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CHAPTER-12B
OPTIONS
FCA RAJESH RITOLIA
8 YEARS TEACHING EXPERIENCE
a) Updated notes can be downloaded free of cost from our website: cassinha.in
b) Updated classes can be covered in future at free of cost
c) Module covers Suggested, RTP, PM upto May 2017
d) 145 Questions are covered in 103 different Questions
e) 16 Questions of Theory
3rd Edition
CHAPTER-12A OPTION DERIVATIVE 12A_A.1
Capital Market
A market where new securities are bought and sold for the It is a Market in which issued securities are sold and
first time is called the New Issues market or the IPO market purchased by investor. It is the stock exchanges and the over-
the-counter market.
12A.1 Derivatives
[T-2] [M04-06] [M03-06] [PM-J17-17, 21] [PM-J15-17, 21] What is a “derivatives’? Briefly explain
the recommendation of the L C Gupta Committee on derivatives.
[N07-5c-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.
(a) Derivatives:
It is a financial asset which derives its value from some specified underlying assets.
Derivatives do 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.
Type of Derivative
Example-1
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
Option
Call Option (Right to Buy UA) Put Option (Right to Sell UA)
It provides to the holder a Right to Buy UA at stike price on or It provides to the holder a Right to Sell UA at stike price on or
before strike date. before strike date.
Excercie of Call Option at expiry date (Lower of Spot Price of UA and Strike Price)
If Spot Price of UA < Strike Price If Spot Price of UA = Strike Price If Spot Price of UA > Strike Price
Status - Out of the Money Status = At the Money Status = In the Money
Excercie of Put Option at expiry date (Higher of Spot Price of UA and Strike Price)
If Spot Price of UA < Strike Price If Spot Price of UA = Strike Price If Spot Price of UA > Strike Price
In Case of Hedging
b) Strike or Exercise Price: The specified price at which the option can be exercised is known as the
Strike Price.
c) Option Premium/Price:
In options, the buyer pays option premium to seller.
In case, the right is not exercised later, then the premium is not refunded by the option writer.
d) By buying Call option Holder fixes upper limit of its purchase price but does not fix lower limit of
purchase price
g) Today 01/09/2012
Question-3 [ICWA-D08]**
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.
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).
(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.
(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.
Question-6 [ICWA-J04]***
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?
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
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-11 [M10-O-4b-8]***
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-12
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.
0.94 1.02 NA NA NA
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.
(a) Breakeven Point for Call Option = Strike Price + Premium Paid
(b) Breakeven Point for Put Option = Strike Price - Premium Paid
Question-14 [ICWA-D03]
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.
Binomial Model/Risk
Expected Gain Approach Price Differencial Approach Black Scholes Model
Neutralisation Method
TFVO today = Value of Option at expiration*PVF TFVO today = Value of Option at expiration*e-rt
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.
TFVCO = Spot Price of UAtoday – PV of Strike Price TFVPO = PV of Strike Price - Spot Price of UAtoday
If CMP of CO < TFVCO, If CMP of CO > TFVCO, If CMP of PO < TFVPO, If CMP of PO > TFVPO,
then arbitrage profit is then arbitrage profit is not then arbitrage profit is then arbitrage profit is not
possible possible possible possible
Today Today
1. Buy CO at CMP = a 1. Buy PO at CMP = a
2. Assuming we have one Share, and sell it at CMP = b 2. Buy one Share at CMP = b
3. Investment (c) = (b – a) at interest rate given 3. Borrow (c) = (a + b) at interest rate given
Question-16A [SP]
Given the following data
Strike Price = Rs.180
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.
Question-17**
Given the following data
Strike Price = Rs.200
Current stock Price = Rs.185
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-17A [SP]
Given the following data
Strike Price = Rs.400
Current stock Price = Rs.370
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.
23
24
24A
25
26 M09-1a-8 45 49
26A
27
a) Assumption of BM: CMP of the share is S and it can take two possible values at maturity, S1 or S2
such that S1 > S > S2.
b) The investor can borrow or lend an amount (B) at risk free rate of interest 'r'
c) The strike price, K, is given
d) 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.
e) 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 + Δ number of units of the underlying asset
Call Option
If CMP of CO > TFVCO, then arbitrage profit is possible If CMP of CO < TFVCO, then arbitrage profit is possible
Today Today
1. Sell Call Option at CMP 1. Buy Call Option at CMP
Buy Replicating Portfolio Sell Replicating Portfolio
2. Buy Δ no of shares at CMP 2. Sell Δ no of shares at CMP
3. Borrow at interest rate given 3. Deposit at interest rate given
(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.
Question–19B [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-24A [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.
BM RNM
Question-25***
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.
Question-26A [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-27 [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%.
[T-5] [M15-7c-04] [PM-J17-56] [PM-J15-52] State any four assumptions of Black Scholes Model
(a) The Black-Scholes model is used to calculate a theoretical price of an Option.
Calculate d2 d2 = d1 - σ√t
It represents the hedge ratio of shares to Options necessary to maintain a fully hedge
Calculate N(d1) and N(d2) from Table
position.
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)
b) 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.
12A.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
Question-31
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-32
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?
12A.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
Question-33
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-33A
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.
(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.
12A.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
Question-35
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.
12A.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
Question-36
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
Question-37
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
(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
100 5 Note: Lower the strike price, higher the call premium.
115 3
(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
(i) Buy 1 Call at K1 + Sell 1 Call at K2 with the same date of expiration.
(ii) K1 > K2
(i) Buy 1 Put at K1 + Sell 1 Put at K2 with the same date of expiration.
(ii) K1 > K2
(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.
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
12A.14 Theory
Q No Exam PM-J15 PM-J16 PM-J17 RTP
T-6 N04-5c-4, M06-2b-4
[T-6] [N04-5c-4] Explain the term ‘intrinsic value of an option’ and the ‘time value of an option.
[M06-2b-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.
1 Calculation of PV of any shares, Bonds etc. from FV, if interest rate is compounding yearly
PV = FV/(1+PIR)
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
Example-2
FV of Share at the end of 6 months =Rs.110
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
2
PV of Share at t0 Rs.110/1.06 110/(1.03) 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
Example-3
FV of Share at the end of 6 months =Rs.110
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)
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
CV of Share = Rs.105
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
CV of Share = Rs.105
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)
IR is Compounding Periodically PV = FV/(1+PIR)n FV = CV*(1+PIR)n
PV = FV*PVF(n Period, PIR) FV = CV/PVF(n Period, PIR)
rt
IR is Continuously Compounding PV = FV/e FV = CV*ert
PV = FV*e-rt FV = CV/e-rt
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
Strike Price Rs.60 Rs.60 Rs.60 Rs.60 Rs.60
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
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
Solution-2A
(a) If share price goes to Rs.53 at expiry
Particulars Call Option Put Option Total
Investor Buy 1 1
Premium Paid Rs.2 Rs.1 Rs.3
Strike Price Rs.52 Rs.50
If market Price of share at expiry Rs.53 Rs.53
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
No of Shares 50 50
Total -50 -50 -100
Solution-2B
(a) If share price = Rs.500 at expiry
Particulars Call Option Put Option Total
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
Strike Price Rs.550 Rs.450
If market Price of share at expiry Rs.500 Rs.500
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
Solution-2C
(a) If share price goes to Rs.350 at expiry
Particulars Call Option Put Option Share Total
Investor Buy 1 for 100 shares 1 for 100 shares
Premium Paid Rs.30*100 Rs.5*100 Rs.3500
Strike Price Rs.550 Rs.450
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
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
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
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
Total Profit to Writer = Gain on Settlement of Option + Profit on sale of Share = Rs.25 + Rs.50 = Rs.75
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.
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-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
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. = $100*35.75 = Rs.3575 m
Solution-10
(c) Hedging through call option
XYZ is to pay £ 300000 in 180 days [$ - Sell and £ - Buy]
[£ is LHC and it is to be purchased, hence for hedging of purchase price, we should buy Call option]
Solution-11
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
Solution-12
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
Solution-13
An American firm is to pay Can$ 1010000 and Can$ 705000 on 31 st July and 30th Sep respectively [Buy Can $ and Sell US
$]
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
Solution-14
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-16
(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
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-16A
(a)
Strike Price of 1 year Call Option = Rs.180
CMP of Share = Rs.200
Maturity Period = 1 year
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
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.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
Settlement of above three transactions under 3 different prices of Share on maturity date
Assume Share price on the exercise date Rs.190 Rs.180 Rs.170
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
(f) Amt receivable from investment (Rs.170*e-0.1) Rs.187.87 Rs.187.87 Rs.187.87
Net Cash Flow [Arbitrage profit] Rs.7.87 Rs.7.87 Rs.17.87
Solution-17
(a)
Strike Price of 6 months Put Option = Rs.200
CMP of Share = Rs.185
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
Solution-17A
(a)
Strike Price of 6 months Put Option = Rs.400
CMP of Shares = Rs.370
Maturity Period = 6 months
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
Solution-18
(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
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(40-50),0] = Rs.0
Hedge Ratio Δ = C1-C2/S1-S2 = 10-0/60-40 = 0.50
Borrowing = Δ*(S2-C2)/1+r = 0.50*(40-0)/1.12 = Rs.17.85 or
Borrowing = Δ*S1-nC1/1+r = (0.50*60-1*10)/1.12 = Rs.17.85 or
Value of Call Option under BM = Δ*CMP of Share – Borrowing = 0.50*50 - 17.85 = Rs.7.15
Maturity Period = 1 year
(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
(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.
(ii)
CMP of Call Option = Rs.5
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
Solution-18A
S1 = Rs.250; S2 = Rs.140; Strike Price = Rs.180; CMP of Share (S) = Rs.190
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(250-180),0] = Rs.70
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(140-180),0] = Rs.0
(i) Hedge Ratio Δ = C1-C2/S1-S2 = 70-0/250-140 = 0.64
(ii) Borrowing = Δ*(S2-C2)/1+r = 0.6363*(140-0)/1.09 = Rs.82.20 or
Borrowing = Δ*S1-nC1/1+r = (0.64*250-1*70)/1.09 = Rs.82.20 or
(iii) TFV of Call option under BM = Δ*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
Solution-19
Exercise Price = Rs.450, S1 = Rs.500, S2 = Rs.400; CMP of Share (S) = Rs.420
Maturity Period = 3 months
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(500-450),0] = Rs.50
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(400-450),0] = Rs.0
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
Solution-19A
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-19B
CMP of Share = Rs.200
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
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(280-220),0] = Rs.60
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(180-220),0] = Rs.0
Solution-20
CMP of Share = Rs.600
Exercise Price of Call Option = Rs.630
S1 = Rs.780
S2 = Rs.480
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(780-630),0] = Rs.150
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(480-630),0] = Rs.0
Solution-22
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
CMP of Call Option = Rs.15
Assume CMP of Call Option = TFV of Call Option under BM
Value of Call option under BM = Δ*CMP of Share – Borrowing
15 = Δ*60 – Δ*S2/(1+PI)
15 = Δ*60 – Δ*42/1.12
15 = Δ*60 – Δ*37.50
Δ*22.50 = 15
Δ = 15/22.50 = 0.667
Δ = 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)
Solution-23
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
Solution-24
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
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(70-60),0] = Rs.10
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(40-60),0] = Rs.0
Interest rate in India (RHC) = 10% p.a.
Interest rate in USA (LHC) = 15% p.a
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
Solution-24A
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
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(45-64),0] = Rs.0
P2 = 1 – 0.4 = 0.6
Value of Call Option at expiration = (12.25*0.4 + 0*0.6) = Rs.4.90
Value of Call Option today = 4.90/1.15 = Rs.4.26
Solution-25
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
C1 = Value of Option at expiration at S1 = Max[(Spot Price at expiration – Strike Price),0] = Max[(140-110),0] = Rs.30
C2 = Value of Option at expiration at S2 = Max[(Spot Price at expiration – Strike Price),0] = Max[(80-110),0] = Rs.0
BM Model
Δ = (C1-C2)/(S1-S2) = (30-0)/(140-80) = 0.50
Borrowing = Δ*S2/1.03 = 0.50*80/1.03 = Rs.38.83
Value of Option = Δ*(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
Value of Call Option today = 8.976/1.03 = Rs.8.71
Solution-26
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
(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
Joint Probability of Rs.48 from Rs.50 JP2 of S4 = P1*P4 0.65*0.35 = 0.2275
Joint Probability of Rs.48 from Rs.50 JP3 of S5 = P2*P5 0.35*0.65 = 0.2275
Joint Probability of Rs.32 from Rs.50 JP4 of S6 = P2*P6 0.35*0.35 = 0.1225
Solution-26A
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
(e) Joint Probability of all four prices at the end of 2nd year
Joint Probability of Rs.110 from Rs.100 JP1 of S3 = P1*P3 0.70405*0.70405 = 0.4956
Joint Probability of Rs.99 from Rs.100 JP2 of S4 = P1*P4 0.70405*0.29595 = 0.2084
Joint Probability of Rs.81 from Rs.100 JP4 of S5 = P2*P6 0.29595*0.29595 = 0.0876
Joint Probability of Rs.99 from Rs.100 JP3 of S6 = P2*P5 0.29595*0.70405 = 0.2084
Solution-27 [P]
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
Solution-28
CMP of Share S = Rs.80
Strike Price of Call Option K = Rs.75
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-28A
CMP of Share S = Rs.185
Strike Price of Call Option K = Rs.170
r = 7% p.a. CC; t = 3 years = 3
SD = 0.18
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-29 [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
Solution-30
(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-31
If Market Price of Share at expiry = Rs.55
Particulars Call Option Put Option Total
Mr X Buy 1 1
Premium Paid Rs.2 Rs.3 Rs.5
Strike Price Rs.65 Rs.60
If market Price of share at expiry Rs.55 Rs.55
Exercise of Option by Mr X No Yes
Value of Option 0 5 +5
Premium Paid -2 -3 -5
Net Gain/ (Loss) -2 +2 0
Solution-32
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-33
If market price of share at expiry = Rs.90
Particulars Call Option Put Option Total
Investor Buy 1 1
Premium Paid Rs.3 Rs.2 Rs.5
Strike Price Rs.97 Rs.97
If market Price of share at expiry Rs.90 Rs.90
Exercise of Option by Holder No Yes
Value of Option 0 +7 +7
Premium Paid -3 -2 -5
Net Gain/ (Loss) -3 +5 +2
Solution-33A
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-34
(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.
(ii)
Solution-35
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-36
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-37
Solution-38
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-38A
(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-39
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
Solution-40
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
Loss is limited to Re.4 per share while the profit is limited to Rs.6 per share.
Solution-41
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
Loss is limited to Re.1 per share while the profit is limited to Rs.9 per share.
Capital Market
A market where new securities are bought and sold for the It is a Market in which issued securities are sold and
first time is called the New Issues market or the IPO market purchased by investor. It is the stock exchanges and the over-
the-counter market.
12A.1 Derivatives
[T-2] [M04-06] [M03-06] [PM-J17-17, 21] [PM-J15-17, 21] What is a “derivatives’? Briefly explain
the recommendation of the L C Gupta Committee on derivatives.
[N07-5c-8]
(a) What are derivatives?
(a) Derivatives:
It is a financial asset which derives its value from some specified underlying assets.
Derivatives do 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.
Type of Derivative
12A.2 Option
[T-3] [N02-03] [PM-J17-24] [PM-J15-24] Write short notes on the Option.
[N97-05] 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.
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.
Option
Call Option (Right to Buy UA) Put Option (Right to Sell UA)
It provides to the holder a Right to Buy UA at stike price on or It provides to the holder a Right to Sell UA at stike price on or
before strike date. before strike date.
Excercie of Call Option at expiry date (Lower of Spot Price of UA and Strike Price)
If Spot Price of UA < Strike Price If Spot Price of UA = Strike Price If Spot Price of UA > Strike Price
Status - Out of the Money Status = At the Money Status = In the Money
Excercie of Put Option at expiry date (Higher of Spot Price of UA and Strike Price)
If Spot Price of UA < Strike Price If Spot Price of UA = Strike Price If Spot Price of UA > Strike Price
In Case of Hedging
b) Strike or Exercise Price: The specified price at which the option can be exercised is known as the
Strike Price.
c) Option Premium/Price:
In options, the buyer pays option premium to seller.
In case, the right is not exercised later, then the premium is not refunded by the option writer.
d) By buying Call option Holder fixes upper limit of its purchase price but does not fix lower limit of
purchase price
g) Today 01/09/2012
There will be maximum 3 Options on same underlying assets of 3 different maturity dates
Question-5**
(a)
Question-6 [ICWA-J04]***
Question-7***
Question-8 [N15-1d-5] [PM-J17-39-FOREX]***
Question-9***
Question-10 [M07-2a-8] [SP]**
Question-11 [M10-O-4b-8]***
Question-12
Question-13 [N13-2b-8] [PM-J17-43-FOREX] [PM-J15-36-FOREX]
Binomial Model/Risk
Expected Gain Approach Price Differencial Approach Black Scholes Model
Neutralisation Method
TFVO today = Value of Option at expiration*PVF TFVO today = Value of Option at expiration*e-rt
Question-15***
(a)
TFVCO = Spot Price of UAtoday – PV of Strike Price TFVPO = PV of Strike Price - Spot Price of UAtoday
If CMP of CO < TFVCO, If CMP of CO > TFVCO, If CMP of PO < TFVPO, If CMP of PO > TFVPO,
then arbitrage profit is then arbitrage profit is not then arbitrage profit is then arbitrage profit is not
possible possible possible possible
Today Today
1. Buy CO at CMP = a 1. Buy PO at CMP = a
2. Assuming we have one Share, and sell it at CMP = b 2. Buy one Share at CMP = b
3. Investment (c) = (b – a) at interest rate given 3. Borrow (c) = (a + b) at interest rate given
Question-16***
Question-16A [SP]
Question-17**
Question-17A [SP]
Call Option
If CMP of CO > TFVCO, then arbitrage profit is possible If CMP of CO < TFVCO, then arbitrage profit is possible
Today Today
1. Sell Call Option at CMP 1. Buy Call Option at CMP
Buy Replicating Portfolio Sell Replicating Portfolio
2. Buy Δ no of shares at CMP 2. Sell Δ no of shares at CMP
3. Borrow at interest rate given 3. Deposit at interest rate given
Question-18***
Question-18A [CS-J04] [SP]
Question-24***
Question-24A [SP]
BM RNM
Question-25***
Calculate d2 d2 = d1 - σ√t
It represents the hedge ratio of shares to Options necessary to maintain a fully hedge
Calculate N(d1) and N(d2) from Table
position.
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)
b) 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.
12A.14 Theory
Q No Exam PM-J15 PM-J16 PM-J17 RTP
T-6 N04-5c-4, M06-2b-4
[T-6] [N04-5c-4] Explain the term ‘intrinsic value of an option’ and the ‘time value of an option.