Options Ques Bank

CA-FINAL
SFM
OPTION
RAJESH RITOLIA, FCA
HELPING HAND INSTITUTE
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Positive Thoughts
NEVER INTERFERE IN ANYBODY'S LIFE AND DO NOT ALLOW ANYBODY TO INTERFERE IN
YOUR LIFE.
Yesterday, I was clever, so I wanted to change the world. Today I am wse, so I am
changing my self
ANGER IS AN ACID THAT CAN DO MORE HARM TO THE VESSEL IN WHICH IT IS STORED
THAN TO ANYTHING ON WHICH IT IS POURED
The world’s hunger is getting ridiculous. There is more fruit in a rich man’s shampoo than
in a poor man’s plate
IF YOU LIGHT A LAMP FOR SOMEONE ELSE, IT WILL ALSO BRIGHTEN YOUR PATH
Fear keeps all good things from growing to their fullest potential.
A flower does not think of competing to the flower next to it. It just blossoms
Chapter Analysis
THEORY
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M11 N11 M12 N12 M13 N13 M14 N14 M15 N15
PRACTICAL
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M11 N11 M12 N12 M13 N13 M14 N14 M15 N15
Chap – 11A SUMMARY OF OPTION 11AA.1
Index Particulars Summary of Topics Q No Exam RTP
11A.0 INDIAN CAPITAL Broadly Indian Financial Market consists of Capital Market, Money Market and the Debt Market
MARKET
11A.0.1 CAPITAL The capital markets are relatively for long term financial instruments.
MARKETS/SECURITIES Role of Capital Market
MARKET
It is the indicator of the inherent strength of the economy.
It is the largest source of funds with long and indefinite maturity for companies and thereby enhances the capital formation in the country.
It offers a number of investment avenues to investors.
The capital market is Primary Market: A market where new securities are bought and sold for the first time is called the New Issues market or the IPO market.
divided into primary and The Primary market also includes issue of further capital by companies whose shares are already listed on the stock exchange.
secondary stock market. Secondary Market A market in which an investor purchases a security from another investor rather than the issuer, subsequent to the
original issuance in the primary market. So, it can be stated that secondary markets are the stock exchanges and the over-the-counter
market.
11A.0.2 STOCK MARKET AND ITS Secondary markets are also referred to as Stock Exchange.
OPERATIONS It is a place where the securities issued by the Government, public bodies and Joint Stock Companies are traded.
There are 24 Stock Exchanges in the country at present, out of which only eight have been given permanent recognition; others need to
apply every year for recognition.
Leading Stock Bombay Stock Exchange Limited:

Exchanges in India: National Stock Exchange
11A.0.3 Functions of Stock Liquidity and Marketability of Securities: Fair Price Determination: Source for Long term Funds: Helps in Capital Formation: Reflects the
Exchanges General State of Economy:
11A.1 Derivatives It is a financial asset which derives its value from some specified underlying assets.
A derivatives does not have any physical existence but emerges out of a contract between two parties.
It does not have any value of its own but its value depends on the value of other physical assets.
The underlying assets may be shares, debentures, tangible commodities etc.
The parties to the contract of derivatives are the parties other than the issuer of the assets.
The transactions in derivatives are settled by the offsetting in the same derivative. The difference in value of the derivatives is settled in
cash.
There is no limit on number of units transacted in the derivative market because there is no physical assets to be transacted.
Types of Derivatives Commodity Derivatives contract can be entered into for different type commodity such as sugar, Jute, Gur etc.
Financial Derivatives are entered in shares, currencies etc.
Basic Derivatives: Futures and Options
Complex derivatives: OTC Derivatives [Over the counter]

Interest Swaps; Caps, Floor and Collar; Forward Rate Agreement; Swaptions; Currency Swaps; Forward Contracts;
Function of Derivatives They help in transferring risk from risk averse people to risk oriented people.
Markets They help in discoveries of future prices.
11A.2 Option Options are contracts which provide the holder the right to sell or buy a specified quantity of an underlying asset at a fixed price on or before
the expiration of the option date.
Options provide a right and not the obligation to buy or sell.
The holder of the option can exercise the option at his discretion or may allow the option to lapse.
Call Option It provides to the holder a right to buy specified assets at specified price on or before a specified date.
Put option It provides to the holder a right to sell specified assets at specified price on or before a specified date.
Strike or Exercise The specified price at which the option can be exercised is known as the Strike Price.
Price
Buyer/ Holder of Person who buys Call/Put Option is called the buyer or holder of Option. Or
Option The person who has right to buy/sell underlying assets is called the buyer or holder of Option
Writer/ Seller of Person who sells Call/Put Option is called the Seller or writer of Option. Or
Option The person who has obligation to buy/sell underlying assets is called Seller or writer of Option of Option
Option In options, the buyer pays option premium to seller.

Premium/Price: The premium is a one-time non-refundable amount for availing the right.
In case, the right is not exercised later, then the premium is not refunded by the option writer.
Exercise of Call Option If Spot Price of underlying assets > Strike Price, then Yes
If Spot Price of underlying assets < Strike Price, then No
Hedging through Call If Holder actually purchase Share through call option, then this transaction is known as hedging
Option If Spot Price of underlying assets > Strike Price, then Purchase/Sale Price = Strike Price
If Spot Price of underlying assets < Strike Price, then Purchase/Sale Price = Market Price
Speculative Transaction If Holder is not required to buy any shares and he has purchased call option for profit purpose, then this transaction is known as speculative
transaction. Gain or loss in such transaction is known as speculative gain or loss.
If Spot Price of underlying assets > Strike Price, then Gain/(Loss) = Spot Price of UA – Strike Price
If Spot Price of underlying assets < Strike Price, then Gain/(Loss) = Nil
Value of Call Option at If Spot Price of underlying assets > Strike Price, then Value of Call Option = Spot Price of UA – Strike Price
expiration If Spot Price of underlying assets <= Strike Price, then Value of Call Option = Nil
Status of Call Option If Spot Price of underlying assets > Strike Price, then In the Money
If Spot Price of underlying assets < Strike Price, then Out of the Money
If Spot Price of underlying assets = Strike Price, then At the Money
By buying Call option Holder fixes upper limit of its purchase price but does not fix lower limit of purchase price
Exercise of Put Option If Spot Price of underlying assets > Strike Price, then No
If Spot Price of underlying assets < Strike Price, then Yes
Hedging through Put If Holder actually purchase Share through call option, then this transaction is known as hedging
Option If Spot Price of underlying assets > Strike Price, then Purchase/Sale Price = Market Price
If Spot Price of underlying assets < Strike Price, then Purchase/Sale Price = Strike Price
Speculative Transaction If Holder is not required to buy any shares and he has purchased call option for profit purpose, then this transaction is known as speculative
transaction. Gain or loss in such transaction is known as speculative gain or loss.
If Spot Price of underlying assets > Strike Price, then Gain/(Loss) = Nil
If Spot Price of underlying assets < Strike Price, then Gain/(Loss) = Strike Price - Spot Price of UA
Value of Put Option at If Spot Price of underlying assets > Strike Price, then Value of Put Option = Nil
expiration If Spot Price of underlying assets <= Strike Price, then Value of Put Option = Strike Price - Spot Price of UA
Status of Call Option If Spot Price of underlying assets > Strike Price, then Out of the Money
If Spot Price of underlying assets < Strike Price, then In the Money
If Spot Price of underlying assets = Strike Price, then At the Money
By buying Call option Holder fixes lower limit of its sale price but does not fix upper limit of Sale price
Summary of Call and Put Spot Price of UA > Strike Price Spot Price of UA < Strike Price
Option
Call Option Put Option Call Option Put Option
Exercise of Option Yes No No Yes
In case of Delivery, Strike Price Market Price Market Price Strike Price
Purchase Price/Sale Price
In Case of Settlement, Spot Price-Strike Price Nil Nil Strike Price – Spot Price
Gain/Loss to Holder
Status In the Money Out of the Money Out of the Money In the Money
Risk of Holder & Maximum gain to Holder Unlimited

Writer in Option
Maximum loss to Holder Premium
Maximum gain to Writer Premium
Maximum loss to Writer Unlimited
American Options: The option holder can exercise the right to buy or sell, at anytime before the expiration or on the expiration date.
European option: The right can be exercised only on the expiry date and not before.
Naked Options and A call option is called a Covered option if it is covered/written against the assets owned by the option writer.
Covered Options: On the other hand, if the option is not covered by the physical asset, it is known as Naked option.
Long and short Buyer of an option = long position

position Seller of an option = short position
11A.3 Calculation of Gain/(Loss) on Settlement of Option 1-3 N-11 N-12

M-10-O
M-10
N-09-O
M-09-O
N-08
M-06
11A.4 Calculation of Value of If Spot Price of Underlying Assets is given on Maturity Date 4 N-12
Option/Intrinsic Value of Call OptionExpiry = Max[(Spot Price – Strike Price),0]
Value at expiration N-10
Value of Put OptionExpiry = Max[(Strike Price – Spot Price),0]
If more than one Spot Price of Underlying Assets is given on Maturity Date with Probability
EVOExpiry = VO1P1 + VO2P2 + VO3P3 + VO4P4
Where VO is value of Option at each price of UA
11A.5 Factors affecting The valuation of an option depends upon a number of factors relating to the underlying asset and the 5
value of Option financial market. Some of these factors are:
a) Current value of the Underlying Asset.
b) Future Price:
c) Strike price of the option: The exercise of the option depends upon the difference between the
strike price and the actual price of the underlying asset. In case of call option, the value of option will
decline as the strike price increases, and in case of put option, the value of the option will increases
as the strike price increases.
d) Expiration time of Option: The longer the time to expiry, higher would be the value of the option.
e) Rate of Interest: The option holder has to pay the option premium up front, i.e., in advance to buy
the option. So, there is always an opportunity cost of this premium. Increase in interest rate will
increase the value of the call option but will reduce the value of the put option.
f) Income from Underlying Asset: During the life of the option, there may arise interest or dividend
income on the underlying assets. The value of the asset will decrease, as the interest or dividend is
paid. So, the value of the call option decreases and the value of the put option increases as more and
more interest and dividends are paid on the underlying assets.
Summary of effect of various factors on value of option
Factor Call Option Value Put Option Value
Increase in value of Underlying Asset Increases Decreases
Extent of Volatility in Value of Asset Increases Increase
Increase in Strike Price Decreases Increases
Longer Expiration Time Increases Increases

Increase in Rate of Interest Increases Decreases
Increase in Income from Asset Decreases Increases
11A.6 Uses of Option 6
Hedging: If Holder of Option buys option for actual delivery, then such transaction is known as hedging. In this case, only Sale/Purchase is to be done
through option
Speculative If any person buys or sells option only for earning profit not for actual delivery, then such transaction is known as speculative transaction.
Transaction Such transaction involves risk. It involves, both sale and purchase are to be done through option
Arbitrage Profit If any person buys or sells option to earn risk less profit on the basis of fair value and actual value of option. Such transaction does not involve
any risk. It involves, both sale and purchase are to be done through option
11A.6.1 Hedging of Foreign In Forex, hedging is done in following ways: 7-11 N-15
Exchange receivable/
Payable through Option (a) If LHC is to be sold in future, then we should buy Put option for hedging of sale price of LHC at given N-13
strike rate. M-10
(b) If LHC is to be purchased in future, then we should buy Call option for hedging of purchase price of LHC M-07
at given strike rate.
11A.7 Breakeven Point for Breakeven Point for Call Option = Strike Price + Premium Paid 12
Call or Put Option Breakeven Point for Put Option = Strike Price - Premium Paid
11A.8 Calculation of Value The value of option is the price at which it can be purchased or sold. Premium payable on option is also
of Option at known as value of option. There are 5 approaches for calculation of value of option.
beginning
(a) Expected Gain Approach
(b) Price Difference Approach
(c) Binomial Model
(d) Risk Neutral Method
(e) Black Scholes Model

11A.9 Expected Gain First we will calculate value of option at expiration. 13
Approach
Then we will calculate value of option at beginning.
TFV of Option today = PV of [Value of Option at expiration]
If interest rate is NCC TFV of Option today = Value of Option at expiration*PVF
If interest rate is CC TFV of Option today = Value of Option at expiration*e-rt
11A.10 Price Differential Under price differential approach, the value of option is taken as equal to difference between PV of Strike 14
Approach Price and Spot Price on the valuation date.
Value of Call Option at Spot Price of Underlying Assetstoday – PV of Strike Price

beginning
Value of Put Option at PV of Strike Price - Spot Price of Underlying Assetstoday
beginning
Calculation of Arbitrage If CMP of Call Option < TFV of Call Option, then arbitrage profit is possible, otherwise not possible. Steps for
Profit from Call Option Arbitrage Profit
under Price Differential
Approach
Steps for calculation of Today

Arbitrage Profit Buy Call Option at CMP = a
Assuming we have one Share, and sell it at CMP = b
Investment (c) = (b – a) at interest rate given
At Maturity date
Gain on Settlement of Call Option = (d)
Purchase of Share from Market = (e)
Realization from Investment (f) = (c)*(1+PIR) or (c)*ert
Arbitrage Profit = (d) + (f) – (e)
Calculation of Arbitrage If CMP of Put Option < TFV of Put Option, then arbitrage profit is possible, otherwise not possible. Steps for 15
Profit from Put Option Arbitrage Profit
under Price Differential
Approach
Steps for calculation of Today

Arbitrage Profit Buy Put Option at CMP = a
Buy one Share at CMP = b
Borrow (c) = (a – b) at interest rate given
At Maturity date
Gain on Settlement of Put Option = (d)
Sale of Share in Market = (e)
Repayment of Borrowing (f) = (c)*(1+PIR) or (c)*ert
Arbitrage Profit = (d) + (e) – (f)
11A.11 Binomial Model/Tree Assumption of BM

Method CMP of share is S and it can take two possible values at maturity, S1 or S2 such that S1 > S > S2.
Borrowing = ∆*S2/(1+r) OR (∆*S1-nC1)/(1+r)
Calculation of Value of The investor can borrow or lend an amount (B) at risk free rate of interest 'r' 16
Option today under BM The strike price, K, is given
C1 = Value of the option at S1 price at expiration = Max((S1-K),0)
C2 = Value of the option at S2 price at expiration = Max((S1-K),0)
Hedge Ratio is known as delta. It refers to the number of units of stock one should hold for each option sold
to create a risk-free hedge.
Hedge Ratio (∆) = (C1 - C2) /(S1- S2)
Value of Call Option under BSM = ∆*CMP of Share – Borrowing
Replicating Portfolio The BM is based on the concept of Replicating Portfolio, which refers to a portfolio consisting of the
underlying asset and a riskless asset, which generates the same cash flow as a specified call/put option.
Borrowing + ∆ number of units of the underlying asset
Arbitrage Profit Steps for Arbitrage Profit

under BM Model
If CMP of a Call Option Today

> TFV of Call Option Sell Call Option at CMP
Buy Replicating Portfolio
Buy ∆ no of shares at CMP
Borrow at interest rate given
Maturity Date
Loss on settlement of Call option (Writer)
Settlement of Replicating Portfolio
Sell ∆ no of shares at Market Price
Repayment of Borrowing
If CMP of a Call Option Today

< TFV of Call Option Buy Call Option at CMP
Sell Replicating Portfolio
Sell ∆ no of shares at CMP
Deposit at interest rate given
Maturity Date
Gain on settlement of Call option (Holder)
Settlement of Replicating Portfolio
Buy ∆ no of shares at Market Price
Realisation of Deposit
11A.11.1 Risk Neutralisation The current price of the share is S and it can take two possible values at maturity, S1 or S2 such that S1 > S 17-21 N-15 M-13
Method > S2.
M-13
Calculation of Option Probability of S1 (P1) = (CMP of Share*(1+PIR) – S2)/(S1 – S2)
M-12
under RNM Probability of S2 (P2) = 1 – P1
M-11
Value of Option at expiration = C1P1 + C2P2
If interest rate is NCC TFV of Option today = Value of Option at expiration*PVF
If interest rate is CC TFV of Option today = Value of Option at expiration* e-rt
Calculation of P1 for S1 = [SP x (1+r)/SP – LP/SP]/[HP/SP – LP/SP] = [1+r – d/u – d]

Probability in
alternative way Where r = PIR; u = S1/S; d = S2/S
11A.11.2 Value of Option for In case of Foreign exchange transaction, interest rate is given for LHC and RHC. 22
foreign currency under P1 = (CMP of Share*(1+PIRHC) - S2*(1+PILHC))/(S1*(1+PILHC) - S2*(1+PILHC))
RNM
11A.11.3 Value of Option under TFV of Option under BM = ∆*(CMP of Share – PV of Dividend) – Borrowing 23
BM or RNM if Dividend Under RNM P1 = [CMP of Share*(1+PIR) – Future Value of Dividend] - S2/(S1 - S2)
is paid
11A.11.4 Two Stage binomial In this case, we will apply movements of price for two periods. 24-25 M-09
method
11A.12 Black Scholes Models BSM computes the fair value of a call option on a share on the basis of five function 26 N-08
CMP of Share (S) N-06
Strike Price (K)

Time to expiry (t)
Interest rate (r) = It is always Continues Compounding
Volatility of the underlying assets (σ) = SD of continuously compounded return of the asset
The model is based on (a) The option is the European option;

the following
(b) The underlying shares do not pay any dividend during the option period;
assumptions;
(c) There are no taxes and the transaction cost;
(d) Share prices move randomly in continuous time;
(e) The short term risk free rate is known and is constant during option period
(f) The short selling in share is permitted without penalty.
Steps for calculation of d1 = [In([S - PV of Dividend]/K) + (r + 0.5 σ2)t]/σ√t

Option under BSM
In = Natural Log i.e. log to the base e.
d2 = d1 - σ√t
Calculate N(d1) and N(d1) = Normal Distribution function of d1

N(d2) from Table
It represents the hedge ratio of shares to Options necessary to maintain a fully hedge position.
Value of Call option = S*N(d1) – K*e-rt xN(d2)

today
11A.12.1 The BSM and the The market price of the share will go down after the payment of the dividend. The value of call option will 27
dividend Payment decrease and the value of the put option will increase as more and more dividends are paid.
Value of call option = (S-PV of Dividend)*N(d1) – K*e-rt *N(d2)
Value of Put option = (S-PV of Dividend)*N(d1) – Strike Price*e-rt *N(d2)
11A.12.2 Value of Put Option K*e-rt *[1-N(d2)] – S*[1-N(d1)] 28

under BSM
11A.13 Different Type of By adopting following strategy, we may earn certain profit in option
Strategy for earning
profit through Option
11A.13.1 Strangle Buy a put and a call option with the same expiration date but with different exercise prices 29-30
Strike Price of the Put (K1)< Strike Price of Call (K2)

Expiry date of Put = Expiry date of Cal
On Maturity date
CMP of UA > K2, Call Option will be exercised
CMP of UA < K1, Put Option will be exercised
K1 < CMP of UA < K2, both option will be lapsed
Strangle is purchased when there is strong move in the market which may be up or down.l
11A.13.2 Straddle Buy/Sell a put and a call option with the same expiration date and same exercise prices 31-32 M-09
Strike Price of the Put (K) = Strike Price of Call (K)

Exercise price of Put = Exercise Price of Call
On Maturity date
CMP of UA > K, Call Option will be exercised
CMP of UA < K, Put Option will be exercised
CMP of UA = K, both option will be lapsed
Straddle is purchased/sold when there is strong move in the market which may be up or down.
11A.13.3 Strips Buy one Call + Buy 2 Puts all with the same exercise price and date of expiration. 33

Expiry Date of Call = Expiry date of Put
On Maturity date
CMP of UA > K, Call Option will be exercised
CMP of UA < K, 2 Put Option will be exercised
Strips is purchased when investor feels that decrease in the stock price is more likely than an increase.
11A.13.4 Straps Buy 2 Call + Buy 1 Puts all with the same exercise price and date of expiration.
Expiry Date of Call = Expiry date of Put
On Maturity date
CMP of UA > K, 2 Call Option will be exercised
CMP of UA < K, 1 Put Option will be exercised
Strap is purchased when investor feels that increase in the stock price is more likely than decrease.
11A.13.5 Butter Flies It involves positions in options with three different strikes prices. 34
Buying a Call at relatively low strike price = K1

Buying a Call at relatively High strike price = K2
Selling 2 Calls at average of K1 and K2 [K3 = (K1+K2)/2]
Expiry Date of all Calls are equal
It is adopted by those who expect insignificant movements in the market price.
This strategy has limited risk and limited profit.
A butterfly can be created using put option
11A.13.6 Condor Spread It is similar to the butterfly spread but involves 4 strike prices instead of 3 strike prices, resulting in a winder 35
profitable range. The strategy can be either call based or put based (but never with calls and puts used
together in the same trade).
Buying 1 Call Option with K1 < S

Selling 1 Call Option with K = S
Selling 1 Call Option with K2 > S
Buying 1 Call Option K3 > K2
Expiry Date of all Calls are equal
This strategy is adopted by those operators who expect insignificant movements in the market price of
underlying asset. This strategy may result in small amount of profit with limited loss.
11A.13.7 BULL SPREADS This strategy is used by those who expect that the market price of the underlying asset will go up. This
trading strategy can be accomplished with either puts or calls.
Bull Call Spread Buy 1 Call at K1 + Sell 1 Call at K2 with the same date of expiration. 36 M-12
K1 < K2
Bull Put Spread Buy 1 Put at K1 + Sell 1 Put at K2 with the same date of expiration. 37
K1 < K2
The options trader employing this strategy hopes that the price of the underlying securities goes up
11A.13.8 Bear spread It is entered by the operators who expect that the prices of underlying asset will decline.
Bear Call Spread Buy 1 Call at K1 + Sell 1 Call at K2 with the same date of expiration. 38
K1 > K2
Bear Put Spread Buy 1 Put at K1 + Sell 1 Put at K2 with the same date of expiration. 39
K1 > K2
11A.13.9 CALENDER SPREAD
Bull calendar spread The strategy is used by those who expect a bullish tendency in the prices. In this strategy the options have
the same strike price but different dates of maturities. The strategy can be either call based or put based (but
never with calls and puts used together in the same trade.
Call based strategy: The operator buys call which long maturity period and sells the call with short maturity period on the same
underlying asset with same strike price. Generally the option premium of the long term call is more than of
short term call; the strategy generally requires an initial investment.
Buy 1 Call at K + Sell 1 Call at K with different date of expiration.

Maturity Period of Call 1 > Maturity Period of Call 2
A bear calendar It is used by option traders who believe that the price of the underlying security will remain stable in the near
Spread term but will eventually fall in the long term. In this case, the operator buys put with long maturity period
and sells the put with short maturity period on the same underlying asset with same strike price.
Buy 1 Put at K + Sell 1 Put at K with different date of expiration.

Maturity Period of Put 1 > Maturity Period of Put 2
Summary of above
Strategies
Strategies Option Option Maturity Date Strike Price
Strangle Buy 1 Call Buy 1 Put Same K of the Put < K of Call
Straddle Buy 1 Call Buy 1 Put Same K of the Put = K of Call
Strips Buy 1 Call Buy 2 Put Same K of the Put = K of Call
Straps Buy 2 Call Buy 1 Put Same K of the Put = K of Call
Butter Flies Buy 1 Call at K1 Sell 2 Call at K3 Same K1 > K2 and

K3 = (K1+K2)/2
Buy 1 Call at K2
Condor Spread Buy 1 Call at K1 Sell 1 Call at K Same K1 < S; K = S

K2 > S; K3 > K2
Buy 1 Call at K3 Sell 1 Call at K2
Bull Call Spread Buy 1 Call at K1 Sell 1 Call at K2 Same K1 < K2

Bear Call Spread Buy 1 Call at K1 Sell 1 Call at K2 Same K1 > K2
Bull Put Spread Buy 1 Put at K1 Sell 1 Put at K2 Same K1 < K2
Bear Put Spread Buy 1 Put at K1 Sell 1 Put at K2 Same K1 > K2
Bull Calendar Spread Buy 1 Call1 at K Sell 1 Call1 at K MP of Call1 > MP of Same
Call2
Bear Calendar Spread Buy 1 Put1 at K Sell 1 Put1 at K MP of Put1 > MP of Put2 Same
11A.14 Theory
Write short notes on Function of Stock Exchange M-11
What is a “derivatives’ M-04
What is the meaning of underlying in relation to a derivative instrument? M-11
Write short notes on the Option. N-02
Factors affecting value of an option M-14
State any four assumptions of Black Scholes Model M-15

Chap – 11A OPTIONS 11AB.1
11A.0 INDIAN CAPITAL MARKET
Broadly Indian Financial Market consists of Capital Market, Money Market and the Debt Market. The
organized part of the Indian financial system can be classified from the point of view of regulatory authority
as
RBI regulating Commercial Banks, Foreign Exchange Markets, Financial Institutions and Primary Dealers.
Primary Dealers are registered participants of the wholesale debt market and bid at auctions for
Government Debt, treasury bills.
SEBI regulating Primary Market, Secondary Market, Derivatives Market and market intermediaries like
Mutual Funds, Brokers, Merchant Banks, depositories.
11A.0.1 INDIAN CAPITAL MARKET
(a) CAPITAL MARKETS/SECURITIES MARKET

The capital markets are relatively for long term financial instruments.
Role of Capital Market

(a) It is the indicator of the inherent strength of the economy.
(b) It is the largest source of funds with long and indefinite maturity for companies and thereby
enhances the capital formation in the country.
(c) It offers a number of investment avenues to investors.
(d)It helps in channeling the savings pool in the economy towards optimal allocation of capital in the
country.
(b) The capital market is divided into primary and secondary stock market.
Primary Market: A market where new securities are bought and sold for the first time is called the
New Issues market or the IPO market. The Primary market also includes issue of further capital by
companies whose shares are already listed on the stock exchange.
Secondary Market A market in which an investor purchases a security from another investor rather
than the issuer, subsequent to the original issuance in the primary market. So, it can be stated that
secondary markets are the stock exchanges and the over-the-counter market.
(c) Differences between Primary and Secondary Markets

(a) Nature of Securities: The primary markets deals with new securities. The stock market, on the
other hand, is a market for old securities. The stock exchanges, therefore, provide a regular and
continuous market for buying and selling of securities.
(b) Nature of Financing: Primary market provides additional funds to the issuing companies either for
starting a new enterprise or for the expansion or diversification of the existing one. In contrast,
the secondary markets can in no circumstance supply additional funds since the company is not
involved in the transaction.
(c) Organisational Differences: The stock exchanges have physical existence and are located in a
particular geographical area. The primary market is not rooted in any particular spot and has no
geographical existence. It is recognized only by the services that it renders to the lenders and
borrowers of capital funds at the time of any particular operation.
11A.0.2 STOCK MARKET AND ITS OPERATIONS

Secondary markets are also referred to as Stock Exchange.
It is a place where the securities issued by the Government, public bodies and Joint Stock Companies are
traded.
There are 24 Stock Exchanges in the country at present, out of which only eight have been given permanent
recognition; others need to apply every year for recognition.
Leading Stock Exchanges in India: The two leading stock exchanges in India are Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE). A brief about them is as under:
Bombay Stock Exchange Limited: It is the oldest stock exchange in Asia with a rich heritage. It was
established as "The Native Share & Stock Brokers Association" in 1875. It is the first stock exchange in the
country to obtain permanent recognition in 1956 from the GOI under the Securities Contracts (Regulation)
Act, 1956. Its index, SENSEX, is tracked worldwide. Earlier an Association of Persons (AOP), the Exchange is
now a demutualised and corporatised entity incorporated under the provisions of the Companies Act, 1956,
pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and
Exchange Board of India (SEBI).
The Exchange has a nation-wide reach with a presence in 417 cities and towns of India. During the year
2004-2005, the trading volumes on the Exchange showed robust growth.
The Exchange provides an efficient and transparent market for trading in equity, debt instruments and
derivatives. The BSE's On Line Trading System (BOLT) is a proprietory system of the Exchange and is BS
7799-2-2002 certified. The surveillance and clearing & settlement functions of the Exchange are ISO
9001:2000 certified.
National Stock Exchange: NSE was promoted by leading Financial Institutions at the behest of the GOI and
was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country.
On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993,
NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market
(Equities) segment commenced operations in November 1994 and operations in Derivatives segment
commenced in June 2000.
It uses satellite communication technology to energise participation from around 320 cities spread all over
the country. NSE can handle up to 6 million trades per day in Capital Market segment.
NSE is one of the largest interactive VSAT based stock exchanges in the world. Today it supports more than
3000 VSATs. The NSE- network is the largest private wide area network in the country and the first
extended C- Band VSAT network in the world. Currently more than 9000 users are trading on the real time-
online NSE application. There are over 15 large computer systems which include non-stop fault-tolerant
computers and high end UNIX servers, operational under one roof to support the NSE applications. This
coupled with the nation wide VSAT network makes NSE the country's largest Information Technology user.
The trading intensity of Indian stock exchanges is impressive by world standards. Among the biggest
exchanges, measured by the number of trades per calendar year, NSE retained rank 3 in all the four years.
BSE climbed from rank 7 to rank 5 between 2002 and 2003, and has stayed at rank 5 ever since.
11A.0.3 Functions of Stock Exchanges

[May-2011-6bi-4] Write short notes on Function of Stock Exchange
Functions of the stock exchanges can be summarized as follows:
(a) Liquidity and Marketability of Securities: Stock market creates continuous market for securities,
enabling them to be liquidated, where investors can convert their securities into cash at any time at the
prevailing market price. Investors can change their portfolio as and when they want to change, i.e. they
can at any time sell one security and purchase another.
(b) Fair Price Determination: This market is almost a perfectly competitive market as there are large
number of buyers and sellers. Due to nearly perfect information, active bidding take place from both
sides. This ensures the fair price to be determined by demand and supply forces.
(c) Source for Long term Funds: Securities are traded and change hands from one investor to the other
without affecting the long-term availability of funds to the issuing companies.
(d) Helps in Capital Formation: There are the nexus between the savings and the investments of the
community.
(e) Reflects the General State of Economy: The performance of the stock markets reflects the boom and
depression in the economy. It indicates the general state of the economy to all those concerned, who
can take suitable steps in time.
11A.1 Derivatives
[May-2004] [M-6] [May-2003] [M-6] What is a “derivatives’? Briefly explain the recommendation of the
L C Gupta Committee on derivatives.
[Nov–2007-5c-8]
(a) What are derivatives?
(b) Who are the users and what are the purposes of use?
(c) Enumerate the basic differences between cash and derivatives market.
[May-2011-7d-4] [RTP-May-2014-20d] What is the meaning of underlying in relation to a derivative

instrument?
(a) Derivatives:
It is a financial asset which derives its value from some specified underlying assets.
The transactions in derivatives are settled by the offsetting in the same derivative. The difference in
value of the derivatives is settled in cash.
There is no limit on number of units transacted in the derivative market because there is no physical
assets to be transacted.
(b) Types of Derivatives

Commodity derivatives and financial derivatives:
Commodity Derivatives contract can be entered into for different type commodity such as sugar, Jute,
Gur etc.
Basic derivatives and Complex derivatives:

Complex Derivatives: OTC Derivatives [Over the counter]
(a) Interest Swaps;
(b) Caps, Floor and Collar;
(c) Forward Rate Agreement;
(d) Swaptions;
(e) Currency Swaps;
(f) Forward Contracts;
(c) Function of Derivatives Markets
They help in transferring risk from risk averse people to risk oriented people.
They help in discoveries of future prices.
(d) Users of Derivatives market

(a) Hedgers ;
(b) Speculators;
(c) Arbitrages;
Ex of Derivative Instrument
Today date = 01/01/2012
Today price of Flat = Rs 95000 = known as spot price
Mr A wants to purchase flat on 31/03/2012, but he has fear that price of flat may go up, then how he can hedge himself
from rising of prices.
To hedge himself he can enter into contract on 01/01/2012 for purchase of flat on 31/03/2012
Mr A has entered into Contract for purchase of flat with Mr B. Terms of the Contract are as follows
Date of Contract = 01/01/2012
Contract price of Flat = Rs.100000 [Strike Price or Contracted Price or Forward Price, Specified Price]
Date of maturity = 31/03/2012 [Strike Date, Expiry date, Maturity Date, Specified Date]
Benefit of Contract
By entering into contract Mr A has fixed its purchase price of Flat at Rs.1 lacs.
Even if price of flat increases/decreases, Mr A has to pay Rs.1 lac.
Now suppose,
Actual price of flat increase or decrease as follows
In case of Settlement (Speculative In case of Delivery (Hedging)
Transaction)
Date Actual price of Long Position of Short Position of Purchase price for Sale price for Mr
Flat Mr A Mr B Mr A B
05/01/2012 Rs.1.2 Lacs +0.2 -0.2 Rs.1 Lacs Rs.1 Lacs
15/03/2012 Rs.0.9 Lacs -0.1 +0.1 Rs.1 Lacs Rs.1 Lacs
Why this gain or loss arises to each party of contract

This is because of Contract between A and B
This contract is known as Derivative Instrument
Gain or loss due to contract arises due to change in prices of flat [Under lying Assets]
Hence contract derives its value from Flat [Underlying Assets]
Value of the derivative instrument [Contract] is equal to gain or loss to each party.
The same type of contract can be done for shares, debenture, etc through stock exchange.
11A.2 Option
[Nov-2002] [M-3] Write short notes on the Option.
[Nov-1997] [M-5] Call and put option with reference to debentures.
(a) Options: Options are contracts which provide the holder the right to sell or buy a specified quantity
of an underlying asset at a fixed price on or before the expiration of the option date.
The holder of the option can exercise the option at his discretion or may allow the option to
lapse.
(b) Call Option: It provides to the holder a right to buy specified assets at specified price on or before a
specified date.
(c) Put option: It provides to the holder a right to sell specified assets at specified price on or before a
specified date.
(d) Strike or Exercise Price: The specified price at which the option can be exercised is known as the
Strike Price.
(e) Buyer/ Holder of Option
Person who buys Call/Put Option is called the buyer or holder of Option. Or
The person who has right to buy/sell underlying assets is called the buyer or holder of Option
(f) Writer/ Seller of Option
Person who sells Call/Put Option is called the Seller or writer of Option. Or
The person who has obligation to buy/sell underlying assets is called Seller or writer of Option of
Option
(g) Option Premium/Price:
In options, the buyer pays option premium to seller.
The premium is a one-time non-refundable amount for availing the right.
In case, the right is not exercised later, then the premium is not refunded by the option writer.
Understanding of Call Option

On 01/01/2012 Ram enters into contract with Shyam with following terms & Conditions
(a) Ram has the right but not the obligation to buy 100 shares of A Ltd on 31/03/2012 @ Rs.50 per shares.
(b) If Ram does not exercise the rights of purchase, then Shyam can not sell it to Ram.
(c) It means ram has purchased the [Rights of Purchase] from Shyam.
(d) Ram has to pay premium [Cost of Rights of Purchase] to Shyam say Rs.5 per share.
Spot price of Shares of A Ltd as on 01/01/2012 = Rs.45

Price of Call Option as on 01/01/2012 = Rs.5
What is the benefit and obligation of above contract to Ram and Shyam
On 31/03/2012
Benefit/(Loss) of Call Option to Ram and Shyam
Actual Market price of share on 31/03/2012 Rs.35 Rs.43 Rs.50 Rs.60 Rs.70
Ram has Rights to Purchase share from Shyam at Rs.50 Rs.50 Rs.50 Rs.50 Rs.50
Where from Ram should buy shares (Lower of above) Market Market Market or Shyam Shyam
Shyam
Exercise of Call option by Ram No No May Yes Yes
Option 1 In case of Hedging/ Actual Delivery
Purchase price of Share to Ram Rs.35 Rs.43 Rs.50 Rs.50 Rs.50
Sell price of Share to Shyam Rs.35 Rs.43 Rs.50 Rs.50 Rs.50
Option 2 In case of Settlement/ Speculative Gain/Loss on maturity date
Gain to Ram due to exercise of Call Option 0 0 0 Rs.10 Rs.20
Loss to Shyam due to exercise of Call Option by Ram 0 0 0 Rs.10 Rs.20
Calculation of net gain/(Loss) = Gain on Maturity –
Premium Paid
Net Gain/(Loss) to Ram -Rs.5 - Rs.5 - Rs.5 Rs.5 Rs.15
Net Gain or (Loss) to Shyam Rs.5 Rs.5 Rs.5 - Rs.5 -Rs.15
Status of Option Out Out At In In
On Maturity Date
(h) Exercise of Call Option

If Spot Price of underlying assets > Strike Price Yes
If Spot Price of underlying assets < Strike Price No
(i) Hedging through Call Option
If Holder actually purchase Share through call option, then this transaction is known as hedging.
If Spot Price of underlying assets > Strike Price Purchase/Sale Price = Strike Price
If Spot Price of underlying assets < Strike Price Purchase/Sale Price = Market Price
(j) Speculative Transaction
If Holder is not required to buy any shares and he has purchased call option for profit purpose, then
this transaction is known as speculative transaction. Gain or loss in such transaction is known as
speculative gain or loss.
If Spot Price of underlying assets > Strike Price Gain/(Loss) = Spot Price of UA – Strike Price
If Spot Price of underlying assets < Strike Price Gain/(Loss) = Nil
(k) Value of Call Option at expiration
If Spot Price of underlying assets > Strike Price Value of Call Option = Spot Price of UA – Strike Price
If Spot Price of underlying assets <= Strike Price Value of Call Option = Nil
(l) Status of Call Option
If Spot Price of underlying assets > Strike Price In the Money
If Spot Price of underlying assets < Strike Price Out of the Money
If Spot Price of underlying assets = Strike Price At the Money
(m) By buying Call option Holder fixes upper limit of its purchase price but does not fix lower limit of
purchase price
Ex of Put Option
On 01/01/2012 Ram enters into contract with Shyam with following terms & Conditions
(a) Ram has the right but not the obligation to sell 100 shares of A Ltd on 31/03/2012 @ Rs.52 per shares.
(b) If Ram does not exercise the rights of sale, then Shyam can not buy share from Ram.
(c) It means Ram has purchased the [Rights of Sale] from Shyam. In other words, Ram has purchased Put
Option from Shyam
(d) Ram has to pay premium [Cost of rights of sale] to Shyam say Rs.6 per share.
Say Spot price of Shares of A Ltd as on 01/01/2012 = Rs.45

While spot price of Put Option [Right of Sale] as on 01/01/2012 = Rs.6
What is the benefit and obligation of above contract to Ram and Shyam
On 31/03/2012
Spot Price of Share as on 31/03/2012 Rs.35 Rs.43 Rs.52 Rs.60 Rs.70
Ram has the rights to sell share to Shyam at Strike Rs.52 Rs.52 Rs.52 Rs.52 Rs.52
Price
Where should Ram sell Shares Shyam Shyam Market Market Market
[Ram should sell at higher of Spot and Strike]
Exercise of Put option by Ram (Holder of Put Yes Yes No No No
option)
Option 1 In case of Hedging/ Actual Delivery
Sale price of Share to Ram 52 52 52 60 70
Purchase price of Share to Shyam 52 52 52 60 70
Option 2 In case of Settlement/ Speculative Gain/Loss on maturity date
Gain to Ram due to exercise of Put Option 17 9 0 0 0
Loss to Shyam due to exercise of Put Option by 17 9 0 0 0
Ram
Calculation of net gain/(Loss) = Gain on Maturity – Premium Paid
Net Gain/(Loss) to Ram 13 3 -6 -6 -6
Net Gain or (Loss) to Shyam -13 -3 6 6 6
Status of Option In In At Out Out
On Maturity Date
(n) Exercise of Put Option

If Spot Price of underlying assets > Strike Price No
If Spot Price of underlying assets < Strike Price Yes
(o) Hedging through Put Option

If Holder actually sell Share through Put option, then this transaction is known as hedging.
If Spot Price of underlying assets > Strike Price Purchase/Sale Price = MarketPrice
If Spot Price of underlying assets < Strike Price Purchase/Sale Price = Strike Price
(p) Speculative Transaction
If Holder is not required to sell any shares and he has purchased put option for profit purpose,
then this transaction is known as speculative transaction. Gain or loss in such transaction is
known as speculative gain or loss.
If Spot Price of underlying assets > Strike Price Gain/(Loss) = Nil
If Spot Price of underlying assets < Strike Price Gain/(Loss) = Strike Price - Spot Price of UA
(q) Value of Put Option at expiration
If Spot Price of underlying assets > Strike Price Value of Put Option = Nil
If Spot Price of underlying assets <= Strike Price Value of Put Option = Strike Price - Spot Price of UA
(r) Status of Put Option

If Spot Price of underlying assets > Strike Price Out of the Money
If Spot Price of underlying assets < Strike Price In the Money
If Spot Price of underlying assets = Strike Price At the Money
(s) By buying Put option Holder fixes lower limit of its sale price but does not fix upper limit of Sale
price
(t) Summary of Call and Put Option
Particulars Spot Price of UA > Strike Price Spot Price of UA < Strike Price
Call Option Put Option Call Option Put Option
Exercise of Option Yes No No Yes
In case of Delivery or Hedging, Strike Price Market Price Market Price Strike Price
Purchase Price/Sale Price
In Case of Settlement, Gain/Loss to Spot Price-Strike Nil Nil Strike Price –
Holder [Speculative Transaction] Price Spot Price
Status In the Money Out of the Money Out of the Money In the Money
(u) Risk of Holder & Writer in Option
Maximum gain to Holder Unlimited

Maximum loss to Holder Premium
Maximum gain to Writer Premium
Maximum loss to Writer Unlimited
(v) American Options: The option holder can exercise the right to buy or sell, at anytime before the
expiration or on the expiration date.
European option: The right can be exercised only on the expiry date and not before.
The possibility of early exercise of right makes the American option to be more valuable than the
European option to the option holder.
(w) Naked Options and Covered Options: A call option is called a Covered option if it is covered/written
against the assets owned by the option writer. In case of exercise of the call option by the option
holder, the option writer can deliver the asset or the price differential. On the other hand, if the option
is not covered by the physical asset, it is known as Naked option.
(x) Long and short position:
Buyer of an option = long position
Seller of an option = short position
(y) Today 01/09/2012

There will be maximum 3 Options on same underlying assets of 3 different maturity dates
Sep Call, Oct Call, Nov Call.
Option is settled on last Thursday of month.
(z) Option is distinguished by Underlying Assets, Maturity Date and Strike Price.
Today Date = 10/09/2012
CMP of Share of X Ltd = Rs.100
Call Option on Share’s of X Ltd may be as follows for Sep month
Sep Call 120, Sep Call 140, Sep Call 110 etc. All three Call options are different product.
11A.3 Calculation of Gain/(Loss) on Settlement of Option

ICAI IRPT ICWA
M-06 M-07 N-12 17
N-08 M-06
M-09-O M-10
N-09-O M-06
M-10-O M-06
M-10 M-04
N-11 M-08
Question-1 [May-2009-O] [M-10] The equity share of VCC Ltd is quoted at Rs.210. A 3-month call
option is available at a premium of Rs.6 per share and a 3-month put option is available at a premium of Rs.
5 per share.
The strike price in both cases in Rs. 220; and
The share price on the exercise day is Rs.200, 210, 220, 230, 240.
(a) Calculate purchase price/Sale Price of Holder in case of actual delivery. [Not part of Q]
(b) Calculate Gain/(Loss) of Holder in case of settlement. [Not part of Q]
(c) Ascertain the net payoffs to the option holder of a call option and a put option.
(d) Ascertain the status of Option. [Not part of Q]
Also indicate the price range at which the call and the put options may be gainfully exercised.
Question-1A [May-2010-O] [M-6] [RTP-Nov-2012-17] [SP]
A call and put exist on the same stock each of which is exercisable at Rs.60. They now trade for:
Market price of stock or stock index Rs.55
Market price of call Rs.9
Market price of put Re.1
Calculate the expiration date cash flow, Investment Value, and net profit from:
(a) Buy 1 call
(b) Write 1 call
(c) Buy 1 put
(d) Write 1 put
For expiration date stock prices is Rs.50, Rs.55, Rs.65, Rs.70
Question-2 [May-2006] [M-7] [ICWA-June-2007] The market received rumour about ABC
corporation's tie-up with a multinational company. This has induced the market price to move up. If the
rumour is false, the ABC corporation stock price will probably fall dramatically. To protect from this an
investor has bought the call and put options.
He purchased one 3 months call with a striking price of Rs.42 for Rs.2 premium, and paid Re. 1 per share
premium for a 3 months put with a striking price of Rs.40.
(a) Determine the Investor's position if the tie up offer bids the price of ABC Corporation's stock up to Rs.43
in 3 months.
(b) Determine the Investor's ending position, if the tie up programme fails and the price of the stocks falls
to Rs.36 in 3 months.
Question-2A [Nov-2008] [M-6] [Nov-2009-O] [M-6] [Nov-2011] [M-8] [May-2010] M-4] [SP] Mr.
X established the following spread on the Delta Corporation's stock
(i) Purchased one 3-month call option with a premium of Rs.30 and an exercise price of Rs.550.
(ii) Purchased one 3-month put option with a premium of Rs. 5 and an exercise price of Rs.450.
Delta Corporation's stock is currently selling at Rs.500. Determine profit or loss, if the price of Delta
Corporation's:
(a) remains at Rs.500 after 3 months.
(b) falls at Rs.350 after 3 months.
(c) rises to Rs.600.
Assume the size option is 100 shares of Delta Corporation.
Question-3 [ICWA-Dec-2008] Rax Investments Ltd. deals in equity derivatives. Their current portfolio
comprises of the following investments.
Infosys Rs.1,400 Call expire December 2010 200 units bought at Rs.50 each (cost)
Infosys Rs.1,425 Call expire December 2010 3,000 units bought at Rs.33 each (cost)
Infosys Rs.1,350 Put expire December 2010 4,000 units bought at Rs.22 each (cost)
What will be the profit or loss to Rax Investments Ltd. in the following situations?
i) Infosys closes on the expiry day at Rs.1,550.
ii) Infosys closes on the expiry day at Rs.1,460.
iii) Infosys closes on the expiry day at Rs.1,280.
(Ignore transaction cost and taxation).
11A.4 Calculation of Value of Option/Intrinsic Value of Option at expiration

ICAI IRPT ICWA
N-10 M-08
N-12 M-08
(a) If Spot Price of Underlying Assets is given on Value of Call OptionExpiry = Max[(Spot Price – Strike Price),0]
Maturity Date Value of Put OptionExpiry = Max[(Strike Price – Spot Price),0]
(b) If more than one Spot Price of Underlying Assets is EVOExpiry = VO1P1 + VO2P2 + VO3P3 + VO4P4
given on Maturity Date with Probability Where VO is value of Option at each price of UA
Question-4 [Nov-2012] [M-8] You as an investor has purchased a 4 month call option on the equity
shares of X Ltd of Rs.10, of which the current market price is Rs.132 and the exercise price Rs.150. You
expect the price to range between Rs.120 to Rs.190. The expected share price of X Ltd and related
probability is given below:
Market price 120 140 160 180 190
Probability 0.05 0.20 0.50 0.10 0.15
Compute the following:
(a) What is the expected value of share price 4 month hence? [Ans: Rs.160.50]
(b) Value of call option at the end of 4 months, if the exercise price prevails. [Rs.10.50]
(c) What is the expected value of option price at expiration. Assuming that the option is held to this time.
[Ans: Rs.14]
Question-4A [Nov-2010] [M-5] [SP] Equity share of PQR Ltd. is presently quoted at Rs.320. The market
price of the share 6 months has the following probability distribution:
Market price 180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
(a) A put option with a strike price of Rs.300 can be written.

(b) You are required to find out expected value of option at (i.e. 6 months) [Ans: Rs.30]
11A.5 Factors affecting value of Option

ICAI IRPT ICWA
[May-2014-7b-4] Factors affecting value of an option

The valuation of an option depends upon a number of factors relating to the underlying asset and the
financial market. Some of these factors are:
b) Future Price: The future price level is a major determinant of the option premium.
c) Strike price of the option: The exercise of the option depends upon the difference between the strike
price and the actual price of the underlying asset. In case of call option, the value of option will decline
as the strike price increases, and in case of put option, the value of the option will increases as the
strike price increases.
Summary of effect of various factors on value of option
Factor Call Option Value Put Option Value
Increase in value of Underlying Asset Increases Decreases
Extent of Volatility in Value of Asset Increases Increase
Increase in Strike Price Decreases Increases
Longer Expiration Time Increases Increases
Increase in Rate of Interest Increases Decreases
Increase in Income from Asset Decreases Increases
Question-5 Assume that TIC Ltd. equity is currently at Rs.500. It is now July 1. Three Call Options are
quoted
TIC (550) Rs.10 Exp. Date 29.11.2002
TIC (500) Rs.50 Exp. Date 29.11.2002
TIC (450) Rs.100 Exp .Date..:..31.1.2003 (Ignore Commissions)
(a) Why the premium on January call (450) is so much higher than the premium on the November (500)
call.
(b) Suppose that you purchased 100 shares of TIC on June 1 at a cost of Rs.475 per share. You wrote (sold)
one contract TIC (450) 31.01.2003 on July 1. Suppose that on 31.1.2003 TIC was at Rs.525.
(i) Would the holder January Call (450) benefit from exercising the call? Why?
(ii) If the call were exercised what is your tax status?
(c) Suppose you do not own TIC shares. You simultaneously write one November (550) and buy one
November (500) call. What is your annualized rate of return if TIC stock closes in November at Rs.575.
(Ignore commissions & dividends).
11A.6 Uses of Option

ICAI IRPT ICWA
M-07 M-08
M-10 M-08
N-13 M-08
N-15 M-05
(a) Hedging: If Holder of Option buys option for actual delivery, then such transaction is known as
hedging. In this case, only Sale/Purchase is to be done through option
(b) Speculative Transaction: If any person buys or sells option only for earning profit not for actual
delivery, then such transaction is known as speculative transaction. Such transaction involves risk. It
involves, both sale and purchase are to be done through option
(c) Arbitrage Profit: If any person buys or sells option to earn risk less profit on the basis of fair value
and actual value of option. Such transaction does not involve any risk. It involves, both sale and
purchase are to be done through option
Ex of hedging for sale

Ram Purchased 1 share of ABC Ltd @300 on 01/01/2012
Ram want to sell these shares on 31/03/2012
How Ram can reduce its risk of sale price.
Ram can buy put option of 3 months of the strike price at which he want to sell the shares say @Rs.350
After 3 months,
Market price of Share Rs.340 Rs.350 Rs.360
Strike price of Put Option Rs.350 Rs.350 Rs.350
Where should Ram sell share Writer Market Market
Sale price for Ram Rs.350 Rs.350 Rs.360
Conclusion: BY buying put option, Ram has fixed lower limit of its sell price but upper limit of sale price is
not fixed.
Hence if market price comes down to Rs.350, he will exercise put option and will sell share at Rs.350.
Hence if market price comes up from Rs.350, he will not exercise put option and will sell share at market
price.
Ex of hedging for purchase

Today Date: 01/01/2012
Ram is to buy 1 share of ABC Ltd @370 on 31/03/2012
How Ram can reduce its risk of increase its purchase price.
Ram can buy call option of 3 months of the strike price at which he want to buy the shares say @Rs.370
After 3 months,
Market price of Share Rs.340 Rs.370 Rs.390
Strike price of Call Option Rs.370 Rs.370 Rs.370
Where from should Ram buy share Market Market Writer
Purchase price for Ram Rs.340 Rs.370 Rs.370
Conclusion: BY buying Call option, Ram has fixed upper limit of its purchase price but lower limit of
purchase price is not fixed.
Hence if market price comes down from Rs.370, he will not exercise call option and will purchase share from
market
Hence if market price comes up from Rs.370, he will exercise call option and will purchase share from write
at strike price.
Question-6 [ICWA-June-2004] A portfolio manager purchased 1000 equity share's of Reliance Industries
Ltd. @ Rs.510 per share. He wants to hedge the position by writing an April call with a strike price of Rs.530
and call premium Rs.10. Alternatively, he wants to hedge by buying put option of strike price Rs.530 and
premium of Rs.10.
(a) Find out his profit or loss if the share price goes up to Rs.560 or Rs.540 or 525 or 490.
(b) Does the strategy of buying a stock and writing a call manage his risk effectively?
(c) Under which circumstance should the portfolio manager buy a put option?
11A.6.1 Hedging of Foreign Exchange receivable/ Payable through Option
(i) In Forex, hedging is done in following ways:

(c) If LHC is to be sold in future, then we should buy Put option for hedging of sale price of LHC at
given strike rate.
(d) If LHC is to be purchased in future, then we should buy Call option for hedging of purchase price of
LHC at given strike rate.
Question-7 UK exporter is to receive $ 10000 in 3 Months. He wants hedging through option. How he can
do so.
Case-1 Strike Rate £ 1 = $ 1.5
Calculate £ receivable if Spot Rate in 3 months; £ 1 = $ 1.7; £ 1 = $ 1.3
Case-2 Strike Rate $ 1 = £ 0.667

Calculate £ receivable if Spot Rate in 3 months; $ 1 = £ 0.6; $ 1 = £ 0.8
Question-8 [Nov-2015] [M-05] XYZ an Indian Firm, will need to pay Yen 500000 on 30th June. In order
to hedge the risk involved in Foreign Currency Transaction, the firm is considering two alternative methods,
i.e. Forward Market Cover and Currency Option Contract.
On 1st April, following quotations JY/INR are as follows:
Spot 3 months Forward
1.9516/1.9711 1.9726/1.9923
The prices for forex currency option on purchase are as follows:
Strike Price JY 2.125
Call Option (June) JY 0.047
Put Option (June) JY 0.098
For excess or balance of JY covered, the firm would use Forward rate as future spot rate.
You are required to recommend the cheaper hedging alternative for XYZ
Question-9 A company has a receivable of $ 100 million in 3 months. A bank has offered him a put option
with exercise price Rs.37/$. The premium payable is Rs. 1 per $. The probability of exchange rate after 3
months is
Probability 0.20 0.30 0.30 0.20
Exchange rate (Rs.1 per $) 35.00 35.50 36.00 36.50
In your opinion, should the company purchase put option? [Ans: Rs.0.25]
Question-9A [May-2007] [M-8] [SP] XYZ Ltd. a US firm will need £3,00,000 in 180 days. In this
connection, the following information is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate Probability
$ 1.91 25%
$ 1.95 60%
$ 2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(a) a forward contract
(b) a money market hedge
(c) an option contract [Ans: $594900]
(d) no hedging
Show calculations in each case.
Question-9B [May-2010] [M-8] [SP] A Ltd of U K has imported some chemical worth of USD 3,64,897
from one of the US suppliers. The amount is payable in six months time. The relevant spot and forward
rates are:
Spot Rate USD 1.5617 – 1.5673
6 months Forward Rate USD 1.5455 – 1.5609
The borrowing rates in UK and US are 7% and 6% respectively and the deposit rates are 5.5% and 4.5%
respectively.
Currency options are available under which one option contract is for GBP 12,500. The option premium for
GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096 (put option) for 6 months
period
The company has three choices:
(i) Forward Cover [Ans: GBP 236102.89]
(ii) Money Market Cover; and [Ans: GBP 236510.10]
(iii) Currency Option [Ans: GBP 227923.00]
Which of the alternatives is preferable by the company?
Question-10 A London based firm has supplied a nuclear machine to a New York based firm for $120m,
payment due in 4 months time. The current spot rate is 1 £ = $ 1.58. The London firm has apprehensions
that USD may decline against British Pound. The London firm is considering the proposal of buying a put
option, 4 months maturity, strike Price 1 £ = $ 1.60. The option premium is $0.0002 per £. Explain the
position of the London firm on maturity if the Spot price of $ on maturity is £0.625; £0.65; £0.615. Also
Calculate Premium Paid by London based firm.
Question-11 [Nov-2013-2b-8] An American firm is under obligation to pay interest of Can$ 1010000 and
Can$ 705000 on 31st July and 30th Sep respectively. The firm is risk averse and its policy is to hedge the
risks involved in all foreign currency transactions. The finance manager of the firm is thinking of hedging the
risk considering two methods i.e. Fixed Forward or Option Contracts.
It is now June 30. Following quotations regarding rates of exchange, US$ per Can$, from the firm’s bank
were obtained.
Spot Rate Can$ 1 = US$0.9284 – 0.9288
1 Month Forward Rate Can$ 1 = US$0.9301
3 Months Forward Rate Can$ 1 = US$0.9356
Price for a Can$/US$ option on a US Stock exchange (cents per Can$, payable on purchase of the option,
contract size Can$ 50000) are as follows:
Strike Price (US$/Can$) Calls Puts
July Sep July Sep
0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
0.95 0.65 1.64 1.92 2.34
According to the suggestion of finance manager if option are to be used, one month option should be bought
at a strike price of 94 cents and three months option at a strike price of 95 cents and for the remainder
uncovered by the options the firm would bear the risk itself. For this, it would use forward rate as the best
estimate of spot. Transaction cost are ignored. Recommended, which of the above two methods would be
appropriate for the American firm to hedge its foreign exchange risk on the two interest payments.
11.A.7 Breakeven Point for Call or Put Option
(a) Breakeven Point for Call Option = Strike Price + Premium Paid
(b) Breakeven Point for Put Option = Strike Price - Premium Paid
Question-12 [ICWA-Dec-2003] Current stock prices is Rs.100, strike price of call option Rs.100, option
premium Rs.5. Find out break even price at which there will be no loss no profit for a call buyer.
11A.8 Calculation of Value of Option at beginning
(a) The value of option is the price at which it can be purchased or sold. Premium payable on option is also
known as value of option. There are 5 approaches for calculation of value of option.
(f) Expected Gain Approach
(g) Price Difference Approach
(h) Binomial Model
(i) Risk Neutral Method
(j) Black Scholes Model
11A.9 Expected Gain Approach
1 First we will calculate value of option at expiration

Then we will calculate value of option at beginning.
a) If interest rate is NCC TFV of Option today = Value of Option at expiration*PVF
b) If interest rate is CC TFV of Option today = Value of Option at expiration* e-rt
Question-13 A six month call option for a share has the exercise price of Rs.38 along with probabilities and
price at expiration date as below:
Probabilities 0.10 0.25 0.30 0.25 0.10
Price of share 30 36 40 44 50
(a) What is the expected price of the share after six months? [Ans: Rs.40]
(b) What is the value of option at expiration? [Ans: Rs.3.30]
(c) What is the value of option at beginning assuming interest rate to be 12% p.a.? [Ans: Rs.3.11]
(d) What is the value of option at beginning assuming interest rate to be 12% p.a. continuously
compounding. [Ans: Rs.3.107]
11A.10 Price Differential Approach
(a) Under price differential approach, the value of option is taken as equal to difference between PV of
Strike Price and Spot Price on the valuation date.
i) Value of Call Option at beginning Spot Price of Underlying Assetstoday – PV of Strike Price
ii) Value of Put Option at beginning PV of Strike Price - Spot Price of Underlying Assetstoday
(b) Calculation of Arbitrage Profit from Call Option under Price Differential Approach
If CMP of Call Option < TFV of Call Option, then arbitrage profit is possible, otherwise not possible.
Steps for Arbitrage Profit
Steps for calculation of Arbitrage Profit
Today
(i) Buy Call Option at CMP = a
(ii) Assuming we have one Share, and sell it at CMP = b
(iii) Investment (c) = (b – a) at interest rate given
At Maturity date
(iv) Gain on Settlement of Call Option = (d)
(v) Purchase of Share from Market = (e)
(vi) Realization from Investment (f) = (c)*(1+PIR) or (c)*ert
Arbitrage Profit = (d) + (f) – (e)
Question-14 Given the following data

Strike Price = Rs.90
Current stock Price = Rs.100
- Risk free rate of interest = 10% p.a. (not continuous compounding)
(a) Calculate theoretical current (fair) price of a European call option expiring after one year. [Ans:
Rs.18.19]
(b) If the price of the call option is Rs.15, then how can arbitrageur make profit. [Ans: Min Arbitrage Profit
is Rs.3.50]
Question-14A [SP] Given the following data

Current Price of one share = Rs.200
- Risk free rate of interest = 10% p.a. (Continuous compounding)
(a) Calculate theoretical current (fair) price of a European call option expiring after one year. [Ans:
Rs.37.13]
(b) If price of the call option is Rs.30, then how can an arbitrageur make profit.
(c) Calculation of Arbitrage Profit from Put Option under Price Differential Approach
If CMP of Put Option < TFV of Put Option, then arbitrage profit is possible, otherwise not possible.
Steps for Arbitrage Profit
Steps for calculation of Arbitrage Profit
Today
(i) Buy Put Option at CMP = a

(ii) Buy one Share at CMP = b
(iii) Borrow (c) = (a – b) at interest rate given
At Maturity date
(iv) Gain on Settlement of Put Option = (d)

(v) Sale of Share in Market = (e)

(vi) Repayment of Borrowing (f) = (c)*(1+PIR) or (c)*ert
Arbitrage Profit = (d) + (e) – (f)
Question-15 Given the following data

Time until expiration = 6 months.
- Risk free rate of interest = 5% p.a. (not continuous compounding)
(a) Calculate theoretical current (fair) price of a European put option expiring after six months.
(b) If European put option price is Rs.5, then how can an arbitrageur make profit.
Question-15A [SP] Given the following data

Time until expiration = 6 months
- Risk free rate of interest = 5% p.a. (Continuous Compounding)
(a) Calculate theoretical current (fair) price of a European put option expiring after six months.
(b) If European put option price is Rs.10, then how can an arbitrageur make profit.
11A.11 Binomial Model/Tree for Option Valuation or Risk Neutralisation Method

ICAI IRPT ICWA
M-09 M-08 M-13 16
M-11 M-05 M-08
M-12 N-08
M-13 M-05
N-15 M-05
(a) It involves constructing of a binomial tree, which represents the two possible values of the asset price
over the life of the option
(b) Assumption of BM
(i) CMP of the is S and it can take two possible values at maturity, S1 or S2 such that S1 > S > S2.
Borrowing = ∆*S2/(1+r) OR (∆*S1-nC1)/(1+r)
CMP of Share = S
(c) Calculation of Value of Option today under BM
(i) The investor can borrow or lend an amount (B) at risk free rate of interest 'r'
(ii) The strike price, K, is given
(iii) C1 = Value of the option at S1 price at expiration = Max((S1-K),0)
(iv) C2 = Value of the option at S2 price at expiration = Max((S1-K),0)
(v) Hedge Ratio is known as delta. It refers to the number of units of stock one should hold for each
option sold to create a risk-free hedge.
Hedge Ratio (∆) = (C1 - C2) /(S1- S2)
(vi) Value of Call Option under BSM = ∆*CMP of Share – Borrowing
(d) The BM is based on the concept of Replicating Portfolio, which refers to a portfolio consisting of the
underlying asset and a riskless asset, which generates the same cash flow as a specified call/put
option.
Replicating Portfolio = Borrowing + ∆ number of units of the underlying asset
(e) Arbitrage Profit under BM Model
If CMP of a Call Option > TFV of Call Option If CMP of a Call Option < TFV of Call Option
Today Today
(a) Sell Call Option at CMP Buy Call Option at CMP

(b) Buy Replicating Portfolio Sell Replicating Portfolio
(i) Buy ∆ no of shares at CMP Sell ∆ no of shares at CMP
(ii) Borrow at interest rate given Deposit at interest rate given
Maturity Date Maturity Date

(a) Loss on settlement of Call option (Writer) Gain on settlement of Call option (Holder)
(b) Settlement of Replicating Portfolio Settlement of Replicating Portfolio
(i) Sell ∆ no of shares at Market Price Buy ∆ no of shares at Market Price
(ii) Repayment of Borrowing Realisation of Deposit
Question-16 The CMP of share is Rs.50. It may be either Rs.60 or Rs.40 after a year. A call option with a
strike price of Rs.50 is available. The rate of interest is 12%.
(a) Calculate value of Call Option.
(b) Show Holding Position of Cash under replicating portfolio.
(c) If Actual price of Call Option is Rs.5 or Rs.8, whether arbitrage profit is possible under BM
Question-16A [CS-June-2004] [SP] The CMP of share of BB Ltd is Rs.190. It may be either Rs.250 or
Rs.140 after a year. A call option with a strike price of Rs.180 is available. The rate of interest is 9%. Rahul
wants to create a replicating portfolio in order to maintain his pay off on the Call Option for 100 shares.
Find out (i) Hedge ratio (ii) Amount of borrowing (iii) fair value of call (iv) his cash flow position after a year.
(f) Limitation of BM
Basic assumption that there are only two possibilities for share price in future is impractical and
hypothetical. Such a strategy may not work because there are more and more possibilities of share
price.
11A.11.1 Risk Neutralisation Method
(a) The current price of the share is S and it can take two possible values at maturity, S1 or S2 such that
S1 > S > S2.
(b) Calculation of Option under RNM
(i) Probability of S1 (P1) = (CMP of Share*(1+PIR) – S2)/(S1 – S2)
(ii) Probability of S2 (P2) = 1 – P1
(iii) Value of Option at expiration = C1P1 + C2P2
(iv) TFV of Option today = PV of [Value of Option at expiration]
1 If interest rate is NCC TFV of Option today = Value of Option at expiration*PVF

2 If interest rate is CC TFV of Option today = Value of Option at expiration* e-rt
Question-17 [May-2011] [M-5] [RTP-May-2013-16] The CMP of an equity share of Pranchant Ltd
Rs.420. Within a period of 3 months, the maximum and minimum price of it is expected to be Rs.500 and
Rs.400 respectively. If the risk free rate of interest be 8% p.a. What should be the value of a 3 month call
option under ‘Risk Neutral Method’ at the strike price of Rs.450. Given e0.02 = 1.0202
(c) Calculation of Probability in alternative way
P1 for S1 = [SP x (1+r)/SP – LP/SP]/[HP/SP – LP/SP] = [1+r – d/u – d]

Where r = PIR; u = S1/S; d = S2/S
Question–17A [SP] Find the value of one year European Call Option using:
Spot Price = Rs.200; u = 1.4; d = 0.90; Exercise Price = Rs.220; r = 0.15
Note: Value of u indicates possible higher price; value of d indicates possible lower price
Question-17B [May-2012] [M-8] [SP] Sumana wanted to buy shares of EIL which has a range of Rs.411
to Rs.592 a month later. The present price per share is Rs.421. Her broker informs her that the price of
these shares can store up to Rs.522 within a month, so she should buy a one month CALL of EIL. In order to
be prudent in buying the call, the share price should be more than or at least Rs.522 the assurance of which
could not be given by her broker.
Though she understands the uncertainly of the market, she wants to know the probability of attaining the
share price Rs.592 so that buying of a one month CALL of EIL at the executing price of Rs.522 is justified.
Advice her. Take the risk free interest to be 3.60% and e0.036 =1.037.
Question-18 [Nov-2015] [M-5] Mr Dayal is interest in purchasing Equity Shares of ABC Ltd which are
currently selling at Rs.600 each. He expects that price of share may go upto Rs.780 or may go down to
Rs.480 in 3 months. The chances of occurring such variations are 60% and 40% respectively. A call option
on the shares of ABC Ltd can be exercised at the end of 3 months with strike price of Rs.630.
(i) What combination of share and option should Mr Dayal select if he wants a Perfect hedge?
(ii) What should be the value of option today (Risk Free rate is 10% p.a.)?
(iii) What is the expected Rate of Return on the option?
Question-19 [May-2013-1c-5] Ramesh owns a plot of land on which he intends to construct apartment
units for sale. No. of apartment units to be constructed may be either 10 or 15. Total construction costs for
these alternatives are estimated to be Rs.600 lakhs or Rs.1025 lakhs respectively. Current market price for
each apartment unit is Rs.80 lakhs. The market price after a year for apartment units will depend upon the
conditions of market. If the market is buoyant, each apartment unit will be sold for Rs.91 lakhs, if it is
sluggish, the sale price for the same will be Rs.75 lakhs. Determine the current value of vacant plot of land.
Should Ramesh start construction now or keep the land vacant? The yearly rental per apartment unit is Rs.7
lakhs and the risk free interest rate is 10% p.a.
Assume that the construction cost will remain unchanged.
(d) Calculation of S1 or S2 if TFV of Option is given
Question-20 [SP] Spot Price Rs.60. A one year European call Option is being quoted in the market at
option premium of Rs.15 with exercise price of Rs.55. Risk-free return = 12% p.a (NCC). The stock can
either rise or fall after a year. It can fall by 30% by what % can it rise.
(e) Value of Put Option under RNM
Question-21 Spot price of Share Euro 500. After six months either 450 or 550. Find the value of European
put opinion with a strike price of Euro 510, if risk free rate is 14% p.a. Use Risk neutral method.
11A.11.2 Value of Option for foreign currency under RNM
In case of Foreign exchange transaction, interest rate is given for LHC and RHC.
P1 = (CMP of Share*(1+PIRHC) - S2*(1+PILHC))/(S1*(1+PILHC) - S2*(1+PILHC))
Question-22 From the following data calculate price of a call option expiring after one year:
Let spot exchange rate = Rs.50 per $
Strike rate = Rs.60 per $
Risk free interest rate for Rupees = 10% p.a.
Risk free interest rate for Dollars = 15% p.a.
Expected range of (Maximum and Minimum) spot rate on = Rs.70 - Rs.40 per $.
maturity of option after one year
Question-22A [SP] From the following data calculate price of a call option expiring after one year.
Let spot exchange rate = Rs.60 per pound.
Exercise/Strike rate = Rs.64 per pound.
Risk free interest rate for Rupees = 15% p.a.
Risk free interest rate for pound = 20% p.a.
Expected range of (Maximum and Minimum) spot rate on maturity of option = Rs. 76.25 – Rs.45 per
after one year pound.
11A.11.3 Value of Option under BM or RNM if Dividend is paid
(i) TFV of Option under BM = ∆*(CMP of Share – PV of Dividend) – Borrowing

(ii) Under RNM P1 = [CMP of Share*(1+PIR) – Future Value of Dividend] - S2/(S1 - S2)
Note: Other formula under RNM will be same
Question-23 The equity share of Madhav Ltd. is quoted at Rs.100 on spot. The company will pay a
dividend of Rs.5 per share after 2 months from today. After three months the price of the equity share will
be either Rs.140 or Rs.80. Assuming risk free rate of interest to be 12% p.a., find the option premium of
three months ECO considering the risk strike to be Rs.110.
11A.11.4 Two Stage binomial method
In this case, we will apply movements of price for two periods.

(a) Calculation of 2 prices of UA at the end of 1st period
S1 = S*d1
S2 = S*u1
(b) Calculation of 4 prices of UA at the end of 2nd period as follows
S3 = S*d1*d2 Or S1*d2
S4 = S*d1*u2 Or S1*u2
S5 = S*u1*d2 Or S2*d2
S6 = S* u1*u2 Or S2*u2
(c) Calculation of Probabilities for S1 and S2
P1 = (S*(1+PIR) – S2)/(S1 – S2)
P2 = 1 – P1
(d) Calculation of Probabilities for S3, S4 from S1 and Probabilities of S5, S6 from S2
P3 = (S1*(1+PIR) – S4)/(S3 – S4)
P4 = 1 – P3
P5 = (S2*(1+PIR) – S6)/(S5 – S6)
P6 = 1 – P3
(e) Calculation of Join Probabilities S3, S4, S5, S6 from S
JP1 of S3 = P1*P3
JP2 of S4 = P1*P4
JP3 of S5 = P2*P5
JP4 of S6 = P2*P6
(f) Calculate Value of Option at Maturity at S3, S4, S5 and S6
Expected value of ECO at maturity = JP1*S3 + JP2*S4 + JP3*S5 + JP4*S6
(g) TFV of Option today = PV of ECO at maturity
(h) Calculation of ACO (American Call Option)
Question-24 [May-2009] [M-8] Consider a two year American call option with a strike price of Rs.50 on a
stock the current price of which is also Rs.50. Assume that there are two time periods of one year and in
each year the stock price can move up or down by equal percentage of 20%. The risk free interest rate is
6%. Using binominal option model, calculate the probability of price moving up and down. Also draw a two
step binomial tree showing prices and payoffs at each node.
Question-24A [SP] Current price of a share is Rs.100. Over each of next six months periods, it is expected
to go up by 10% or to go down by 10%. Risk free rate is 8% p.a. cc. What is the value of 1 year ECO with a
strike price of Rs.100. Use RNM.
Question-25 [SP] The equity share of Murari Ltd. is currently selling at Rs.100. Find the value of 6 months
maturity put option, strike price Rs.101, risk free rate of interest 12% p.a. Over 3 months period, it is
expected to go up by 10% or go down by 10%. Over next 3 months period, it is expected to go up by 8% or
go down by 6%.
11A.12 Black Scholes Models

ICAI IRPT ICWA
Nov-2006 M-08 Dec-2006
Nov-2008 M-12 Dec-2008
[May-2015-7c-04] State any four assumptions of Black Scholes Model

(a) The Black-Scholes model is used to calculate a theoretical price of an Option.
(b) BSM computes the fair value of a call option on a share on the basis of five function
(i) CMP of Share (S)
(ii) Strike Price (K)
(iii) Time to expiry (t)
(iv) Interest rate (r) = It is always Continues Compounding
(v) Volatility of the underlying assets (σ) = SD of continuously compounded return of the asset
(c) The model is based on the following assumptions;

(a) The option is the European option;
(e) The short term risk free interest rate is known and is constant during option period
(d) Steps for calculation of Option under BSM
(i) d1 = [In([S - PV of Dividend]/K) + (r + 0.5 σ2)t]/σ√t
(ii) d2 = d1 - σ√t
(iii) Calculate N(d1) and N(d2) from Table
N(d1) = Normal Distribution function of d1
(iv) Value of Call option today = S*N(d1) – K*e-rt xN(d2)
Note K*e-rt*N(d2) represents this borrowing which is equivalent to the present value of the exercise price
times an adjustment factor of N(d2)
Question-26 The share of FM Ltd is currently sold for Rs.60. There is a call option available at strike price
Rs.56 for a period of 6 month. Find out the value of the call option given that the rate of interest of the
investor is 14% and the SD of the return of the share is 0.3. Use BSM
Question-26A [Nov-2006] [M-8] [ICWA – June-2007]
From the following data for certain stock, find the value of a call option:
Price of stock now = Rs.80
Exercise price = Rs.75
Standard deviation of continuously compounded annual return = 0.40
Maturity period = 6 months
Annual interest rate = 12%
Given
In 1.0667 = 0.0645
Question-26B [Nov-2008] [M-12] [SP] following information is available for X company and call option:
Current share price Rs.185
Option exercise price Rs.170
Risk free interest rate 7%
Time of the expiry of option 3 years
Standard deviation 0.18
Calculate the value of option using black scholes formula.
11A.12.1 The BSM and the dividend Payment
(a) The market price of the share will go down after the payment of the dividend. The value of call option
will decrease and the value of the put option will increase as more and more dividends are paid.
(b) Value of call option = (S-PV of Dividend)*N(d1) – K*e-rt *N(d2)
(c) Value of Put option = (S-PV of Dividend)*N(d1) – Strike Price*e-rt *N(d2)
Question-27 [ICWA-Dec-2006] The share of E Ltd is trading at Rs.408 and the call option exercisable in
three months time has an exercise price of Rs.400. SD is estimated to be 22% per year. The annualized
Treasury Bill rate is 5%. The company is going to declare a dividend of Rs.10 and is expected to be paid in
two months time.
What is the value of call option.
11A.12.2 Value of Put Option under BSM
Value of Put option = K*e-rt *[1-N(d2)] – S*[1-N(d1)]
Question-28 [ICWA-Dec-2008] [SP] The share of A Ltd is trading at Rs.120 and the put option
exercisable in three months time has an exercise price of Rs.112. SD is estimated to be 30% per year. The
annualized Treasury Bill rate is 7%. What is the value of Put option.
11A.13 Different Type of Strategy for earning profit through Option

ICAI IRPT ICWA
May-2009 M-8 M-12 7
By adopting following strategy, we may earn certain profit in option
11A.13.1 Strangle
a) Buy a put and a call option with the same expiration date but with different exercise prices
b) Strike Price of the Put (K1)< Strike Price of Call (K2)
c) Expiry date of Put = Expiry date of Call
d) On Maturity date
(i) CMP of UA > K2, Call Option will be exercised

(ii) CMP of UA < K1, Put Option will be exercised

(iii) K1 < CMP of UA < K2, both option will be lapsed
e) Strangle is purchased when there is strong move in the market which may be up or down.
Question-29 What will be the payoff profile of a trader who adopts strangle strategy under following
details:
Option Strike Price Premium
Put Rs.60 Rs.3
Call Rs.65 Rs.2
Question-30 A person purchased a call with an exercise of Rs.190 at a premium of Rs.5. He also purchased
a put with an exercise price of Rs.185 at a premium of Rs.6. Both the options have same expiration date. At
what price (s) will the strangle break-even?
11A.13.2 Straddle
a) Buy/Sell a put and a call option with the same expiration date and same exercise prices
b) Strike Price of the Put (K) = Strike Price of Call (K)
c) Exercise price of Put = Exercise Price of Call
c) On Maturity date
(i) CMP of UA > K, Call Option will be exercised

(ii) CMP of UA < K, Put Option will be exercised
(iii) CMP of UA = K, both option will be lapsed
d) Straddle is purchased/sold when there is strong move in the market which may be up or down.
Question-31 Equity shares of Casio Ltd. are being currently sold for Rs.90 per share. Both the call option
and the put option for a 3 month period are available for a strike price of Rs.97 at a premium of Rs.3 per
share and Rs.2 per share respectively. An investor wants to create a straddle position in this share. Find out
his net payoff at the expiration of the option period; if the share price on that day happens to be Rs.90 or
Rs.105 or Rs.97.
Question-31A Mr.X purchased 3-months call as well 3-months put, both at strike price of CHF 75. Premium
of Call CHF 3: Premium of put- CHF 2. Prepare a table and draw a graph to show pay-offs of Mr. X if
expiration prices are 60,65,70,71,72,73,74,…..80,85, or 90. Do the same exercise for Y as well. Find
whether the maximum amount of loss to Mr. X is equal to call premium plus put premium.
Question-32 [May-2009] [M-8] On 19h April following are the spot rates
Spot rate Euro 1 = $1.20; $ 1 = Rs.44.80
Following are the quotes of European Options:
Currency Pair Call/Put Strike Price Premium Expiry Date
EUR/USD Call 1.20 $0.035 July 19
EUR/USD Put 1.20 $0.04 July 19
USD/INR Call 44.80 Rs.0.12 Sep.19
USD/INR Put 44.80 Rs.0.04 Sep.19
(a) A trader sells an at-the-money spot straddle expiring at three months (July 19). Calculate gain or loss if
three months later the spot rate is Euro 1 = $1.2900
(b) Which strategy gives a profit to the dealer if five months later (Sep. 19) expected spot rate is $1 =
Rs.45.00. Also calculate profit for a transaction USD 1.5 million.
11A.13.3 Strips
i) Buy one Call + Buy 2 Puts all with the same exercise price and date of expiration.
ii) Strike Price of the Put (K) = Strike Price of Call (K)
iii) Expiry Date of Call = Expiry date of Put
iv) On Maturity date
(1) CMP of UA > K, Call Option will be exercised

(2) CMP of UA < K, 2 Put Option will be exercised
(3) CMP of UA = K, both option will be lapsed
Strips is purchased when investor feels that decrease in the stock price is more likely than an increase.
Question-33 Mr. A purchases a call of 1 shares of A Ltd with 3 months expiration at a strike price of Rs.60.
Call Premium Rs.1 per share. At the same time he purchases put of 2 shares of same company with same
expiration, same strike price, same option premium per share. Find his pay off if the spot price on maturity
is 55, 56, ….65.
11A.13.4 Straps
a) Buy 2 Call + Buy 1 Puts all with the same exercise price and date of expiration.
b) Strike Price of the Put (K) = Strike Price of Call (K)
c) Expiry Date of Call = Expiry date of Put
d) On Maturity date
(i) CMP of UA > K, 2 Call Option will be exercised

(ii) CMP of UA < K, 1 Put Option will be exercised
(iii) CMP of UA = K, both option will be lapsed
Strap is purchased when investor feels that increase in the stock price is more likely than decrease.
11A.13.5 Butter Flies
a) It involves positions in options with three different strikes prices.

b) Buying a Call at relatively low strike price = K1
Buying a Call at relatively High strike price = K2
Selling 2 Calls at average of K1 and K2 [K3 = (K1+K2)/2]
c) Expiry Date of all Calls are equal
d) It is adopted by those who expect insignificant movements in the market price.
e) This strategy has limited risk and limited profit.
f) A butterfly can be created using put option
Question-34 Current Spot Price of Share Rs.61. Call options in the market:
Strike price Premium
Rs.55 Rs.10
Rs.60 Rs.7
Rs.65 Rs.5
Mr. X buys one call at strike price 55 and one call at strike price 65. He sells 2 calls with strike price 60.
Give pay-offs if spot price on expiry on 51, 52…70
11A.13.6 Condor Spread
a) It is similar to the butterfly spread but involves 4 strike prices instead of 3 strike prices, resulting in a
winder profitable range. The strategy can be either call based or put based (but never with calls and
puts used together in the same trade).
b) Buying 1 Call Option with K1 < S

Selling 1 Call Option with K = S
Selling 1 Call Option with K2 > S
Buying 1 Call Option K3 > K2
c) Expiry Date of all Calls are equal
d) This strategy is adopted by those operators who expect insignificant movements in the market price of
underlying asset. This strategy may result in small amount of profit with limited loss.
Question-35 Suppose spot price is Rs.100

A) Buy call at a strike price of Rs.97 Call premium Rs.2 per share
B) Sell call at a strike price of Rs.100 Call premium Rs.1.50 per share
C) Sell call at a strike price of Rs.102 Call premium Rs.1 per share
D) Buy call at a strike price of Rs.103 Call premium Rs.0.70 per share
11A.13.7 BULL SPREADS
(a) Bull Spread This strategy is used by those who expect that the market price of the underlying asset
will go up. This trading strategy can be accomplished with either puts or calls.
(b) Bull Call Spread
(i) Buy 1 Call at K1 + Sell 1 Call at K2 with the same date of expiration.
(ii) K1 < K2
Question-36 Call market data

Strike price Call premium
100 5 Note: Lower the strike price, higher the call premium.
115 3
Question-36A [RTP-May-2012-7] The current spot price of share of ABC Ltd is Rs.121 with strike price of
Rs.125 and Rs.130 are trading at a premium of Rs.3.30 and Rs.1.80 respectively. Mr X a speculator is
bullish about the share price over next six months. However, he is also of belief that share price could also
go down. He approaches to you for advice, you are required to:
(a) Suggest a strategy that Mr X can adopt which puts limit on his gain and loss.
(b) How much is maximum possible profit.
(c) Draw out a rough diagram of the strategy adopted.
(d) What will be break-even price of the share?
[Assume – No brokerage fees and interest cost/gains]
(c) Bull Put Spread
(i) Buy 1 Put at K1 + Sell 1 Put at K2 with the same date of expiration.
(ii) K1 < K2
(iii) The options trader employing this strategy hopes that the price of the underlying securities
goes up
Question-37 Put market data

Strike price Put premium
105 1 Note: Lower the strike price, lower the put premium.
115 10
11A.13.8 Bear spread
(a) It is entered by the operators who expect that the prices of underlying asset will decline.
(b) Bear Call Spread
(i) Buy 1 Call at K1 + Sell 1 Call at K2 with the same date of expiration.
(ii) K1 > K2
Question-38 Call market data

Strike price Call premium
95 8 Note: Lower the strike price, higher the call premium.
105 2
(c) Bear Put Spread
(i) Buy 1 Put at K1 + Sell 1 Put at K2 with the same date of expiration.
(ii) K1 > K2
Question-39 Put market data
Strike price Put premium

95 2 Note: Lower the strike price, higher the put premium.
105 3
11A.13.9 CALENDER SPREAD
(a) Bull calendar spread- The strategy is used by those who expect a bullish tendency in the prices. In
this strategy the options have the same strike price but different dates of maturities. The strategy can
be either call based or put based (but never with calls and puts used together in the same trade.)
(b) Call based strategy:, the operator buys call which long maturity period and sells the call with short
maturity period on the same underlying asset with same strike price. Generally the option premium of
the long term call is more than of short term call; the strategy generally requires an initial investment.
(i) Buy 1 Call at K + Sell 1 Call at K with different date of expiration.
(ii) Maturity Period of Call 1 > Maturity Period of Call 2
Example: Spot price of a share is Rs.40. Mr. X purchases call option maturity 3 months at a premium of
Rs.2 per share strike price Rs.45. He writes a call maturity 1 month at a premium of Re. 1 per share strike
price Rs.45. The net cost of the strategy Re.1. Suppose the spot price on one month maturity call is Rs.42.
The call is not exercised. Mr. X does not have to pay anything. Now suppose the spot price on the 3 months
maturity call is Rs.47. Net profit Re.1 per share.
(c) A bear calendar Spread is used by option traders who believe that the price of the underlying
security will remain stable in the near term but will eventually fall in the long term. In this case, the
operator buys put with long maturity period and sells the put with short maturity period on the same
underlying asset with same strike price.
(i) Buy 1 Put at K + Sell 1 Put at K with different date of expiration.
(ii) Maturity Period of Put 1 > Maturity Period of Put 2
Summary of above Strategies

Sl Strategies Option Option Maturity Date Strike Price
1 Strangle Buy 1 Call Buy 1 Put Same K of the Put < K of Call
2 Straddle Buy 1 Call Buy 1 Put Same K of the Put = K of Call
3 Strips Buy 1 Call Buy 2 Put Same K of the Put = K of Call
4 Straps Buy 2 Call Buy 1 Put Same K of the Put = K of Call
5 Butter Flies Buy 1 Call at K1 Sell 2 Call at K3 Same K1 > K2 and
Buy 1 Call at K2 K3 = (K1+K2)/2
6 Condor Spread Buy 1 Call at K1 Sell 1 Call at K Same K1 < S; K = S
Buy 1 Call at K3 Sell 1 Call at K2 K2 > S; K3 > K2
7 Bull Call Spread Buy 1 Call at K1 Sell 1 Call at K2 Same K1 < K2
8 Bear Call Spread Buy 1 Call at K1 Sell 1 Call at K2 Same K1 > K2
9 Bull Put Spread Buy 1 Put at K1 Sell 1 Put at K2 Same K1 < K2
10 Bear Put Spread Buy 1 Put at K1 Sell 1 Put at K2 Same K1 > K2
11 Bull Calendar Spread Buy 1 Call1 at K Sell 1 Call1 at K MP of Call1 > MP of Call2 Same
12 Bear Calendar Spread Buy 1 Put1 at K Sell 1 Put1 at K MP of Put1 > MP of Put2 Same
11A.14 Theory
Question-1 [May-2011-6bi-4] Write short notes on Function of Stock Exchange
Functions of the stock exchanges can be summarized as follows:
(a) Liquidity and Marketability of Securities: Stock market creates continuous market for securities,
enabling them to be liquidated, where investors can convert their securities into cash at any time at the
prevailing market price. Investors can change their portfolio as and when they want to change, i.e. they
can at any time sell one security and purchase another.
(b) Fair Price Determination: This market is almost a perfectly competitive market as there are large
number of buyers and sellers. Due to nearly perfect information, active bidding take place from both
sides. This ensures the fair price to be determined by demand and supply forces.
(c) Source for Long term Funds: Securities are traded and change hands from one investor to the other
without affecting the long-term availability of funds to the issuing companies.
(d) Helps in Capital Formation: There are the nexus between the savings and the investments of the
community.
(e) Reflects the General State of Economy: The performance of the stock markets reflects the boom and
depression in the economy. It indicates the general state of the economy to all those concerned, who
can take suitable steps in time.
Question-2
[May-2004] [M-6] [May-2003] [M-6] What is a “derivatives’? Briefly explain the recommendation of the
L C Gupta Committee on derivatives.
[Nov–2007-5c-8]
(d) What are derivatives?
(e) Who are the users and what are the purposes of use?
(f) Enumerate the basic differences between cash and derivatives market.
[May-2011-7d-4] [RTP-May-2014-20d] What is the meaning of underlying in relation to a derivative
instrument?
(a) Derivatives:
It is a financial asset which derives its value from some specified underlying assets.
The transactions in derivatives are settled by the offsetting in the same derivative. The difference in
value of the derivatives is settled in cash.
There is no limit on number of units transacted in the derivative market because there is no physical
assets to be transacted.
(b) Types of Derivatives

Commodity derivatives and financial derivatives:
Commodity Derivatives contract can be entered into for different type commodity such as sugar, Jute,
Gur etc.
Basic derivatives and Complex derivatives:

Complex Derivatives: OTC Derivatives [Over the counter]
(g) Interest Swaps;
(h) Caps, Floor and Collar;
(i) Forward Rate Agreement;
(j) Swaptions;
(k) Currency Swaps;
(l) Forward Contracts;
(c) Function of Derivatives Markets
They help in transferring risk from risk averse people to risk oriented people.
They help in discoveries of future prices.
(d) Users of Derivatives market

(d) Hedgers ;
(e) Speculators;
(f) Arbitrages;
The basic differences between cash and the derivative market and enumerated below:-
(a) In cash market we can purchase even one share whereas in futures of option minimum lots are fixed.
(b) Cash market is more risky than future and option segment because in futures and option” risky is
limited unto 20%.
(c) Cash assets may be meant for consumption or investment. Derivate contracts are for hedging, arbitrage
or speculation.
(d) The value of derivative contract is always based on and linked to the underlying security. Though this
linkage may not be on point to point basis.
(e) In the cash market, a customer must open securities trading account with a security depository whereas
to trade futures a customer must open a future trading account witch a derivative broker.
(f) Buying securities in cash market involves putting up all the money upfront whereas buying futures
simply involves putting up all the margin money.
(g) With the purchase of share of the company in cash market, the holder becomes part owner of the
company. While in future it does not happen.
Question-3 [Nov-2002] [M-3] Write short notes on the Option.

[Nov-1997] [M-5] Call and put option with reference to debentures.
(a) Options: Options are contracts which provide the holder the right to sell or buy a specified quantity
of an underlying asset at a fixed price on or before the expiration of the option date.
The holder of the option can exercise the option at his discretion or may allow the option to lapse.
(b) Call Option: It provides to the holder a right to buy specified assets at specified price on or before a
specified date.
(c) Put option: It provides to the holder a right to sell specified assets at specified price on or before a
specified date.
(d) Strike or Exercise Price: The specified price at which the option can be exercised is known as the
Strike Price.
Question-4 [May-2014-7b-4] Factors affecting value of an option

The valuation of an option depends upon a number of factors relating to the underlying asset and the
financial market. Some of these factors are:
b) Future Price: The future price level is a major determinant of the option premium.
c) Strike price of the option: The exercise of the option depends upon the difference between the strike
price and the actual price of the underlying asset. In case of call option, the value of option will decline
as the strike price increases, and in case of put option, the value of the option will increases as the
strike price increases.
Question-5 [May-2015-7c-04] State any four assumptions of Black Scholes Model

(a) The Black-Scholes model is used to calculate a theoretical price of an Option.
(b) BSM computes the fair value of a call option on a share on the basis of five function
(i) CMP of Share (S)
(ii) Strike Price (K)
(iii) Time to expiry (t)
(iv) Interest rate (r) = It is always Continues Compounding
(v) Volatility of the underlying assets (σ) = SD of continuously compounded return of the asset
(c) The model is based on the following assumptions;
(a) The option is the European option;
(e) The short term risk free interest rate is known and is constant during option period
(d) Steps for calculation of Option under BSM
(i) d1 = [In([S - PV of Dividend]/K) + (r + 0.5 σ2)t]/σ√t
(ii) d2 = d1 - σ√t
(iii) Calculate N(d1) and N(d2) from Table
N(d1) = Normal Distribution function of d1
(iv) Value of Call option today = S*N(d1) – K*e-rt xN(d2)
Note K*e-rt*N(d2) represents this borrowing which is equivalent to the present value of the exercise price
times an adjustment factor of N(d2)
Question-6 [Nov-2004] [M-4] Explain the term ‘intrinsic value of an option’ and the ‘time value of an
option.
[May-2006] [M-4] Distinguish between Intrinsic value and time value of an option.
(a) Intrinsic value is the value that any given option would have if it were exercised today.
Intrinsic Value of an Option at any day

Intrinsic value of Call option (to Holder) at expiration = Max [(Spot Price - Strike Price), or 0]
Intrinsic value of put option (to Holder) at expiration = Max [(Strike Price - Spot Price), or 0]
(b) Time Value: This is the second component of an option’s price. It is defined as any value of an option
other than the intrinsic value. From the above example, if Wipro is trading at Rs.105 and the Wipro
100 call option is trading at Rs.7, then we would conclude that this option has Rs.2 of time value (Rs.7
option price – Rs.5 intrinsic value = Rs.2 time value). Options that have zero intrinsic value are
comprised entirely of time value.
Time value is basically the risk premium that the seller requires to provide the option buyer with the
right to buy/sell the stock upto the expiration date. This component may be regarded as the Insurance
premium of the option. This is also known as “Extrinsic value.” Time value decays over time.
From Basic Concepts
1 Calculation of PV of any shares, Bonds etc. from FV, if interest rate is compounding yearly
PV = FV/(1+PIR)
PV = FV*PVF(1 Period, PIR)
PIR is interest rate of 1 period
Example-1
FV of Share at the end of 6 months =Rs.110
Period = 6 months
Interest Rate = 12% p.a. [Compounding Yearly]
PIR of 6 months = 6%
PV of Share at t0 = FV/(1+PIR of 6 months) = 110/1.06 = Rs.103.77 OR
PV of Share at t0 = FV*PVF(1 Period, 6%) = Rs.110*0.943 = Rs.103.73
2 Calculation of PV of any shares, Bonds etc. from FV, if interest rate is compounding periodically
Period, Future Value and Interest Rate should be given with period of compounding
PV = FV/(1+PIR)n
PV = FV*PVF(n Period, PIR)
PIR is interest rate for each compounding period
n = No of Compounding in Period Given
Example-2
Period = 6 months
Interest Rate = 12% p.a. [Compounding Half Yearly, Quarterly, Monnthly]
Compounding Half yearly Quarterly Monthly
PIR 6% for 6 months 3% for 3 months 1% for 1 month
No of Compounding in Year 1 2 6
n n
PV of Share at t0 FV/(1+PIR of 6 months) FV/(1+PIR of 3 months) FV/(1+PIR of 1 months)n
PV of Share at t0 Rs.110/1.06 110/(1.03)2 110/(1.01)6
PV of Share at t0 Rs.103.77 Rs.103.68 Rs.103.625
Alternative
PV of Share at t0 FV*PVF(1 Period, 6%) FV*PVF(2 Period, 3%) FV*PVF(6 Period, 1%)
PV of Share at t0 Rs.110*0.943 Rs.110*0.9425 Rs.110*0.9420
PV of Share at t0 Rs.103.73 Rs.103.675 Rs.103.62
4 Calculation of PV of any shares, Bonds etc. from FV, if interest rate is compounding continuously
Period, Future Value and Interest Rate should be given
PV = FV/ert
PV = FV*e-rt
t = Period in Months /12 or Period in days/365
Example-3
Period = 6 months
Interest Rate (r) = 12% p.a. [Continuously Compounding]
t = 6/12 = 0.5 years
PV of Share at t0 = FV/ert = 110/e0.12*0.5 = Rs.110/e0.06 = Rs.110/1.0618 = Rs.103.5977 OR
PV of Share at t0 = FV*e-rt = Rs.110*e-0.12*0.5 = Rs.110*e-0.06 = Rs.110*0.9417 = Rs.103.587
5 Calculation of FV of any shares, Bonds etc. from PV, if interest rate is compounding yearly
Period, Current Value and Interest Rate should be given
FV = CV*(1+PIR)
FV = CV/PVF(1 Period, PIR)
PIR is interest rate of 1 period
Example-4
CV of Share = Rs.105
Period = 6 months
Interest Rate = 12% p.a. [Compounding Yearly]
PIR of 6 months = 6%
FV of Share at end of 6 months = CV*(1+PIR of 6 months) = 105*1.06 = Rs.111.30 OR
FV of Share at end of 6 months = CV/FVF(1 Period, 6%) = Rs.105/0.9433 = Rs.111.31
6 Calculation of FV of any shares, Bonds etc. from CV, if interest rate is compounding periodically
Period, Current Value and Interest Rate should be given with period of compounding
FV = CV*(1+PIR)n
FV = CV/PVF(n Period, PIR)
PIR is interest rate for each compounding period
n = No of Compounding in Period Given
Example-5
Period = 6 months
Interest Rate = 12% p.a. [Compounding Half Yearly, Quarterly, Monthly]
Compounding Half yearly Quarterly Monthly
PIR 6% for 6 months 3% for 3 months 1% for 1 month
No of Compounding in Year 1 2 6
FV of Share at six months CV*(1+PIR of 6 months)n CV*(1+PIR of 3 months)n CV*(1+PIR of 1 months)n
FV of Share at six months Rs.105*1.06 105*(1.03)2 105*(1.01)6
FV of Share at six months Rs.111.30 Rs.111.39 Rs.111.45
Alternative
FV of Share at six months CV/PVF(1 Period, 6%) CV/PVF(2 Period, 3%) CV/PVF(6 Period, 1%)
FV of Share at six months Rs.105/0.943 Rs.105/0.9425 Rs.105/0.9420
FV of Share at six months Rs.111.31 Rs.111.40 Rs.111.465
7 Calculation of FV of any shares, Bonds etc. from CV, if interest rate is compounding continuously
Period, Future Value and Interest Rate should be given
FV = CV*ert
FV = CV/e-rt
t = Period in Months /12 or Period in days/365
Example-6
Period = 6 months
Interest Rate (r) = 12% p.a. [Continuously Compounding]
t = 6/12 = 0.5 years
FV of Share at end of 6 months = CV*ert = 105*e0.12*0.5 = Rs.105*e0.06 = Rs.105*1.0618 = Rs.111.489
OR
FV of Share at end of 6 months = CV/e-rt = Rs.105/e-0.12*0.5 = Rs.105/e-0.06 = Rs.105/0.9417 = Rs.111.5005
Summary of above
Particulars Calculation of PV Calculation of FV
IR is Compounding Yearly PV = FV/(1+PIR) FV = CV*(1+PIR)
PV = FV*PVF(1 Period, PIR) FV = CV/PVF(1 Period, PIR)
n
IR is Compounding Periodically PV = FV/(1+PIR) FV = CV*(1+PIR)n
PV = FV*PVF(n Period, PIR) FV = CV/PVF(n Period, PIR)
IR is Continuously Compounding PV = FV/ert FV = CV*ert
PV = FV*e-rt FV = CV/e-rt
11A.0.3 Characteristics of Stock Exchanges in India

Traditionally, a stock exchange has been an association of individual members called member brokers
formed for the express purpose of regulating and facilitating the buying and selling of securities by the
public and institutions at large. A stock exchange in India operates with due recognition from the
Government under the Securities & Contracts (Regulations) Act, 1956. The member brokers are essentially
the middlemen, who transact in securities on behalf of the public for a commission or on their own behalf.
A stock exchange is typically governed by a board, consisting of directors. Some Members of the Board are
nominated by the Government. Government nominees include representatives of the Ministry of Finance, as
well as some public representatives, who are expected to safeguard the interest of investors in the
functioning of the exchanges. The board is headed by a President, who is an elected member, usually
nominated by the government, from among the elected members. The Executive Director, who is appointed
by the stock exchange with government approval, is the operational chief of the stock exchange. His duty is
to ensure that the day-to-day operations of the stock exchange are carried out in accordance with the rules
and regulations governing its functioning. SEBI has been set up in Mumbai by the Government to oversee
the orderly development of stock exchanges in the country. All companies wishing to raise capital from the
public are required to list their securities on at least one stock exchange. Thus, all ordinary shares,
preference shares and debentures of publicly held companies are listed in one or more stock exchanges.
Stock exchanges also facilitate trading in the securities of the public sector companies as well as
government securities.
Chap – 11A OPTIONS-SOLUTION 11AC.1
Solution-1
Call Option
Share price on the exercise date Rs.200 Rs.210 Rs.220 Rs.230 Rs.240
Strike Price of call Option Rs.220 Rs.220 Rs.220 Rs.220 Rs.220
Where from Holder should buy shares [Lower] From Market From Market From Market From Writer From Writer
Whether Holder would exercise Call option No No No Yes Yes
(a) Purchase of Share to Holder Rs.200 Rs.210 Rs.220 Rs.220 Rs.220
(b) Gain to Holder due to Call Option 0 0 0 Rs.10 Rs.20
Maximum loss to Holder is premium paid -Rs.6 -Rs.6 -Rs.6 -Rs.6 -Rs.6
(c) Net Gain or (Loss) to Holder -Rs.6 - Rs.6 - Rs.6 Rs.4 Rs.14
(d) Status of Option Out Out At In In
Put Option
Share price on the exercise date Rs.200 Rs.210 Rs.220 Rs.230 Rs.240
Strike Price Rs.220 Rs.220 Rs.220 Rs.220 Rs.220
Where should holder sell shares [Higher] To Writer To Writer To Market To Market To Market
Whether holder would exercise Put option Yes Yes No No No
(a) Sale Price of Share to Holder Rs.220 Rs.220 Rs.220 Rs.230 Rs.240
(b) Gain to Holder due to Put Option Rs.20 Rs.10 0 0 0
Maximum loss to Holder is premium paid -Rs.5 -Rs.5 -Rs.5 -Rs.5 -Rs.5
(c) Net Gain or (Loss) to Holder Rs.15 Rs.5 - Rs.5 - Rs.5 - Rs.5
(d) Status of Option In In At Out Out
(ii) price range at which the call and the put options may be gainfully exercised.
In case of Call Option, If Share Price on exercise date is more than Rs.220
In case of Put Option, If Share Price on exercise date is Less than Rs.220
Solution-1A
Premium of call option = Rs.9
Premium of put option = Rs.1
(i) Expiration date cash flows [Means purchase price or sale price on Exercise of Option]
Stock prices Rs.50 Rs.55 Rs.60 Rs.65 Rs.70
Buy 1 Call [Purchase price for Holder on Exercise of Call Option i.e [Lower] 0 0 0 Rs.60 Rs.60
Write 1 Call [Sale price for Writer on Exercise of Call Option by Holder] 0 0 0 Rs.60 Rs.60
Buy 1 Put [Sale price for Holder on Exercise of Put Option] [Higher] Rs.60 Rs.60 0 0 0
Write 1 Put [Purchase price for writer on Exercise of Put Option] Rs.60 Rs.60 0 0 0
(ii) Investment value = Expiration value of Option = Gain on exercise of Option

Buy 1 Call [Gain to Holder of Call Option] = Value of Call Option 0 0 0 5 10
Write 1 Call [Loss to Writer of Call Option] 0 0 0 -5 -10
Buy 1 Put [Gain to Holder of Put Option] = Value of Put Option 10 5 0 0 0
Write 1 Put [Loss to Writer of Put Option] -10 -5 0 0 0
(iii) Calculation of net profit/ Loss

Buy 1 call [Gain/(Loss) – Premium Paid] -9 -9 -9 -4 1
Write 1 call [Gain/(Loss) – Premium Paid] 9 9 9 4 -1
Buy 1 put [Gain/(Loss) – Premium Paid] 9 4 -1 -1 -1
Write 1 put [Gain/(Loss) – Premium Paid] -9 -4 1 1 1
Solution-2
(a) If share price goes to Rs.43 at expiry
Particulars Call Option Put Option Total
Investor Buy 1 1
Premium Paid Rs.2 Rs.1 Rs.3
Strike Price Rs.42 Rs.40
If market Price of share at expiry Rs.43 Rs.43
Exercise of Option Yes No
Value of Option Rs.1 Nil
Gain 1 0 1
Premium Paid -2 -1 -3
Net Gain/ (Loss) -1 -1 -2
(c) If share price goes to Rs.36 at expiry

Investor Buy 1 1
Exercise of Option No Yes
Value of Option 0 4
Gain 0 4 4
Net Gain/ (Loss) -2 3 1
This can be done with 100 shares
Solution-2A
(a) If share price = Rs.500 at expiry
Mr X Buy 1 1
Premium Paid Rs.30 Rs.5
No of Shares in One Option 100 100
Total Premium Paid Rs.3000 Rs.500 Rs.3500
Exercise of Option by Mr X No No
Value of Option 0 0
Gain 0 0 0
Premium Paid - 3000 - 500 - 3500
Net Gain/ (Loss) - 3000 - 500 - 3500
(b) If share price = Rs.350 at expiry

Mr X Buy 1 1
Exercise of Option by Mr X No Yes
Value of Option 0 100*100 = Rs.10000 Rs.10000
Gain 0 10000 10000
Premium Paid - 3000 - 500 - 3500
Net Gain/ (Loss) - 3000 9500 6500
(c) If share price = Rs.600 at expiry

Mr X Buy 1 1
Exercise of Option by Mr X Yes No
Value of Option Rs.50*100 = Rs.5000 0
Gain 5000 0 5000
Premium Paid - 3000 - 500 - 3500
Net Gain/ (Loss) 2000 -500 1500
Solution-3
(a) If share price = Rs.1550 at expiry
Particulars Call 1400 Option Call 1425 Option Put 1350 Option Total
Investor Buy 200 3000 4000
Premium Paid Rs.50*200 = 10000 Rs.33*3000 = 99000 Rs.22*4000 = 88000 197000
Strike Price Rs.1400 Rs.1425 Rs.1350
Expiry Date Dec, 2010 Dec, 2010 Dec, 2010
If market Price of share at Expiry Rs.1550 Rs.1550 Rs.1550
Exercise of Option by Holder Yes Yes No
Value of Option 150*200 = 30000 125*3000 = 375000 0 405000
Gain 30000 375000 0 405000
Premium Paid -10000 -99000 -88000 -197000
Net Gain/ (Loss) 20000 276000 -88000 208000
(b) If share price = Rs.1460 at expiry

Particulars Call Option Call Option Put Option Total
Exercise of Option by Holder Yes Yes No
Value of Option 60*200 = 12000 35*3000 = 105000 0 117000
Gain 12000 105000 0 117000
Premium Paid -10000 -99000 -88000 -197000
Net Gain/ (Loss) 2000 6000 -88000 -80000
(c) If share price = Rs.1280 at expiry

Particulars Call Option Call Option Put Option Total
Exercise of Option by Holder No No Yes
Value of Option 0 0 70*4000 = 280000 280000
Gain 0 0 280000 280000
Premium Paid -10000 -99000 -88000 -197000
Net Gain/ (Loss) -10000 -99000 192000 83000
Solution-4
(a) Expected price of share at expiry date = 120*0.05 + 140*0.2+160*0.5+180*0.1+190*0.15 = Rs.160.50
(b) If price of shares is equal to exercise price i.e. Rs.150 prevails on expiration date than the value of call option at
expiration
= Max [(Spot Price of ShareAt Expiry – Strike Price), 0] = [(150–150),0] = Rs.0
(c) Expected value of option at expiration

MKT price at expiration Exercise price (MP – EP) Value of Option Prob. Expected value of Option
120 150 120 – 150 = -30 0 0.05 0
140 150 140 – 150 = -10 0 0.20 0
160 150 160 – 150 = 10 10 0.50 5
180 150 180 – 150 = 30 30 0.10 3
190 150 190 – 150 = 40 40 0.15 6
Expected value of option 14
Solution-4A
(a) Expected price of share at expiry date = 180*0.1 + 260*0.2 + 280*0.5 + 320*0.1 + 400*0.1 = Rs.282
(b) Expected value of put option at expiration

Share Price Strike Price Value of Put Option Prob Expected Value of Option
180 300 120 0.1 12
260 300 40 0.2 8
280 300 20 0.5 10
320 300 0 0.1 0
400 300 0 0.1 0
30
Expected Value of Put Option at expiration = Rs.30
Solution-5
(a) Premium on Nov call is less than premium on Jan Call because of 2 reasons
(i) Greater the time to expiration, premium would be more. Time period of Jan Call is more than Nov call hence Premium
of Jan Call is more than Nov Call.
(ii) In case of Call Option, lower the strike price of option, option premium would be more. In case of Jan Call, Strike price
is less than Nov call hence premium of Jan Call is more than Nov Call.
(b)
(i) Position of Holder of Jan Call 450
Exercise price of Jan Call = Rs.450
Premium paid = Rs.100
On expiration date 31/01/2003 the mkt. price is 525. It is more than the exercise price. Hence, the Holder of Call Option
would exercise the call option.
Value of option to Holder = Market Price of Share – Exercise Price = 525 – 450 = Rs.75
Premium paid by Holder of Call option = Rs.100
Net gain/(Loss) to Buyer = Rs.75 – Rs.100 = - Rs.25
(ii) Tax Status of Writer from Jan Call

Loss to Writer on settlement of Jan Call - Rs.75
Premium received by Writer + Rs.100
Net Gain to Writer on Settlement of Jan + Rs.25
Profit/ Loss on Sale of Shares

Sale Price of Share at Market + Rs.525
Less: Purchase of Share Rs.475
Profit on Sale of Shares + Rs.50
Total Profit to Writer = Gain on Settlement of Option + Profit on sale of Share = Rs.25 + Rs.50 = Rs.75
(c) If we does not own any shares

Particulars Nov Call (550) Nov Call (500) Total
Position Write Hold
Premium +10 -50 -40
Exercise of Option by Holder Yes Yes
Gain/Loss -25 +75
Premium +10 -50 -40
Net Gain/ (Loss) -15 +25 +10
Period of investment = July to Nov = 5 months

% Annualized Return = Profit*100/Initial Investment = 10*100/40x12/5 =60%
Solution-6
Alternative 1: For Hedging of sale price, he is writing Call Option
Manager writes call option means he is writer of call Option. He is under obligation to sell shares. [For Understanding]
Calculation of Profit & loss on Call Option from Writers Point of View
Share price on the exercise date Rs.560 Rs.540 Rs.525 Rs.490
Strike Price of call Option Rs.530 Rs.530 Rs.530 Rs.530
Where from Holder should buy shares [Lower of Two] From Writer From Writer From Market From Market
Exercise of Call option by Holder Yes Yes No No
Purchase price for Holder in case of deliver Rs.530 Rs.530 Rs.525 Rs.490
Sale price for Writer Rs.530 Rs.530 Rs.525 Rs.490
Purchase price for Writer Rs.510 Rs.510 Rs.510 Rs.510
Gain/(Loss) to Writer Rs.20 Rs.20 Rs.15 -Rs.20
Premium received by Writer Rs.10 Rs.10 Rs.10 Rs.10
Net Gain or (Loss) to Writer Rs.30 Rs.30 Rs.25 -Rs.10
Conclusion: Selling a call option for hedging of sale price is not proper strategy as by doing this, upper limit of sale price
is fixed but lower limit is not fixed.
Alternative 2: Buying Put Option for hedging of sale price
Manager purchased put option means he is holder of put Option. He has right to sell the shares. [For Understanding]
Share price of share on the exercise date Rs.560 Rs.540 Rs.525 Rs.490
Strike Price of Put Option Rs.530 Rs.530 Rs.530 Rs.530
Where should holder sell shares [higher of two] Market Market Writer Writer
Exercise of put option by holder No No Yes Yes
Sale price for manger Rs.560 Rs.540 Rs.530 Rs.530
Purchase price for manager Rs.510 Rs.510 Rs.510 Rs.510
Gian/(Loss) to manager Rs.50 Rs.30 Rs.20 Rs.20
Premium Paid by manager Rs.10 Rs.10 Rs.10 Rs.10
Net Gain or (Loss) to Manager Rs.40 Rs.20 Rs.10 Rs.10
Conclusion: buying a put option for hedging of sale price is proper strategy as by doing this, lower limit of sale price is
fixed but upper limit is not fixed.
(b) Buying a share and writing a call does not protect investor from risk as by writing a call investor has fixed upper limit
of sale price but lower limit is not fixed. Hence he has fixed his profit and did not fix loss.
(c) Put option can be purchased for hedging selling price of underlying assets in future.
Solution-7 UK exporter is to receive $10000 in 3 months. [$ - Sell; £ - Buy]

We will check that LHC is to be sold or purchased.
If LHC is to be sold then we should buy Put Option for hedging
If LHC is to be purchased then we should buy Call Option for hedging
Case-1 Strike Rate £ 1 = $ 1.5
LHC is £ i.e. to be purchased, hence UK Exporter will buy call Option at Strike Rate £ 1 = $ 1.5 for hedging of purchase
price of £
On maturity date
SR of £ on maturity date $ 1.7 $ 1.3
Strike Rate of Call Option $ 1.5 $ 1.5
Where should holder buy £ [Lower of two] Writer Market
Exercise of Call option by holder Yes No
Purchase price of £ $ 1.5 $ 1.3
£ receivable by selling $ 10000 = $ 10000/1.5 = £ 6667 $ 10000/1.3 = £ 7692
Case-2 Strike Rate $ 1 = £ 0.667

LHC is $ i.e. to be sold, hence UK Exporter will buy put Option at Strike Rate $ 1 = £ 0.667 for hedging of sale price of $
On maturity date
SR of $ on maturity date £ 0.6 £ 0.8
Strike Rate of Put Option £ 0.6667 £ 0.667
Where should holder sell $ [Higher of two] Writer Market
Exercise of Put option by holder Yes No
Sale price of $ £ 0.6667 £ 0.8
£ receivable by selling $ 10000 = $ 10000*0.6667 = £ 6667 $ 10000*0.8 = £ 8000
Solution-8
XYZ is to pay JY 500000 in 3 months [JY – Buy; Rs.-Sell]
SR Rs. 1 = JY 1.9516 – 1.9711
3 months FR Rs. 1 = JY 1.9726 – 1.9923
(a) Hedging through Forward Cover
Rs. required to buy JY 500000 at 3months FR = JY 500000/1.9726 = Rs.253472.60
(b) Hedging through Option

Strike Rate Rs. 1 = JY 2.125
LHC is Rs. i.e. to be sold, hence XYZ will buy put Option at Strike Rate Rs. 1 = JY 2.125 for hedging of sale price of Rs.
No of Put Option to be purchased = JY500000/2.125 = 235295
Premium payable = 235295*0.098 = JY 23059
Rs. required to pay Premium = JY 23059/1.9516 = Rs.11815
On maturity date
Assuming Put option is exercisable, hence
Rs. required to buy JY 500000 at Strike Rate = JY 500000/2.125 = Rs.235295
Total payment under Put Option = 235295+11815 = Rs.247110
Conclusion: Hedging through Put option I better
Solution-9
$100 m is receivable and it is to be sold by Company [$ - Sell; Rs. – Buy]
Option 1 No Hedging
If Put option is not purchased
Expected exchange rate after 3 months = 35*0.20 + 35.50*0.30 + 36*0.30 + 36.50*0.20 = 35.75
Expected exchange rate after 3 month $ 1 = Rs.35.75
Amt receivable in $ = $100 m
Amt receivable in Rs. = $100*35.75 = Rs.3575 m
Option 2 Hedging through put Option

[$ is LHC and it isto be sold, hence for hedging of sale price, we should buy put option]
Put option is purchased for sell of $ 100 m at strike Rate $ 1 = Rs.37
Premium paid = $ 1 = Rs.1
On Expiry Date
Exchange rate Strike Rate $ should Sale price of $ Premium Net Sale price Prob Net Sale Rate
after 3 months be sold Paid
$1 = Rs.35.00 $1 = Rs.37.00 To Writer $1 = Rs.37.00 $1 = Rs.1 $1 = Rs.36.00 0.20 7.20
$1 =
Rs.36.00
Amt receivable in $ = $100 m
Amt receivable in Rs. = $100*36 = Rs.3600 m
Conclusion: We should purchase put option.
Solution-9A
(c) Hedging through call option
XYZ is to pay £ 300000 in 180 days [$ - Sell and £ - Buy]
[£ is LHC and it is to be purchased, hence for hedging of purchase price, we should buy Call option]
Strike rate of Call Option = £ 1 = $ 1.97; Premium on Call Option £ 1 = $ 0.04

Expected Spot rate Strike Exercise of Purchase Rate Prem Total Purchase Prob. Expected
in 180 days Rate Call Option (Delivery) paid per unit Purchase Rate
1.91 1.97 No 1.91 0.04 1.95 0.25 0.4875
1.95 1.97 No 1.95 0.04 1.99 0.60 1.194
2.05 1.97 Yes 1.97 0.04 2.01 0.15 0.3015
£ 1 = 1.983
$ required to buy £3,00,000 at Expected purchase rate = £3,00,000*1.983 = $594900
Solution-9B
Strike Rate GBP 1 = USD 1.70 [USD-RHC–Buy; GBP-LHC-Sell]
LHC is GBP i.e. to be sold, hence A Ltd will buy put Option at Strike Rate GBP 1 = USD 1.70 for hedging of sale price of
GBP
Size of 1 Put Option Contract = GBP 12500
No of GBP to be sold = USD 364897/1.70 = GBP 214645.30
No of Put Option to be purchased = GBP 214645.30/12500 = 17.17 Contract i.e. 17 Contracts
No of GBP to be sold by 17 Contract = 12500*17 = GBP 212500
Hence USD that can be purchased by selling GBP 212500 by put Option = GBP 212500*1.70 = USD 361250
Balance USD would be purchased at FR of 6 month = 364897 – 361250 = USD 3647 @ 1.5455
Premium payable = 212500*0.096 = USD 20400
GBP required to pay Premium at SR = USD 20400/1.5617 = GBP 13062.70
On maturity date
Assuming Put option is exercisable, hence
GBP required to buy USD 3647 at FR = USD 3647/1.5455 = GBP 2359.75
Total Payment under Put Option = 212500+2359.75+13062.70 = GBP 227922.50

Option Payment
Forward cover GBP 236102.89
Money market GBP 236510.10
Currency option GBP 227923.00
The company should take currency option for hedging the risk.
Solution-10
London firm has supplied machine to New York for $120 m
London firm will receive $120 m in 4 months. [$ - Sell, £ - Buy]
Strike rate of 1 £ = $ 1.60
[£ is LHC and it is to be purchased, hence for hedging of purchase price, we should buy Call option]
But in question, it is stated that for hedging London based firm has purchased put option for selling $ hence we will
calculate strike rate by making $ as LHC
Strike Rate 1 $ = £ 1/1.60 = £0.625
After 4 months
Exchange rate $ 1 = £0.625 £0.65 £0.615
Strike Rate of put option £0.625 £0.625 £0.625
Where should holder sell $ [Higher of Two] Market Market Writer
Exercise of Put option by holder No No Yes
Sale price of $ for London Firm £0.625 £0.65 £0.625
Amt receivable in £ £0.625*120 = £75 m £0.65*120 = £78 m £0.625*120 = £75 m
(ii)
Put Option Premium £ 1 = $0.0002
No of $ to be sold through Put Option = $120
No of £ to be purchased through put option at strike rate = $120/1.60 = £ 75m
Premium paid on purchase of Put Option = £ 75*0.0002 = $ 0.015 m
Today Spot rate 1 £ = $ 1.58 or
$ 1 = £1/1.58 = £ 0.6329
Premium paid on purchase of Put Option in £ = $0.015*SR = $0.015/1.58 = £ 0.009494 m
Solution-11
An American firm is to pay Can$ 1010000 and Can$ 705000 on 31st July and 30th Sep respectively [Buy Can $ and Sell US
$]
Option 1 - Forward Cover

1 Month Forward Rate Can$ 1 = US$0.9301
3 Months Forward Rate Can$ 1 = US$0.9356
For hedging, an American firm will purchase

1 month forward contract for Can$ 1010000 @ Can$ 1 = US$0.9301
3 month forward contract for Can$ 705000 @ Can$ 1 = US$0.9356
US $ required to buy Can$ 1010000 at the end of 1 month = Can$ 1010000*0.9301 = US $ 939401
US $ required to buy Can$ 705000 at the end of 3 months = Can$ 705000*0.9356 = US $ 659598
Option 2 – Option Cover

Strike Rate of 1 month call option Can$ 1 = US$0.94 [Premium payable 1.02 cents payable]
Strike Rate of 3 month call option Can$ 1 = US$0.95 [Premium payable 1.64 cents payable]
No of Can $ in 1 call option = 50000
Hedging of 1 month obligation

American Firm will purchase 1 month call option = 1010000/50000 = 20.2 contracts means 20 Contract
In 20 contracts, firm can hedge only Can $ = 50000*20 = Can $ 1000000
Balance Can $ 10000 will be purchased at spot rate of 1 month
Premium payable for 20 contracts = Can$1000000*1.02 cents = US $ 10200
For hedging of 3 months obligation

American Firm will purchase 3 month call option = 705000/50000 = 14.1 contracts means 14 Contract
In 14 contracts, firm can hedge only Can $ = 50000*14 = Can $ 700000
Balance Can $ 5000 will be purchased at spot rate of 3 month
Premium payable for 14 contracts = Can$700000*1.64 cents = US $ 11480
Total payment under option

July Sep
Particulars Can $ Rate US $ Can $ Rate US $
No of Can $ Covered by Option 1000000 0.94 940000 700000 0.95 665000
Balance Can $ not covered by option 10000 0.9301 9301 5000 0.9356 4678
Total Cost under option 959501 681158
Comments: Payment under forward cover is less than option cover, hence forward cover is recommended in both
obligation.
Solution-12
Current price of share = Rs.100
Strike price of Call Option = Rs.100
Premium Paid = Rs.5
Break even price for call option = Strike Price + Premium paid = 100+5 = Rs.105
Spot price on expiry date = Rs.105
If Market price of share on maturity is Rs.105, then there will be not profit or loss.
Solution-13
(a) Expected Price of Share at expiry date = 30*0.1 + 36*0.25 + 40*0.3 + 44*0.25 + 50*0.1 = Rs.40
(b) Value of Call Option at expiration
Market price of Strike Price of Exercise of Call Value of Call Probability Expected Value of Call
Share at Expiration Call Option option by Holder Option at Option at Expiration
[Lower] expiration
30 38 No 0 0.10 0
36 38 No 0 0.25 0
40 38 Yes 2 0.30 0.60
44 38 Yes 6 0.25 1.50
50 38 Yes 12 0.10 1.20
3.30
Expected value of Call Option at expiration date = Rs.3.30
(c) Interest rate 12% p.a. NCC

Period of Option = 6 months
Interest rate for 6 months = 6%
Value of Option today = Value of Option at expiration/(1+PIR) = 3.30/1.06 = Rs.3.11
(d) Interest rate = 12% p.a. CC

Period of Option = 6 months = 0.5 Yrs
Value of Option today = Value of Option at expiration*e-rt = 3.30*e-0,12*0.5 = 3.30*e-0.06 = Rs.3.30*0.94176 = Rs.3.107
Solution-14
(a)
Strike Price of 1 year Call Option = Rs.90
Today Spot Price of Share = Rs.100
Maturity Period = 1 year
Interest rate = 10% p.a. NCC
Value of Call Option today = Today Spot Price of Share – (Strike Price/1+PIR) = 100 – 90/1.1 = Rs.18.19
(b) CMP of 1 year Call Option = Rs.15
CMP of Call Option < TFV of Call Option, hence arbitrage profit is possible.
Arbitrage process for Call Option
Following three transaction are done today
(a) Buy Call Option by paying premium of Rs.15
(b) It is assumed the person holds the share which he sells at the CMP at Rs.100
(c) Balance = (100-15) = Rs.85 is invested @10% for 1 year
At the end of 1 year
Settlement of above three transactions under 3 different prices of Share on maturity date
Assume Share price on the exercise date Rs.93 Rs.90 Rs.85
Strike Price of Call Option Rs.90 Rs.90 Rs.90
Exercise of call option (Lower) Yes No No
(d) Gain to Holder on settlement of Call Option +Rs.3 Rs.0 Rs.0
(e) Purchase of share from market -Rs.93 -Rs.90 -Rs.85
(f) Amt receivable from investment (Rs.85*1.1) Rs.93.50 Rs.93.50 Rs.93.50
Net Cash Flow [Arbitrage profit] Rs.3.50 Rs.3.50 Rs.8.50
Solution-14A
(a)
Strike Price of 1 year Call Option = Rs.180
CMP of Share = Rs.200
Interest rate = 10% p.a. CC
TFV of Call Option today = CMP of share - Strike Price*e-rt = 200 - 180*e-0,10*1 = 200 - 180*e-0.1
= 200 - 180*0.904837 = Rs.37.129
(b) CMP of Call option = Rs.30
CMP of Call Option < TFV of Call Option, hence arbitrage profit is possible.
Arbitrage process for Call Option
(a) Buy Call Option by paying premium of Rs.30
(b) It is assumed the person holds the share which he sells at the CMP at Rs.200
(c) Balance = (200-30) = Rs.170 is invested @10% for 1 year CC
At the end of 1 year
Strike Price of Call Option Rs.180 Rs.180 Rs.180
Exercise of call option (Lower) Yes No No
(d) Gain to Holder on settlement of Call Option +Rs.10 Rs.0 Rs.0
(e) Purchase of share from market -Rs.190 -Rs.180 -Rs.170
-0.1
(f) Amt receivable from investment (Rs.170*e ) Rs.187.87 Rs.187.87 Rs.187.87
Solution-15
(a)
Strike Price of 6 months Put Option = Rs.200
Maturity Period = 6 months
Interest rate = 5% p.a. NCC
TFV of Put Option today = Strike Price*PVF(6months, 2.5%) - CMP of Share = 200*0.97561 - 185 = Rs.10.122
(b) CMP of Put Option = Rs.5

CMP of Put Option < TFV of Put Option, hence arbitrage profit is possible
Arbitrage process for Put Option

(a) Buy Put Option by paying premium of Rs.5
(b) Buy share at the CMP at Rs.185
(c) Borrow = (5+185) = Rs.190 @2.5% for 6 months
At the end of 6 months
Strike Price of Put Option Rs.200 Rs.200 Rs.200
Exercise of call option (Higher) Yes No No
(d) Gain to Holder on settlement of Put Option Rs.10 0 0
(e) Sale of share in market Rs.190 Rs.200 Rs.210
(f) Repayment of borrowing (Rs.190*1.025) - Rs.194.75 - Rs.194.75 - Rs.194.75
Solution-15A
(a)
Strike Price of 6 months Put Option = Rs.400
CMP of Shares = Rs.370
Interest rate = 5% p.a. CC
Value of put option today = Strike Price*e-rt - CMP of Share = 400*e-0.05*1/2 – Rs.370
= 400*e-0.025 – Rs.370 = 400*0.975323 - 370 = Rs.20.129
(b) CMP of Put Option = Rs.10

CMP of Put Option < TFV of Put Option, hence arbitrage profit is possible
Arbitrage process for Put Option

(a) Buy Put Option by paying premium of Rs.10
(b) Buy share at the CMP at Rs.370
(c) Borrow = (10+370) = Rs.380 @2.5% for 6 months CC
At the end of 6 months
Strike Price of Put Option Rs.400 Rs.400 Rs.400
Exercise of call option (Higher) Yes No No
(d) Gain to Holder on settlement of Put Option Rs.10 0 0
(e) Sale of share in market +Rs.390 +Rs.400 +Rs.410
.025
(f) Repayment of borrowing Rs.380*e = Rs.380*1.025302 - Rs.389.61 - Rs.389.61 - Rs.389.61
Solution-16
(a)
S1 = Rs.60; S2 = Rs.40; Strike Price (K) = Rs.50; CMP of Share (S) = Rs.50
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(60-50),0] = Rs.10
Hedge Ratio ∆ = C1-C2/S1-S2 = 10-0/60-40 = 0.50
Borrowing = ∆*(S2-C2)/1+r = 0.50*(40-0)/1.12 = Rs.17.85 or
Borrowing = ∆*S1-nC1/1+r = (0.50*60-1*10)/1.12 = Rs.17.85 or
Value of Call Option under BM = ∆*CMP of Share – Borrowing = 0.50*50 - 17.85 = Rs.7.15
(b)
Now, the investor can have two possible strategies:
Option Cash Flow at t0
1 Buy one Call Option by paying a premium - 7.50
2 Buy Replicating Portfolio
(a) Buy 0.50 shares at CMP of Rs.50 -25.00
(b) Borrowing @12% p.a. for 1 year +17.50
- 7.50
Holding position of cash under both option at expiration

Market Price of Share S1 = Rs.60 S2 = Rs.40
1 Strike Price of Call Option Rs.50 Rs.50
Exercise of Call Option by Holder (Lower) Yes No
Gain on Settlement of Call Option (Lower) +10 0
2 Settlement of Replicating Portfolio
(a) Sale of 0.5 Share at CMP +30 +20
(b) Repayment of borrowing = Rs.17.50*1.12 -20 -20
+10 0
(c) (i)
CMP of Call Option = Rs.8
TFV of Call Option = Rs.7.15
CMP of Call Option > TFV of Call Option, hence we should sell call option and buy a replicating portfolio.
Process for Arbitrage Profit

Today
Particulars Cash Flow at t0
(a) Sell Call Option at CMP (Writer) +8
(b) Buy Replicating Portfolio
(i) Buy 0.5 Shares at CMP -25
(ii) Borrow (25-8) = Rs.17 for 1 year @12% p.a. +17
0
Cash Position at the end of one year

Particulars Share price = Rs.60 Share price = Rs.40
(a) Loss to Writer on settlement of Call Option -10 0
(b) Settlement of Replicating Portfolio
(i) Sale of 0.50 Shares at Market Price +30 +20
(ii) Repayment of borrowing = 17*1.12 -19.04 -19.04
Arbitrage profit +0.96 +0.96
(ii)
TFV of Call Option = Rs.7.15
CMP of Call Option > TFV of Call Option, hence we should buy call option and sell a replicating portfolio.
Process for Arbitrage Profit
Today
Particulars Cash Flow at t0
(a) Buy Call Option at CMP (Holder) -5
(b) Sell Replicating Portfolio
(i) Sell 0.5 Shares at CMP +25
(ii) Deposit (25-5) = Rs.20 for 1 year @12% p.a. -20
0
Cash Position at the end of one year

Particulars Share price = Rs.60 Share price = Rs.40
(a) Gain to Holder on settlement of Call Option +10.00 0.00
(b) Settlement of Replicating Portfolio
(i) Purchase of 0.50 Shares at Market Price -30.00 -20.00
(ii) Amt receivable from Deposit = 20*1.12 +22.40 +22.40
Arbitrage profit +2.40 +2.40
Solution-16A
S1 = Rs.250; S2 = Rs.140; Strike Price = Rs.180; CMP of Share (S) = Rs.190
(i) Hedge Ratio ∆ = C1-C2/S1-S2 = 70-0/250-140 = 0.64
(ii) Borrowing = ∆*(S2-C2)/1+r = 0.6363*(140-0)/1.09 = Rs.82.20 or
Borrowing = ∆*S1-nC1/1+r = (0.64*250-1*70)/1.09 = Rs.82.20 or
(iii) TFV of Call option under BM = ∆*Today Spot Price –Borrowing = 0.64*190 – 82.20 = Rs.39.40
Assuming CMP of Call Option = Rs.39.40
(iv)
Now, the investor can have two possible strategies:
Option Cash Flow at t0
1 Buy one Call Option by paying a premium - 39.40
2 Buy Replicating Portfolio
(a) Buy 0.64 shares at CMP of Rs.190 -121.60
(b) Borrowing (121.60-39.40) = Rs.82.20 @ 9% p.a. for 1 year +82.20
- 39.40
Holding position of cash under both option at expiration

Market Price of Share S1 = Rs.250 S2 = Rs.140
1 Strike Price of Call Option Rs.180 Rs.180
Exercise of Call Option by Holder (Lower) Yes No
Gain on Settlement of Call Option (Lower) +70 0
2 Settlement of Replicating Portfolio
(a) Sale of 0.64 Share at Market Price 250*0.64 = Rs.160 140*0.64 = Rs.90
(b) Repayment of borrowing = Rs.82.20*1.09 -90 -90
+70 0
Solution-17
Exercise Price = Rs.450, S1 = Rs.500, S2 = Rs.400; CMP of Share (S) = Rs.420
P1 = Prob of S1 = [Current Price*ert - S2]/(S1 - S2) = (420*1.0202 – 400)/(500-400) = 0.28484
P2 = Prob of S2 = 1 – 0.28484 = 0.71516
Value of Call Option at expiration = C1P1 + C2P2 = 50*0.28484 + 0*0.71516 = Rs.14.242
Value of Call Option today = 14.242*e-rt = 14.242*0.9802 = 13.96
Not part of Solution

Value of Call Option under BM
Hedge Ratio ∆ = C1-C2/S1-S2 = (50-0)/(500-400) = 0.5
Borrowing = ∆*(S2-C2)/1+r = 0.5*(400-0) *e-rt = Rs.200*0.9802 = 196.04
Value of Call Option under BM = ∆*Today Spot Price – Borrowing = 0.5*420 – 196.04 = Rs.13.96
Solution-17A
Exercise Price of Call Option = Rs.220
u = 1.4; d = 0.90; r = 0.15
S1 = CMP of Share*u = Rs.200*1.4 = Rs.280
S2 = CMP of Share*d = Rs.200*0.9 = Rs.180
Risk Neutralisation Method

P1 = Prob of S1 = [Current Price*(1+PI) - S2]/S1 - S2 = [200*(1.15) – 180]/[280-180] = 0.5
P2 = 1 – 0.5 = 0.5
Value of Call Option at expiration = C1P1 + C2P2 = 60*0.5 + 0*0.5 = Rs.30
Value of Call Option today = 30/1+PI = 30/1.15 = Rs.26.09
Solution-17B
S1 = Rs.592; S2 = Rs.411; CMP of Share = Rs.421; IR = 3.6% for one month CC [Assume]
P1 = Prob of S1 = [CMP of Share*ert - S2]/(S1 - S2) = (421*1.037 – 411)/(592 - 411) = 0.14
Prob of S1 = 0.14
Solution-18
Exercise Price of Call Option = Rs.630
S1 = Rs.780
S2 = Rs.480
(i) Hedge Ratio ∆ = C1-C2/S1-S2 = 150-0/780-480 = 0.5

For 1 call option, writer should buy 0.5 share for perfect hedge.
(ii) Value of Option Today
Risk Neutralisation Method
P1 = 0.6
P2 = 0.4
Value of Call Option at expiration = C1P1 + C2P2 = 150*0.6 + 0*0.4 = Rs.90
Value of Call Option today = 90/1+PI = 90/1.025 = Rs.87.80
Solution-19
(i) If apartments are to be sold now
Particulars Option 1 Option 2
No of Apartments 10 15
Construction Cost (Lacs) 600 1025
CMP of each Unit (Lacs) 80 80
Market value of Apartment (Lacs) 800 1200
Profit (Lacs) 200 175
Option 1 is better
(ii) If apartments are to be sold after 1 year

Particulars Buoyant Market Sluggish Market
Option 1 Option 2 Option 1 Option 2
No of Apartments 10 15 10 15
Construction Cost at t0 (Lacs) 600 1025 600 1025
MP of each Unit at the end of Year (Lacs) 91 91 75 75
Market value of Apartment at the end of year (Lacs) 910 1365 750 1125
Profit (Lacs) 310 340 150 100
If market is buoyant, than Option 2 is better and if market is sluggish than Option 1 is better
(iii) Determination of Value of Vacant Plot

We will use Binomial Model (Risk Neutral Method) as follows
If flat is constructed at t0 and given on rent for 1 year than
If market is buoyant, then S1 = 91+7 = 98 lacs
If market is sluggish, then S2 = 75+7 = 82 lacs
P1 = Prob of S1 = [Current Price*(1+PI) - S2]/S1 - S2 = [80*(1.1) – 82]/[98-82] = 0.375
P2 = 1 – 0.375 = 0.625
Expected profit at the end of year = 340*0.375 + 150*0.625 = Rs.221.25 lacs
PV of Expected Profit = 221.25/1.1 = Rs.201.12 lacs
Value of vacant land = Rs.201.12 lacs
Solution-20
CMP of Share = Rs.60; d = 0.7; Period = 1 year; RF = 12%; Exercise Price = Rs.55
S1 = ?
S2 = CMP of Share*d = 60*0.70 = Rs.42
Suppose Hedge ratio = n
Calculation of value of hedge position at expiration date
Assume CMP of Call Option = TFV of Call Option under BM
Value of Call option under BM = ∆*CMP of Share – Borrowing
15 = ∆*60 – ∆*S2/(1+PI)
15 = ∆*60 – ∆*42/1.12
15 = ∆*60 – ∆*37.50
∆*22.50 = 15
∆ = 15/22.50 = 0.667
∆ = C1-C2/S1-S2
0.667 = [(S1-55)-0]/(S1-42)
0.667S1 – 0.667*42 = S1-55
0.333 S1 = (55-28.014)
S1 = 26.986/0.333 = Rs.81
u = S1/S = 81/60 = 1.35
Alternative Solution
P1 = (60*1.12-42)/(S1-42)
P1 = 25.20/(S1-42)
P2 = 1 – P1
C1 = S1-55
C2 = 0
Value of Call Option today = C1P1 + C2P2/(1+PIR)
15 = (S1-55)*25.20/(S1-42)*1.12
15 = 25.2S1 – 1386/(1.12S1-47.04)
15*(1.12S1 - 47.04) = 25.2S1 – 1386
16.8S1 – 705.60 = 25.2S1 – 1386
8.4S1 = 680.4
S1 = 680.4/8.4 = Rs.81
Solution-21
CMP of Share = Euro 500; S1 = Euro 550; S2 = Euro 450; Rf = 14%; Exercise Price of Put Option = Euro 510
Period of Put Option = 6 months
PI for 6 months = 7%
C1 = Value of Put Option at expiration at S1 = Max[(Strike Price - Spot Price at expiration),0] = Max[(510-550),0] = Rs.0
C2 = Value of Put Option at expiration at S2 = Max[(Strike Price - Spot Price at expiration),0] = Max[(510-450),0] =
Rs.60
Prob of S1 = (Current Price*ert - S2)/(S1 - S2) = (500*1.072508 – 450)/(550-450) = 0.86254

P2 = 1 – 0.86254 = 0.13746
Value of Put Option at expiration = C1P1 + C2P2 = 0*0.86254 + 60*0.13746 = Rs.8.24
Value of Put Option today = Value of Put Option at expiration/1+PI = 8.24/1.07 = Rs.7.70
Solution-22
Today Spot Rate 1 $ = Rs.50
Period of Call Option = 1 year
Exercise Rate 1 $ = Rs.60
Expiration date higher Rate S1 = 1 $ = Rs.70
Expiration date Lower Rate S2 = 1 $ = Rs.40
Interest rate in India (RHC) = 10% p.a.
Interest rate in USA (LHC) = 15% p.a
P1 = (Today Spot Rate*(1+PIRHC) - S2*(1+PILHC))/(S1*(1+PIRHC) - S2*(1+PIRHC))

= (50*1.1 – 40*1.15)/(70*1.15-40*1.15) = 0.2609
P2 = 1 – 0.2609 = 0.7391
Value of Call Option at expiration = (10*0.2609 + 0*0.7391) = Rs.2.609
Value of Call Option today = 2.609/1.1 = Rs.2.37
Note: Cross Checking

1) Suppose the Indian investor has Rs.50
If he invest the money in India then value at year end = 50*1.1 = Rs.55
2) Suppose Rs.50 is converted in 1 $ amt and invested in USA
At one year end 1 $ amt will be equal to = 1.15 $
Year end value of invested amt (at higher price) = Rs.1.15 x 70 = Rs.80.50
Year end value of invested amt (at lower price) = Rs.1.15 x 40 = Rs.46
Prob of High Price of 1 $ = [50 x (1.1) – 46]/[80.50 - 46] = 0.2609
Expected overall value invested amount = 80.5*0.2609 + 46*0.7391 = Rs.55
Solution-22A
Today Spot Rate 1 £ = Rs.60
Exercise Rate 1 £ = Rs.64
Expiration date higher Rate 1 £ = Rs.76.25 = S1
Expiration date Lower Rate 1 £ = Rs.45.00 = S2
Interest rate in India (RHC) = 15% p.a.
Interest rate in London (LHC) = 20% p.a
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(76.25-64),0] =
Rs.12.25
P1 = (Current Price*(1+PIRHC) - S2*(1+PILHC))/(S1*(1+PIRHC) - S2*(1+PIRHC))

= (60*1.15 – 45*1.20)/(76.25*1.20-45*1.20) = 0.4
P2 = 1 – 0.4 = 0.6
Value of Call Option at expiration = (12.25*0.4 + 0*0.6) = Rs.4.90
Solution-23
CMP of share = Rs.100
Dividend payable after 2 months = Rs.5
S1 = 140; S2 = Rs.80; Rf = 12%; Strike price = Rs.110
Interest rate for 2 months = 2%
PV of Dividend at T0= Rs.5/1.02 = Rs.4.9019
Future value of Dividend at the end of 3 months = Rs.5*1.01 = Rs.5.05
BM Model
∆ = (C1-C2)/(S1-S2) = (30-0)/(140-80) = 0.50
Borrowing = ∆*S2/1.03 = 0.50*80/1.03 = Rs.38.83
Value of Option = ∆*(CMP of Share – PV of Dividend) – Borrowing = 0.50*(100 – 4.90) – 38.83 = Rs.8.72
RNM
P1 = (CMP of Share*(1+PI) - S2 – FV of Dividend)/(S1 - S2) = (100*1.03 – 80 - 5.05)/(140-80) = 0.2992
P2 = 1 – 0.2992 = 0.7008
Value of Call Option at expiration = C1P1 + C2P2 = (30*0.2992 + 0*0.7008) = Rs.8.976
Solution-24
Stock prices in the two step Binominal tree
CMP of Share = Rs.50; u = 1.2; d = 0.8; IR = 6%
(a) S1 for first year = Rs.60; S2 for first year = Rs.40
(c)
P1 of Rs.60 = (1+R-d)/(u-d) = (1.06-0.80)/(1.20-0.08) = 0.26/0.04= 0.65
P2 of Rs.40 = 1-0.65 = 0.35
(b) Four possibilities regarding possible prices for next year

Possibilities Possible Price
Up by 20% in first year and again up by 20% in next year = S3 = S*d1*d2 50*1.2*1.2 = 72
Up by 20% in first year and down by 20% in next year = S4 = S*d1*u2 50*1.2*0.8 = 48
Down by 20% in first year and up by 20% in next year = S5 = S*u1*d2 50*0.8*1.2 = 48
Down by 20% in first year and down by 20% in next year = S6 = S*u1*u2 50*0.8*0.8 = 32
(d) Calculation of Prob of all four prices

Prob of Rs.72 from Rs.60 in 2nd year = P3 = (S1*(1+PIR) – S4)/(S3 – S4) (60*1.06-48)/(72-48) = 0.65
Prob of Rs.48 from Rs.60 in 2nd year = P4 = P4 = 1 – P3 = 1-0.65 = 0.35
nd
Prob of Rs.48 from Rs.40 in 2 year = P5 = (S2*(1+PIR) – S6)/(S5 – S6) = (40*1.06-32)/(48-32) = 0.65
(e) Joint Probability of all four prices at the end of 2nd year
Joint Probability of Rs.72 from Rs.50 JP1 of S3 = P1*P3 0.65*0.65 = 0.4225
(f) Computation on value of ECO at expiration of 2nd Period

Price of Share on maturity Strike Price Value of Call Option JP Expected Value of Option
72 50 22 0.4225 9.295
48 50 0 0.455 0
48 50 0 0.455 0
32 50 0 0.1225 0
9.295
Expected value of Call option at the end of 2nd year = 9.295
(g) TFV of ECO option today = 9.295*e-0.12 = Rs.9.295*0.88692 = Rs.8.2439
American Option
Computation on value of American Call Option at end of First year at Point B
Price on maturity Strike Price Value of Call Option Prob. Expected Gain
72 50 22 0.65 14.30
48 50 0 0.35 0
Expected value of ACO at point B = 14.30/1.06 = 13.49
Computation on value of ACO at end of First year at Point C

Price on maturity Strike Price Value of Call Option Prob. Expected Gain
48 50 0 0.65 0
32 50 0 0.35 0
Expected value of option at point C = 0/1.06 = 0
Value of ACO at the end of first year = 13.49*0.65 + 0*0.35 = Rs.8.7685

Value of ACO today = 8.7685/1.06 = Rs.8.272
Solution-24A
Today spot price of share = Rs.100; u = 1.1; d = 0.9; IR = 8%
(a) S1 = 110; S2 = Rs.90; for first six months
Rf = 8%; Strike price = Rs.100
(c)
P1 of Rs.110 = (100xe0.08x.50 – 90)/(110-90) = 0.70405
P2 of Rs.90 = 0.29595
(b)
Four possibilities regarding possible prices for next six months
Possibilities Possible Price
Up by 10% in first 6 months and again up by 10% in next 6 months = S*d1*d2 100x1.1x1.1 = 121
Up by 10% in first 6 months and down by 10% in next 6 months = S*d1*u2 1600x1.1x0.9 = 99
Down by 10% in first 6 months and down by 10% in next 6 months = S*u1*u2 100x0.9x0.9 = 81
Down by 10% in first 6 months and up by 10% in next 6 months = S*u1*d2 100x0.9x1.1 = 99
(d) Calculation of Prob of all four prices

Prob of Rs.121 from Rs.110 in 1 year = P3 = (S1*(1+PIR) – S4)/(S3 – S4) = (100* e0.04 - 90)/(110-90) = 0.70405
Prob of Rs.99 from Rs.110 in 1 year = P4 = P4 = 1 – P3 = 1-0.70405 = 0.29595
0.04
Prob of Rs.81 from Rs.90 in 1 year = P5 = (S2*(1+PIR) – S6)/(S5 – S6) = (90*e - 81)/(99-81) = 0.70405
(e) Joint Probability of all four prices at the end of 2nd year
(f) Computation on value of ECO at expiration of 2nd Period

Price of Share on maturity Strike Price Value of Call Option JP Expected Value of Option
121 100 21 0.4956 10.41
99 100 0 0.2084 0
99 100 0 0.2084 0
81 100 0 0.0876 0
10.41
Expected value of Call Option at maturity = 10.41
TFV of Call Option today = 10.41*e-0.08 = Rs.9.61
Solution-25
CMP of share S = Rs.100
Rf = 12%; Strike price K = Rs.101
For first 3 months
Pricing going up by 10% over first 3 months time, hence S1 = 110;
Pricing going down by 10% over first 3 months time, hence S2 = 90;
Interest for 3 months = 3%
P1 of Rs.110 = (100*1.03 -90)/(110 -90) = 0.65
P2 of Rs.90 = 1-0.65 = 0.35
For the next 3 months

Pricing going up by 8% over next 3 months and Pricing going down by 6% over next 3 months time, hence expected
price at the end of 6 months and their probability
Price at the end % of Change Expected Price at the Probability of Price Joint JP
of 3 months in Price end of 6 months Probability
110 8% up Rs.118.80 (110*1.03-103.40)/(118.80- 0.65*0.6429 0.4179
103.40) = 0.6429
110 6% Down Rs.103.40 1-0.6429 = 0.3571 0.65*0.3571 0.2321
90 8% up Rs.97.20 0.6429 0.35*0.6429 0.2250
90 6% Down Rs.84.60 0.3571 0.35*0.3571 0.1250
Computation of Expected value of EPO at expiration

Price on maturity Strike Price of Put Option Value of Put Option Prob. Expected Value of Put Option
118.80 101 0 0.4179 0
103.40 101 0 0.2321 0
97.20 101 3.80 0.2250 0.855
84.60 101 16.40 0.1250 2.05
2.905
Expected value of Put at Maturity = Rs. 2.905
TFV of Put Option today = 2.905/1.06 = Rs.2.7406
Solution-26
(a) CMP of Share S = Rs.60
Strike Price of Call Option K = Rs.56
r = 14% p.a. CC; t = 6 months = 0.5
SD = 0.3
(d1) = [In (S/K) + (r + 0.5*SD2)*t]/SD√t
(d1) = [In (60/56) + (0.14 +0.5*0.09)*0.5]/0.3√0.5 = [In(1.0714) + (0.0925)]/0.2121 = (0.0689 + 0.0925)/0.2121
(d1) = 0.760
d2 = d1 - σ√t = 0.760 - 0.3√0.5 = 0.760 – 0.2121 = 0.548
N(d1) = N(0.760) = 0.500 + 0.2764 = 0.7764

N(d2) = N(0.548) = 0.500 + 0.2070 = .7070
Value of the call option = S*N(d1)–Ke-rtN(d2) = 60*0.7764–56*e-.07*0.7070 = 60*0.7764–56*0.9324*0.7070 = Rs.9.66
Solution-26A
CMP of Share S = Rs.80
r = 12% p.a. CC; t = 6 months = 0.5
SD = 0.4
(d1) = [In (S/K) + (r + 0.5*SD2)*t]/SD√t
(d1) = [In(80/75) + (0.12 + 0.5*0.40*0.40)*0.5]/0.40*√0.5 = In(1.0667) + 0.1]/0.4*√0.5
= (0.0645 + 0.1)/0.2828 = 0.5817
d2 = d1 - σ√t = 0.5817 – 0.2828 = 0.2989
Nd1 = N (0.5817) = N(0.58) + [N(0.59) - N(0.58)]*0.17 = 0.7190 + (0.7224-0.7190)*0.17 = 0.7195
Nd2 = N (0.2989) = N(0.29) + [N(0.30) - N(0.29)]*0.89 = 0.6141 + (0.6179-0.6141)*0.89 = 0.6174
e-rt = e-0.12 x 0.50 = e-0.06 = 0.9417
Value of Call Option = S*N(d1) – K*e-rt *N(d2) = 80*0.7195 – 75*e-0.06*0.6174 = 57.56 – 46.305*0.9418 = Rs.13.95
Solution-26B
CMP of Share S = Rs.185
r = 7% p.a. CC; t = 3 years = 3
SD = 0.18
(d1) = [In (S/K) + (r + 0.5*SD2)*t]/SD√t

(d1) = [In(185/170) + (0.07 + 0.5*0.18*0.18)*3]/0.18*√3
= In(1.08823) + 0.2586]/0.18*1.7320
= (0.08454 + 0.2586)/0.31176 = 1.1006
d2 = d1 - σ√t = 1.1006 – 0.31176 = 0.78884
Nd1 = N(1.1006) = 0.8643
Nd2 = N(0.78884) = N(0.78) + [N(0.79) - N(0.78)]*0.884 = 0.7823 + (0.7852-0.7823)*0.884 = 0.7848
e-rt = e-0.07*3 = e-0.21 = 0.810584
Value of Call Option = S*N(d1) – K*e-rt *N(d2) = 185*0.8643 – 170*0.810584*0.7848 = 159.8955 – 108.1448
= Rs.51.75
Solution-27 [P]
Dividend receivable = Rs.10 after 2 months
PV of Dividend = Rs.10*e-rt = Rs.10*e-0.05*2/6 = Rs.10*e-0.01667 = 10*0.983479 = 9.83479
e-0.01667 = e-0.01667 = e-0.01 + [e-0.02 - e-0.01]*0.667 = 0.99005 + (0.980199-0.99005)*0.667 = 0.983479
(d1) = [In (Current Price of Share-PV of Dividend/Strike Price) + (r + 0.5*SD2)*t]/SD√t
(d1) = [In(408-9.83479/400) + (0.05 + 0.5*0.22*0.22)*0.25]/0.22*√0.25 = In(0.995413) + 0.01855]/0.22*0.5
= (-0.00543713 + 0.01855)/0.11 = 0.119
d2 = d1 - σ√t = 0.119 – 0.11 = 0.009
Nd1 = N(0.119) = N(0.11) + [N(0.12) - N(0.11)]*0.9 = 0.5438 + (0.5478-0.5438)*0.9 = 0.5474
Nd2 = N(0.009) = N(0.00) + [N(0.01) - N(0.00)]*0.9 = 0.5 + (0.5040-0.5)*0.9 = 0.5036
Working Note
In(0.995413) = In(9.95413/10) = In(9.95413) – In(10) = 2.29715287 – 2.30259 = - 0.00543713
In(9.95413) = In(9.95) + [In(9.96) – In(9.95)]*0.413 = 2.29757 – (2.29858-2.29757)*0.413 = 2.29715287
e-rt = e-0.05*0.25 = e-0.0125 = e-0.01 + [e-0.02 - e-0.01]*0.25 = 0.99005 + (0.980199-0.99005)*.25 = 0.987587
Value of Call Option = (S-PV of Dividend)*N(d1) – K*e-rt *N(d2)

= (408-9.83479)*0.5474 – 400*0.987587*0.5036 = 217.9556 – 198.9395 = Rs.19.0161
Solution-28
(d1) = [In (Current Price of Share/Strike Price) + (r + 0.5*SD2)*t]/SD√t
(d1) = [In(120/112) + (0.05 + 0.5*0.3*0.3)*0.25]/0.3*√0.25 = In(1.0714) + 0.02375]/0.3*0.5
= (0.068961 + 0.02375)/0.15 = 0.6180
In(1.0714) = In(1.07) + [In(1.08) - In(1.07)]*0.14 = 0.067659 + (0.076961-0.067659)*0.14 = 0.068961
d2 = d1 - σ√t = 0.618 – 0.15 = 0.468
Nd1 = N(0.618) = N(0.61) + [N(0.62) - N(0.61)]*0.8 = 0.7291 + (0.7324-0.7291)*0.8 = 0.73174
Nd2 = N(0.468) = N(0.46) + [N(0.47) - N(0.46)]*0.8 = 0.6772 + (0.6808-0.6772)*0.8 = 0.68008
e-rt = e-0.07*0.25 = e-0.0175 = e-0.01 + [e-0.02 - e-0.01]*0.75 = 0.99005 + (0.980199-0.99005)*.75 = 0.982662
Value of Put Option = K*e-rt *(1-N(d2)) - S*(1-N(d1)) = 112*0.982662(1-0.68008) – 120*(1-0.73174) =
= Rs.3.0186
Solution-29
If Market Price of Share at expiry = Rs.55
Mr X Buy 1 1
Exercise of Option by Mr X No Yes
Value of Option 0 5 +5
Net Gain/ (Loss) -2 +2 0
If Market Price of share at Expiry = Rs.60

Mr X Buy 1 1
Value of Option 0 0 0
If Market Price of share at expiry = Rs.65

Mr X Buy 1 1
If Market Price of share at expiry = Rs.76

Mr X Buy 1 1
Exercise of Option by Mr X Yes No
Net Gain/ (Loss) 9 -3 6
Solution-30
Cost =Premium of both the options =Rs.11
Break-even will be there in following two mutual exclusive cases:
Breakeven point on exercise of Put Option = Strike Price of Put Option – Premium Paid = Rs.185 – Rs.11 = Rs.174
Breakeven point on exercise of Call Option = Strike Price of Call Option + Premium Paid = Rs.190 + Rs.11 = Rs.201
Comments: If Market Price of Share on Expiration is Rs.174 or Rs.201 then there will be no profit or loss.
Solution-31
If market price of share at expiry = Rs.90
Investor Buy 1 1
Exercise of Option by Holder No Yes
Value of Option 0 +7 +7
Net Gain/ (Loss) -3 +5 +2

Investor Buy 1 1
Exercise of Option by Holder No No

Investor Buy 1 1
Exercise of Option by Holder Yes No
Value of Option +8 0 +8
Net Gain/ (Loss) +5 -2 +3
So, the investor will be benefited whether price is less than or more than the strike price on the expiry day.
Solution-31A
Total Premium paid = CHF = 2+3 = CHF 5
Strike price of Call and Put = CHF 75
MP of Share at Maturity Gain on Put Option to X Gain on Call option to X X’s pay-off Y’s pay-off
60 15 0 -5 (prem.) + 15 =+10 -10
65 10 0 -5 (prem.) +10 =+5 -5
70 5 0 -5 (prem.) + 5 =+0 0
71 4 0 -5 (prem.) + 4 = -1 +1
72 3 0 -5 (prem.) + 3 = -2 +2
73 2 0 -5 (prem.) + 2 = -3 +3
74 1 0 -5 (prem.) + 1 = -4 +4
75 0 0 -5 (prem.) + 0 = -5 +5
76 0 1 -5 (prem.) + 1 = -4 +4
77 0 2 -5 (prem.) + 2 = -3 +3
78 0 3 -5 (prem.) + 3 = -2 +2
79 0 4 -5 (prem.) + 4 = -1 +1
80 0 5 -5 (prem.) + 5 = -0 0
85 0 6 -5 (prem.) + 10 = 5 -5
90 0 7 -5 (prem.) + 15 = 10 -10
Solution-32
(i) Straddle is a portfolio of a CALL & a PUT option with identical Strike Price. A trader sells Straddle of at the Money
Straddle will be selling a Call option & a put option with Strike Price of USD per EUR.

Investor sell (Writer) 1 1
Premium Received ($) 0.035 0.04 0.075
Strike Price Euro 1 = $ 1.20 $ 1.20
If market Price of Rate at expiry $ 1.29 $ 1.29
Gain to Holder 0.09 0 0.09
Loss to Writer 0.09 0 0.09
Premium Received 0.035 0.04 0.075
Net Loss 0.055 -0.04 0.015
(ii)
Particulars Call Option Put Option
Premium Paid Rs.0.12 Rs.0.04
Strike Price Rs.44.80 Rs.44.80
Gain 0.20 0
Premium Paid 0.12 Rs.0.04
Net Gain/ (Loss) 0.08 -0.04
Hence we should buy call option to earn profit
Net gain on purchase of call option for USD 1500000 = USD 1500000*0.08 = Rs.120000
Solution-33
Strike price of Call and Put Option = Rs.60
Premium on call and put option = Rs.1
Maturity Period of both Option = 3 months
Spot Price of Share Strike Price of Exercise of Gain on Exercise of Gain Total Gain Premium Net
at expiration Call and Put Call Call Put on Put Paid Payoff
55 Rs.60 No 0 Yes 5 0+5*2=10 -3 7
56 Rs.60 No 0 Yes 4 0+4*2=8 -3 5
57 Rs.60 No 0 Yes 3 0+3*2=6 -3 3
58 Rs.60 No 0 Yes 2 0+2*2=4 -3 1
59 Rs.60 No 0 Yes 1 0+1*2=2 -3 -1
60 Rs.60 No 0 No 0 0+0*2=0 -3 -3
61 Rs.60 Yes 1 No 0 1+0*2=1 -3 -2
62 Rs.60 Yes 2 No 0 2+0*2=2 -3 -1
63 Rs.60 Yes 3 No 0 3+0*2=3 -3 0
64 Rs.60 Yes 4 No 0 4+0*2=4 -3 1
65 Rs.60 Yes 5 No 0 5+0*2=5 -3 2
Solution-34
Net Premium = -10-5+14 = -1
Pay-off table
Spot price Call at 55 Two Calls at 60 Call at 65 Premium Pay-off
51 - - - -1 -1
52 - - - -1 -1
53 - - - -1 -1
54 - - - -1 -1
55 - - - -1 -1
56 1 - - -1 0
57 2 - - -1 +1
58 3 - - -1 +2
59 4 - - -1 +3
60 5 - - -1 +4
61 6 -2 - -1 +3
62 7 -4 - -1 +2
63 8 -6 - -1 +1
64 9 -8 - -1 0
65 10 -10 - -1 -1
66 11 -12 1 -1 -1
67 12 -14 2 -1 -1
68 13 -16 3 -1 -1
69 14 -18 4 -1 -1
70 15 -20 5 -1 -1
Solution-35
Condor Spread
Buy 1 Call (97)
Sell 1 Call (100)
Sell 1 Call (102)
Buy 1 Call (103)
Net Premium = -2+1.50+1-0.70 = -0.20
Market price of Share on maturity Call 97 Call 100 Call 102 Call 103 Net premium Net profit/loss
96 0 0 0 0 -0.20 -0.20
97 0 0 0 0 -0.20 -0.20
98 1 0 0 0 -0.20 +0.80
99 2 0 0 0 -0.20 +1.80
100 3 0 0 0 -0.20 +2.80
101 4 -1 0 0 -0.20 +2.80
102 5 -2 0 0 -0.20 +2.80
103 6 -3 -1 0 -0.20 +1.80
104 7 -4 -2 1 -0.20 +1.80
Solution-36
Strategy: Buy Call with lower strike price, sell with higher strike price.
Net Premium Paid = 5 – 3 = Rs.2.
Spot Price of Share at Exercise of Call Exercise of Call Gain on Call Loss on Call Premium Net
expiration (100) (115) (100) (115) Paid Payoff
95 No No 0 0 -2 -2
100 No No 0 0 -2 -2
105 Yes No 5 0 -2 3
110 Yes No 10 0 -2 8
115 Yes No 15 0 -2 13
125 Yes Yes 25 -10 -2 13
Maximum Loss Rs.2 and maximum Gain Rs.13
Solution-36A
(a) The best strategy for Mr X would be long call spread.
Strategy: Buy Call with lower strike price (Rs.125), sell with higher strike price (Rs.130)
(b) Payoff Position can be computed as follows:
Net Premium Paid = 3.30 – 1.80 = Rs.1.50
Spot Price of Share at Exercise of Call Exercise of Call Gain on Call Loss on Call Premium Net
expiration (125) – Holder (130) – Writer (125) (130) Paid Payoff
124 No No 0 0 -1.50 -1.50
125 No No 0 0 -1.50 -1.50
126 Yes No 1 0 -1.50 -0.50
127 Yes No 2 0 -1.50 0.50
128 Yes No 3 0 -1.50 1.50
129 Yes No 4 0 -1.50 2.50
130 Yes No 5 0 -1.50 3.50
131 Yes Yes 6 -1 -1.50 3.50
Maximum Loss Rs.1.50 and maximum Gain Rs.3.50
Break even price of Share = Strike Price + premium Paid = 125+1.50 = 126.50
Solution-37
Bull Put Spread
Buy Put Option of 105 by paying Premium of Rs.1
Sell Put Option of 115 by receiving Premium of Rs.10
Net Premium received = Rs.9
Spot Price of Share at Exercise of Put Exercise of Put Gain on Put Loss on Put Premium Total
expiration (105) (115) (105) (115) Received Gain
100 Yes Yes 5 -5 9 9
105 No Yes 0 -5 9 4
110 No Yes 0 -10 9 -1
115 No No 0 0 9 9
120 No No 0 0 9 9
125 No No 0 0 9 9
Comment
Loss is limited to Re.1 per share while the profit is limited to Rs.9 per share.
The bull spread limits the investor’s upside (profit) as well as downside risk (loss).
Solution-38
Bear Call Spread
Buy Call Option of 105 by paying Premium of Rs.2
Sell Call Option of 95 by receiving Premium of Rs.8
Net Premium Received = Rs.6
Spot Price of Share at Exercise of Call Exercise of Call Gain on Call Loss on Call Premium Total
expiration (105) (95) (105) (95) Received Gain
90 No No 0 0 6 6
95 No No 0 0 6 6
100 No Yes 0 -5 6 1
105 No Yes 0 -10 6 -4
110 Yes Yes 5 -15 6 -4
115 Yes Yes 10 -20 6 -4
Comment
Solution-39
Bear Put Spread
Buy Put Option of 105 by paying Premium of Rs.3
Sell Put Option of 95 by receiving Premium of Rs.2
Net Premium Paid = Rs.1
Spot Price of Share at Exercise of Put Exercise of Put Gain on Put Loss on Put Premium Total
expiration (105) (95) (105) (115) Paid Gain
90 Yes Yes 15 -5 -1 9
95 Yes No 10 0 -1 9
100 Yes No 5 0 -1 4
105 No No 0 0 -1 -1
110 No No 0 0 -1 -1
115 No No 0 0 -1 -1
Comment
Chap – 11A OPTIONS-SELF PRACTICE 11AD.1

Options Ques Bank

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CA-FINAL

Index Particulars Summary of Topics Q No Exam RTP

Leading Stock Bombay Stock Exchange Limited:

Basic Derivatives: Futures and Options

Complex derivatives: OTC Derivatives [Over the counter]

Option In options, the buyer pays option premium to seller.

Exercise of Option Yes No No Yes

Risk of Holder & Maximum gain to Holder Unlimited

Maximum gain to Writer Premium

Maximum loss to Writer Unlimited

Long and short Buyer of an option = long position

11A.3 Calculation of Gain/(Loss) on Settlement of Option 1-3 N-11 N-12

Factor Call Option Value Put Option Value

Increase in value of Underlying Asset Increases Decreases

Extent of Volatility in Value of Asset Increases Increase

Increase in Strike Price Decreases Increases

Longer Expiration Time Increases Increases

Increase in Income from Asset Decreases Increases

11A.6 Uses of Option 6

(e) Black Scholes Model

TFV of Option today = PV of [Value of Option at expiration]

If interest rate is NCC TFV of Option today = Value of Option at expiration*PVF

If interest rate is CC TFV of Option today = Value of Option at expiration*e-rt

Value of Call Option at Spot Price of Underlying Assetstoday – PV of Strike Price

Steps for calculation of Today

Steps for calculation of Today

11A.11 Binomial Model/Tree Assumption of BM

Borrowing = ∆*S2/(1+r) OR (∆*S1-nC1)/(1+r)

Arbitrage Profit Steps for Arbitrage Profit

If CMP of a Call Option Today

If CMP of a Call Option Today

If interest rate is NCC TFV of Option today = Value of Option at expiration*PVF

If interest rate is CC TFV of Option today = Value of Option at expiration* e-rt

Calculation of P1 for S1 = [SP x (1+r)/SP – LP/SP]/[HP/SP – LP/SP] = [1+r – d/u – d]

CMP of Share (S) N-06

Strike Price (K)

The model is based on (a) The option is the European option;

Steps for calculation of d1 = [In([S - PV of Dividend]/K) + (r + 0.5 σ2)t]/σ√t

Calculate N(d1) and N(d1) = Normal Distribution function of d1

Value of Call option = S*N(d1) – K*e-rt xN(d2)

11A.12.2 Value of Put Option K*e-rt *[1-N(d2)] – S*[1-N(d1)] 28

Strike Price of the Put (K1)< Strike Price of Call (K2)

Strike Price of the Put (K) = Strike Price of Call (K)

Strike Price of the Put (K) = Strike Price of Call (K)

Buying a Call at relatively low strike price = K1

Buying 1 Call Option with K1 < S

11A.13.9 CALENDER SPREAD

Buy 1 Call at K + Sell 1 Call at K with different date of expiration.

Buy 1 Put at K + Sell 1 Put at K with different date of expiration.

Strategies Option Option Maturity Date Strike Price

Straddle Buy 1 Call Buy 1 Put Same K of the Put = K of Call

Strips Buy 1 Call Buy 2 Put Same K of the Put = K of Call

Straps Buy 2 Call Buy 1 Put Same K of the Put = K of Call

Butter Flies Buy 1 Call at K1 Sell 2 Call at K3 Same K1 > K2 and

Condor Spread Buy 1 Call at K1 Sell 1 Call at K Same K1 < S; K = S

Bull Call Spread Buy 1 Call at K1 Sell 1 Call at K2 Same K1 < K2

Bull Put Spread Buy 1 Put at K1 Sell 1 Put at K2 Same K1 < K2

Bear Put Spread Buy 1 Put at K1 Sell 1 Put at K2 Same K1 > K2

Write short notes on Function of Stock Exchange M-11

What is a “derivatives’ M-04

What is the meaning of underlying in relation to a derivative instrument? M-11

Write short notes on the Option. N-02

Factors affecting value of an option M-14

State any four assumptions of Black Scholes Model M-15

Borrowing = ∆S2/(1+r) OR (∆S1-nC1)/(1+r)

Value of Call option = SN(d1) – Ke-rt xN(d2)

11A.12.2 Value of Put Option Ke-rt [1-N(d2)] – S*[1-N(d1)] 28

P1 = (CMP of Share(1+PIRHC) - S2(1+PILHC))/(S1(1+PILHC) - S2(1+PILHC))