Options The Upside Without Downside

Prof Mahesh Kumar Amity Business School profmaheshkumar@rediffmail.com

What is an option? 
An option confers on the buyer the eligibility to buy or sell a sum of the foreign currency at a pre determined rate on a future date without an obligation to do so.  On the due date the buyer of the option may elect to buy/ sell as per his entitlement or he may choose to let it go unused.  Either of the decision is binding on the seller, who has no discretion.

Features of Options Contract
1) Parties: There are two parties to option Parties contract- the option buyer and the option seller. The option buyer is the holder of the right under the contract either to buy or sell an asset by certain date for a certain price. Normally it would be exporter or importer or corporate treasurer who would be buying the options. The option seller also known as the writer of the option makes the right available to the buyer. Normally the writer of the options will be the bank which provides the instrument to its customers.

Features of Options Contract
2. Call and Put Options: A contract under which Options the option buyer has the right to purchase the specified currency is called the call option. A contract conferring the right to the buyer to sell the specified currency is called the put option. Generally, the US dollar is the base currency and the other currency of the contract is the foreign currency that is being bought or sold.

Features of Options Contract
3) Premium: Premium is the fee payable by the Premium: buyer of the option to the seller at the time of entering into the contract. The premium paid is not refundable whether the buyer ultimately exercises his right or not. The major factors which influence premium of an option are: a) The difference between the exercise price and the spot price. b) The maturity periods. c) Volatility of price movements. d) Interest rates etc.

Features of Options Contract
4) Strike Price: The exchange rate at which the Price currencies are agreed to be exchanged under the contract is the strike price. 5) Maturity Date: The date on which the contract Date expires is the maturity date. 6) Execution: Based on the period when the Execution: buyer can exercise his right of contract options are classified into two types viz. European Options and American Options. European Options can be exercised only on the maturity date while American options can be exercise on any date during the currency of the contract.

Difference between forward futures and options
Forwards/ Future  Both the parties have committed to some action. Option  The holder of the option has the right but not the obligation to some action. 
Purchase of an option requires an upfront fees. 

It costs a trader nothing (except for the margin requirements) to enter into forward or futures contract.

Types of Options
There are two basic types of options: 1. A call option which gives the holder of the option the right to buy an asset by a certain date for certain price. 2. A put option gives the holder of the right to sell an asset by a certain date for a certain price.
Option Type
Call Put

Buyer of Option (Long Position)
Right to buy an asset Right to sell an asset

Writer of Option (Short Position)
Obligation to sell asset Obligation to buy asset

Types of Options
The date specified in the contract is known as the expiration date, the exercise date, the strike date or the maturity. maturity. The price specified in the contract is known as price. the exercise price or strike price. American option can be exercised at any time up to the expiration date. European option can be exercised only on the expiration date itself. Most of the options traded on exchange are American.

Option Positions
There are four types of option positions: 1. 2. 3. 4. A A A A long position in a call option. long position in a put option. short position in a call option. short position in a put option.

Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity

Payoff K Payoff K ST
Long Put

Payoff K ST
Long call

ST
Short Call

Payoff K ST
Short Put

Options: A Zero Sum Game
Write & Purchase Call Option:

Profit and Loss

Long Call Zero-Sum-Game

Premium Earned x
Stock Price at Expiration

Premium Paid Short Call

Options: A Zero Sum Game
Write & Pull Call Option:

Profit and Loss

Long Put Premium Earned
Stock Price at Expiration

Short Put

Premium Paid

Terminology
Options are referred to as: 1. In-the-money: an option which would give the holder a In-the-money positive cash flow if it were exercised immediately. 2. At-the-money: an option which would lead to zero cash At-the-money flow if it were exercised immediately. 3. Out-of-the-money: an option which would lead to a Out-of-the-money negative cash flow if it were exercised immediately. If S is the stock price and X is the strike price then, Condition S>X S=X S<X Call Option In the money At the money Out of money Put Option Out of money At the money In the money

Terminology
All options of the same type (calls or puts) are referred to as an option class e.g. SBI calls are one class whereas SBI puts are another class. An option series consists of all the options of a given class with the same expiration date and strike price. In other words, an option series refers to a particular contract that is traded. The SBI 50 calls are an option series.

The Underlying Asset
The asset that can be bought or sold with an option is known as the underlying asset, or simply, the underlying. There is a wide variety of assets on which options are traded the world over and include: Agricultural commodities Foreign currencies Interest rates Stock indices and individual stocks (as of now 31 stocks permitted). Futures

1. 2. 3. 4. 5.

Types of Options
Three types of options are available: a) OTC options b) Exchange Traded Options c) Options on Futures

Over-the-counter (OTC) Options 
They are available with individual banks.  They are tailor made to the requirements of the buyer with regard to the maturity, price and size of the contract.  Buyer bears the counterparty risk.  Confined to large volumes and between big players.  Since it is a non standard variety premiums are high.

Exchange Traded Options 
Traded at organized exchange.  Contract in standard maturities and standard amounts.  The contract is with the clearing house of the exchange therefore counterparty risk is minimized.

Options on Futures 
Future contract is the underlying security.  A futures option is the right, but not the obligation, to enter into futures contract at a certain future price by a certain date.  A call futures option is the right to enter into a long futures contract at a certain price.  A put futures option is the right to enter into a short futures contract at a certain price.

Example for Call Future Option 
An investor has bought a July call future option on gold with a strike price of $300 per ounce. The contract size is 100 ounces of gold.  Suppose the investor exercises the option when July gold futures price is $340 and the most recent settlement price is $338  When the investor exercises future call option, the investor receives a long futures contract plus a cash amount equal to (338300)*100=$3800. The investor decides to close out the long futures position immediately for a gain of (340-338)*100=$200. The total payoff from the decision to exercise is therefore $4000

Example for Put Futures Option 
An investor buys September put futures option contract on corn. The contract size is 5000 bushels. The strike price is 200 cents.  The investor exercises when the September corn future price is 180 and the most recent settlement price is 179.  The investor receives a short futures contract plus cash amount of (2-1.79)*5000=$1050. The investor decides to close out the short futures position immediately for a loss of (1.80-.79)*5000=$50. The total payoff from the decision to exercise is therefore $1000

Reasons for Popularity of Futures Options 
Future contracts are more liquid and easier to trade than the underlying asset.  Future price is known immediately from trading on futures exchange whereas the spot price of the underlying asset may not be readily available.  When exercising the futures option, it does not lead to the delivery of the underlying asset and are normally settled in cash.  The futures option and futures are traded in pits side by side in the same exchange. This facilitates hedging, speculation and arbitrage. It also tends to make markets more efficient.  Futures option tend to entail lower transaction costs than spot options in many situations.

Pay-Off Under Options 
The peculiarity of options is that the buyer has the right to exercise his right without obligation whereas seller has only obligation.  For the buyer of the option, the extent of loss is limited to the premium paid whereas theoretically there is no limit on profit he can make.  For the seller of the option the maximum gain is limited to the premium received whereas the extent to which he can lose is unlimited.

Execution of Contracts
Based on the prevailing spot execution of option contract considered: a) In-the-money options In-theb) Out-of-the-money options Out-of-thec) At-the-money options At-the

price may

the be

In-the-money Options 
An option is in-the-money if it would be advantageous for the holder of the option to exercise his right.  A call option is in-the-money if on the maturity date the spot price of the currency being bought is higher that the strike price under the option contract.  A put option is in-the-market, if at maturity the spot price of the underlying currency is cheaper than the strike price under the contract.  The difference between the option price and the spot price on maturity is know as the intrinsic value of the option. option.

Out-of-the money Options 
An option is out of the money if it is not advantageous for the buyer to exercise his right.  A call option is out of the money if the spot price for the currency bought under option is lower that the strike price agreed under the contract.  A put option is out of the money on the maturity date where the spot price for the currency sold is higher than the strike price under the option contract.  When the option is out of the money, the buyer does not exercise his right and the seller stands to gain by the premium he received under the contract.

At-the-money Options 
An option contract is at-the-money when the strike price is equal to the spot rate for the currency concerned on the due date of the contract. It makes no difference to either of the parties whether exercises the option or not.

Intrinsic Value and Time Value
The premium or the price of the option is made of two components: The intrinsic value also termed as parity value. The time value also termed as premium over parity. The intrinsic value refers to the amount by which it is in money if it is in-the-money. An option which is out-of-money or at-the-money has a zero intrinsic value.

1. 2.  

Intrinsic Value and Time Value 
For a call option, which is in-the-money, the intrinsic value is the excess of stock price (S) over the exercise price (X) while for at-the-money and out-of-money option, the intrinsic value is zero. Symbolically it is represented as: Intrinsic value of call option = Max(0,S-X) In case of an in-the-money put option, the intrinsic value is represented as Max(0,X-S) 

Intrinsic Value and Time Value 
Often it is optimal for the holder of an in-the-money option to wait rather than exercise immediately. The option is then said to have time value. The time value of an option is the difference between the premium of the option and the intrinsic value of the option. For a call or put option, which is at-the-money or outof-money, the entire premium amount is the time value. For an in-the-money option, time value may or may not exist. In case of a call which is in-the-money, the time value exists if the call price, C, is greater than the intrinsic value, S-X   

Intrinsic Value and Time Value 
Generally, other things being equal, the longer the time of call to maturity, the greater shall the time value be. Time value of a call=C-Max(0,S-X) Time value of a put= P-Max(0,X-S) Consider the following data about calls on a stock:

Option

Exercise Stock Call Classification Price (X) Price (S) Option Price (C) 1 Rs.80 Rs.83.50 Rs.6.75 In the money 2 Rs 85 Rs.83.50 Rs.2.50 Out of money Find the intrinsic value and time value of the stock. Option Stock Exercise Call Intrinsic Val Time Value Price (S) Price (X) Option Price (C) Max (0,S-X) ,SC- Max(0,S-X) Max(0,S1 Rs.83.50 Rs.80 Rs.6.75 Rs.3.50 6.75-3.50=Rs.3.25 2 Rs.83.50 Rs.85 Rs.2.50 0 2.50-0=Rs.2.50

Determinants of Option Value 
1. 2. 3. 4. 5. 6.

The intrinsic value of option depends on: Spot rate Strike price Expiration date (time to expiration) Risk free rate in the domestic currency. Risk free rate of interest in foreign currency Volatility of the spot rate

Determinants of Option Value
1. Spot rate: The effect of this variable on the option price rate: is quite evident. In the case of call option, the higher the spot rate, the higher the option premium and vice versa. A put option becomes less valuable with the rise in spot price and vice versa. Strike Price: Strike price is the price at which the deal Price: will take place when the option (call or put) is exercised. A call option tends to vary inversely with the strike price. With the rise in strike price the call option tends to lose value. This is because the holder stands to lose when he exercises the call option. A put option moves in direct relation with the strike price and with the rise in strike price, the holder tends to gain on exercising the option.

2.

Determinants of Option Value
3. Time to expiration: With the increase in the expiration: time to expiration, both call and put options gain value. This is because the option with a longer time to expiration, other things being held constant, will have a higher time value.

Option and Option Clearing Corporation (OCC)
The provisions specified in the options contract are guaranteed by the Options Clearing Corporations. The option clearing corporations act as an intermediary between buyers and sellers by issuing standardized options and by ensuring that the options contracts are honoured. OCC by itself does not buy and sell options (like market makers) but comes into picture only after two parties trade a contract. It takes an opposite position to each of the traders- a short position in respect of the party with long position and a long position against a party with short position. Buyer of an option relies on the OCC for the fulfillment of contractual obligations. Similarly option writer has an obligation to the OCC.

Option and Option Clearing Corporation (OCC) 
The first organized market in options in currencies opened in Philadelphia in 1982.  Many other markets have since developed for example, at Amsterdam, London, Paris, Montreal, Vancouver, New York, Chicago, Singapore etc.

Open Interest
The number of outstanding positions at a given time is known as open interest. The open interest in an option contract is an index of its liquidity. The financial press regularly publishes information on the open interest position in addition to the usual price data.

Exercise of Option
Most of the option holders do not exercise their options because they do not want to take a position in the underlying stock and investors make a closing transaction to effectively cancel their positions. However when an option holder decide to exercise an option, the Clearing Corporation randomly assigns the exercise notice to an option writer, which typically a brokerage firm. The brokerage firm, in turn, assigns it to one (or more) of their customers who wrote the option. It is important to note that once an exercise notice is issued to a particular writer, the writer is not allowed to cancel out the position by using a closing transaction. Thus the writer carries the risk that the option may be exercised and that he may be called upon to make a delivery. However this does not pose a difficulty if the underlying asset is freely traded in the market.

Covered and Naked Calls
If the holder of a call decides to exercise the call, then the writer of the call has the obligation to sell the underlying asset to the holder of the call at the strike price. The writer of the option would receive an amount equal to the exercise price. The call writer may or may not be holding the underlying asset. If a call writer own the asset underlying the call, he is said to have written a covered call. If a call is written where the writer does not have the asset underlying the call option, the call is said to be naked call. Similarly in case of put option, if the holder of the option decides to exercise the option, the put writer is obliged to accept the underlying asset at the strike price.

Margin Requirements
The performance of option contracts is assured by the OCC. In order to ensure that the writer of a naked call can fulfill the terms of the contract, margin requirements exist. The writers of option are required to meet the margin requirements. The margin requirements vary depending upon the brokerage firm, the price of the underlying asset, the price of the option and whether the option is call or put. As a general rule, initial margins are at least 30% of the security price when the option is written plus the intrinsic value of the option. Margin has an influence on the degree of financial leverage that the investor has and consequently on the return and risk on the position.

Buyer-Seller Attitudes
Call holders- Bullish Call writers- Bearish Put holders- Bearish Put writers- Bullish

Options- As Tool for Hedging 
An exporter who expects to execute the contract and receive foreign exchange after six months can enter into put option for six months which entitles him to sell the foreign currency on maturity at an agreed pre determined price. If on maturity, the spot price for the currency is more favorable to the exporter he may not choose to exercise his eight of selling under the contract and can instead sell in the market at the spot rate.  Similarly an importer can enter into µcall option¶ entitling him to buy foreign currency at the future date.

Options- As Tool for Hedging 
Option contract is useful especially in covering foreign exchange risk under contingent conditions like when company enters into bids and where other methods of hedging like forward contract may prove to be costly.

Option Products Available In India 
Banks in India are permitted to offer options of plain vanilla European type.  Pure vanilla type options are pure call and put options.  Apart from pure vanilla type products, Banks are also allowed to sell some exotic products, some which are explained in the subsequent slides.

Barrier Options
Barrier options take effect or are canceled when a particular level in the spot rate is either reached or breached. Two types of barrier options- Knock - in options and knock-out options. knockoptions.

Barrier Options: Knock In Options 
Knock-in option becomes effective when the spot rate reaches a particular rate.  The reaching of the specified level may be from a higher level to a lower level. In this case the option will be valid when the spot rate is below the specified level. Such option is µdown-andlevel. µdown-andin¶ option. option.  If the option is to become effective when the spot rate is to be reached from below and the spot rate are above the specified level. Such level. option is µup-and-in¶ option. µup-andoption.

Barrier Options: Knock Out Options 
Knock out options become effective when the specified spot rate level is breached.  The breach can occur from above, in which case the option is ineffective when the spot rate is below the specified level. The option is level. µdownµdown-and out¶ option. option.  An option which becomes ineffective when the spot rate goes above a specified level is an µupµupandand-out¶ option. option.

Participating Forwards 
The disadvantage of forward contract is that an exporter or importer who hedges his position by this instrument is not able to benefit from favorable movements in exchange rate, although he gets complete protection from unfavorable movements.  Participatory forward is an arrangement whereby the hedger is able to get protection from unfavorable movements in exchange rate as under a forward contract and also share gains in the favorable movements.  The participatory forward is a cost effective arrangement.

Example: Participatory Forwards 
Let us say that an exporter in India has a receivable of USD 10 lakhs due in 3 months The three months forward rate is Rs. 46.55 per dollar.  If he books a forward contract, he will get Rs. 46.55 per dollar on due date irrespective of the spot rate prevailing. If the spot rate on the due date is Rs. 46.40 his notional gain is 15 paisa per dollar. If the spot rate is Rs. 46.80, his notional loss is 25 paisa per dollar.

Example: Participatory Forwards 
If he enters into a participating forward under which he gets full protection against dollar depreciating below 46.55 and also gain, say 40%, in its appreciation above this level.  Suppose the spot rate on due date is Rs. 46.40. The entire USD 10 lakhs will be purchased by the bank at Rs. 46.55.  If the spot rate is Rs. 46.80, 60% of USD 10 lakhs will be bought by the bank at Rs. 46.55 and the balance 40% at the spot rate of Rs. 46.80.  Thus the hedger in this case is able to participate in the favorable movement in the rate by 40%

Example: Participatory Forwards
The mechanism underlying this mechanism is, the exporter will buy put option for USD 10 lakhs at Rs. 46.55. He will sell call option for USD 6 lakhs at the same strike price of 46.55 Suppose the spot rate on the due date is Rs. 46.40. The exporter will find that it is beneficial to exercise his right under the put option he bought with the strike price of Rs. 46.55. Thus he gets Rs. 46.55 per dollar on the entire USD 10 lakhs. The bank which has bought from him the call option for USD 6 lakhs will find that the option is out-of-the-money and let it expire.

Example: Participatory Forwards 
If the spot rate is Rs. 46.80 the exporter will find it not advantageous to exercise his put option and let it expire. The bank will find its call option is in-the-money and buy USD 6 lakhs at Rs. 46.55, the strike price under the option. The balance USD 4 lakhs will be purchased by the bank at the market rate of USD 46.80.

Range Forwards 
Range Forwards are similar in structure to participating forwards. It involves simultaneous buying and selling of call and put option. This variant of option is used when the exporter wishes to reduce the cost of the option and is also willing to limit his gain from the possible fluctuation in the currency.

Range Forwards- Example
Now if the exporter wishes to reduce the cost of the option and is willing to limit his gains then  He can write (i.e. sell) a USD call/yen option to his bank for USD 1 million, say at strike price of USD1= YEN 110. Under the option the bank has the option to buy USD 1 million at the strike rate at the end of sixth month.  The customer can collect the premium say of USD 40000 from the bank for writing this option.  If the premium received is USD 40000 then the net cost of both the option is USD 10000

Range Forwards- Example 
If an exporter expects to receive USD 1 million in 6 months¶ time and decides to receive it as yen and his break even is 105 yen per dollar, he may buy USD put/yen option of USD 1=105 yen i.e. he can sell dollar to the bank at this rate).  For buying the put option, the exporter pays the premium of USD 50000. This is the cost of the option.  If the dollar appreciates and on the due date the rate is USD1 = Yen 120, he will not exercise the option and prefer to receive the higher value of Yen at the spot rate.  If the Yen appreciates and the rate on the due date is USD 1= Yen 100, he will exercise the option.

Range Forwards- Example
The underlying mechanism is:  Let us say the exchange rate on the due date is USD1 =YEN 120. The exporter will not exercise the option. But the bank will exercise its option to buy dollars at Yen 110. The customer will receive Yen 110 million from the bank for the export proceeds.  If the exchange rate turns out to be Yen 100, the exporter will exercise his option and require the bank to pay his Yen 105 million against the remittance. It would not be advantageous for the bank to exercise its call option at this price.  Thus under the range option, the exporter gets protection from exchange fluctuation in the range of Yen 105-110.

Ratio Range Forwards 
Ratio Range Forwards is a more flexible variation of range forwards. It is a combination of straight forward option and range forward options. The main difference is that the amounts of the option bought and sold are different. The ratio of the two amounts can be so chosen as to bring down the net payment of premium even to zero.

Option Tunnel with Zero Premium 
Since the premium represents a non-negligible cost, banks propose to their clients the option with zero premium called tunnel but protection is available within certain limits. Illustrative Tunnel with Zero Premium Maturity Narrow Range Wider Range 1 month 35.00-35.60 34.25-36.25 2 month 35.50-36.00 34.00-36.30 3 month 35.75-36.35 33.80-36.50

Option Tunnel with Zero Premium 
An Indian importer buys a 1 month tunnel with zero premium, of narrow range. This implies that if after a month¶s time the dollar rate is INR 35.70 he would pay INR/USD is 35.60 But on the other hand if the dollar rate is INR 34.90 he will have to pay Rs.35 per dollar. If the dollar price is established somewhere within the range, then he would have to pay actual market price. The importance of tunnel lies in the fact that one does not have to pay premium but at the same time time do not allow the operator to get the full advantage of a favorable evolution of rates. 

 

Factors Affecting Premium

Currency

Call

Option

There are three determinants affecting call option premium: a) Level of the existing spot price relative to the strike price: The higher the spot rate relative to price the strike price, the higher the call option price will be, This is due to higher probability of buying the currency at substantially lower rate than what you would sell it for.

Factors Affecting Premium

Currency

Call

Option

b) Length of time before the expiration date: It is date generally expected that the spot rate has a greater chance of rising high above the strike price if it has a longer period of time to do so. Thus call options with higher duration are priced higher than those with shorter duration. c) Potential Variability of Currency: The greater the Currency variability of the currency, the higher the probability that the spot rate will be above the strike price. Thus the more volatile currencies have higher call option prices.

Factors Affecting Premium

Currency

Put

Option

There are three determinants affecting call option premium: a) Level of the existing spot price relative to the strike price: The lower the spot rate relative to price the strike price , the more valuable the put option will be, because there is a higher probability that the put option will be exercised.

Factors Affecting Premium

Currency

Put

Option

a) Length of time before the expiration date: A date longer period creates a higher probability that the currency will move into range where it will be feasible to exercise the option ( whether it is put or call ). Thus longer the time to expiration, the greater the put option premium will be. b) Potential Variability of Currency: The greater Currency the variability of the currency, the greater the put option premium will be, again reflecting higher probability that the option may be exercised.

Example 

A French importer has bought an equipment from a US firm for USD 1 million on 1 March in the current year to be paid for in 3 months. The importer fears an appreciation of the USD. He decides to cover himself in the µoption market¶. The data are: Exchange rate FFr/USD is 5.00 or USD/FFR is 0.20 He is considering call option for the purpose as he will be required to buy foreign exchange (USD). The characteristics of call option are: Strike price FFr/USD is 5.05 Maturity date 1st June Premium 3 percent

Example 

A French importer has bought an equipment from a US firm for USD 1 million on 1 March in the current year to be paid for in 3 months. The importer fears an appreciation of the USD. He decides to cover himself in the µoption market¶. The data are: Exchange rate FFr/USD is 5.00 or USD/FFR is 0.20 He is considering call option for the purpose as he will be required to buy foreign exchange (USD). The characteristics of call option are: Strike price FFr/USD is 5.05 Maturity date 1st June Premium 3 percent

Solution
The buyer of the call option i.e. importer pays the premium amount of USD 30000 (=1 million*0.03) or FFr 150000 (=30000*5).  On 1st June there are three possibilities: a) The currency has appreciated and the spot rate is FFr 5.5/USD. In this situation, the holder of the call option will exercise the option and buy the dollars at the strike price of FFr 5.05/USD. He will thus buy FFr 5.05 million (=5.05*1.0 million) Total cost =(5050000+150000) FFr = 5.20 million FFr Thus, his net price is FFr/USD 5.20 instead of 5.50 

Solution
b. The US currency has undergone a depreciation and on 1st June, it is FFr 4.75/USD  In this situation, he abandons his call option and buys dollars from the market at FFr 4.75/USD. His total payment is thus (4.75*1.O million +0.15 million) FFr =4.90 million FFr Thus his net price is FFr/USD is 4.9 instead of USD 4.75

Solution
c) The US dollar is at FFr 5.05. Here he can afford to be indifferent to either the market option or call option. He will pay the dame price whether he resorts to one or to the other. He pays: (5050000+150000) FFr. =5.20 million FFr.  This implies he has never to pay more than FFr 5.20 million, whatever be the level of appreciation of the USD.

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