE STRATEGY BY
HAVING A LOSS. OUTSIDE THIS RANGE
WE HAVE A PROFIT POTENTIAL. SO
PROFIT AND LOSS ON A SHORT POSITI-
ON IN A STRANGLE IS REVERSE OF THAT
OF THE LONG POSITION.
STRIPS AND STRAPS
A STRIP CONSISTS OF A LONG POSITION
IN ONE CALL AND TWO PUTS WITH THE
SAME EXERCISE PRICE AND EXPIRATION
DATE. THE BUYER OF A STRIP BELIEVES
THAT THERE WILL BE A BIG STOCK
PRICE MOVE BUT THE STOCK PRICE IS
MORE LIKELY TO FALL THAN IT IS TO
RISE.

STRIPS AND STRAPS
A STRAP CONSISTS OF A LONG POSITION
IN TWO CALLS AND ONE PUT WITH THE
SAME STRIKE PRICE AND EXPIRATION
DATE. A STRAP IS LIKE A STRIP THAT IS
SKEWED IN THE OPPOSITE DIRECTION.
THE BUYER OF A STRAP EXPECTS
BULLISH AND BEARISH POSSIBILITIES
FOR THE OPTIONED SECURITY WITH A
PRICE RISE BEING MORE LIKELY.
SPREAD STRATEGIES.
THESE ARE EMPLOYEDFOR EXPLOITING
MODERATELY BULLISH OR BEARISH
BELIEFS ABOUT THE MARKET.THEY
INVOLVE USE OF OPTIONS.
1. VERTICAL SPREADS OR PRICE SPREADS:
THESE INVOLVE BUYING AN OPTION AND
SELLING ANOTHER OPTION OF THE SAME
TYPE AND TIME TO EXPIRATION BUT
WITH DIFFERENT EXERCISE PRICE.

SPREAD STRATEGIES
2. HORIZONTAL SPREAD (TIME) INVOLVES
BUYING AN OPTION AND SELLING ANOTHER
OPTION OF THE SAME TYPE WITH SAME
EXERCISE PRICE BUT WITH A DIFFERENT TIME
OF EXPIRATION.
3. DIAGONAL SPREAD INVOLVES BUYING AN
OPTION AND SELLING ANOTHER OF THE SAME
TYPE WITH A DIFFERENT EXERCISE PRICE AND
DIFFERENT TIME TO EXPIRATION.

BULLS AND BEAR SPREAD
IF WE WISH TO BUY A BULL SPREAD USING
CALLS THEN WE BUY A CALL WITH A LOWER
STRIKE PRICE AND SELL A CALL AT A HIGHER
STRIKE PRICE.THIS STRATEGY IS CALLED A
SPREAD BECAU-SE ITINVOLVES BUYING AN
OPTION AND SELLING A RELATED OPTION TO
LIMIT THE RISK.THIS STRATEGY ALSO LIMITS
THE PROFIT POTENTIAL.THE COST OF A BULL
SPREAD IS COST OF THE OPTION BOUGHT
LESS THE COST OF THE OPTION SOLD.

BOX SPREAD
IT IS A COMBINATION OF BULL AND BEAR
SPREADS WITH CALLS AND PUTS RESPECTIVE-
LY WITH THE SAME SET OF EXERCISE
PRICES.IF X1 AND X2 ARE STRIKE PRICES
AVAILABLE WITH CALLS AND PUTS THEN A BOX
SPREAD INVOLVES BUYING AND SELLINGA PUT
WITH STRIKE PRICES X2 AND X1.FOR A RISK
AVERSE INVESTOR THIS STRATEGY IS IDEAL
AS IT GIVES A PAYOFF OF THE DIFFERENCE
BETWEEN THE HIGHER AND THE LOWER
STRIKE PRICES i.e. X2-X1.

BUTTERFLY SPREAD
A BUTTERFLY SPREAD CAN BE EXECUTED
BY USING FOUR IDENTICAL OPTIONS
WITH THE SAME UNERLYING STOCK BUT
WITH DIFFERENT EXERCISE PRICES. A
TRADER WHO IS LONG ON THE
BUTTERFLY SPREAD BUYS A CALL WIRTH
A LOW EXERCISE PRICE,BUYS A CALL
WITH A HIGH EXERCISE PRICE AND
SELLS TWO CALLS AT INTERMEDIATE
EXERCISE PRICE.
OPTION PRICING MODEL
DETERMINANTS OF OPTION PRICES:-
THE FOLLOWING ARE THE IMPORTANT
FACTORS WHICH INFLUENCE THE
OPTION PRICING.
1.CURRENT PRICE OF THE OPTION:THE
OPTION PRICE WILL CHANGE AS THE
STOCK PRICE CHANGES.THE OPTION
PRICE INCREASES IF THE STOCK PRICE
INCREASES AND VICE VERSA.

DETERMINANTS OF OPTION
PRICES
2. STRIKE PRICE OF THE OPTIONS:-
THE STRIKE PRICE IS FIXED FOR THE LIFE
OF THE OPTION. OTHER THINGS
REMAINING SAME IN CASE OF CALL
OPTION THE LOWER THE STRIKE PRICE
THE HIGHER WILL BE THE OPTION PRICE
AND VICE VERSA.

PRICES
3.TIME TO EXPIRATION OF THE OPTION:-
OPTIONS ARE WASTING ASSETS. AS IT
HAS A FIXED TIME PERIOD.THE LONGER
THE TIME PERIOD TO EXPIRATION THE
HIGHER IS THE OPTION PRICE.THIS IS
BECAUSE AS THE TIME TO MATURITY
DECREASES LESSER TIME REMAINS FOR
THE STOCK PRICE TO FALL/INCREASE.

PRICES
4. EXPECTED STOCK PRICE VOLATILITY:-
FLUCTUATIONS IN STOCK PRICES IN
FUTURE IS A MAJOR FACTOR TO
INFLUENCE THE OPTION PRICE AS
GREATER THE EXPECTED VOLATILITY OF
THE PRICE OF THE STOCK THE MORE AN
INVESTOR WOULD BE WILLING TO PAY
FOR THE OPTION AND MORE PREMIUM
THE WRITER WOULD DEMAND.

PRICES
5.RISK FREE INTEREST RATE:- INTEREST
RATE IS AN IMPORTANT FACTOR WHICH
CREATES IMPACT ON THE OPTION PRICE.
THE HIGHER THE INTEREST RATE( SHO-
RT TERM RISK FREE) THE GREATER THE
COST OF BUYING THE UNDERLYING AND
CARRYING IT TO THE EXPIRATION DATE
OF THE CALL OPTION.HENCE THE HIGH-
ER THE INTERESTT RATE THE GREATER
THE PRICE OF THE CALL OPTION.
PRICES
6. ANTICIPATED CASH PAYMENTS ON THE
STOCK:-IT TENDS TO DECREASE THE
PRICE OF A CALL OPTION BECAUSE THE
CASH PAYMENTS MAKE IT MORE ATTRA-
CTIVE TO HOLD STOCK THAN TO HOLD
THE OPTION.ON THE OTHERHAND FOR
PUT OPTION CASH PAYMENTS ON THE
STOCK TEND TO INCREASE THE PRICE.

PARAMETERS EXPLAINING
BEHAVIOUR OF STOCK PRICES
1.EXPECTED RETURN FROM THE STOCK:-
THIS IS THE ANNUALIZED AVERAGE
RETURN EARNED BY THE INVESTORS IN
A SHORT PERIOD DENOTED BY u. THE
EXPECTED RETURN DESIRED BY INVEST-
ORS FROM STOCK DEPENDS ON THE
RISKINESS OF THE STOCK. HIGHER THE
RISK HIGHER THE RETURN, AND THE
MARKET INTEREST RATE.
2. VOLATILITY:- THE VOLATILITY OF STO-
CK, σ IS A MEASURE OF UNCERTAINITY
ABOUT THE RETURNS PROVIDED BY THE
STOCK.VOLATILITIES ARE EXPRESSED IN
% PER ANNUM.IT IS DEFINED AS “ THE
VOLATILITY OF A STOCK PRICE IS THE
STANDARD DEVIATION OF THE RETURN
PROVIDED BY THE STOCK IN ONE YEAR
WHEN THE RETURN IS EXPRESSED
USING CONTINOUS COMPOUNDING”.
THE SD OF THE PROPORTIONAL CHANGE
IN STOCK PRICE IN TIME „T‟:- ASSUME σ
ON A STOCK IS 30%PA.TO FIND THE
CHANGE IN SIX MONTHS THEN σ
=30√0.5 =21.2% AND FOR 3 MONTHS IT
IS 30√0.25 =15%.SO SD WILL INCREASE
AS THE PERIOD LENGTHEN.GRAPHICALLY
THE CURVE BECOMES FLATTER AND
WIDER.
MODELS OF VALUATION OF
OPTIONS
1.BINOMIAL OPTION PRICING MODEL:-
THIS MODEL WAS DEVELOPED BY COX,
ROSS AND RUBINSTEIN IN 1979.THIS
MODEL ASSUMES THAT THE PRICES
CHANGE IN FOLLOW A BINOMIAL
DISTRIBUTION. IT FOLLOWS THE
EUROPEAN CALL OPTIONS.IT SOLVES
THE PROBLEM NUMERICALLY RATHER
THAN ANALYTICALLY.

BINOMIAL PRICING MODEL -
ASSUMPTIONS
1. THERE ARE NO TRANSACTION COSTS,
NO BID/ASK SPREAD ,NO MARGIN
REQUIREMENTS, NO RESTRICTION ON
SHORT SALES,NO TAXES
2. THERE IS NO RISK OF DEFAULT BY THE
OTHER PARTY IN THE CONTRACT.
3. MARKETS ARE COMPETITIVE, i.e.
MARKET PARTICIPANTS ACT AS PRICE
TAKERS AND NOT MAKERS.

BINOMIAL PRICING MODEL-
ASSUMPTION
4.THERE ARE NO ARBITRAGE OPPORTUNI-
TIES.PRICES HAVE ADJUSTED IN SUCH A
WAY SO THAT THERE ARE NO ARBITR-
AGE OPPORTUNTIES IN THE MARKET.
5.THERE ARE NO INTEREST RATE UNCERT-
AINITY.THIS IS ASSUMED TO REDUCE
THE COMPLEXITY OF THE PRICING PROB-
LEMS.

THE BINOMIAL MODEL
THE MODEL IS BASED ON THE ASSUMPT-
ION THAT IF A SHARE PRICE IS OBSERV-
ED AT THE START AND END OF A PERIOD
OF TIME IT WILL TAKE ONE OF THE TWO
VALUES AT THE END OF THAT PERIOD i.e
THE MODEL ASSUMES THAT THE SHARE
PRICE WOULD MOVE UP OR DOWN TO A
PREDETERMINED LEVEL.

ONE STEP BINOMIAL MODEL
CONSIDER A SITUATION WHERE A STOCK
PRICE IS CURRENTLY Rs 20 AND IT IS
KNOWN THAT AFTER 3 MONTHS IT MAY
BE EITHER RS 22 OR RS 18. WE ALSO
ASSUME A EUROPEAN CALL OPTION TO
BUY THE STOCK FOR Rs 21 IN 3 MONTHS
IN THIS OPTION WE ARE ESTIMATING
TWO VALUES i.e. Rs 22 AND Rs 18, IF
THE VALUE TURNS UPTO 22 THE OPTION
VALUE WILL BE Re 1 AND IF 18 IT IS 0.
THE SITUATION=
So = INITIAL STOCK PRICE Rs 20
S1 = STOCK PRICE AFTER PERIOD
U0 = UP FACTOR
D0 = DOWN FACTOR
S1 = u0(S0) WHEN STOCK PRICE =22 AND
S1 = D0(S0) WHEN STOCK PRICE = 18.

WHEN THE INITIAL STOCK PRICE =20,uo =
22-20=2/20, 1.10 AND THE DOWN FACT-
OR Do= 20-18=2/20, 0.90. THESE ARE
CALLED AS PRICE RELATIVES. THE ASSU-
MPTION THAT THE STOCK PRICE CAN
TAKE ONLY ONE OF THE TWO POSSIBLE
VALUES AT THE END OF EACH INTERVAL
IS REFERRED AS THE BINOMIAL MODEL.

CONSIDER A PORTFOLIO CONSISTING OF
A LONG POSITION IN ΔSHARES OF THE
STOCK AN A SHORT POSITION IN CALL
OPTION. WE CAN FIND OUT THE VALUE
OF PORTFOLIO WHICH IS RISKLESS. IF
THE SHARE PRICE MOVES UP FROM 20
TO 22 THE VALUE OS SHARES WILL BE
22Δ AND THE VALUE OF THE OPTION
WILL BE 1 i.e. 22-21.
THE TOTAL VALUE OF THE OPTION WILL
BE 22Δ – 1. IF THE PRICE FALLS TO 18
THE VALUE OF THE SHARES IS 18Δ AND
THE VALUE OF THE OPTION IS ZERO SO
THAT THE TOTAL VALUE OF THE PORT-
FOLIO IS 18Δ+0 = 18Δ. THE PORTFOLIO
IS RISKLESS IF THE VALUE OF Δ IS CHO-
SEN SO THAT THE FINAL VALUE OF THE
PORTFOLIO IS THE SAME FOR BOTH OF
THE ALTERNATIVE STOCK PRICES.
THIS MEANS 22Δ – 1=18Δ
4 Δ = 1, Δ= 0.25
A RISKLESS PORTFOLIO IS, THEREFORE:-
LONG: 0.25, SHORT: 1 OPTION. IF THE
STOCK PRICE MOVES UPWARD TO 22
THE VALUE OF THE PORTFOLIO WILL BE
22*0.25-1 =4.5. IF THE STOCK PRICES
MOVES DOWNWARD TO 18 THE VALUE IS
18*0.25 = 4.5.

SO IRRESPECTIVE OF WHETHER THE STOCK
PRICE MOVES UP OR DOWN, THE VALUE OF
THE PORTFOLIO IS ALWAYS 4.5 AT THE END
OF THE LIFE OF THE OPTION.
ANALYSING THE RISK FREE PORTFOLIO MUST
EARN RISK FREE INTEREST. ASSU-MING RISK
FREE INTEREST @ 12%PA, THE VALUE OF THE
PORTFOLIO TODAY MUST BE THE PRESENT
VALUE OF 4.5 OR 4.5e-0.12*O.25 =4.367

THE CURRENT PRICE OF THE STOCK IS 20,
ASSUMING OPTION PRICE DENOTED BY f THE
VALUE OF THE PORTFOLIO TODAY IS 20*0.25
– f = 5 – f. IT FOLLOWS THAT 5 – f =4.367 OR
f= 0.633.
THIS MEANS THAT CURRENT VALUE OF OPTION
MUST BE 0.633. IF THE VALUE OF THE OPTION
WERE MORE THAN 0.633 THE PORTFOLIO
WOULD COST LESS THAN 4.367 TO SET UP
AND WOULD EARN MORE THAN THE RISK FREE
RATE AND VICE VERSA.

BLACK AND SCHOLES OPTION
PRICING MODEL
THIS IS THE MOST COMMONLY USED OPT-
ION PRICING MODEL IN FINANCE.IT WAS
DEVELOPED IN 1973 BY FISHERBLACK
AND MYRON SCHOLES AND WAS DESI-
GNED TO PRICE EUROPEAN OPTIONS ON
NON-DIVIDEND PAYING STOCKS. LATER
IT WAS MODIFIED FOR AMERICAN OPTI-
ONS,OPTIONS ON DIVIDEND PAYING
STOCK, AND FOR FUTURE CONTRACTS.
BLACK AND SCHOLES MODEL-
ASSUMPTIONS.
1. IT ASSUMES THAT THE EXPECTED
RETURN AND STANDARD DEVIATION
ARE CONSTANT. (u AND σ ARE
CONSTANT)
2. THERE ARE NO TAXES AND TRANSACT-
ION COSTS.
3. ALL SECURITIES/STOCKS ARE PERFECT-
LY DIVISIBLE.

BLACK AND SCHOLES MODEL -
ASSUMPTIONS
4. NO DIVIDEND PAYMENTS ON STOCK
DURING THE LIFE OF THE OPTION.
5.THERE ARE NO RISKLESS ARBITRAGE
OPPORTUNITIES.
6.STOCK TRADING IS CONTINOUS.
7. INVESTORS CAN BORROW OR LEND AT
THE SAME RISK FREE RATE OF INTEREST
8.THE SHORT TERM RISK FREE INTEREST
RATE „r‟ IS CONSTANT.
BLACK AND SCHOLES MODEL
THE FOUNDATION OF THE MODEL IS THE
CONSTRUCTION OF A HYPOTHETICAL
RISK FREE PORTFOLIO, CONSISTING OF
LONG CALL OPTIONS AND SHORT
POSITIONS IN THE UNDERLYING STOCK
ON WHICH AN INVESTOR EARNS THE
RISKLESS RETURN.IT IS ANALOGOUS TO
THE NO –ARBITRAGE ANALYSIS.

THE REASON WHY A RISKLESS PORTFOLIO CAN
BE SET UP IS BECAUSE THE STOCK PRICE AND
THE OPTION PRICE ARE BOTH AFFECTED BY
THE SAME UNDERLY-ING SOURCE OF
UNCERTAINITIES AND FACTORS. IN SHORT
PERIOD THE STOCK PRICE IS PERFECTLY
CORRELATED WITH THE OPTION PRICE AND
THE PRICE OF A PUT OPTION IS PERFECTLY
NEGATIVELY CORRELATED WITH THE PRICE OF
THE UNDERLYING STOCK.

IN THIS WAY IN BOTH CASES WHEN AN
APPROPRIATE PORTFOLIO OF THE STO-
CK AND OPTION IS CREATED, PROFIT
AND LOSS FROM STOCK POSITION WILL
OFFSET THE PROFIT AND LOSS FROM
OPTION POSITION SO THAT THE
OVERALL VALUE OF THE PORTFOLIO AT
THE END OF THE SHORT PERIOD OF
TIME IS KNOWN WITH CERTAINITY.
BLACK AND SCHOLES PRICING
FORMULA.
C=SN(d1)-Ke-rt N(d2) (CALL OPTION)
P= Ke-rt N(-d2) – SN(-d1) (PUT OPTION)
d1 = ln(S/K) + rT + 0.5σ√T
σ√T
D2 = ln(S/K) + rT - 0.5σ√T
σ√T or d2=d1- σ√T

BLACK AND SCHOLES PRICING
FORMULA
C= CALL OPTION, P=PUT OPTION, S= STO-
CK PRICE, K= STRIKE PRICE, e= EXPON-
ENTIAL ( CONSTANT VALUE 2.7182818),
r=RISK FREE INTEREST RATE ANNUAL,
T= TIME TO EXPIRY IN YEARS,σ=SD OF
RETURNS (VOLATILITY) AS A DECIMAL,
e-rt IS PRESENT VALUE OF A FUTURE SUM
OF MONEY, ln= NATURAL LOG,Nd1 IS
THE AREA UNDER THE DISTRIBUTION TO
THE LEFT OF d1 AND Nd2 IS LEFT OF d2.
HEDGING WITH OPTIONS
HEDGING THROUGH FINANCIAL DERIVATI-
VES IS AN IMPORTANT STRATEGY OF FI-
NANCIAL INSTITUTIONS,TRADERS,AND
OTHER DEALAERS. THE ULTIMATE ECON-
OMIC FUNCTION OF FINANCIAL DERIVA-
TIVES IS TO PROVIDE MEANS OF RISK
REDUCTION. AS SEEN EARLIER HEDGERS
USING FUTURES BASICALLY ATTEMPT TO
LOCK IN A SPECIFIC PRICE.
IN CASE OF OPTIONS HEDGERS SEEK TO
SET A SPECIFIC FLOOR OR CEILING
PRICE. FOR EX:- AN OPTION HEDGER
CAN ESTABLISH A FLOOR PRICE FOR A
LONG PUT POSITION AND IN CASE OF A
LONG CALL POSITION A CEILING PRICE
IS ESTABLISHED. SO OPTIONS CAN BE
REGARDED AS MEANS OF INSURANCE
AGAINST ADVERSE PRICE MOVEMENTS.
ANYONE WHO IS AT A RISK FROM A PRICE
CHANGE CAN USE OPTIONS TO OFFSET
THAT RISK. FOR EX:- A CALL OPTION
CAN BE USED AS A MEANS OF ENSURING
A MAXIMUM PURCHASE PRICE IN WHICH
IF THE MARKET PRICE EXCEEDS THE
STRIKE PRICE THEN THE OPTION CAN BE
EXERCISED IN ORDER TO BUY AT THE
STRIKE PRICE AND VICE VERSA.
THE CONCEPT OF FIXED HEDGE.
WHEN THE SIZE OF THE OPTION BEING
HEDGED MATCHES THE AMOUNT OF THE
UNDERLYING COVERED BY THE OPTIONS
THE HEDGE IS REFERRED TO AS A FIXED
HEDGE. A FIXED HEDGE WITH OPTION
RETAINS AN EXPOSURE AND ENTAILS A
COST.WHILE PROTECTION IS OBTAINED
FROM A STOCK PRICE MOVEMENT IN
ONE DIRECTION EXPOSURE IS RETAINED
TO A MOVEMENT IN OTHER DIRECTION.
THE CONCEPT OF FIXED HEDGE
THIS PROFIT POTENTIAL IS PAID FOR IN
THE FORM OF OPTION PREMIUM. SO IT
SHOULD BE DECIDED WHETHER HEDGI-
NG IS REALLY DESIRABLE. IF SO WHETH-
ER OPTIONS CONSTITUTE THE APPROPR-
IATE HEDGING INSTRUMENT. BECAUSE
IF THERE IS NO INTENTION TO SELL
THEN THERE IS NO NEED TO HEDGE.

NAKED AND COVERED POSITION
ONE STRATEGY OPEN TO THE HEDGER IS
TO DO NOTHING. THIS INVOLVES WHAT
IS KNOWN AS A NAKED OPTION. A
NAKED CALL OPTION IS ALSO TERMED
AS A CALL OPTION THAT IS NOT USED
FOR HEDGING AN EXISTING EXPOSURE.
AN ALTERNATIVE IS COVERED POSITION.
THIS INVOLVES BUYING THE STOCK AS
SOON AS THE OPTION HAS BEEN SOLD.
NAKED AND COVERED POSITION
IF THE OPTION IS EXERCISED THIS
STRATEGY WORKS WELL. IF THE OPTION
IS NOT EXERCISED THE COVERED
POSITION COULD PRICE TO BE
EXPENSIVE. HOWEVER NEITHER A
NAKED POSITION NOR A COVERED
POSITION PROVIDES A SATISFACTORY
HEDGE.

A STOP - LOSS STRATEGY
THIS IS AN INTERESTING HEDGING STRA-
TEGY WHERE THE STOCKS ARE PURCHA-
SED AND SOLD AGAINST WRITING A
CALL OR PUT OPTION.FOR EX:- A FIRM
WHICH HAS A CALL OPTION WITH
EXERCISE PRICE OF X TO BUY ONE UNIT
OF STOCK. THE HEDGING STRATEGY IS
TO BUY THE STOCK AS SOON AS THE
PRICES RISE OVER X AND SELL AT FALL.
A STOP LOSS STRATEGY.
THE OBJECTIVE OF THIS STRATEGY IS TO
HOLD A NAKED POSITION WHENEVER
THE STOCK PRICE IS LESS THAN X AND
COVERED POSITION IF THE STOCK PRICE
IS HIGHER THAN X. THE STRATEGY IS
DESIGNED TO ENSURE THAT THE FIRM
OWNS THE STOCK WHEN THE OPTION IS
IN THE MONEY AND DOES NOT OWN IT
IF THE OPTION IS OUT OF THE MONEY.
ZERO-COST OPTION STRATEGY
THIS STRATEGY INVOLVES WHEN AN OPT-
ION IS PURCHASED AT A PARTICULAR
PREMIUM AND AT THE SAME TIME, SELL-
ING AN OPTION WHICH GIVES SAME
SIZE TO THE RECEIPT OF PREMIUM. IT
MEANS PAYING THE PREMIUM ON ONE
OPTION AND RECEIVING THE PREMIUM
ON THE OTHER OPTION AND THUS
BEARING ZERO COST ON THE OPTION.
ZERO COST OPTION STRATEGY
ZERO COST OPTIONS ARE INSTRUMENTS
WHICH CAN BE BROKEN DOWN INTO:-
1.PARTICIPTING FORWARDS:- ALL THE
CONSTITUENTS HAVE THE SAME STRIKE
PRICE. FOR HEDGING AGAINST PRICE
FALL A PURCHASE OF OUT OF THE
MONEY PUTS COULD BE FINANCED BY
THE SALE OF A SMALLER NUMBER OF IN
THE MONEY CALLS.
ZERO COST OPTION STRATEGIES
IN THIS STRATEGY PUT OPTIONS WILL
FULLY COVER AGAINST THE PRICE FALL
WHEREAS THE CALL OPTION WOULD
NOT FULLY NEGATE THE BENEFITS OF A
PRICE RISE. SO IN THIS SITUATION NET
EFFECT IS THAT OF A FORWARD CONTR-
ACT THAT ALLOWS SOME PARTICIPAT-
ION IN THE BENEFITS OF A PRICE RISE.

ZERO COST OPTION STRATEGIES
2.RANGE FORWARDS:- THIS IS ALSO CALL-
ED AS CYLINDER OR SPLIT SYNTHETIC.
IN THIS TECHNIQUE CONSTITUENTS
OPTIONS HAVE DIFFERENT STRIKE PRIC-
ES.EX:- IN CASE OF FALLING PRICES,
HEDGING CAN BE BY BUYING A PUT
OPTION WITH A STRIKE PRICE BELOW
THE STOCK PRICE AND FINANCING THE
SAME BY WRITING A CALL OPTION WITH
A STRIKE PRICE ABOVE STOCK PRICE.
ZERO COST OPTION STRATEGY
AS A RESULT THERE WILL BE ADVANTAGE
OF ALLOWING SOME PROFIT FROM A
RISE IN THE STOCK PRICE, BUT AT THE
COST OF HAVING NO PROTECTION
AGAINST A PRICE FALL UNTIL THE
STOCK PRICE REACHES THE STRIKE
PRICE OF THE PUT OPTION.

DELTA HEDGING
DELTA HEDGING IS THE STRATEGY USED
TO IMMUNIZE PORTFOLIOS FROM SMALL
CHANGES IN THE PRICES OF THE UNDER-
LYING ASSET IN THE FUTURES SMALL
INTERVAL OF TIME.THE DELTA OF AN
OPTION IS THE RATIO OF THE CHANGE.
IF THE DELTA IS 0.50 IT MEANS THAT
THE OPTION PREMIUM WILL CHANGE BY
50% FOR THE CHANGE IN THE PRICE OF
STOCK.
DELTA HEDGING
IF AN OPTION WITH A DELTA OF 0.50 IS
USED A HEDGE THEN TWO OPTIONS
MUST BE HELD FOR EVERY UNIT OF THE
ASSET IN ORDER TO EQUATE BOTH THE
OPTION AND ASSET PORTFOLIOS. THE
MINIMUM VARIANCE HEDGE RATIO IS
THE RECIPROCAL OF THE OPTION DELTA
IF DELTA IS 0.50 THEN THE HEDGE RAT-
IO IS 2.AS AN OPTION DELTA CHANGES
THE HEDGE RATIO WILL BE CHANGED.
DELTA HEDGING
Δ = ΔC/ ΔS WHERE Δ IS DELTA, ΔC IS CH-
ANGE IN CALL PRICE, ΔS IS CHANGE IN
ASSET (STOCK) PRICE. A DELTA EQUAL
TO 0.7 FOR A CALL OPTION IMPLIES
THAT FOR A ONE UNIT CHANGE IN THE
STOCK PRICE OR INDEX THE OPTION
WOULD MOVE 0.7 POINTS. ALSO A Δ=
-0.8 FOR APUT OPTION MEANS THAT THE
PUT OPTION PREMIUM WILL DECLINE BY
8O PAISE IF THE STOCK RISES BY Re 1.
DELTA HEDGING
IN TERMS OF THE B-S MODEL FOR A CALL
OPTION THE DELTA IS GIVEN BY N(d1),
WHILE FOR A PUT OPTION IT IS EQUAL
TO N(d1)-1.EX IF N(d1) = 0.6443 THE
DELTA FOR CALL OPTION IS 0.6443-1 =
0.3557. SO IF THE PRICE OF THE ASSET
RISES BY Re 1 THE PRICE OF THE CALL
OPTION WILL RISE BY 64 PAISE WHILE
THE PRICE OF PUT OPTION WILL FALL BY
35 PAISE.
DELTA HEDGING
EVIDENTLY THE CALL DELTA WOULD ALW-
AYS BE GREATER THAN ZERO AND LESS
THAN ONE. DEEP IN THE MONEY CALL
OPTIONS WOULD HAVE DELTA CLOSE TO
UNITY WHILE DEEP IN THE MONEY PUT
OPTIONS WOULD SHOW A DELTA NEARI-
NG -1.OPTIONS THAT ARE FAR OUT OF
THE MONEY HAVE DELTA VALUES CLOSE
TO ZERO.
THETA θ
OPTION VALUES INCREASE WITH THE LEN-
GTH OF TIME TO MATURITY. THE EXPEC-
TED CHANGE IN THE OPTION PREMIUM
FROM A SMALL CHANGE IN THE TIME TO
EXPIRATION IS TERMED AS THETA, i.e.
IT IS A RATE OF CHANGE IN THE OPTION
PORTFOLIO VALUE AS TIME PASSES.IT IS
ALSO CALLED AS TIME DELAY OF THE
PORTFOLIO.
THETA θ
THETA IS CALCULATED AS THE CHANGE IN THE
OPTION PREMIUM OVER THE CHANGE IN TIME.
θ = Δ PREMIUM/ Δ TIME
THE OPTION PREMIUMS DETERIORATE AT AN
INCREASING RATE AS THEY APPROACH
EXPIRATION. IT IS ALSO OBSERVED THAT
MOST OF THE OPTION PREMIUMS DEPENDING
ON THE INDIVIDUAL OPTION IS LOST IN THE
FINAL 30 DAYS TO EXPIRATION. THAT IS WHY
THETA IS BASED ON SQUARE ROOT OF TIME.
THETA
THIS EXPONENTIAL RELATIONSHIP BETW-
EEN OPTION PREMIUM AND TIME IS
SEEN IN THE RATIO OF OPTION VALUE
BETWEEN THE FOUR MONTH AND THE
ONE MONTH AT THE MONEY MATURITI-
ES. IT WILL BE:- PREMIUM OF 4 MONTHS
PREMIUM OF 1 MONTH
= √4/√1 =2/1 = 2 TIMES.

GAMMA
THE GAMMA ẛ OF THE PORTFOLIO OF OPT-
IONS ON AN UNDERLYING ASSET MAY BE
DEFINED AS THE RATE OF CHANGE OF
THE PORTFOLIO‟S DELTA WITH RESPECT
TO THE PRICE OF THE UNDERLYING
INSTRUMENT.IN OTHER WORDS IT IS
THE CHANGE IN DELTA PER UNIT
CHANGE IN THE PRICE OF THE ASSET.

GAMMA
IF THE GAMMA IS SMALL AND NOT SIGNI-
FICANT IT MEANS THAT THE DELTA
CHANGES VERY SLOWLY THEN ADJUST-
MENTS FOR KEEPING DELTA NEUTRAL
NEED RELATIVELY INFREQUENTLY. IF
GAMMA IS VERY HIGH WICH MEANS
THAT DELTA IS HIGHLY SENSITIVE TO
STOCK PRICE THEN THE ADJUSTMENT
TO MAKE DELTA NEUTRAL IS NEEDED.
VEGA (v)
IT MAY BE DEFINED AS THE RATE OF CHA-NGE
OF THE VALUE OF THE PORTFOLIO OF THE
OPTIONS WITH RESPECT TO CH-ANGE
(VOLATILITY) OF THE UNDERLYING ASSET.
VOLATILITY IS STATED IN PERCENTAGE PER
ANNUM.IT IS THE SD OF DAILY PERCENTAGE
CHANGES IN THE UNDERLYING STOCK PRICE.
i.e. THE VALUE OF AN OPTION IS LIABLE TO
CHANGE BECAUSE OF MOVEMENTS IN STOCK
PRICES OVER THE PASSAGE OF TIME.

VEGA (v)
IF VEGA IS HIGH IN ABSOLUTE TERMS THE
PORTFOLIO VALUE IS VERY SENSITIVE
TO CHANGES IN VOLATILITY. IF THE
STOCK‟S VOLATILITY RISING THEN THE
RISK OF THE OPTION‟S BEING EXERCI-
SED IS INCREASING, THE OPTION‟S PRE-
MIUM WOULD ALSO BE INCREASING.
VEGA = Δ PREMIUM/ Δ VOLATILITY.

RHO AND PHI
THE RHO OF A PORTFOLIO OF OPTIONS
MAY BE DEFINED AS THE RATE OF
CHANGE IN THE VALUE OF THE PORTFO-
LIO OPTION WITH RESPECT TO THE
INTEREST RATE. i.e. THE EXPECTED
CHANGE IN THE OPTION PREMIUM FROM
A SMALL CHANGE IN THE DOMESTIC
INTEREST RATE. RHO = Δ PREMIUM / Δ
DOMESTIC INTEREST RATE.
RHO AND PHI
IN CASE OF CURRENCY OPTIONS WE HAVE
DOMESTIC INTEREST RATE AND FOREI-
GN INTEREST RATE. WHEN THE CHANGE
IN THE OPTION VALUE IS DUE TO FOREI-
GN INTEREST RATE IT IS CALLED AS PHI.
PHI = Δ IN OPTION PREMIUM/Δ FOREI-
GN INTEREST RATE.

Risk MGMT Mod 4 &amp 5

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Risk MGMT Mod 4 &amp 5

Uploaded by

Copyright:

Available Formats

RISK MANAGEMENT USING

11 July 2013 PROF. D.GOPINATH 1

11 July 2013 PROF. D.GOPINATH 2

11 July 2013 PROF. D.GOPINATH 3

11 July 2013 PROF. D.GOPINATH 4

11 July 2013 PROF. D.GOPINATH 5

11 July 2013 PROF. D.GOPINATH 7

CALL OPT PUT OPT

11 July 2013 PROF. D.GOPINATH 8

11 July 2013 PROF. D.GOPINATH 9

OPTIONS CAN BE CLASSIFIED INTO:-

1. CALL AND PUT OPTIONS.

11 July 2013 PROF. D.GOPINATH 10

11 July 2013 PROF. D.GOPINATH 11

11 July 2013 PROF. D.GOPINATH 12

11 July 2013 PROF. D.GOPINATH 14

11 July 2013 PROF. D.GOPINATH 18

11 July 2013 PROF. D.GOPINATH 19

11 July 2013 PROF. D.GOPINATH 20

11 July 2013 PROF. D.GOPINATH 23

INTRINSIC VALUE IS:-

11 July 2013 PROF. D.GOPINATH 28

11 July 2013 PROF. D.GOPINATH 29

11 July 2013 PROF. D.GOPINATH 30

11 July 2013 PROF. D.GOPINATH 31

11 July 2013 PROF. D.GOPINATH 32

11 July 2013 PROF. D.GOPINATH 33

11 July 2013 PROF. D.GOPINATH 34

11 July 2013 PROF. D.GOPINATH 36

11 July 2013 PROF. D.GOPINATH 38

11 July 2013 PROF. D.GOPINATH 39

11 July 2013 PROF. D.GOPINATH 40

11 July 2013 PROF. D.GOPINATH 45

11 July 2013 PROF. D.GOPINATH 48

11 July 2013 PROF. D.GOPINATH 49

11 July 2013 PROF. D.GOPINATH 50

11 July 2013 PROF. D.GOPINATH 51

11 July 2013 PROF. D.GOPINATH 52

11 July 2013 PROF. D.GOPINATH 56

11 July 2013 PROF. D.GOPINATH 59

11 July 2013 PROF. D.GOPINATH 66

11 July 2013 PROF. D.GOPINATH 68

11 July 2013 PROF. D.GOPINATH 69

11 July 2013 PROF. D.GOPINATH 70

11 July 2013 PROF. D.GOPINATH 71

11 July 2013 PROF. D.GOPINATH 73

11 July 2013 PROF. D.GOPINATH 74

11 July 2013 PROF. D.GOPINATH 75

11 July 2013 PROF. D.GOPINATH 76

11 July 2013 PROF. D.GOPINATH 78

11 July 2013 PROF. D.GOPINATH 82

11 July 2013 PROF. D.GOPINATH 83

11 July 2013 PROF. D.GOPINATH 84

11 July 2013 PROF. D.GOPINATH 85

11 July 2013 PROF. D.GOPINATH 87

11 July 2013 PROF. D.GOPINATH 88

11 July 2013 PROF. D.GOPINATH 91

11 July 2013 PROF. D.GOPINATH 92

11 July 2013 PROF. D.GOPINATH 93

11 July 2013 PROF. D.GOPINATH 95

11 July 2013 PROF. D.GOPINATH 97

11 July 2013 PROF. D.GOPINATH 98