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ADVANCED FINANCIAL MANAGEMENT - DERIVATIVES

DERIVATIVES: MANAGING FINANCIAL RISK _________________________________________________________________________________________________________________ INTRODUCTION Derivative instruments are defined by the Securities Contracts (Regulation) Act to include (1) a security derived from a debt instrument, share, secured/unsecured loan, risk instrument or contract for differences, or any other form of security and (2) a contract that derives its value from the prices/ index of prices of underlying securities. Derivative contracts have several variants. The most common variants are forwards, futures and options. Three broad categories of participants—hedgers, speculators and arbitrageurs—trade in the derivatives market. The derivatives market performs a number of economic functions. First, prices in an organised derivatives market reflect the perception of the market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivatives contract. Thus, derivatives help in the discovery of the future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them those who have an appetite for them. Third, derivatives, due to their inherent nature, are linked the underlying cash markets. With the introduction of derivatives, the underlying market witnesses1 higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades shift to a more controlled environment of derivatives market In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Finally, derivatives markets help increase savings and investment in the long run. FORWARD CONTRACTS A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date, for a certain specified price. The other party assumes a short position and -agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity arc negotiated bilaterally by the parties to contact. Forward contracts are normally traded outside stock exchanges. They are popular on the Over the Counter (OTC) market. The salient features of forward contracts are as follows: (i) (ii) (iii) (iv) (v) They are bilateral c an asset/security tracts and, hence, exposed to counterparty risk; Each contract is customer designed, and, hence, is unique in terms of contract size, expiration date and the a. date for a type and quality; The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset and If a party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in a high price being charged.

However, forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transaction volume. Forward contracts are very useful in hedging and speculation. A classic hedging application would be that of an exporter who expects to receive payment in dollars, three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to dollars forward, he can lock-on a rate today and reduce his certainty. Similarly, an importer who required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, he can go along on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin up-front. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies Tel. No.: 25394777 / 67120221 E-mail: info@quoinacademy.com Website: www.quoinacademy.com(1)

Basis Basis: is defined as the futures price minus the spot price. (iv) Future contracts are a significant improvement over forward contracts as they eliminate counterparty risk and offer more liquidity. This is the last day on which the contract will be traded. A futures contract may be offset prior to maturity by entering into an equal and føfb’s daily opposite transaction. the counterparty risk remains a very serious issue. No. It parties to buy/sell is a standardized contract with a standard underlying instrument. and a standard timing of such settlement. the other suffers. a new contract having three month expiry is introduced for trading. This often makes them design terms of the deal that are very convenient in that specific situation. a standard quantity an asset /security and quality of the underlying instrument that can be delivered. Expiry Date: It is the date specified in the futures contract.com(2) . When one of the two sides to the transaction declares bankruptcy. two months and three months expiry cycles that expire on the last Thursday of the month. FUTURES/FUTURE CONTRACTS Futures markets are designed to solve the problems that exist in forward markets. avoid the problem of illiquidity. futures contracts are standardized and stock ex-change traded. On the Friday following the last Thursday. The basic problem in the first two is that they have too much flexibility and generality. Thus. For instance. The standardised items in a futures contract are: (i) Quantity of the underlying. at the end of which it will cease to exist. a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. Futures Terminology Important terms associated with futures contracts are as follows: Spot Price: The price at which an instrument/asset trades in the spot market.quoinacademy. the index futures contracts typically have one month. To facilitate liquidity in the futures contracts. Limitations: Forward markets are afflicted by several problems: (i)Lack of centralization of trading. Counterparty risk arises from the possibility of default by any one party to the transaction. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. the exchange specifies certain standard features for the contract. hence. Even when forward markets trade standarised contracts and. (ii) (ii) Liquidity and (iii) (iii) Counterparty risk. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future. But unlike forward contracts.com Website: www.ADVANCED FINANCIAL MANAGEMENT . Contract Cycle: The period over which a contract trades. There will be a different basis for each delivery month for each Tel. Future Price: The price at which the futures contract trade in the future market. For instance.DERIVATIVES leverage to the speculator. (iii) (iii) The date/month of delivery. the contract size of the NSE future market is 200 Nifties.: 25394777 / 67120221 E-mail: info@quoinacademy. (ii) (ii) Quality of the underlying. but makes the contracts non-tradable. at a certain price. Contract Size: The amount of asset that has to be delivered under one contract.

The underlying asset in this case is the Nifty portfolio.38. When the index moves up. Hence. 15. At a market lot of 200.quoinacademy. it means that the losses as well as profits. Hence. The underlying asset in this case is the Nifty portfolio. the futures price converges to the spot price. less the income earned on the asset.. the long futures position starts making profits and when the index move down it starts making losses. Futures contracts have linear payoffs. The pay off for futures is illustrated below.690 — Rs 2. Take the case of a speculator who sells a two month Nifty index futures contact when the Nifty stands at 1220.040 to his broker. If the balance in the margin account falls below the maintenance margin. When the index moves down. Initial Margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is the initial margin.000. are unlimited.DERIVATIVES contract. He has a potentially unlimited upside as well as downside. No. If the index closed at 2. this means he paid Ps 2. Pay off for Seller of Futures: Short Futures The pay off for a person who sells a futures contract is similar to the pay off for a person who shorts an asset. on January 15.520. Example: X sold a January Nifty futures contract for Rs 5. Take the case of a speculator who buys a two month Nifty index futures contract when the Nifty stands at 1220. On the futures expiration day. Payoffs Payoff for Futures A pay off is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. that is.720 — Ps 2.38. basis will be positive. How much profit/loss did he make? Solution: X bought one futures contract costing him Rs 5. Maintenance Margin: This is somewhat lower than the initial margin. Each Nifty futures contract is for the delivery of 200 Nifties.000. This is set to ensure that the balance in the margin account never becomes negative. Cost of Carry: The relationship between futures prices and spot prices can be summarised in terms of the cost of carry. For this he had to pay an initial margin of Rs 43.690) x 200 = Rs 6. Tel. At a market lot of 200. This measures the storage cost plus the interest that is paid to finance the asset.720 this must be the futures close price as well. Pay off for Buyer of Futures: Long Futures The pay offs for a person who buys a futures contract is similar to the pay off for a person who holds an asset.040 to his broker.com Website: www.520) x 200 = Rs 34. the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. the futures price converges to the spot price. Marking to Market: In the futures market.720. If the index closed at 2.000. The pay off for futures.000. the index closed at 2. for buyers (long futures) and sellers (short futures) is discussed below.690 per Nifty future. This is called marking to market. On the futures expiration day.ADVANCED FINANCIAL MANAGEMENT . Example: On January. for the buyer and the seller of futures contracts. On January 25. In simple words. Each Nifty futures contract is for the delivery of 200 Nifties. the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price.000. he would have made profit of (Rs 2. In a normal market. This reflects that futures prices normally exceed spot prices.38. He has a potentially unlimited upside as well as downside.com(3) .690 per Nifty future. this works out to be Ps 2. X bought a January Nifty futures contract that cost him Rs 5.000. the index closed at 2. For this he had to pay an initial margin of Rs 43.38. How much profit/loss did me make? Solution: X sold one futures contract costing in Rs 5. the short futures position starts making profits and when the index moves up.: 25394777 / 67120221 E-mail: info@quoinacademy.520 this must be the futures close price as well. he would have made of profit of (Rs 2. On January 25. at the end of each trading day. it starts making losses.

390 — Rs 1. that is whenever the futures price moves away from the fair value. this means he paid Rs 1. If the index closed at 1.000.520 to his broker.69. arbitrage opportunities would exist. annually/semi-annually) the price of the contract is defined as: F= S+ C where F= Futures price. Hence. According to this model. For this he had to pay an initial margin of Rs 21. Hence. The components of holding cost vary with contracts on different assets.-of-Carry Cost of carry Model. If the index closed at 1. On the futures expiration day. Each Nifty futures contract is for the delivery of 200 Nifties. the holding cost may even be negative.000. At times. On the futures expiration day.69.com(4) . this works out to be Rs 1. On January 25. The Cost-of-Carry Model The cost-of-carry model explains the dynamics of pricing that constitute the estimation of the fair value of futures. on January 15. How much profit/loss did he make? Solution: X bought one futures contract for Rs 2.69. he made of loss of (Rs 1.quoinacademy.: 25394777 / 67120221 E-mail: info@quoinacademy.390.69. and C = Holdings costs or carry posts This can also be expressed as: F= S (1 + r) T where r = Cost of financing and T = Time till expiration If F< S(1 + r) or F>S(1+r) .com Website: www.000.ADVANCED FINANCIAL MANAGEMENT . The fair value calculation of futures is used to decide the no arbitrage limits on the price of a future contract. At a market lot of 200. this must be the futures close price as well. Pricing Futures The pricing of futures is illustrated below with. the index closed at 1.000.345 per Nifty future. For this he had to pay an initial margin of Rs 21.280. Using continuous compounding. Each Nifty contract is for the delivery of 200 Nifties.520 to his broker. the index closed at 1. How much profit/loss did he make? Solution: X sold one futures contract for Rs 2.000. Example: X sold one January Nifty futures contract for Ps 2. In the case of equity futures.390.280.345 per Nifty future. where interest rates are compounded at discrete intervals. the futures price converges to the spot price.DERIVATIVES Example: On January 15. 9. there would be chances for arbitrage. the futures price converges to the spot price. the holding cost is the cost of financing minus the dividends returns. he made of loss of (Rs 1.345) x 200 = Rs. (2) Pricing equity index futures and (3) Pricing stock futures.280) x 200 = Rs 13. X bought one January Nifty futures contract that cost him Rs 2. this must be the futures close price as well.345 — Rs 1. using discrete compounding. S= Spot price.000. On January 25. No. (for example. In a market lot of 200. reference to (1) The Cost. the holding cost is the cost of financing plus cost of storage and insurance purchased and so on. In the case of commodity futures. the Equation would be expressed as T T Tel.

DERIVATIVES F= Se rT where r = Cost of financing (using continuously compounded interest rate). however.5.200 and Nifty trades with a multiplier of 200. The pricing of equity index futures is illustrated below with reference to (i) expected dividend amount and (ii) expected dividend yield. The value of the contract is 200 x Rs 1200 = Rs 2.com Website: www.com(5) . a crucial aspect of dealing with equity futures.000 x 0.ADVANCED FINANCIAL MANAGEMENT . The current value of Nifty is 1.000/kg. The better the forecast of dividend offered by a security.07).15) x 90/365 Rs 724. T= Time till expiration. two and three-month contracts. Year 1. Year 1. Money can be borrowed at a rate of 15 per cent per annum. F= Rs 700 (1. the one month contract was for 10. The dividend is received 15 days later and. its value in Nifty is Rs 16. Solution: Let us assume that XL will be declaring a dividend of Rs 10 per share after 15 days of purchasing the contract. Stock index futures are cash settled. Hence. Assuming an annual cost of financing of 15 per cent and no storage cost. where the carrying cost is the cost of financing the purchase of the portfolio underlying the index. let us take an example of a futures contract on a commodity and work out the cost of contract.8O0/14€. If.71828 To illustrate cost of carry. The amount of dividend received is Rs 1. we divide the compounded dividend figure by 200. of silver is assumed to be Rs 7.000 ÷ 10) [1.quoinacademy. If XL has a weight of 7 per cent in Nifty.40. Example: Nifty futures trades on a stock exchange (NSE) as one. the futures price is Tel. the better is the estimate of the futures price. compounded only for the reminder of the 45 days. The main differences between commodity and equity index futures are that: (i) (ii) There are no costs of storage involved in holding equity and Equity comes with a dividend stream. the fair value of the future price of 100 gms of silver one month hence (January 30.: 25394777 / 67120221 E-mail: info@quoinacademy. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty.000. If the market price of XL is Rs 140. is an accurate forecasting of dividends. and e= 2. it would involve storage cost and the price of the future contract would be Rs 708 plus the cost of storage. No. a traded unit of Nifty involves 120 shares (Rs 16.15] x 30/365 = Rs 708 If the contract is for a three month period expiring on March 30. which is a negative cost if you are long the stock and a positive cost if you are short the stock. Thus. Pricing Equity Index Futures A futures contract on the stock market gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Compute the price of a new two month futures contract on Nifty of X Ltd (XL).200 (120 x Rs 10). Therefore cost of carry = financing cost — dividends. minus the present value of dividends obtained from the stocks in the index portfolio. hence. as opposed to commodity futures. we need to reduce the cost-of-carry to the extent of the dividend received.800 (Rs 2. Thus. Year 1) would be as follows: F= S (1 + r) + C= Rs 700 (Rs 7. The spot price January 1. there is no delivery of the underlying stocks. T Pricing Index Futures Given Expected Dividend Amount The pricing of index futures is also based on the cost-of-carry model.000 kgs.40. To calculate the futures price. the cost of financing would increase the future price. that is.

there are few historical cases of clustering of dividends in any particular month. The difference between the spot price and the futures price is called the basis. and (ii) Stocks come with a dividend stream. Like index futures. and T= holding period Example: A two month futures contract trades on the NSE. However. transactions costs are very important in the business of arbitrage. It simply involves multiplying the spot price by the cost of carry. cost of carry = financing cost — dividends. No. F= futures price. The better the forecast of dividend offered by a security. Example: SBI futures trade on NSE as one.365 = Rs 1. What will the price of a unit of new two month futures contract on the SBI be if no dividends are expected during the two month period.30 Tel.com(6) . the better is the estimate of the futures price. the main difference Stock between commodity and stock futures are that: (i) There are no costs of storage involved in holding stock. pricing futures on that stock is very simple. which is a contract that negative cost if you are long) the stock and a positive cost if you are short the stock. Money can be borrowed a 15 per cent per annum.quoinacademy.224. r = cost of financing. If it is not. minus the present value of dividends obtained from the stock.3) Where. there is no delivery of the underlying stocks. The pricing of stock futures is discussed below (shares). that is. a crucial aspect of dealing with stock futures.200 (1 + 0. If no dividends are expected during the life of the contract. S= spot index value. these pricing models give an approximate idea about the true future price. Pricing Stock Futures A futures contract on a stock gives its owner the right and obligation to buy or sell the stocks. How these arbitrage opportunities can be exploited is discussed subsequently. Just as in the case of index futures. assuming spot price of the SBI is Rs 228? Solution: Futures price. F= S (1 + r— q)T (28. F = Rs 228 x (1. two and three-month contracts. On the date of expiration. stock futures are also cash settled.com Website: www. What is the fair value of the futures contract? Solution: Fair value = Rs 1. (ii) when dividend is expected.DERIVATIVES Pricing Index Futures Gwen Expected Dividend Yield If the dividend flow throughout the year is generally uniform. As the date of expiration comes near. The spot value of Nifty is Rs 1. There is nothing but cost-of-carry related arbitrage that drives the behaviour of the futures price.15 — 0.200.15) x 60/365 = Rs 233. Moreover.ADVANCED FINANCIAL MANAGEMENT . The price observed in the market is the outcome of the price discovery mechanism (demand-supply principle) and may differ from the so called true price. the basis reduces: there is a convergence of the futures price towards the spot price.35 The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price. when (i) no dividend is expected. then there is an arbitrage opportunity. The cost of financing is 15 per cent and the dividend yield on Nifty is 2 per cent annualised. it is useful to calculate the annual dividend yield. where the carrying cost is the cost of financing the purchase of the stock. Thus.: 25394777 / 67120221 E-mail: info@quoinacademy. as opposed to commodity futures. Arbitrage opportunities can also arise when the basis (difference between spot and futures price) or the spreads (difference between prices of two futures contracts) during the life of a contract are incorrect. Therefore. Pricing Stock Futures When No Dividend Expected The pricing of stock futures is also based on the cost-of-carry model. the basis is zero. is an accurate forecasting of dividends.02) x 60. q = expected dividend yield.

the two parties have committed themselves to doing something. the futures price. No. (iii) Option payoffs. Writer of an Option The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises the option on him. This section discusses and illustrates options as a derivative contract. the purchase of an option requires an upfront payment. Tel. Thus. What will the price of a unit of new two-month futures contract on XL be if dividends are expected during the two month period? Assume that XL will be declaring a dividend of Rs 10 per share after 15 days of purchasing the contract. and properties of an American option are frequently deduced from those of its European counterpart.com(7) . Solution: To calculate the futures price. An option gives the holder of the holder of the option the right to do something. Most exchange traded options are American. Call Option A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Like index futures contracts. Buyer of an Option The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. The holder does not have to necessarily exercise this right. hence. European options are easier to analyse than American options. There are two basic types of options.: 25394777 / 67120221 E-mail: info@quoinacademy. F = Rs 140 x (1. Put Option A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. A contract gives the holder the right to buy or sell shares at the specified price. The amount of dividend received is Rs 10. American options can be exercised at any time upto the expiration date. Stock Options Stock options are options on individual stocks.quoinacademy. Option Terminology Index Options These options have the index as the underlying. index options contracts are also cash settled. The market price of XL may be assumed as Rs 140. two and three month contracts. Whereas it costs nothing (except margin requirements) to enter into a futures contract. call options and put options. Example: XL futures trade on NSE as one. with reference to (i) Option terminology. OPTIONS/OPTIONS CONTRACTS Options are fundamentally different from forward and futures contracts. pricing involves reducing the cost of carry to the extent of the dividends. The dividend is received 15 days later and. compounded only for the remainder of 45 days.ADVANCED FINANCIAL MANAGEMENT .08. Some options are European while others are American. (iv) Pricing options and (v) Using stock options. In contrast. in a forward or futures contract. The net carrying cost is the cost of financing the purchase of the stock.15) x 60/365 — [10 x (1. European options can be exercised only on the expiration date itself.com Website: www. we need to reduce the cost-of-carry to the extent of dividend received. minus the present value of dividends obtained from the stock. (ii) Comparison of options and futures.15) x 45/3651 = Rs 133.DERIVATIVES Pricing Stock Futures When Dividends Are Expected When dividends are expected during the life of the futures contract.

Both calls and puts have time value. the put is OTM if the index is above the strike price. There is no possibility of the options position generating any further loss to him (other than the funds already paid for the option). In the case of a put. The intrinsic value of a call is the amount the option is ITM. K is the strike price and St is the spot price. If the index is much lower than the strike price. Tel. Out-of-the-Money Option An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. If the call is OTM.St ). If the index is much higher than the strike price. if it is ITM.quoinacademy. At a practical level. the greater is an option’s time value.a level that is less than the strike price (that is.(St — K] which means the intrinsic value of a call is the greater of 0 or (St — K). This characteristic makes options attractive to many occasional market participants who cannot put in the time to closely monitor their futures positions. Expiration Date The date specified in the options contract is known as the expiration date.ADVANCED FINANCIAL MANAGEMENT . the call is said to be deep OTM. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (that is. an option would have no time value. It is also referred to as the option premium. Usually.DERIVATIVES Option Price/Premium Option price is the price that the option buyer pays to the option seller. spot price > strike price). the call is said to be deep ITM. its intrinsic value is zero. spot price = strike price). In contrast. the strike date or the maturity. No.com(8) . Putting it another way. Intrinsic Value of an Option The option premium can be broken down into two components (i) intrinsic value and (ii) time value. the maximum time value exists when the option is ATM. the put is ITM if the index is below the strike price. A call option on the index is out-of-the. At expiration. that is. Strike Price The price specified in the options contract is known as the strike price or the exercise price.com Website: www. the intrinsic value of a put is Max[0. An option on the index is at-the-money when the current index equals the strike price (that is. In the case of a put. In-the-Money Option An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. the intrinsic value of a call is Max[O. the option buyer pays for the option in full at the time it is purchased. Similarly. other things being equal.: 25394777 / 67120221 E-mail: info@quoinacademy. K— St] . the greater of 0 or (K. spot price < strike price). At-the-Money Option An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately.money when the current index stands at . Time Value of an Option The time value of an option is the difference between its premium and its intrinsic value. An option that is OTM or ATM only has time value. he only has an upside. The longer the time to expiration. the exercise date. Futures and Options Options are different from futures in several respects. futures are free to enter into hut can generate very large losses. After this.

To buy a put option on the Nifty is to buy insurance that reimburses the full extent to which the Nifty drops below the strike price of the put option. Pay off Profile for Buyer of Call Options: Long Call A call option gives the buyer the right to pay the underlying asset at the strike price specified in the option. the investor is aid to be “long” the asset. his losses are pote-ntially unlimited. However. the payoff is exactly the opposite. which gives the investor protection against extreme drops in the Nifty. If upon expiration. More generally. the profits are potentially unlimited.220 and buys it back at a future date at an unknown price. The higher the spot price. His profits are limited to the option premium.220. However. The higher the spot price.ADVANCED FINANCIAL MANAGEMENT .. options offer “non-linear payoffs”. the buyer lets his option expire unexercised and the writer gets to keep the premium. S. Hence. Pay off Profile of Buyer of Asset: Long Asset In this basic position. the writer of the option starts making losses. For a writer. These nonlinear pay offs are fascinating as they lend themselves to be used to generate various pay offs by using combinations of options and the underlying. Pay off Profile for Writer to Call Options: Short Call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. the writer of the option charges a premium. it means that the losses for the buyer of an option are limited. the more profit he makes. an investor buys the under-lying asset. If upon expiration the spot price of the underlying is less than the strike price. the buyer will exercise the option on the writer. as the spot price increases. The investor sold the index at 1. Whatever is the buyer’s profit is the seller’s loss. In simple words. the more is the loss he makes. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If the index rises. The investor would make profit if the index goes up. The distinction between futures and option is summarised in Table Distinction Between Futures and Options Options Payoffs A pay off for derivative contacts is the likely profit/loss that would accrue to the market participant with change in the price of the underlying asset. We illustrate below six basic pay offs. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If the index falls.220 and sells it at a future date at an unknown price. Anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. the Nifty for instance. a wide variety of innovative and useful payoff structures can be created. Pay off Profile for Seller of Asset: Short Asset In this basic position.com(9) . No. for 1. Tel.DERIVATIVES Buying put options is buying insurance. he loses. the Nifty for instance. he makes a profit.: 25394777 / 67120221 E-mail: info@quoinacademy. an investor shorts the und-erlying asset. The optionality characteristic of options results in a non-linear pay off for options. Once it is sold. His loss in this case is the premium he paid for buying the option. whereas futures only have “linear payoffs”.com Website: www. the spot price exceeds the strike price. If upon expiration. the spot price exceeds the strike price. he profits. for 1. the investor is said to be “short” the asset.quoinacademy. S. If the spot price of the underlying is less than the strike price. Selling put options is selling insurance. he lets his option expire unexercised. This is attractive to many people and to mutual funds creating “guaranteed return products”. Once it is purchased. By combining futures and options. If the index falls he would lose. For selling the option. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of Nifty index fund.

If upon expiration the spot price is below the strike price. This requires continuous compounding. For selling the option. His downside is limited to this premium. They then reason that this hedged combination of options and stock should grow in value at the risk free rate. The end result is the Black and Scholes Model.1133. The result then is a partial differential equation. which is the continuously compounded equivalent of 12 per cent per annum.12 or 0. meaning that the logarithm of the stock’s return will follow the normal (bell shaped) distribution. By forming a portfolio consisting of a long position in stock and a short position in calls. The r that figures in this is 1 n(1 ÷ r). This hedged portfolio is obtained by setting the number of shares of stock equal to the approximate change in the call price for a change in the stock price. The buyer’s profit is the seller’s loss. This mix of stock and calls must be revised continuously. the buyer gets his option expire unexercised and the writer gets to keep the premium. namely. Ther@. No. if the interest rate per annum is 12 per cent. If the spot price of the underlying is higher than the strike price. This optionality has a value expressed in terms of the option price. he lets his option expire unexercised.are various models that help us get close to the true price of an option.ADVANCED FINANCIAL MANAGEMENT . Tel. Black-Scholes Option Pricing Model/Formulae Black and Scholes start by specifying a simple and well known equation that models the way in which stock prices fluctuate. called Geometric Brownian Motion. They then turn to a little known result in a specialised field of probability known as stochastic calculus.DERIVATIVES Pay off Profile for Buyer of Put Options: Long Put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. the writer of the option charges a premium. the exercise price. Pricing Options An option buyer has the right but not the obligation to exercise on the seller.: 25394777 / 67120221 E-mail: info@quoinacademy. Just like in other free markets. The lower the spot price. The Black-Scholes formulas for the prices of European calls and puts on a non-dividend paying stock are: • The Black-Scholes equation is done in continuous time. the more is the profit he makes. This process is known as delta hedging. His loss in the case is the premium he paid for buying the option. They then propose that the option’s price is determined by only two variables that are allowed to change: time and the underlying stock price. but his upside is potentially unlimited. If upon expiration the spot price of the underlying is more than the strike price. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.com(10) . This result defines how the option price changes in terms of the change in the stock price and time to expiration. the nsk associated with the stock is eliminated. you need to use I n 1. The other factors. The solution is found by forcing a condition called a boundary condition on the model that requires the option price to converge to the exercise value at expiration. it is the supply and demand in the secondary market that drives the price of an option. The worst that can happen to a buyer is the loss of the premium paid by him. the volatility. the buyer will exercise the option on the writer. and the risk free rate do affect the option’s price but they are not allowed to change. he makes a profit. Pay off Profile for Writer of Put Options: Short Put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. Example. Most of these are variants of the celebrated Black-Scholes Model for pricing European options. If upon expiration the spot price happens to be below the strike price. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.quoinacademy.com Website: www. This equation. implies that stock returns will have a lognormal distribution.

180 option using the Black-Scholes option pricing formula. with some adjustment. and more. • σ a measure of volatility. It is found that the put option prices decline as the risk free rate increases. The owner of the long-life option has all the exercise opportunities open to the owner of the short-life option. however. the chance that the stock will do very well or very poorly increases. therefore. options become less valuable and as the strike price decreases they become more valuable.180 is available for trading. the underlying stocks in the exact amount necessary to replicate the index. index options should be valued in the same way as ordinary options on common stock.15. • X is the exercise price.12). Risk Free Interest Rate: The affect of the risk free interest rate is less clear cut. is the annualised standard deviation of continuously compounded returns on the underlying. they need to be converted into annualised sigma. The value of both calls and puts. Therefore. therefore.19.150. replacing the current index value S in the model with q is the annual dividend yield and T is the time to expiration in years. the assumption being that investors can purchase. Put options behave exactly in the opposite way to call options. can be used to price American calls and puts options on Tel. This has a negative affect on the value of call options and a positive affect on the value of put options.quoinacademy. make adjustments for the dividend payments.25. increases as volatility increases. N (d1) is called the delta of the option. S= 1. without cost.com(11) . therefore. for a call option. always be worth at least as much as the short life option.: 25394777 / 67120221 E-mail: info@quoinacademy. Pricing Index Options Under the assumption of the Black-Scholes Options Pricing Model. which is a measure of change in option price with respect to change in the price of the underlying asset. The put price on an option with the same strike works out to be Rs 67. No. stocks are infinitely divisible and the index follows a diffusion process such that the continuously compounded returns distribution of the index is normally distributed.150. and it has a volatility of 30 per cent per annum. Call option. We take T 0. Time to Expiration: Both put and call American options become more valuable as the time to expiration increases. Volatility:The volatility of a stock price is a measure of how uncertain we are about future stock price movements. The Strike Price In the case of a call. Pricing Stock Options Much of what was discussed about index options also applies to stock options. therefore.ADVANCED FINANCIAL MANAGEMENT . We can calculate the price of the 1. S the spot price and T the time to expiration measured in years. As volatility increases. as the strike price increases.9 Example : A three-month call option on the Nifty with a strike of 1. Consider the case of two options that differ only as far as their expiration date is concerned. The annual risk free rate is 12 per cent. we get the call price as Rs 70. The Stock Price The payoff from a call option will be the amount by which the stock prices exceeds the strike price. become more valuable as the stock price decreases and less valuable as the stock price increases. The long-life option must.com Website: www. and 0= 0. Dividends: Dividends have the effect of reducing the stock price on the ex-dividend date. On a average there are 250 trading days in a year. the stock price has to make a larger upward move for the option to go in-the-money. When daily sigma are given. r=ln(1.180. The factors that affect option prices are listed below. Application of Black-Scholes Option Pricing Formula to Stock Options The Black-Scholes option pricing formula. as the strike price increases. X= 1. whereas the prices of calls always increase as the risk free interest rate increases. To use the Black-Scholes formula for index options we must. The payoff from a put option will be the amount by which the strike price exceeds the stock price. The Nifty stands at Rs 1. becomes more valuable as the stock price increases and less valuable as the stock prices decreases. that is.DERIVATIVES • N 0 is the cumulative normal distribution. Substituting these values in the formula.3. Consider Example 28. • sigmaannual = sigmadaily X √Number of trading days per year. Put options.

strike price.166. S= Rs 50 and X= Rs 45. Since the option is exercised just before the stock goes ex-dividend. and Sd= [S—D/ (1 = r) ] = Rs 47.1644 years hence.166 years. We have now two call options. that is. Following these adjustments.com Website: www.: 25394777 / 67120221 E-mail: info@quoinacademy. American options can be exercised any time prior to expiration. When no dividends are expected during the life of the option. we get the price of the short option as Rs 5. The discount rate on dividend is also taken to be 6 per cent. • The details of the short option are: T= 0. T Tel.com(12) .ADVANCED FINANCIAL MANAGEMENT .25 years. at Rs 5.5. However. we get the price of the long option as Rs 3.56. the option can be valued simply by substituting the values of the stock price.10.06. when valuing options on dividend paying stock. D 2. The unadjusted stock price is used.06. starting date till just before the stock goes ex-dividend. it is sometimes optimal to exercise the option just before the underlying stock goes ex-dividend. r— 0. X= Rs 45. which can be exercised just before the ex-dividend date. • The details of the long option are: T— 0. Therefore. we should consider exercise possibilities at to times: (i) just before the underlying stock goes ex-dividend and (ii) at the expiration of the options contract. stock volatility. The stock price to be used in the Black-Scholes option pricing formula is Sd. Some adjustment needs to be made before using the Black-Scholes formula. risk free rate and time-to-expiration in the BlackScholes formula. the adjusted price of the stock after deducing the present value of the dividends.5. the unadjusted stock price of Ps 50 is used.58. the risk free rate of interest is 6 per cent per annum and that the cx dividend adjustment of 2. and the other being a short maturity option with a time-to-maturity from the. However. Sd. D= 2. the time to expiry is shortened to be the period up to the ex-dividend date. the American option on the dividend paying stock would be valued at the higher of the two options. Using these values. when dividends are expected during the life of the option. is used in the BlackScholes Model. r= 0. the present value of the dividends is deducted from the stoik price and the adjusted value. Example: Assume that the price of a stock is Rs 50. and a short maturity call option with a maturity of 0. the Black-Scholes model can be applied.DERIVATIVES stocks.5 will occur 0. The volatility of the stock is 20 per cent. Thus. The actual value of the option will be the highest of the two valuations. which can be exercised on the expiration date.52. No. using the above approximation. Pricing American options becomes a little difficult because unlike European options. In addition. The first step is to value the option on the assumption that it will be exercised on expiry. Hence. owning an option on a dividend paying stock today is like owning two options: one being a long maturity option with a time-to-maturity from the starting date till the expiration day. S= P. the exercise price is Rs 45.quoinacademy. a long maturity call option with a maturity of 0. Using these values.s 50. Consider Example 28. We will now value both these options.25.84. Thus. it is never optimal to exercise a call option on a non-dividend paying stock before expiration. The second step is to assume that the option will be exercised just before the exdividend date.