DERIVATIVE PRODUCTS

OPTIONS
 Introduction to Options
• Let us assume there is a farmer who is due to harvest potato is 2
months time.
• Say, the farmer has found someone who has agreed to purchase the
potato at Rs. 50 per kg after 2 months. Farmer is short (sold) the
potato forward.
55
Sell at 50

Agreement

Sell at 50 45

Cash flows
today 2 months

• What is the one thing the farmer would like to change in the contract?
 Introduction to Options
• At harvest (2 months from now) farmer would like to
– Sell at 50 if market price is 45
– Sell at market price if its higher than 50
Sell at market price of
55
55
Agreement
Sell at agreed price of
50 45
Cash flows
today 2 months

• Since he enjoys an option, he pays a premium

– Similar to an insurance !
– Farmer is said to have bought (long) a put option
 Put option
• Put option is a contract that gives the holder the right, but
not the obligation, to sell the underlying asset at specified
price on a specified date
• The option to exercise lies with the buyer, the other party
(seller) has to oblige
• The put option seller (short) collects the option premium
upfront
 Put Option: Payoffs
55

Pay Rs.3

Long 45

2 months 55

Receive Rs. 3

Short 45

Cash flows
today 2 months
 Put Option: Payoffs
55
Sell at market for 55

Pay Rs.3

Long Sell at 50 45

2 months 55


Receive Rs. 3

Short Buy at 50 45

Cash flows
today 2 months
 Put Option: Payoff Diagram
Payoff Payoff
Stock for for Payoff
Price Long Short
40 10 -10 15
42 8 -8 10
44 6 -6
46 4 -4 5
48 2 -2 0
40 42 44 46 48 50 52 54 56 58 60
50 0 0
-5
52 0 0
54 0 0 -10
56 0 0
-15
58 0 0
60 0 0 Payoff for Long Payoff for Short
 Put Option: P&L Diagram
Stock P&L for P&L for
Price Long Short Payoff
40 7 -7 8
42 5 -5 6
44 3 -3 4
46 1 -1 2
48 -1 1 0
50 -3 3 40 42 44 46 48 50 52 54 56 58 60
-2
52 -3 3
-4
54 -3 3
-6
56 -3 3
58 -3 3 -8
60 -3 3 P&L for Long P&L for Short
 Introduction to Options
• Lets look at the chips manufacturer who was long futures
Buy at 50 55

Agreement

Buy at 50 45

Cash flows
today 2 months
• What is the one thing he would like to change in the contract?
 Introduction to Options
• 2 months from now the chips manufacturer would like to
– Buy at 50 if market price is 55
– Buy at market price if its lower than 50
Buy at agreed price of
55
50
Agreement
Buy at market price of
45 45
Cash flows
today 2 months

• Since he enjoys an option, he pays a premium

– Manufacturer is said to have bought (long) a call option
 Call option
• Call option is a contract that gives the holder the right, but
not the obligation, to buy the underlying asset at specified
price on a specified date
• The option to exercise lies with the buyer, the other party
(seller) has to oblige
• The call option seller (short) collects the option premium
upfront
 Call Option: Payoffs
55

Pay Rs.3

Long 45

2 months 55

Receive Rs. 3

Short 45

Cash flows
today 2 months
 Call Option: Payoffs
Buy at agreed price 55
of 50

Pay Rs.3

Long Don’t exercise 45

Sell at agreed price of

2 months 55
50

Receive Rs. 3

Short  45

Cash flows
today 2 months
 Call Option: Payoff Diagram
Payoff Payoff
Stock for for Payoff
Price Long Short
40 0 0 15
42 0 0 10
44 0 0
46 0 0 5
48 0 0 0
40 42 44 46 48 50 52 54 56 58 60
50 0 0
-5
52 2 -2
54 4 -4 -10
56 6 -6
-15
58 8 -8
60 10 -10 Payoff for Long Payoff for Short
 Call Option: P&L Diagram
Stock P&L for P&L for
Price Long Short Payoff
40 -3 3 8
42 -3 3 6
44 -3 3 4
46 -3 3 2
48 -3 3 0
50 -3 3 40 42 44 46 48 50 52 54 56 58 60
-2
52 -1 1
-4
54 1 -1
-6
56 3 -3
58 5 -5 -8
60 7 -7 P&L for Long P&L for Short
 Option Terminologies
• Strike Price: Specific price at which option buyer can buy/sell the
underlying
– Also called Exercise Price
• Expiration Date: Specific date on which the contract expires
• European Option: Can be exercised only at maturity
• American Option: can be exercised any time during the life of the
option
 Option Terminologies
• Option Moneyness
• ATM – At the Money
• ITM – In the Money
• OTM – Out of the Money
 Option Terminologies

Call Put
12 OTM ITM 12 ITM OTM
10 10
8 8
6 6
4 4
2 2
0 0
40 42 44 46 48 50 52 54 56 58 60 40 42 44 46 48 50 52 54 56 58 60
ATM ATM
 Option Moneyness
• This is 18th May 2015. Nifty is currently trading at 8350.
• Which of these call options are ITM, OTM and ATM

Strike Price Moneyness

8200
8350
8500
 Option Moneyness
• This is 18th May 2015. Nifty is currently trading at 8350.
• Which of these call options are ITM, OTM and ATM

Strike Price Moneyness

8200 ITM
8350 ATM
8500 OTM
 Concept Check: Long Call Option

• If I am long call option

– Am I entitled to receive dividend payment on
the underlying stock?
– What are the different ways in which I can get
out of the long position?
 Concept Check: Put vs Short Selling

• Is buying a put option equivalent to short

selling the underlying?
 Concept Check: Long call vs Short put

• Is buying a call option same as selling a put

option?
 Concept Check: Long call vs Short put

• Is buying a call option same as selling a put

option?
Long Call Short Put

Option to buy Obligation to buy

Unlimited upside, known at Limited upside known at

maturity inception
Limited downside known at Unlimited downside known at
inception maturity
FORWARD PRICING
 Arbitrage : Toy Model
• The current prices of asset 1 and asset 2 are 95 and 43, respectively
• Tomorrow, one of two states will come true
Asset 1 = 100
Asset 2 = 50
Asset 1 = 95
Asset 2 = 43
Asset 1 = 80
Asset 2 = 40
• Do you see any possibility to make risk-free money out of this
situation?
 No-arbitrage pricing :Toy Model
• No-arbitrage model: The payoff of asset 1 is twice as much
as the payoff of asset 2 in all states, then the price of asset
1 should be twice as much as the price of asset 2.
– The price of asset 1 is too high relative to the price of asset 2.
– The price of asset 2 is too low relative to the price of asset 1
– Sell asset 1 and buy asset 2, you are guaranteed to make money –
arbitrage
– Selling asset 1 alone or buying asset 2 alone is not enough
 Forward / Futures Pricing
Suppose that:
The spot price of gold is US$900
The 1-year forward price of gold is US$1,020
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
 Forward / Futures Pricing
Suppose that:
- The spot price of gold is US$900
- The 1-year forward price of gold is US$900
- The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
 The Forward Price of Gold
If the spot price of gold is S and the forward price for a
contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year risk-free rate of interest.
In our examples, S = 900, T = 1, and r =0.05 so that
F = 900(1+0.05) = 945
 Pop Quiz
• Consider two stock A & B both currently trading
at Rs. 100 in the spot market
– Further, assume stock A is more volatile than stock B
– Which contract have a higher futures price
• Contract to buy stock A one year from now
• Contract to buy stock B one year from now
How do you explain this?
Assumptions behind futures price
• What are the assumptions that we have made in pricing
futures contracts?
– Market is efficient; there is no arbitrage
– No transaction costs; brokerage, etc.
– Short selling is permitted
 Short selling
• Short selling involves selling securities you do not own
• Your broker borrows the securities from another client and sells them
in the market in the usual way
• At some stage you must buy the securities back so they can be
replaced in the account of the client
• You must pay dividends and other benefits the owner of the securities
receives
Concept Check: What happens at
expiry?
• Say today RPL is trading at 100 in the spot market
– One month futures price is 105 (say)
• After one month at time of expiry of futures contract, RPL
is trading at 120 in spot market
– What would be the market price of futures contract?
OPTION STRATEGIES
 Directional View
• You find that company XYZ has huge
foreign borrowing maturing shortly and the
Indian rupee has started becoming weak.
You strongly believe that company XYZ is
going to hit its lows in the near future. What
trading strategies would be take?
 Range View
• In the last few trading session Nifty has been highly volatile.
Date Close Returns
5-May-15 8324.8  
6-May-15 8097 -2.8%
7-May-15 8057.3 -0.5%
8-May-15 8191.5 1.7%
11-May-15 8325.25 1.6%
12-May-15 8126.95 -2.4%
13-May-15 8235.45 1.3%
14-May-15 8224.2 -0.1%
15-May-15 8262.35 0.5%

• You expect this to persist. What strategy would you

recommend?
Range View: Straddle
Range View: Strangle
 Range View
• Nifty currently is trading as 8200
• If I buy a 8000 call and a 8400 call and fund
these by selling two 8200 calls what’s my
underlying view?
Range View: Butterfly
 Synthetic Option
• What will be the payoff if you decide to
– Buy a put
– Buy the underlying stock
– Fund this by borrowing
OPTION PRICING
 No arbitrage model
110

100

90

Assume a stock currently priced at 100

At the end of 1 month from now it can either be 110 / 90

What should be the price of ATM European Call option on this

stock?
 No arbitrage model
110 10

100 ?

90 0
Stock Call

Assume a stock currently priced at 100

At the end of 1 month from now it can either be 110 / 90

What should be the price of ATM European Call option on this

stock?
 No arbitrage model
110 10

100 ?

90 0
Stock Call

No arbitrage / Replicating portfolio model

-Option can be constructed using some combination of its underlying

- Since its possible to replicate the option using its underlying, cost of
replicating portfolio should match with option cost?
 No arbitrage model
110

100

90
Stock

10 a * 110 + b = 10

0 a * 90 + b = 0
Call
 No arbitrage model
10 a * 110 + b = 10

Call 0 a * 90 + b = 0

a * 110 – a * 90 = 10

a = 0.5

and b = - 45
 No arbitrage model
10 a * 110 + b = 10

Call 0 a * 90 + b = 0

a * 110 – a * 90 = 10

a = 0.5
where a -> # of stocks to buy
and b = - 45 b -> amount required to fund purchase of stock
 No arbitrage model
10 a * 110 + b = 10

Call 0 a * 90 + b = 0

Call Price = 0.5 * 100 – 45 = 5

Since in both states of nature the payoff of

portfolio matches payoff of option; price you pay
for the portfolio today should be equal to price of
option. (No arbitrage model)
 Black-scholes model
10 a * 110 + b = 10

Call 0 a * 90 + b = 0

Call Price = 0.5 * 100 – 45 = 5

Limitation of the model: We consider limited states of nature; in

reality stock can take infinite possible value at maturity

- To model this we need a closed form solution -> BSM model

 Testing convergence of Binomial to BS

• Whenever we do a finite approximation we

need to have some approximation for up &
down movement
• Generally accepted approximation
 Black-scholes model
We saw that the price of call option

c=a*S+b

For a European call, BS gives “a” as N(d1) and “b” as

 Black-scholes model
Similarly we can get price of Put option as
 Black-Scholes model
• Black scholes model requires five inputs
– Contractual terms – Strike price, Time to maturity
– Market observables: Spot price, Risk free rate
– Volatility
• Does volatility fall under either of the above two categories?
 Black-Scholes model
• Some critical assumptions on these inputs
– Volatility / Risk free rates do not change over the life of the option?
– No transaction costs, no taxes, no short sale constraints, no borrowing / lending
restrictions
– Options are European in nature
OPTION GREEKS
 Greeks
• Option Sensitivity a.k.a. Greeks
– Change in price of option with respect to
change in some underlying parameters
 Option Greeks
• Delta
– Sensitivity of option price to underlying price

• Delta of Futures?
• Delta of Call vs Put?
• Delta of OTM / ATM / ITM ?
 Option Greeks
• Gamma
– Rate of variation of delta to stock price
– Gamma of Futures?
– Gamma of Call vs Put?
• Theta
– Change in option value with passage of time
• Vega
– Sensitivity of option price to volatility
• Rho
– Sensitivity of option price to interest rate