WEEK 9
a specified price (the "Strike" price).
 OPTION MARKETS
Option Terminology
 Buy - Long
 Sell – Short
Call
- Holder has the right to purchase an
asset for a specified price
Put
- Holder has the right to purchase an asset
for a specified price
Key Elements
 Exercise or Strike Price
 Price Specified price set in option
contract
 Premium or Price
 Price of option
 Maturity or Expiration
 When to exercise an option
Option
 is a contract between two parties in
which one party has the right but not
obligation to do something, usually
to buy or sell some underlying asset.
 The right without obligation has
some financial value. To realize the
financial values, it is necessary to
purchase the derivative instrument
– the rights.
 At the day first, the option
writer/seller receive certain
percentage of exercise/strike price
for the compensation of selling rights
of assets (stocks, bonds, etc) to the
option holder/buyer.
 There are two types of option
contracts
 Call option and
 Put option
 The purchaser of an Option has
rights (but not obligations) to buy or
sell the asset during a given time for
 An Option to buy is known as a
"Call," and an Option to sell is called
a "Put"
 The seller of a Call Option is
obligated to sell the asset to the party
who purchased the option (rights).
The seller of a Put Option is
obligated to buy the asset.
 Thus, the options is the rights of
future which is granted by the option
contract to the buyer or the seller (the
option holder or option writer,
respectively) against the payment of
option premium.
American options – can be exercised any
time until exercise date
European options – can be exercised only on
exercise date
CALL OPTION
 is a contract that grants the holder the
right to buy an asset at a fixed price
at during a particular period of time.
 As an option buyer, if the stock price
is lower than the strike price, the
holder would buy the stock at market
price after considering the option
premium, instead of exercising the
option.
  The call option buyer anticipate the
upward movement in stock price so
that this is a bullish attitude.
 The difference (+ve) between the
market price and striking price is the
reward for option holder.
 The value of call option at expiration
is as follows:
Vc = Max (Vs – E, 0)
Where,
Vc = Value of call option
Vs = Market price of stock at expiration
E = Exercise price
For example, if the exercise price is $115
and current market price of the stock is
$132, what is the value of call? If the option
premium is $10, what is the profit and loss
status for buyer?
Soln: Vc = Max (Vs – E, 0)
= Max (132 – 115)
= Max 17
Profit = Vc – Pc
= 17 – 10 = 7
BEP for call option seller = (E + Pc)
should be equal to market price at expiration
Exercise: Call Option  If the strike
price is Rs 20 and the option premium is Rs
10. Calculate the profit and loss of option
buyer and option seller at different market
prices (Rs 15, 17, 20, 23, 25, 30, 35) (10
min)
PUT OPTION
 Put option gives the put
holder the right to sell the
underlying assets at a
specified price, within a
specified period of time.
 The writer of the put option
promises to buy the stock.
 The put option holder
exercises the option if the
stock price is lower than the
exercise price.
 The put option holder
anticipating downward
movement in the stock price
so that this is the bearish
attitude.
 The value of put option at
expiration can be calculated
as follows:
Vp = Max (E – Vs, 0)
Where,
Vp = Value of put option
Vs = Market price of
stock at expiration
E = Exercise price
For example, if the exercise price is Rs 135
and market price of the stock is Rs 115,
what is the value of put? If the option
premium is Rs 10, what is the profit and loss
status for buyer?
Soln: Vp = Max (E – Vs, 0)
= Max (135 – 115)
= Max Rs 20
Profit = Vp – Pp
= 20 – 10
= Rs 10 BEP for put option
buyer = (E - Pc) should be equal to
market price at expiration
Exercise: Put Option
If the strike price is Rs 20 and the option
premium is Rs 10. Calculate the profit and
loss of option buyer and option seller at
different market prices (Rs 15, 17, 20, 23,
25, 30, 35)
TERMINOLOGIES/ FEATURES OF
OPTIONS
 Strike price or exercise price or
contract price
 Option price or option premium 
  The option buyer or option holder
 The option seller or option writer
 Expiration date
 Underlying assets (stock, bond,
index, currency, commodity, etc)
 Moneyness (at the money i.e. market
price = strike price; in the money i.e.
TYPES OF OPTIONS BASED ON
market price > strike price; out of
UNDERLYING ASSETS
money i.e. market price < strike
 Stock options
price)
 Index options
 Exercising the option
 Currency options
 Option position (Option seller is in
 Future options
short position, Option buyer is in
long position)
STOCK OPTIONS
 A privilege, sold by one party to
OPTION TRADING MECHANISM
another, that gives the buyer the
right, but not the obligation, to buy
 Option Exchange
(call) or sell (put) a stock at an
An exchange is a legal
agreed -upon price within a certain
corporate entity organized for the
period or on a specific date.
trading of securities, options, or
futures which is governed by
INDEX OPTIONS
corporate rules and regulations. It
 A financial derivative that gives the
may utilize a trading floor or may be
holder the right, but not the
an electronic exchange.
obligation, to buy or sell a basket of
 Over the Counter (OTC)
stocks, such as the S&P 500, at an
OTC options were written for
agreed-upon price and before a
specific buyers by particular seller,
certain date. An index option is
and traded in the OTC facilities. The
similar to other options contracts, the
cost establishing an of OTC options
difference being the underlying
contracts, however, are higher than
instruments are indexes. Options
for exchange options.
contracts, including index options,
allow investors to profit from an
expected market move or to reduce
the risk of holding the underlying
instrument.

CURRENCY OPTIONS
 A contract that grants the holder the
right, but not the obligation, to buy
or sell currency at a specified
exchange rate during a specified
period of time. For this right, a
premium is paid to the broker, which
will vary depending on the number
of contracts purchased. Currency
 options are one of the best ways for
corporations or individuals to hedge
against adverse movements in
exchange rates.

FUTURE OPTIONS
 An option on a futures contract gives
the holder the right to enter into a
specified futures contract. If the
option is exercised, the initial holder
of the option would enter into the
long side of the contract and would
buy the underlying asset at the
futures price. A short option on a
futures contract lets an investor enter
into a futures contract as the short
who would be required to sell the
underlying asset on the future date at
the specified price.

WEEK 8

MARKET STRUCTURE
On the exchange floor, each futures contract
is traded at a designated location in a
polygonal or circular platform called a pit.
The price of a futures contract is determined
by open outcry of bids and offers in an
auction market. Floor traders include two
types: locals and floor brokers.
FUTURES VERSUS FORWARD
CONTRACTS
A forward contract, just like a futures
contract, is an agreement for the future
delivery of something at a specified price at
the end of a designated period of time.
 RISK AND RETURN
CHARACTERISTICS OF FUTURES
CONTRACTS
Long futures: An investor whose opening
position is the purchase of a futures contract
Short futures: An investor whose opening
position is the sale of a futures contract. The
long will realize a profit if the futures price
increases. The short will realize a profit if
the futures price decreases.
PRICING OF FUTURES CONTRACTS
To understand what determines the futures
price, consider once again the futures
contract where the underlying instrument is
Asset XYZ. The following assumptions will
be made:
1. In the cash market Asset XYZ is
selling for $100.
2. Asset XYZ pays the holder (with
certainty) $12 per year in four
quarterly payments of $3, and the
next quarterly payment is exactly 3
months from now.
3. The futures contract requires
delivery 3 months from now.
4. The current 3-month interest rate at
which funds can be loaned or
borrowed is 8% per year.
What should the price of this futures
contract be? That is, what should the futures
price be? Suppose the price of the futures
contract is $107. Consider this strategy:
 Sell the futures contract at $107.
 Purchase Asset XYZ in the cash
market for $100.
 Borrow $100 for 3 months at 8% per
year.
1. From Settlement of the Futures
Contract
Proceeds from sale of Asset XYZ to settle
the futures contract
Payment received from investing in Asset = $3
XYZ for 3 months
Total proceeds = $110
1. From the Loan
Repayment of principal of loan = $ 100
Interest on loan (2% for 3 months) = $2
Total outlay $102
Profit =$8