Pricing and Valuation

of Derivatives
Example for Cost of Carry Model
Example
Consider a futures contract on a non-dividend paying share which is currently trading
at the spot market for ₹70. The future contract will mature in three months and the
continuously compounded risk-free rate of return is 8% per annum. Calculate futures
contract price with lot size of 100 shares.

Solution
Since, it is a non-dividend paying share, we will use

to calculate futures contract price.

Pricing of options
Options can be classified as Call options and Put Options.
1. Call Option: It allows the option holder the right to buy a specified asset at specific
price at a specified future date.
For example, A enters into an agreement with B to purchase 100 shares of ABC Ltd.
for ₹100 each on or before a specified date. A is the option holder and B is the option
writer.
2. Put Option: A put option provides the option holder with the right to sell specified
assets at specified price at a specified future date.

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 For example, A enters into an agreement with B to sell 100 shares of ABC Ltd.
for ₹100 each on or before a specified date. A is the option holder and B is the
option writer.

Another classification of options is American Option and European Options:

1. American Option: In this, the option holder can exercise the right to buy or sell at
any time before or at the expiry date.
2. European Option: In this, the right to buy or sell can only be exercised on the expiry
date not before that.

For example, an investor buys a call option at a strike price of ₹30 for a premium of ₹6.
The current market price is ₹28. Find out the profit or loss of the investor if the market
price of share is ₹18, 24, 26, 28, 31, 36 or 39 on the expiry date.

Solution:
The profit or loss of the investor can be summarized as:

Case of Call Option for Option Holder

Share Price 18 24 26 28 31 36 39

Premium Paid -6 -6 -6 -6 -6 -6 -6

Exercise Option Yes Yes Yes

Cost of Share (Call) -30 -30 -30

Sale of Share 31 36 39

Net Pay Off -6 -6 -6 -6 -5 0 3

As we can see that in case of call option for option holder, the loss is restricted to the
amount of premium paid and the possibility of gain is unlimited.

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Profit (₹)

Profit
0
30 36 39
Loss
-6

Loss (₹)

Now, let’s discuss the same scenario for option writers.

Case of Call Option for Option Holder

Share Price 18 24 26 28 31 36 39

Premium received 6 6 6 6 6 6 6

Exercise Option Yes Yes Yes

Price of Share (Call) 30 30 30

Purchase of Share -31 -36 -39

Net Pay Off 6 6 6 6 5 0 -3

In case of call option for option writer, the possibility of gain is restricted to ₹6 and
possibility of loss is unlimited.

4
Profit (₹)

6
Profit
0
30 36 39
Loss

Loss (₹) Call option writer

Reference:
§ Rustagi, R. P. (2021). Investment Management Theory and Practice. Sultan Chand & Sons.
§ Tripathi, V. (2020). Fundamentals of Investments. Taxmann
§ Chandra, P. (2017). Investment Analysis and Portfolio Management. McGraw-hill Education.