Option and contingent claims

(ASSIGNMENT#2......3rd SEMESTER Fall-2020-21)

Submitted by

BY

Tamoor Safdar (19014954-027)

Bilawal Hussain(19014954-011)

Shoaib khan(19014954-017)

Komal Akram(19014954-030)

Zunaira Arshad(19014954-018)

EFN-401 (International finance)

M.Com A

Sir Sajid Mehmood

Department of Commerce

UNIVERSITY OF GUJRAT
 Table of contents
Sr no Title Page no

1 Option and option market 03

2 06
Put call parity

3 Contingent claims 08

4 Currency derivatives 09

5 References 11
 Option and contingent claims (summery)
1. Option and option market
An option is the right (But not an obligation) to force and a transaction to occur at some future time on
terms and condition agreed to now.

1.1 Call Option

Right to buy an underlying asset at fixed price.
For example, now that you know the basics of options, here is an example of how they work. The strike
price of $70 means that the stock price must rise above $70 before the call option is worth anything;
furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.

Put Option
Right to sell an underlying asset at fixed price.
For example, each option contract is worth 100 shares, so this gives him the right to sell 100 shares of
Ford at $11 before the expiration date. ... Let's say the stock falls to $8 per share. Max would be able to
sell 100 shares at $11 instead of the current $8 market price .

Exercise Price
A fixed price at which an underlying asset can be traded . Pursuant to the terms of option contract. Also
known as Strike Price For example,
It means the call options are trading in the money by $5. Sam’s profit would be $5 less the premium or
cost he paid for the option. If Wells Fargo is trading at $50, and the strike price of his call option is $55,
that option is out of the money.

1.2 How Options Are Created and traded.

Options on shares are created by company whose shares underlie option market or by parties who have no
association with the company. First these call option may be issued to investors as a means of raising
capital for company. Sale of option will raise capital and capital may inflow if options are subsequently
exercised. Second company may issue call option to senior employees or directors of company. In case of
listed company’s option of this kind form a part of compensation packages for managers and are not a
significant source of capital of company. One or other parties will be shareholders in company.
After negotiation the contract will specify following.,
1. Type and number of shares to be optioned
2. Exercise Price
3. Expiry date
4. Price of option
5. Adjustment to be made in the event of change in capital structure.

1.3 Options Contracts and Futures Contracts

The biggest difference between options and futures is that futures contracts require that the
transaction specified by the contract must take place on the date specified. Options, on the other
hand, give the buyer of the contract the right but not the obligation to execute the transaction. Also
related difference is concern payment.
There is no future payment required if future contract made until the expiry date bot when the option
contract is made the buyer must pay option price to writer immediately.

1.4 Payoff Structure for Call and Put

A Set of future cash flows.
Table
Payoff structure of call with exercise price of 34$

IF SHARE PRICE ($) ON CALL Then payoff (cash flow)($) to the call
EXPIRY DATE holder is
32 0
32.50 0
33 0
33.50 0
34 0
34.50 0.50
35 1
35.50 1.50
36 2
36.50 2.50
1.5 Identify and explain the factors that affect option prices
1. CURRENT SHARE PRICE
The higher the current share price, greater is the probability that the share price will increase
above the exercise price and much higher than call price other things being equal.
Instinctive value
A value of an option if excised immediately .
2. Exercise Price
Other thing remain same or equal if the exercise price is higher probability is lower than the share price
will increases above the exercise price
3. Term of expiry
Other things remain same Longer term expiry greater the probability that the share price will increase
above the exercise price and greater than call price.
Value of an option in excess of its instinct value.
4. Risk free interest rate
Buyer of call option can pay for share the right of deferred payment is valuable because interest rate is
positive.so deferred payment is valuable.
 5. Expected dividends
Cash dividends affect option prices through their effect on the underlying stock price. Because the stock
price is expected to drop by the amount of the dividend on the ex-dividend date, high cash dividends
imply lower call premiums and higher put premiums.

2. Put call parity

For European options on shares that do not pay dividends there is an equilibrium relationship between the
prices of put option and calls that are written on the same underlying shares are traded and have the same
exercise price and term of expiry.

Formula used for call parity

C
X=w-p+ 1+ r
Minimum value of calls and puts
Assuming frictionless markets and same number of dominance frame work used earlier to drive the put
call parity theorem the mini mum value of a European call on a share that does not pay dividends

Formula
C
Min w- Max (QP- )
1+ r

3. The black-SCHOLES model of call option pricing

1. Assumptions

 There exists a constant risk free interest rate at which investor can borrow and
lend unlimited amounts.
 There is no transaction costs, taxes are other sources of friction.
 There are no dividends rights issues or other complicating features.
 The call is of the European type.
2. Risk free hedging
With the help of shares and calls it is possible to develop a portfolio that has no risk. The recognition of
this possibility was an important factor that led to the development of this model.

The black SCHOLES equation

Risk free hedging is used to provide and an equilibrium condition. The return on all risk free portfolios
including of course one constructed as outlined above must in equilibrium be equal to risk free interest
rate

4. Binomial option prices

The black-SCHOLES is an alternative approach of the binomial option pricing, is often easier to apply
and more friendly adapted to a range of option pricing problems.
 4.1 pricing a single period call option
Feature of binomial option pricing is the assumption that after each time period the price of the
underlying can be one of only two numbers. Hence the use of term binomial which means two numbers.
This assumption looks very unrealistic but gives very realistic answers.

4.1 Risk neutrality as a solution method

Situation in which investors are indifferent to risk assets are therefore priced such that they are expected
to yield the risk free interest rate

4.2 Binomial Option pricing with many time periods

Single period is not realistic out the basic principles can be extended to more than one period. In practice
it is usual to use 100 or 200 time periods. The calculation usually made using computers.

 There are three stages

 Stage 1 building a lattice of share prices
 Stage 2 calculating the optical payoffs at expiry from the expiry share prices.
 Stage 3 calculating the option prices by calculating expected values and then discounting at the
risk free interest rate.
4.3 Applying the Binomial approach to other option problems
Once the lattice of share prices is laid out a put option on a share that does not pay dividends . The put
option payoffs are calculated and then the same procedures of discounting expected values issue
undertaken. The American feature is easily incorporated simply by checking at each node whether the
calculated option price is less than the payoff value from immediate exercise.

5. Options on foreign currency

A option on foreign currency is a contract that confers the right to buy an agreed quantity of that foreign
currency at a given exchange rate. Options on foreign currency are traded in organized markets such as
Philadelphia exchange. As well as over the counter markets and by private arranged contracts.

5.1 combinations of options on foreign currency

The most frequent uses that have been made of options on foreign currency involve combining two are
more such options. E.g. options can be combined to produce an arrangement sometimes known as range
forward or collar.

6. Option forwards and futures

There are simple relationship between prices of European type option and forward prices. As forward
contracts are most frequently encountered in foreign currency dealings, we will explain the relationship
using option on foreign currency and forward contracts.
 7. Options and futures
A number of future exchanges including the Sydney futures exchange have introduced options on the
more heavily traded future contracts. A call option on futures confers on the buyer of the call the right to
enter into a future contract as a buyer.

7.1 pricing option on futures

We first consider the pricing of option on forward contracts. Assume that

 The expiry date of a call on a forward contract coincides with the expiry date of the forward
contract.
 The call is European type

8. Contingent claims
An option on shares is simply an agreement that allows a choice about buying or selling shares to be
made at a later date, the choice will be exercised it is in the interest of the option holder to do so. The
decision will depend on the future value of the share. A contingent claims is an asset whose value
depends on the given value of other assets.

8.1Right issues
A simplest contingent claims arises when a company raises new share capital by way of right issue. The
shareholder is given the right to purchase new shares in the company. The right must be sold or taken up
by specified date.

8.2 convertible bonds

A convertible bond is a type of debt security that, in addition to paying interest gives the investor right to
convert the security into shares of the company.

8.3 Valuation of levered shares and risky zero-coupon debt

One of the first contracts to be identified as a contingent claims was a share in a company that has debt
outstanding. Such shares are known as levered shares because the companies cannot offer government
guarantees, there is some risk of default.

8.4 Valuation of levered shares and risky-coupon paying debt

This approach can also be applied to the problem of valuing risky coupon paying debt and valuing the
share of the company that has issued that type of debt.

8.5 Default risk structure of interest rates

It is the relationship between the default risk and promised yield on debt for given term to maturity.

8.6 project evaluation and real options

Net present value approach to project evaluation which is based on analogy between a proposed
investment project and a bond .

 Option to abandon
 Option to reopen
 Option to defer
 Option to study
 Option to expand

Currency derivatives
1. forward Market
A forward market facilitates the trading of forward contracts on currencies. A forward contract is an
agreement between a corporation and a financial institution to exchange a specified amount of a currency
at a specified exchange rate.

2. Currency future market

Currency future contracts are contracts specifying a standard volume of a particular currency to
be exchanged on a specific settlement date. The currency futures contracts are similar to forward
contracts in terms of their obligations, but they differ from forward contracts in how they traded.
3. Currency option market
Currency option provide the right to purchase or sell currencies at specified price up to a
specified expire date. They available for many currencies the Australian dollar , British pound,
Brazilian real etc.
4. Currency call option
A currency call option grants the right to buy a specific currency at a designated price within a
specific period of time.
5. Currency put options
The owner of the currency put option has the right to sell a currency at a specified price within a
specified period of time.
6. Others forms of currency options
There are some other forms of currency options these are given bellow
 Conditional currency option
 European currency option

Currency option prices

Boundary conditions
First step in pricing currency options is to recognize boundary conditions that force the option premium to
be in lower and upper bounds.
(a) Lower bounds
The call option premium (C) has a lower bound of at least zero or the spread between the
underlying spot exchange rate (S) and the exchange price (X) whichever is greater
C=MAX (0,S-X)
(b) Upper bound
The upper bound for a call option premium is equal to the spot exchange
C=S

Application of pricing Models

Boundary condition can be used to determine the possible range for a currency option premium; they
do not precisely indicate the appropriate premium for the option. Pricing models have been developed
to price currency options. Based on information about an option and about currency, pricing models
can be deriving the premium on a currency option.
References
Options and contingent claims pdf notes ch19
International financial management 13 edition by Jeff Madura