2. Derivatives
Derivatives are financial contracts which
derive their values from the underlying assets
or securities.
Some examples are:
Options
Futures
Swaps
3. Option
An option is the right, but not the obligation
to buy or sell something on a specified date
at a specified price.
In the securities market, an option is a
contract between two parties to buy or sell
specified number of shares at a later date for
an agreed price.
Three parties are involved in the option
trading, the option seller, buyer and the
broker.
4. Process
The option seller or writer is a person who
grants someone else the option to buy or sell.
He receives a premium on its price.
The option buyer pays a price to the option
writer to induce him to write the option.
The securities broker acts as an agent to find
the option buyer and the seller, and receives
a commission or fee for it.
5. Call Options
The call option that gives the right to buy.
The contract gives the particulars of:
The name of the company whose shares are to be
bought or the underlying asset.
The number of shares to be purchased.
The purchase price or the exercise price or the
strike price of the shares to be bought.
The expiration date, the date on which the
contract or the option expires.
6. Put Options
Put option gives its owner the right to sell (or
put) an asset or security to someone else.
Like the call option the contract contains:
StrongAlif lyeficnormat tmarkeis
reflct edonpric es.
Sem istronge ficentm arket
Al publicnf ormatin is
refl ectdons ecurityp ices
Weakly eficnt market
Alhistref oricalnfteds ormatincuy
The name of the company whose shares are to be
sold.
The number of shares to be sold.
The selling price or the striking price.
The expiration date of the option.
7. Factors Affecting
the Value of Call Option
1. The market price of the underlying asset
2. The striking price
3. Option period
4. Stock volatility
5. Interest rates
6. Dividends
8. Intrinsic Value and Time Value
The price of an option has two components
intrinsic value or expiration value and time value.
Call option intrinsic value
or expiration value = Stock price – Striking price
Put option intrinsic value
or expiration value = Striking price – Stock price
Time value = Premium – Intrinsic value
9. Gain or Loss of Call Buyer
When the market price exceeds the strike
price by just enough to cover the premium,
the profit is zero for the buyer if he exercises
the option.
This is the point of no profit and no loss and
hence known as break-even point.
If there is a rise in the price of the stock
beyond the break-even point, the call buyer
gains profit.
10. Call Buyer’s Position
Option Profit
30
25 Profit line to
20 Call option buyer
Market price of
15 optioned stock
10 Exercise Price
Intrinsic
(Rs 50)
5 value
0
10 20 30 40 60 70 80 90 100
–5
Loss of Premium
– 10 Break-even Rs 55
– 15
– 20
– 25
11. Call Writer’s Gain or Loss
When the market price is lower than the
strike price, the call buyer may not exercise
his option, hence the premium is the only
profit the call writer can gain.
If the price increases further it would be a
loss to the call writer.
12. Writing a Call
O p tio n p r o fit
25
20
15
10 I n t r in s ic v a lu e
M a r k e t p r ic e o f
5 o p t io n e d s t o c k
P r e m iu m g a in
0
10 20 30 40 60 70 80 90 100
– 5 B re a k -e v e n R s 5 5
E x e rc is e P ric e
(R s 5 0 )
– 10
– 15
L o s s lin e to
c a ll w r ite r
– 20
– 25
13. Put Buyers Position
Put buyer gains in the bearish market when
the price falls.
When the price increases, the put buyer has
to pay the premium alone and his liability is
limited to the premium amount he has paid.
14. Put Buyers Gain or Loss
40
Profit line to p ut buyer
30
20
Intrin sic value
10
Break-even Exercise Price Rs 50
Rs 45 Price of the
optioned stock
30 70 90
Premium loss
10
20
15. Put Writer’s Position
The gains of the put buyer are the losses of
the put writer.
If the market price increases the put writer
will gain the premium because the put buyer
may not be willing to sell the shares at the
lower rate i.e., the strike price is lower than
the market price.
16. Writing a Put
30
20 Break-even Rs 45
Strike Price Rs 50
10 Intrinsic value
Premium gain
0
20 40 60 80
–5 Price of the
optioned stock
– 15
Loss line of put writer
– 25
– 35
17. Profits in
Stocks, Bonds and Options
Stock, Bond and Option Details
Stock Bond Call
Put
Current price Rs 70 Rs 100 Rs 5
Rs 5
Exercise price --- --- Rs 70
Rs 70
Terms to expiration --- 6 months 6 months 6
months
Prices at termination Variable Rs 100 Variable
18. Bond Return Profit Rs
30
20
10
Return
Stock Price at
Termination
40 50 60 80 90 100
10
20
Exercise Price
30 = 70
LOSS Rs
20. Selling the Stock Short
P R O F IT R s
30
E x e r c is e P r ic e
20 = 70
10
S to c k P r ic e a t
40 50 60 80 90 100 T e r m in a tio n
10
20
30
LO SS R s
21. Investment in Calls
Protective – buy the stock and buy a put
Covered call writing – own the stock and sell a call
Artificial convertible bonds – buy bonds and buy
calls
22. The Black-Scholes Option
Pricing Model
The Black-Sholes model (1973) is given
below: V = P{N(d1 )} − eRTS{N(d 2 )}
ln(P/S) + (R + 0.5σ 2 )T
d1 =
σ T
d 2 = d1 − σ T
23. where V = Current value of the option
P = Current price of the underlying share
N(d1), N(d2) = Areas under a standard normal
function
S = Striking price of the option
R = Risk free rate of interest
T = Option period
σ = Standard deviation
e = Exponential function
24. Futures
Futures is a financial contract which derives
its value from the underlying asset.
There are commodity futures and financial
futures.
In the financial futures, there are foreign
currencies, interest rate, stock futures and
market index futures.
Market index futures are directly related with
the stock market.
25. Forward and Futures
In a forward contract, two parties agree to buy
or sell some underlying asset on some future
date at a stated price and quantity.
The forward contract involves no money
transaction at the time of signing the deal.
Forward contract safeguards and eliminates the
price risk at a future date.
But the forward market has the problem of:
(a) lack of centralisation of trading
(b) liquidity
(c) counterparty risk
26. Future Market
The three distinct features of the future markets
are:
Standardised contracts
Centralised trading
Settlement through clearing houses to avoid
counterparty risk
27. Benefits of the Index Based Futures
Liquidity: The index based futures attract a much more substantial
order flow and have greater liquidity in the market.
Information: Information flow is more in the index than in the case
of securities. The insiders are privileged to have more information in
securities.
Settlement: In the settlement, stocks have to be delivered either in
the physical mode or in the depository mode. No such delivery is
needed in the index based futures. They are settled through cash.
28. Less volatile: The changes that occur in index
values are less compared to the price changes
that occur in the individual securities. This leads
to lower prices for the index futures and can
work with lower margins.
Manipulation: The securities in the index are
carefully selected, keeping the liquidity
considerations and as such are hard to
manipulate. But security prices could be
manipulated more easily than the index.
Beneficial to the mutual funds.
