Options Notes

DERIVATIVES ANALYSIS AND VALUATION
Contents –
• Introduction to Options
• Types of Options
• Option Pay offs
• Option Trading Strategies
• Factors Affecting value of an option
• Greeks
• Implied Volatility
• Put Call Parity Equation
• Option Valuation techniques
• Commodity Derivatives
• Embedded Derivatives
1. Introduction
An Investor’s portfolio usually comprises of various assets. Assets may be stocks,
bonds, ETFs, and even mutual funds. Options are another class of assets which are used
by the investor for hedging his /her portfolio or for speculation or for the purpose of
arbitrage. Options are contracts that give the holder of the derivative, the right, but
not the obligation, to either buy or sell an amount of some underlying assets say stock,
foreign exchange, commodity, index, interest rate etc. at a pre-determined price within
a certain period or on a specific date regardless of changes in underlying’s market
price during that period.
The person buying the option is called “Holder of the Option” and the person selling
the option is called “Writer of the Option.” The holder of the call option will have right
to exercise the contract and the writer of the option will have the obligation to honour
the contract. The writer of the option receives option premium from the holder of the
option.
Derivatives 1FIN by IndigoLearn 1

2. Types of Options
2.1 Call Option
Call Option gives the buyer the right, but not the obligation, to buy the
underlying asset at the price specified in the option contract – such price is known as
the strike price. A person purchases the call option on a belief that the price of
underlying asset will increase in the future. A person writes the call option on a belief
that the price of underlying asset will not increase in the future.
2.2 Put Option
Put Option gives the buyer the right, but not the obligation, to sell the underlying asset
at the price specified in the option contract – such price is known as the strike price. A
person purchases the put option on a belief that the price of underlying asset will
decrease in the future. A person writes the put option on a belief that the price of
underlying asset will not decrease in the future.
2.3 European Options
It is an option which gives buyer a chance to exercise the contract only at the maturity
date. There is no freedom to the buyer of an early exercise in European option. In
Indian Market most of the options are European style options.
2.4 American Options
It is an option which allows the holder to exercise the option at any time before and
including the date of expiration. It allows an investor to capture profit as soon as the
asset / underlying price moves favorably.
2.5 Stock Options
Stock options involve no commitments on the part of the buyers of the options
contracts individual to purchase or sell the stock. The option is usually exercised by the
buyers only if the price of the stock has risen above the specified price (in case of call
option) or fallen (in case of put option) below the specified price at the time of entering
into option contracts.
These options are just contracts that give you the right to buy or sell the stock at a
specific price on a specific date. Investing in options limits the risk, allows the buyer to
participate in the reward with a small amount of capital.
2.6 Stock INDEX options
These are options on stock indices like Sensex, NIFTY etc. Index represents a basket of
stocks. These options are used as hedging tool by the portfolio managers to make a

bet on the level of the index going up, an investor buys a call option outright. To make
the opposite bet on the index going down, an investor buys the put option.
3. Option Pay offs

3.1 Pay-off for a Call Buyer
The buyer of an option has the right but not the obligation to exercise the option. The
call buyer exercises the option when the market price is above the strike price. The
buyer enjoys the profit if the market price is above the strike price. Loss to the buyer
is limited to the premium paid.
Maximum Loss Premium paid

Maximum Gain Theoretically infinite
Pay off = Max (0, (ST – X)) – C
X – Strike Price; S – Spot Price; T – Time period; C – Call Premium
For Example:
Type Holder of Call Option

Current Market Price Rs. 2,000
Strike Price Rs. 2,100
Premium Rs. 100
In the given situation, maximum loss to the holder is Rs. 100 (Premium paid).
Break – even stock price = Strike price + Premium = Rs. 2,200
Long Call Pay off

500
400
300
200
Profit
100
0
1700 1800 1900 2000 2100 2200 2300 2400 2500 2600
-100
-200
Share Price on Maturity

3.2 Pay off for a Call Seller
The call seller (writer) has the obligation to deliver the asset to the buyer at the
predetermined price. The maximum gain is limited to the premium received. The loss
to the call seller is theoretically infinite. Above the strike price, seller faces increasing
losses as the underlying asset price increases.
Maximum Loss Theoretically Infinite

Maximum profit Premium received
Pay off = Min ((X – ST), 0) + C
X – Strike Price; S – Spot Price; T – Time period ; C – Call Premium
For Example:
Type Writer of Call Option

Premium Rs. 100
The payoff graph of short call is opposite of the long position. In the given situation,
maximum profit to the writer is Rs. 100 (Premium received).
Break – even price = Strike price + Premium = Rs. 2,200
Short Call Pay off

200
100
0
1700 1800 1900 2000 2100 2200 2300 2400 2500 2600
-100
Profit
-200
-300
-400
-500

3.3 Pay-off for a Put Buyer
The put buyer exercises the option when the market price is below the strike price. The
buyer enjoys the profit if the market price is below the strike price. Loss to the buyer
is limited to the premium paid.
Maximum Loss Premium paid

Maximum Gain (X – 0)
Max (0, (X - ST))- P
X – Strike Price; S – Spot Price; T – Time period; P – Put Premium
For Example:
Type Holder of Put Option

Premium Rs. 100
In the given situation, maximum loss to the holder is Rs. 100 (Premium paid).
Break – even price = Strike price - Premium = Rs. 1,800
Long Put Pay off

350
300
250
200
150
Profit
100
50
0
-50 1500 1600 1700 1800 1900 2000 2100 2200 2300 2400
-100
-150

3.4 Pay off for a Put Seller
The put seller (writer) has the obligation to buy the asset from the buyer at the
predetermined price. The maximum gain is limited to the premium received. The seller
experiences a loss when the current market price goes below the strike price.
Maximum Loss (X – 0)
Maximum Gain Premium received
Min ((ST - X), 0) + P
X – Strike Price; S – Spot Price; T – Time period; P – Put Premium
For Example:
Type Writer of Put Option

Premium Rs. 100
The payoff graph of short put is opposite of the long position. In the given situation,
maximum profit to the writer is Rs. 100 (Premium received).
Break – even price = Strike price - Premium = Rs. 1,800
Short Put Pay off

200
100
0
Profit
1500 1600 1700 1800 1900 2000 2100 2200 2300 2400
-100
-200
-300
-400
3.5 In the Money, At the Money, Out the Money options
Situation Call Option Put Option

Spot Price > Strike Price In the Money (ITM) Out the Money (OTM)
Spot Price = Strike Price At the Money (ATM) At the Money (ATM)
Spot Price < Strike Price Out the Money (OTM) In the Money (ITM)
4. Option Trading Strategies

4.1 Bull Call Spread
This option trading strategy is designed to benefit from underlying asset’s limited
increase in price. This strategy uses two call options in which one option has lower
strike price and other option has higher strike price.
The strategy is to buy one At the Money call option and pay the premium.
Simultaneously, write an Out the Money call option and collect the premium. Both the
options belong to same expiry series and each leg involves same number of options.
For Example:
Particulars Buy call Sell call

Current Market Price Rs. 100 Rs. 100
Strike Price Rs. 100 Rs. 130
Tenure 1 Month 1 Month
Premium Rs. 5 Rs. 3
The premium received by selling a call option partially offsets with the premium that
the investor paid for buying the call. Net premium is Rs. -2. The losses and gains from
the bull call spread are limited due to lower and upper strike prices.
Bull Call Spread

30
25
20
15
Profit
10
0
90 100 110 120 130 140 150
-5
Current Market Price
Net Profit / Loss
Key outcomes from the strategy are given below
Net Debit from the Premium paid (Rs. 2)

strategy Less: Premium received
Spread Higher Strike Price Rs. 30
Less: Lower strike Price
Maximum Loss Net Debit from the (Rs. 2)
strategy
Maximum Profit Spread Rs. 28
Less: Net Debit

4.2 Bear Put Spread
An investor would implement this strategy when the market outlook is moderately
bearish i.e., if the investor expects that the market to go down in the near term while
at the same time, does not expect it to go down much.
The strategy is to buy an In the Money Put option and selling an Out the Money Put
option. Both the options should belong to same expiry and same underlying asset.
For Example:
Particulars Buy put Sell put

Premium Rs. 25 Rs. 5
The premium received by selling a put option partially offsets with the premium that
the investor paid for buying the put. Net premium is Rs. -20.
Bear Put Spread

15
10
5
Net Profit/Loss
0
60 70 80 90 100 110 120 130
-5
-10
-15
-20
-25
Net Profit/Loss
Key outcomes of the strategy are given below
Net Debit from the Premium paid (Rs. 20)

strategy Less: Premium received
Spread Higher Strike Price Rs. 30
Less: Lower strike Price
Maximum Loss Net Debit from the strategy (Rs. 20)
Maximum Profit Spread Rs. 10
Less: Net Debit

4.3 Long Straddle
Long straddle is an investment strategy where the investor simultaneously buys both
At the Money put and call option for an underlying asset with the same strike price
and the same expiration date. The holder of the options will get profit from the long
straddle when the price of the underlying asset rises or falls by an amount which is
more than the premiums paid by him. The profit potential is virtually unlimited. The
quantum of profit depends upon the volatility of underlying asset.
For Example:
Particulars Buy call Buy put

Long Straddle
15
10
5
Profit /Loss
0
-5 70 80 90 100 110 120 130
-10
-15
-20
-25
Profit/Loss
Maximum loss is experienced when markets do not move and stay at ATM. Maximum
loss is equal to net premium paid.

4.4 Short Straddle
Short straddle is an investment strategy where the investor simultaneously sells both
At the Money put and call option for an underlying asset with the same strike price
and the same expiration date. The maximum profit for the writer of the options is the
amount of premium collected by writing the options. The potential loss can be
unlimited.
For Example:
Particulars Sell call Sell put

Short Straddle
25
20
15
Profit /Loss
10
5
0
70 80 90 100 110 120 130
-5
-10
-15
Profit/Loss
The objective of short straddle is to defend the premium received. Maximum profit
equals premium received. It applies only when underlying price ends up exactly at the
strike price at expiration.
4.5 Long Strangle
A strangle is an option strategy in which the investor holds a position in both Out the
Money (OTM) call and put option with different strike prices, but with same expiration
date and underlying asset.
This strategy works if investor thinks that underlying asset is experiencing a large price
movement in the near term but not sure about the direction.
This strategy is like straddle strategy but strangle uses options at different strike prices.
For Example:

Particulars Buy call Buy put
Premium Rs. 5 Rs. 5
Long Strangle
15
10
5
Profit /Loss
0
60 70 80 90 100 110 120 130 140
-5
-10
-15
Profit/Loss
The maximum loss is restricted to net premium paid. The loss would be maximum
between the two strike prices. The potential profit is unlimited.
4.6 Butterfly Spread
The butterfly spread option is a neutral option strategy that has limited risk. This
strategy involves a combination of various bull spreads and bear spreads. A holder of
the option combines four option contracts having the same expiry date at three strike
price points, which can create a perfect range of prices and make some profit for the
holder.
Investor buys two option contracts – one In the Money (ITM) call option and one Out
the Money (OTM) call option and sells two At the Money (ATM) call option.
This strategy works in a non-directional market and less volatile market.
For Example:

Particulars Buy ITM Call Buy OTM Call Sell ATM Call
(1 option) (1 option) (2 options)
Current Market Price Rs. 100 Rs. 100 Rs.100
Strike Price Rs. 90 Rs. 110 Rs. 100
Tenure 1 Month 1 Month 1 Month
Premium Rs. 12 Rs. 3 Rs. 5
Long Call Butterfly

6
2
Profit/Loss
0
80 90 100 110 120 130 140
-2
-4
-6
Profit/Loss
The maximum profit is equal to the difference between the lowest and middle strike
prices less net cost of premium. i.e., Rs. 100 - Rs. 90 – Rs. 5 = Rs. 5
5. Factors Affecting Value of an option

There are different mathematical formulae, or models, that are designed to compute
the fair value of an option. Option price is dependent upon current market price of the
underlying asset, strike price, time for expiry of the option, interest rates and volatility.
Each factor affecting the value of the option is given below.
5.1 Current Market Price
The value of call option and put option are affected by changes in the current market
price of the asset.

Increase in Current Market Increase in value Decrease in value
Price
Decrease in Current Decrease in value Increase in value
Market Price
5.2 Strike Price

In the Money Option (ITM) Highly Priced
Out the Money Option (OTM) Cheaper rate
At the Money Option (ATM) Relatively cheaper when compared to
ITM option.
5.3 Time for Expiry
Option premium is summation of time value and intrinsic value. Option sellers are
always compensated for the time risk. Both call and put options lose their value as the
expiration approaches. The more time for expiry, the likelihood for the option to expire
In the Money (ITM) is higher. An out of the money with short tenure will have less
value. An out of the money with long tenure will have more value. In the Money (ITM)
options with short tenure will have more value.
5.4 Volatility
Volatility is a measure of risk. It can be seen as the standard deviation of returns from
the mean. Volatility positively impacts the values of call and put options. An increase
in the volatility of the stock increases the value of the call options and of the put option.
The holder of the option will only exercise the option when it is favorable and chooses
to forgo the premium when the price movement is negative. Higher volatility means
higher upside risk or higher downside risk. This is the reason why higher volatility
makes call options and put options more valuable.
5.5 Interest Rates
An increase in the interest rates reduces the present value of the strike price and makes
the call option more valuable and the put option less valuable.

High Interest Rates Increase in value Decrease in value
Low Interest Rates Decrease in value Increase in value
6. Greeks
The Greeks are a collection of statistical values (expressed as percentages) that give
the investor a better overall view of how a stock has been performing. These statistical
values can be helpful in deciding what options strategies are best to use. These are
based on past performance. These trends can change drastically based on new stock
performance.
6.1 Delta (Δ)

Delta measures the rate of change in the option premium due to the change in the
price of the underlying asset. Delta for call option is positive and delta for put option
is negative. This is because put option and underlying asset price are inversely related.
Delta is also called Hedge ratio.
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒐𝒑𝒕𝒊𝒐𝒏

𝑫𝒆𝒍𝒕𝒂 (𝚫) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒔𝒕𝒐𝒄𝒌
6.2 Gamma (ɣ)
Gamma measures rate of change of delta. It is always positive for both call and put
options.

𝐆𝐚𝐦𝐦𝐚 (ɣ) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒅𝒆𝒍𝒕𝒂
6.3 Theta (θ)
Option sellers are always compensated for the time risk. Theta refers to rate of decline
in the value of an option due to the passage of time. It can also be referred to as the
time decay of an option. It is referred as change in price of the option due to the
change in time.

𝐓𝐡𝐞𝐭𝐚 (𝛉) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒊𝒎𝒆 𝒑𝒆𝒓𝒊𝒐𝒅
6.4 Vega (V)
This measures option sensitivity to volatility. It is the change in the option price for a
one-point change in the volatility. Vega is also used for hedging.

𝐕𝐞𝐠𝐚 (𝐕) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑽𝒐𝒍𝒂𝒕𝒊𝒍𝒊𝒕𝒚
6.5 Rho (ρ)
It is a rate at which the price of derivative changes relative to the change in the risk-
free rate of interest. Rho measures the sensitivity of an option or options portfolio to
the change in interest rate.

𝐑𝐡𝐨 (𝛒) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞
7. Implied Volatility (IV)

Implied volatility represents the expected volatility of an underlying asset over the life
of the option. Implied volatility is influenced by the market’s expectation of the share
price direction. This concept is important in option trading because it is helpful in
determining the likelihood of a stock reaching a specific price by a certain time.
Different traders trade in options by using their self-computed volatilities. Based on
supply and demand as well as expectations of the traders, option prices are
determined in an exchange – the volatility that is implied by these prices, by back
working on Black Scholes formula, retaining other pricing inputs constant, is known as
implied volatility.
It is important to note that the implied volatility shows the market’s opinion of the
underlying asset’s potential moves, but it does not forecast the direction.
8. Put Call Parity Equation

The term ‘parity’ refers to state of being equal or having equal value. This equation is
useful to calculate the value of put option if we know the value of call option and vice
versa. Put-call parity defines the relationship the price a European put option has with
a European call option, provided they belong to the same class. The underlying asset
of these two options need to be the same; they must have the same strike price and
the same expiration date. If Put Call Parity is violated, arbitrage opportunities arise.
Put-call parity states that simultaneously holding a short put option and long call
option of the same class will deliver the same return as holding a share of same
underlying asset, with the same expiration, by borrowing an amount equivalent to the
present value of the option's strike price. i.e C - P= S0 - (K x e-rt)
Put Call Parity equation can be re written as
C + (K x e-rt) = P + S0
C - Price of call option.
K x e-rt - Present value of the strike price
P - price of Put option

S0 - Spot price.
9. Option Valuation Techniques

Various valuation techniques are used to arrive at the value of the options i.e premium,
based on the probability of movement in the share price. Various methods exist for
valuing options and they use variables such as current market price, strike price, time,
volatility. Some commonly used techniques are Risk neutral method, Binomial model,
Portfolio pay off method, Black Scholes model.
9.1 Risk Neutral Method
The key assumption in computing risk-neutral probabilities is the absence of

arbitrage. This method is used for figuring fair prices of an underlying asset. It
assumes that the expected value in the options market is equal to expected
value in futures market.
Under this method, it is expected that the spot price of the asset has two
probabilities.
Probability of going up is denoted by “P”
Probability of coming down is denoted by “1-P”
Upward movement of the spot price is denoted by “u”
Downward movement of the spot price is denoted by “d”
Based on values of u, d, and interest rate, probability of up and down moves
can be arrived at as below:
Expected Value of a share in the Futures Market =
Expected Value of the share as implied in the Options Market
S0 x ert = S0 x u x P + S0 x d x (1-P)
S0 x ert = S0 (u x P + d x (1-P))
ert = u x P +d – Pd
ert – d = P (u-d)
ert −𝑑
p= 𝑢−𝑑
9.2 Binomial Model
The binomial model breaks down the time to expiration into potentially a very large
number of time intervals, or steps. This requires the use of probability and future
discrete projections through which a tree of stock prices is initially produced working
forward from the present to expiration. This method also is based on principles of Risk
Neutral valuation

With this model, there are two possible outcomes with each iteration, a move up or a
move down that follow a binomial tree. The probability of the price going up is
denoted by P and probability of going down is denoted by (1 – P). The value of option
at each iteration is the present value of expected value of subsequent nodes raised
from that node.
The big advantage the binomial model has over the Black-Scholes model is that it can
be used to accurately price American options. This is because with the binomial model
it's possible to check for option price at every point in an option's life (i.e., at every step
of the binomial tree) for the possibility of early exercise.
Value of a European call Option at the end nodes is computed as
Max (0, (St1 – K)))
In the central nodes the price of the European call option is PV of future expected
values arising out of that node.
American option can also be exercised before maturity of the option if it is in favor of
option holder. Value of American call option at a particular node after one period is
given as
Max (0, PV of future expected values, (St1 – K))
Where, K is the strike price and St1 is the spot price of underlying asset after one period.
Binomial tree is represented as follows
S0uu
S0u
S0 S0ud
S0d
S0dd
9.3 Portfolio Replication Method

This method is based on the underlying assumption that two assets that provide the
same cash flow must have the same value. The replicating portfolio approach to
valuing options finds a portfolio of assets that has the same payoff as the option on
expiry. The replicating portfolio can be formed from any asset, but it is usually
comprised of bonds (lending or borrowing) and stocks (short or long positions). The
number of shares to buy or sell to create a replicating portfolio will depend upon
hedge ratio, which is also called as delta.
Call Option Replicating portfolio is

i) Borrow money
ii) Purchase delta shares
Put Option Replicating portfolio is
i) Sell delta shares
ii) Lend money (PV of asset)
9.4 Black Scholes Merton Method
This is the mathematical model for pricing an option contract. This model takes inputs
such as asset price, strike price, interest rates, time, and volatility. This method is based
upon following assumptions.
• European options are considered

• No transaction costs,
• Short term interest rates are known and are constant
• Stocks do not pay dividend
• Stock price movement is like a random walk
• Stock returns are normally distributed over a period & stock prices are log
normally distributed
• The variance of the return is constant over the life of an Option
The formula for calculating the theoretical option price is as follows
C = S0 N(d1) – K e-rt N(d2)

𝑺𝟎 𝛔𝟐
𝐥𝐧 ( 𝑲 ) + (𝒓 + 𝟐 ) 𝐓
𝒅𝟏 =
𝛔√𝐓
d2 = d1 - 𝛔√𝐓
The variables are
S0 – Current stock Price

K – Strike Price
T - time remaining until expiration, expressed as a percent of a year
r - current continuously compounded risk-free interest rate
σ - annual volatility of stock price (the standard deviation of the short-term returns
over one year)
ln – Natural Logarithm
N(x) - standard normal cumulative distribution function (Area under Normal Curve)
Cumulative values of area under a Standard Normal Distribution are provided at the end of the notes
N(d1) represents the hedge ratio
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)
The Black-Scholes model has one major limitation that it cannot be used to accurately
price options with an American-style exercise as it only calculates the option price at
one point of time i.e., at expiration. It does not consider the steps along the way where
there could be the possibility of early exercise of an American option.

10. Commodity Derivatives
A commodity is a raw material or primary product
that may be related to food, energy, metals, or any
other property, is tradable and regularly used for
human consumption directly or indirectly. It can be
categorized as a kind of good that can be bought and
sold freely in consideration for something else or
money. Commodity trading is essentially part of every
society, and it is an age-old concept. Formalized and organized form of commodity
trading has grown in the last few decades.
The first organized exchange, the Chicago Board of Trade (CBOT) was established in
1848. In 1894, the Chicago Produce Exchange - which is now known as Chicago
Mercantile Exchange (CME) was formed.
Commodities constitute a major asset class like equities, fixed income instruments and
money market instruments. The value or the price of commodity changes as per the
demand supply situation in the commodity market. Commodity Derivative is the
contract whose value is derived from the underlying commodity that is to be settled
on a specific future date.
Major commodity exchanges in India are Multi Commodity Exchange (MCX) and
National Commodity and Derivatives Exchange (NCDEX). Commodity derivatives
available for trading through exchanges are bullion, Base metals like copper and zinc,
energy, cereals, oil seeds, spices etc.
Indian Energy Exchange (IEX) is India’s premier energy marketplace, providing a

nationwide automated trading platform for the physical delivery of electricity
For Example:
TATA Steel makes use of commodity futures contracts and options to manage its
purchase price risk for certain commodities like zinc and tin to cover sales contracts
with fixed metal prices.
If National Thermal Power Corporation Limited (NTPC) has surplus power, it can sell its
power to the exchange. State governments or individual parties can purchase the
power from the exchange
10.1 Necessary Conditions to Introduce Commodity Derivatives
• A commodity should be durable, and it should be possible to store it.

• Units must be homogeneous.

• The commodity must be subject to frequent price fluctuations due to large
supply and demand,
• Supply must flow naturally to market and there must be breakdowns in an
existing pattern of forward contracting.
The total set of customer needs concerning commodity derivatives are
▪ Instrumental needs i.e., price risk reduction (hedging)

▪ Convenience needs i.e., flexibility in doing business, easy access to market,
efficient clearing system.
10.2 Participants of Commodity Derivative Market
The commodity derivative market includes participants with different investment

objectives and risk profiles. This allows the market to function effectively. The
participants play different roles in the market by using the commodity futures contract.
Hedgers, Speculators, Arbitragers and Retail investors are the participants in the
Commodities Derivative Markets. Foreign Institutional Investors (FII's) and Non-
Resident Indians (NRI's) are not permitted to participate in the Commodity Futures
market in India.
Buyer of a derivative contract Seller of a derivative contract

➢ Pays an initial margin ➢ Accepts the margin
➢ Buy the right to buy or sell a ➢ Agrees to fulfill the contract by
commodity at certain price, buying or selling the commodity
certain date in the future at agreed price, agreed date in the
future.
The investor can choose to settle commodity derivative contracts in cash, instead of
taking delivery of the commodity upon maturity of the contract. Cash settlement
comprises exchange of difference in the spot price of the commodity and the exercise
price as per the futures contract. The option of cash settlement lies only with the seller
of the contract.
Arbitragers are the ones who find price gaps in the commodity markets either in Spot
market or Derivative market or both. They encash these differences by placing trades
thus adding liquidity to markets.
Hedgers on the other hand are either producers or consumers who take a position in
the market to lock their price risk.
Speculators are other big players in the commodity market. This segment of traders
comes into market with a price directional view and takes positions accordingly.

Speculators has a choice of taking a position based either on fundamental news of the
commodity or technical analysis of price movements.
10.3 Factors Influencing Commodity pricing
• Demand-Supply situation
• Government Trade Policies
• Global economic situation
• Currency Movements
• Geo-political tensions
• Market sentiments
• Investment Funds
• Weather dynamics
• Seasonal cycles
10.4 Benefits of Trading in Commodity Derivatives
• To complement investment in companies that uses commodities.

For Example: Invest in steel derivatives rather than investing in the shares of
TATA steel
• Diversification of Portfolio
• Inflation protection
• Hedge against event risk
• Provides high liquidity
• Trading on lower margin
• The commodity market is highly volatile. It experiences huge swing in prices.
10.5 Commodity Futures
It is an agreement/contract between two parties to buy or sell an asset at a certain

time in the future at a certain price. Future contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.
This is the easiest and cheapest way to invest in commodities.
Commodity Futures are available for trading in exchanges for participation by retail
investors, corporates, hedgers.
Commodity futures price takes into consideration interest rate (r), Storage cost (S) and
convenience yield (C) and time.
Commodity Futures Price = Spot (S0) x e(r+s-c)t
10.6 Commodity Options

Options are of two types – calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before
a given future date. Puts give the buyer the right, but not obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
10.7 Commodity Swaps
A commodity swap is a kind of derivative contract wherein two parties agree

to swap cash flows depending on the cost of an underlying commodity. A commodity
swap is typically used to protect against price fluctuations in the market concerning
a commodity.
There are two types of commodity swaps: fixed-floating or commodity-for-interest.
10.7.1 Fixed-Floating Swaps
They are just like the fixed-floating swaps in the interest rate swap market with the
exception that both indices are commodity-based indices.
10.7.2 Commodity-for-Interest Swaps
They are like the equity swap in which a total return on the commodity in question is
exchanged for some money market rate (plus or minus a spread).
10.8 Valuation of Commodity Swaps
Commodity swaps are characterized by some peculiarities. These include the following
factors
• The cost of hedging

• The institutional structure of the commodity market
• The liquidity of the underlying commodity market
• Seasonality and its effects on the underlying commodity market
• The variability of the futures bid/offer spread
• Brokerage fees
• Credit risk
• Capital costs and administrative costs

11. Embedded Derivatives
An embedded derivative is a derivative instrument that is embedded in another

contract -the host contract. The host contract might be a debt or equity instrument, a
lease, an insurance contract or a sale or purchase contract. Derivatives require to be
marked-to-market through the income statement, other than qualifying hedging
instruments. This requirement on embedded derivatives is designed to ensure that
mark-to-market through the income statement cannot be avoided by including -
embedding -a derivative in another contract or financial instrument that is not marked-
to market through the income statement.
A derivative embedded in a host contract is closely related to the host contract if the
embedded derivative comprises contingent rentals based on related sales.
For example –
(a) Closely related to host contract

An inflation index term in a debt instrument if it is not leveraged and relates to
the inflation index in the economic environment in which the instrument is
denominated. An entity would not account for embedded derivative separately
from the host contract.
(b) Not closely related to host contract

Equity conversion feature embedded in a debt instrument i.e., investment in
convertible bonds. An entity would account for embedded derivative separately
from the host contract.
Embedded derivatives that are separated from the host contract are accounted for at
fair value with changes in fair value taken through the income statement.

Z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
- 0.5000 0.5040 0.5080 0.0120 0.0160 0.0199 0.5239 0.0279 0.0319 0.0359
0.10 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.20 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6064 0.1064 0.6103 0.6141
0.30 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.40 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.50 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.60 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.70 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.80 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.90 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.00 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.10 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.20 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.30 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.40 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.50 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.60 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.70 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.80 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.90 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.00 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.10 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.20 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.30 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.40 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.50 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.60 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.70 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.80 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.90 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.00 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990

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DERIVATIVES ANALYSIS AND VALUATION

Derivatives 1FIN by IndigoLearn 1

2.2 Put Option

2.3 European Options

2.4 American Options

2.5 Stock Options

2.6 Stock INDEX options

Derivatives 1FIN by IndigoLearn 2

3. Option Pay offs

Maximum Loss Premium paid

Pay off = Max (0, (ST – X)) – C

X – Strike Price; S – Spot Price; T – Time period; C – Call Premium

Type Holder of Call Option

Break – even stock price = Strike price + Premium = Rs. 2,200

Long Call Pay off

Derivatives 1FIN by IndigoLearn 3

Maximum Loss Theoretically Infinite

Type Writer of Call Option

Break – even price = Strike price + Premium = Rs. 2,200

Short Call Pay off

Derivatives 1FIN by IndigoLearn 4

Maximum Loss Premium paid

Max (0, (X - ST))- P

X – Strike Price; S – Spot Price; T – Time period; P – Put Premium

Type Holder of Put Option

Break – even price = Strike price - Premium = Rs. 1,800

Long Put Pay off

Derivatives 1FIN by IndigoLearn 5

Min ((ST - X), 0) + P

X – Strike Price; S – Spot Price; T – Time period; P – Put Premium

Type Writer of Put Option

Break – even price = Strike price - Premium = Rs. 1,800

Short Put Pay off

3.5 In the Money, At the Money, Out the Money options

Situation Call Option Put Option

4. Option Trading Strategies

Derivatives 1FIN by IndigoLearn 6

Particulars Buy call Sell call

Bull Call Spread

Net Profit / Loss

Key outcomes from the strategy are given below

Net Debit from the Premium paid (Rs. 2)

Derivatives 1FIN by IndigoLearn 7

Particulars Buy put Sell put

Bear Put Spread

Key outcomes of the strategy are given below

Net Debit from the Premium paid (Rs. 20)

Derivatives 1FIN by IndigoLearn 8

Particulars Buy call Buy put

Derivatives 1FIN by IndigoLearn 9

Particulars Sell call Sell put

4.5 Long Strangle

Derivatives 1FIN by IndigoLearn 10

4.6 Butterfly Spread

This strategy works in a non-directional market and less volatile market.

Derivatives 1FIN by IndigoLearn 11

Long Call Butterfly

5. Factors Affecting Value of an option

5.1 Current Market Price

Situation Call Option Put Option

5.2 Strike Price

Derivatives 1FIN by IndigoLearn 12

5.3 Time for Expiry