UNIT- 7:

OPTIONS AND THEIR VALUATION

Distinction between futures and options
 Though both futures and options are contracts or
agreements between two parties, yet there lies some
point of difference between the two.
 Futures contracts are obligatory in nature where both
parties have to oblige the performance of the contracts,
but in options, the parties have the right and not the
obligation to perform the contract.
 In option one party has to pay a cash premium (option
price) to the other party (seller) and this amount is not
returned to the buyer whether no insists for actual
performance of the contract or not.
 In future contract no such cash premium is
transferred by either of the two parties (only
margin is required).
 In futures contract the buyer of contract realizes
the gains/profit if price increases and incurs losses
if the price falls and the opposite in case of vice-
versa.
 But the risk/rewards relationship in options are
different (the buyer will loose only the premium
amount).
 Option price (premium) is the maximum price that
seller of an option realizes.
 Options: Concept
 An option belongs to the family of derivative securities.
 It is a contract that confers the right to its owner/holder but not the
obligation to buy or sell a specified security at a specified price on or
before a given date.
 Options are a special type of financial contracts in that the buyer of the
option has the right to buy or sell the securities but is under no
obligation to do so.
 The buyer of the option is placed in an advantageous/favourable
situation as he will exercise his option only when it is profitable to do so.
 In other words, the seller/writer of the option is in disadvantageous
position as he is under obligation to buy or sell the securities in case the
buyer exercises his option.
 In operational terms, the seller/writer of the option runs the risk of loss
for assuming which he charges option premium from the buyer of the
option.
 There are different kinds of options, such as stock options, commodity
options, and currency options.
 Important terms associated with options
1. Parties to the contract:
Buyer of an option: is the one, who by paying the option
premium buys the right to buy/sell securities but not the
obligation to exercise his option on the seller/ writer of the
option.
Writer of an option: is the one, who receives the option
premium and is thereby obliged to sell/buy the securities if the
buyer exercises the option on him.
2. Option price/Premium
– Is the price that the option buyer pays to the option seller.
(Or) The seller or writer grants the right to the buyer in
exchange for a certain sum of money called option price or
option premium.
– Premium compensates the writer for giving such a right.
(profit of the writer).
3. Expiration date: is the date specified in the options
contract by which the option can be exercised. It is
also known as the exercise date, the strike date or the
maturity date.
4. Strike price: the price specified in the options
contract at which the buyer can exercise his right to
buy or sell the securities is known as the strike price
or the exercise price.
5. Options traded on an exchange are called exchange–
traded options and options not traded on an
exchange are called over-the-counter options.
Exchange-traded options are standardized in terms of
quantity, expiration date, strike prices, type of option,
and mode of settlement.
6. At-the-money option: is an option that would
lead to zero cash flow (no profit/no loss) to the
holder if it were exercised immediately.
7. In-the-money option: is an option that would
lead to a positive cash flow to the holder if it were
exercised immediately.
8. Out-of-the-money option: is an option that
would lead to a negative cash flow to the holder if
it were exercised immediately.
Call option Put option
ATM: Exercise price = Market price Exercise price = Market price
ITM: Exercise price <Market price Exercise price > Market price
OTM: Exercise price > Market price Exercise price < Market price
9. American option provides the holder or writer to
buy or sell an underlying asset, which can be
exercised at any time before or on the date of
expiry of the option.
10. European option can be exercised only on the
date of expiry or maturity.
 Note: Given the fact that European options are
easier to analyze than American options, and
properties of an American option are frequently
deduced from those of its European counterpart,
our discussion in this unit primarily focuses on
European options.
 Types of Options
 Options are essentially of two types, namely, call options and
put options.
 Call Option:
 A call option is a contract that gives the holder the right but not
the obligation to buy (i.e., to call in) specified securities at a
specified price on the maturity date.
 Value of Call Option to Buyer:
 In case of a call option the buyer of call will exercise the option
if the strike/exercise price (E) is less than the current
market/prevailing market share price/spot price (S1).

Call option Exercise/not exercise

If E > S1 Not exercise

If E < S1 Exercise the option

 The intrinsic value of an option is called fundamental or underlying value.
 It is the difference between the market/spot/current price and the strike
price of the underlying asset.
 The value of call option (C1) on is expiration date can be calculated as
follows:
 C1 = Max (S1 – E, 0)
 Where Max implies the maximum value of S1 – E or Zero whichever is
higher.
S1 is the current/spot price and E is the exercise/strike price of the
underlying asset and as clear from the above Table, the call option holder
will exercise the call option if the exercise price is less than the current
market price i.e. if E < S1.
 The difference between S1 and E will be positive and this is known a
positive intrinsic value and in case if S1 = E then the intrinsic value is zero.
 In any case it cannot be negative because then the holder will not exercise
the option.
 Case – 1: Suppose the market price of equity
share of ABC company on the expiration date is
$140 and the exercise price is $125. What is the
value of call option? Ignoring the option premium,
taxes, transaction costs and time value of money.
 The value of call option is $15 ($140 - $125).
 In case, the market price of equity share on
expiration date turns out to be $120, the value of
call option (C1) would not be negative $5 ($120 -
$125); it would be zero as the investor would not
purchase shares at $125 (investor would not
exercise his call option) which is available in the
market at lesser price i.e., $120.
 Gain/Loss to Call Option Buyer
 Assuming no taxes, no transaction costs and no time
value of money but assuming with premium, the
following one can help you to understand how to
determine the gain/loss to call option buyer.
 The purchase of call option primarily requires the
payment of premium to the option writer.
 Assuming premium (P) paid is $5 per share, the gain (G)
to the call-holder of ABC company (assuming market
price of equity share, S1 = $140 and Exercise price, E =
$125) will be reduced by the amount of P as shown by
equation below:
 G = Max (S1 – E, 0) – P
 = ($140 - $125) - $5 = $10.
 In case the market price of equity share is $120,
the loss to the call-holder would be $5 (equivalent
to the amount of the premium paid).
 His loss will not increase to $10 (E – S1 = $125 -
$120 = $5 + $5 (premium paid)) because the call-
holder is under no obligation to buy the share.
 He will obviously not buy the (exercise) share at
$125 whose market price is $120.
 Therefore, it can be generalize that the loss is
equal to premium paid whenever E > S1.
 Put Option:
 A put option is just the opposite of a call option.
 A put option gives the holder the right but not the
obligation to sell securities (i.e., to put them) on or by
a certain date at a fixed exercise price.
 In other words, the writer/seller of the put option has
the obligation to buy securities in case the put owner
decides to exercise his option.
 Since the put option writer is at the receiving end, he
receives the put premium (as a compensation for risk
assumed) from the put buyer.
 The put option holder will exercise his right to sell the
securities should the price of the securities fall below
exercise price (E) at the date of expiration.
 Put option Exercise/not exercise
If E > S1 Exercise

If E < S1 Not exercise the option

 Consider the following case to understand the put

option.
 Case-2: Suppose an investor wants the right to sell ABC
company’s equity shares at $135 after 2 months. He is to
buy a 2-month put option with a $135 exercise price.
 In case the market price of ABC company’ share price
increases to $150 (S1>E), the put option will expire
worthless as it will be more profitable for an investor to
sell in the open market at $150 than to the put option
writer at $135.
 Assuming the market price of the share falls
below the strike/exercise price, say to $125, it will
be profitable for the put option holder to exercise
his put option right as it fetches him $135
compared to $125 he can otherwise obtain from
the market.
 The following equations can be inferred from
above case study.
 The equation can serve as a benchmark/guide
when to exercise/avail put option and when not
to exercise/avail it.
 E > S1, exercise/avail put option........................ (1)
 E < S1, do not exercise/avail put option............ (2)
 Like call options, put options cannot have negative
value as the put option owner will not sell securities
at a lower price (compared to the higher price
available in the market) to the put option writer.
 Its value will be either zero as per equation (2) (when
he does not exercise his put option right) or higher
when E > S1 (exercise his put option since the value is
positive).
 Accordingly, value of put option = Max (E - S1,0).
 For example, the exercise price (E) is $135 and market
price of share (S1) is $125. What is the value of call
option? Ignoring the option premium, taxes,
transaction costs and time value of money.
 Value of put option is $10 ($135 - $125).
Option Payoffs
 The optionality characteristic of options results in
a non-linear payoff for options.
 In simple words, it means that the losses for the
buyer of an option are limited; however the
profits are potentially unlimited.
 The writer of an option gets paid the premium.
 The payoff from the option writer is exactly
opposite to that of the option buyer.
 His profits are limited to the option premium;
however his losses are potentially unlimited.
 Call Option Payoffs:
 A call option gives the buyer the right but not
obligation to buy the underlying asset at the strike
price specified in the option.
 The profit/loss that the buyer makes on the option
depends on the spot price of the underlying.
 If upon expiration, the spot price/market price exceeds
the strike price, (exercise call option) he makes a profit.
 Higher the spot price, more is the profit he makes.
 If the spot price of the underlying is less than the strike
price, he lets his option expire un-exercised.
 His loss in this case is the premium he paid for buying
the option.
 Case-3: Suppose an investor buys 3-month 100 call option contracts (one
call option contract consists of 100 equity shares) of ABC with strike price
of $125 and call option premium of $5 per share.
 The one call option contract involves cost/investment of $500 (i.e., 100
equity shares × $5).
 Therefore, the total sum invested is $50,000 (i.e., $500 per contract × 100
contracts).
 After three months, if the market price of ABC turns out to be $125 or
less, the option is of no value and the investor losses $50,000.
 In case ABC’s price moves up to more than $125 on the date of expiration
of the contract, the investor would exercise his option as the share price
exceeds the exercise price.
 Assume ABC has risen to $150 per share.
 The investor gains $25 per share (i.e., $150, S1 - $125, E).
 His gross profit would be $250,000 (i.e., $25 per share × 100 contracts ×
100 shares per contract).
 His net profit will be $200,000 ($250,000 - $50,000 option premium paid).
 An investment of $50,000 would yield him a profit of $200,000.
 Put Option Payoffs:
 A put option gives the buyer the right but not
obligation to sell the underlying asset at the strike
price specified in the option.
 The profit/loss that the buyer makes on the option
depends on the spot price of the underlying.
 If upon expiration, the spot price is below the strike
price, (exercise put option) he makes a profit.
 Lower the spot price, more is the profit he makes.
 If the spot price of the underlying is higher than the
strike price, he lets his option expire un-exercised.
 His loss in this case is the premium he paid for
buying the option.
 Case-4: Assume an investor buys 3-month 200 put option
contracts (each contract involving 100 shares) of ABC with strike
price of $200 and put option premium of $8 per share. On the
date of maturity, ABC is selling (market price) at $180. Assume
also in case the market price of ABC ends up with a price of $210.
 Required:- Compute his payoff on the position?
 The investor will obviously exercise his option of selling 20,000
shares (200 contracts × 100 shares) at strike price of $200 has the
market price is lower at $180.
 His gross profit will be $400,000 (20,000 shares × $20 profit per
share).
 His net profits will be $240,000 ($400,000 – put option premium
of $160,000 on 20,000 shares @ $8 per share.
 In case the market price of ABC ends up with a price higher than
strike price i.e., $210, the put option has zero value as the investor
can sell his shares in open market at a higher price.
 He would loss the $160,000 put option premium.
Factors Influencing Option Valuation
 The following factors which determine the
value/worth of a call option.
Current share price,
Exercise price,
Risk-free rate/interest rate,
Time to expiration/maturity, and
Price volatility of share.
 Case-5: Suppose an investor is interested in buying a call option
to purchase ABC share to be exercised exactly after one year with
exercise price of $130; the share’s current market price (S 0) is
$125 and the risk-free rate available on securities/ T-bills (R f) is
7%.
 Assume further that the share price of ABC will be either $140 or
at $160 after one year.
 Since the exercise price is $130, the call option will either carry
the value of $10 (i.e., $140 - $130) or of $30 (i.e., $160 - $130).
 In both the situations, the call option will be in the money to the
investor.
 Let us assume further that the investor wants to have the same
value of investment/financial return (i) either from purchase of
shares (ii) or from buying a call option.
 In case of the latter alternative, the investor is required to invest
present value of the exercise price ($130) in T-bills/risk-free
securities to exercise call option at year-end 1.
 The requisite sum is provided by the following
equation.
 E/(1 + Rf)t
= $130/ (1 + 0.07)
= $130 × 0.935 (PV of dollar one at year-end
1 discounted at 7%) = ($121.55).
In both the situations the value of his
investments (depending on the price of
share at year-end 1) will be the same as
shown below:
Value of investment at year-end 1 (i) when share are
purchased and (ii) when call options are purchase
in conjunction with T-bills.
Particulars Amount
(Year –end 1)
(a) When call value is $10:
(i) Compounded value of $121.55 invested at 7% $130
risk-free rate [$121.55 (1 + 0.07)]
(ii) Plus call value 10
(iii) Equal to market price of share $140
(b) When call value is $30:
(i) Compounded value of $121.55 $130
(ii) Plus call value 30
(iii) Equal to market price of share $160
 Since both the alternatives have the same
financial returns, they must a priori have the same
value today.
 Since the current price of the share is $125, the
value of the call option today (C0) is logically given
by the following equation.
C0 = S0 – E/(1 + Rf)t ………………………………………(3)
= $125 – ($130/1.07) = $125 - $121.55 = $3.45
 The value of call option has to be $3.45 as shown
below. The investment outlay under both the
alternatives is the same.
 Particulars Amount
(A) Investment in shares $125
(B) Investment in risk-free securities and call option :
Risk-free securities/T-bills $121.55
Plus: Call option premium 3.45 $125
 From equation (3), follows the generalization that the value of
a call option is the current market price of share less the PV of
exercise price (discounted at risk-free rate of return).
 To put it differently, the value of call option is a function of (i)
current share price, S0, (ii) exercise price, E, (iii) risk-free rate of
return, Rf, and (iv) time to expiration/maturity, t.
 The impact of these factors on call option value is explained
below:
 Current share price:
 The current share price prevailing in the market has a positive
impact on the call value.
 In other words, the higher is the current market price (S 0), the
higher is the value of the call option.
 Other things being equal, assume in Case study – 5, the value
of S0 is $127 (instead of $125), the value of call option, C0
increases by $2 [from $3.45 to $5.45 (i.e., $127 - $121.55)].
 Exercise price:
 The exercise price on the date of expiration has a
negative influence on the value of a call option,
that is, the value of C0 is negatively related to E;
the higher the value of E, the lower is the value of
C0 and vice-versa.
 Assuming other factors constant and the value of
E increase to $132, the value of C0 decreases to
$1.68 (i.e., $125 - $123.42, PV of $132 × 0.935).
 Risk-free rate:
 Risk-free rate (interest rate) has a positive relationship with
the value of call option.
 The higher is the interest rate the higher is the C0.
 This is so because the final payment for the purchase of
shares is delayed till the time the option is exercised at some
future date.
 The higher is the Rf the lower is the PV of exercise price;
since this price is to be subtracted from S0 as per equation
(3), the value of call option increases.
 To put differently, the PV of exercise price will be less with
higher discount rate causing higher value of C0.
 Assuming 10% discount rate (in place of 7%), the value of C0
increases to $6.83 (i.e., $125 - $118.17, PV of $130 × 0.909,
PV factor at 10%), other factors remaining unchanged.
 Time to expiration/maturity:
 It is very evident from the right part of equation (3),
[E/(1 + r)t] that the higher is the value of t, the lower
will be the PV of exercise price (to be paid in future
year, t).
 Since this amount is to be subtracted from S0, to
determine C0, it obviously implies the higher value of
call option, assuming other things remain constant.
 In case study – 5, let us assume time to expiration of
2 years instead of 1 year.
 The value of call option enhances to $11.51 (i.e.,
$125 - $113.49, PV of $130 × 0.873, PV factor for 2
years at 7% rate of discount).
 The above four factors are the only relevant
factors affecting the value of call option when an
option is certain to finish in the money.
 However, in practice, the option may finish out of
the money also.
 In the latter situation, the fifth factor related to
price volatility of share becomes relevant.
 Price volatility of share:
 The volatility in the share price significantly
influences the call option value.
 In operational terms, the greater is the
possibility/likelihood of extreme outcomes, the
greater is the call option value to its holder, all
other things remaining the same.
 In statistical terms, the greater is the
variance/standard deviation of the financial
returns on the associated share, the more is the
worth/value of the option to its owner.
The Black-Scholes Option Pricing Model
 We know that there are five factors which
influence the value of option: current share price,
exercise price, risk-free rate of interest, time to
expiration on the option and price volatility of
share (measured in terms of variance).
 The BS model makes, inter-alia, use of the above
propositions and factors to determine the value of
call option.
 The additional/redeeming feature of the BS model
is that it takes into account the changes in the
price of shares at shorter and shorter intervals.
 Assumptions:
 The BS model is based on the following
assumptions:
It considers only those options which can be exercised
at their maturity, that is European options.
The market is efficient and there are no transaction
costs and taxes.
Information is available to all investors with no costs.
The risk-free rate or interest rate are known and
constant during the period of option contract.
Investors can borrow as well as lend at this rate.
No dividend is paid on the shares.
 Given these assumptions, the BS model formulas
for the prices of European calls and puts on a non-
dividend paying stock are:
 Value of call option =
C0 = S0 N(d1) - E N(d2)
erft

 Value of put option =

E
P0 = C0 – S0 +
erft
(or)
E E
Po = S0 N(d1) - N(d2) - S0 +
erft erft
Case study-6: The following information available
to a market participant.
Spot price/currently selling price = $60
Exercise price of call option = $56
Risk-free interest rate (continuously
compounded) = 14% per annum.
Time remaining for expiration = 6 months.
Volatility of the share/standard deviation = 30%.
Required:- Based on the above information,
determine the value of an European call option
and put option as per the Black-scholes formulas?