7.

2 OPTIONS

An option is a contractual agreement that gives the option buyer the right, but not the obligation, to

SXUFKDVHLQWKHFDVHRIDFDOORSWLRQRUWRVHOOLQWKHFDVHRIDSXWRSWLRQDVSHFLHGLQVWUXPHQWDWD

VSHFLHGSULFHDWDQ\WLPHRIWKHRSWLRQEX\HUVFKRRVLQJE\RUEHIRUHD[HGGDWHLQWKHIXWXUH8SRQ
H[HUFLVHRIWKHULJKWE\WKHRSWLRQKROGHUDQRSWLRQVHOOHULVREOLJHGWRGHOLYHUWKHVSHFLHGLQVWUXPHQW
DWWKHVSHFLHGSULFH
)RUVWRFNRSWLRQVWKHDPRXQWLVXVXDOO\VKDUHV(DFKRSWLRQFRQWUDFWKDVDEX\HUFDOOHGWKHKROGHU
DQGDVHOOHUNQRZQDVWKHZULWHU,IWKHRSWLRQFRQWUDFWLVH[HUFLVHGWKHZULWHULVUHVSRQVLEOHIRUIXOOOLQJ
WKHWHUPVRIWKHFRQWUDFWE\GHOLYHULQJWKHVKDUHVWRWKHDSSURSULDWHSDUW\,QWKHFDVHRIDVHFXULW\
WKDWFDQQRWEHGHOLYHUHGVXFKDVDQLQGH[WKHFRQWUDFWLVVHWWOHGLQFDVK)RUWKHKROGHUWKHSRWHQWLDO
ORVVLVOLPLWHGWRWKHSULFHSDLGWRDFTXLUHWKHRSWLRQ:KHQDQRSWLRQLVQRWH[HUFLVHGLWH[SLUHV1R
VKDUHVFKDQJHKDQGVDQGWKHPRQH\VSHQWWRSXUFKDVHWKHRSWLRQLVORVW)RUWKHEX\HUWKHXSVLGHLV
XQOLPLWHG2SWLRQFRQWUDFWVOLNHVWRFNVDUHWKHUHIRUHVDLGWRKDYHDQDV\PPHWULFDOSD\RIISDWWHUQ)RU
WKHZULWHUWKHSRWHQWLDOORVVLVXQOLPLWHGXQOHVVWKHFRQWUDFWLVFRYHUHGPHDQLQJWKDWWKHZULWHUDOUHDG\
RZQV WKH VHFXULW\ XQGHUO\LQJ WKH RSWLRQ 2SWLRQ FRQWUDFWV DUH PRVW IUHTXHQWO\ DV HLWKHU OHYHUDJH RU
SURWHFWLRQ$VOHYHUDJHRSWLRQVDOORZWKHKROGHUWRFRQWUROHTXLW\LQDOLPLWHGFDSDFLW\IRUDIUDFWLRQ
RIZKDWWKHVKDUHVZRXOGFRVW7KHGLIIHUHQFHFDQEHLQYHVWHGHOVHZKHUHXQWLOWKHRSWLRQLVH[HUFLVHG
$V SURWHFWLRQ RSWLRQV FDQ JXDUG DJDLQVW SULFH XFWXDWLRQV LQ WKH QHDU WHUP EHFDXVH WKH\ SURYLGH
WKHULJKWDFTXLUHWKHXQGHUO\LQJVWRFNDWD[HGSULFHIRUDOLPLWHGWLPH5LVNLVOLPLWHGWRWKHRSWLRQ
SUHPLXPH[FHSWZKHQZULWLQJRSWLRQVIRUDVHFXULW\WKDWLVQRWDOUHDG\RZQHG+RZHYHUWKHFRVWVRI
WUDGLQJRSWLRQVLQFOXGLQJERWKFRPPLVVLRQVDQGWKHELGDVNVSUHDGLVKLJKHURQDSHUFHQWDJHEDVLV
WKDQWUDGLQJWKHXQGHUO\LQJVWRFN,QDGGLWLRQRSWLRQVDUHYHU\FRPSOH[DQGUHTXLUHDJUHDWGHDORI
REVHUYDWLRQDQGPDLQWHQDQFH
Features of Options
7KHLPSRUWDQWIHDWXUHVRIRSWLRQVFRQWUDFWVDUHDVIROORZV
x
x
x
x
x
x

x
x

The buyer has the right to buy or sell the asset.

7R DFTXLUH WKH ULJKW RI DQ RSWLRQ WKH EX\HU RI WKH RSWLRQ PXVW SD\ D SULFH WR WKH VHOOHU 7KLV LV
FDOOHGWKHRSWLRQSULFHRUWKHSUHPLXP
7KHH[HUFLVHSULFHLVDOVRFDOOHGWKH[HGSULFHVWULNHSULFHRUMXVWWKHVWULNHDQGLVGHWHUPLQHGDW
WKHEHJLQQLQJRIWKHWUDQVDFWLRQ,WLVWKH[HGSULFHDWZKLFKWKHKROGHURIWKHFDOORUSXWFDQEX\
RUVHOOWKHXQGHUO\LQJDVVHW
([HUFLVLQJLVXVLQJWKLVULJKWWKHRSWLRQJUDQWV\RXWREX\RUVHOOWKHXQGHUO\LQJDVVHW7KHVHOOHUPD\
KDYHDSRWHQWLDOFRPPLWPHQWWREX\RUVHOOWKHDVVHWLIWKHEX\HUH[HUFLVHVKLVULJKWRQWKHRSWLRQ
7KHH[SLUDWLRQGDWHLVWKHQDOGDWHWKDWWKHRSWLRQKROGHUKDVWRH[HUFLVHKLVULJKWWREX\RUVHOOWKH
XQGHUO\LQJDVVHW
7LPHWRH[SLUDWLRQLVWKHDPRXQWRIWLPHIURPWKHSXUFKDVHRIWKHRSWLRQXQWLOWKHH[SLUDWLRQGDWH
$WH[SLUDWLRQWKHFDOOKROGHUZLOOSD\WKHH[HUFLVHSULFHDQGUHFHLYHWKHXQGHUO\LQJVHFXULWLHVRU
DQHTXLYDOHQWFDVKVHWWOHPHQWLIWKHRSWLRQH[SLUHVLQWKHPRQH\:HZLOOGLVFXVVWKHGHJUHHV
RI PRQH\QHVV ODWHU LQ WKLV VHVVLRQ 7KH FDOO VHOOHU ZLOO GHOLYHU WKH VHFXULWLHV DW WKH H[HUFLVH SULFH
DQG UHFHLYH WKH FDVK YDOXH RI WKRVH VHFXULWLHV RU UHFHLYH HTXLYDOHQW FDVK VHWWOHPHQW LQ OLHX RI
GHOLYHULQJWKHVHFXULWLHV
'HIDXOWVRQRSWLRQVZRUNWKHVDPHZD\DVWKH\GRZLWKIRUZDUGFRQWUDFWV'HIDXOWVRQRYHUWKH
FRXQWHURSWLRQWUDQVDFWLRQVDUHEDVHGRQFRXQWHUSDUWLHVZKLOHH[FKDQJHWUDGHGRSWLRQVXVHD

clearing house.

2SWLRQ 3UHPLXP LV WKH FRQVLGHUDWLRQ IRU WKH :ULWHU RI WKH RSWLRQ IRU DVVXPLQJ RU WDNLQJ XS WKH
OLDELOLW\WRSHUIRUP,WLVWKHSULFHWREHSDLGE\WKH+ROGHULUUHVSHFWLYHRIZKHWKHUWKHRSWLRQLV
H[HUFLVHGRUQRW

ADVANCED FINANCIAL MANAGEMENT I 7.65

Financial Derivatives as a Tool for Risk Management

Differentiate Options from Forward Contracts and Futures Contracts:
Aspect

Forward Contracts

Futures Contracts

Option Contracts

Trading
Place

1RVSHFLFSODFH&DQ
EHWUDGHGOLNHDQ\
FRPPRGLW\

7UDGHGRQ6WRFN
([FKDQJHV

7UDGHGRQ6WRFN
([FKDQJHV

Settlement/
Cash Flow

$WWKHWLPHRIGHOLYHU\RI
3URW/RVVLVVHWWOHGRQ
DVVHWLHDWWKHHQGRIWKH DGDLO\EDVLVEDVHGRQ
FRQWUDFWSHULRG
movement in Current
)XWXUHV3ULFH

Closure of
Contract

Price Fixation

Delivery is must.

1HJRWLDWHGEHWZHHQ

parties to the contract.

2SWLRQZULWHUFROOHFWV

premium at the inception

of the contract.

3K\VLFDO'HOLYHU\

3K\VLFDO'HOLYHU\

3D\PHQWRISULFH
GLIIHUHQWLDO

3D\PHQWRISULFH
GLIIHUHQWLDO

7DNLQJDQRSSRVLWH
SRVLWLRQDQG

7DNLQJDQRSSRVLWH
SRVLWLRQDQG

cancelling out the

contract.

canceling out the

contract.

'HWHUPLQHGE\WKHPDUNHW ([HUFLVH3ULFH6WULNH
IRUFHVLHEDVHGRQ
3ULFH[HGE\WKH6WRFN
'HPDQGDQG6XSSO\
([FKDQJH3UHPLXPLV
PDUNHWGHWHUPLQHG

Contracts are not

Contracts are

Contracts are

Obligation to
Perform

%RWKSDUWLHVDUHXQGHU

%RWKSDUWLHVDUHXQGHU

2QO\WKH:ULWHU6HOOHU
RIWKHRSWLRQLVXQGHU

Timing

&RQWUDFWVFDQEHHQWHUHG ([FKDQJHZRXOG[WKH
LQWRIRUDQ\SHULRGDWDQ\ H[SLU\GDWH&RQWUDFWVFDQ
time.
EHHQWHUHGLQWRDQ\WLPH
IRUSHULRGVXSWRWKHH[SLU\
GDWHIRUWKDWFRQWUDFW

([FKDQJHZRXOG[WKH
H[SLU\GDWH&RQWUDFWVFDQ
EHHQWHUHGLQWRDQ\WLPH
IRUSHULRGVXSWRWKHH[SLU\
GDWHIRUWKDWFRQWUDFW

Guarantee of
Performance

3HUIRUPDQFHLVQRW
JXDUDQWHHG7KHUHLV
OLTXLGLW\ULVN

QROLTXLGLW\ULVN

Nature

VWDQGDUGL]HG7KHVHDUH
FXVWRPL]HG

obligation to perform.

VWDQGDUGL]HG

obligation to perform.

VWDQGDUGL]HG

obligation to perform.

6WRFN([FKDQJHZLOOHQVXUH 6WRFN([FKDQJHZLOOHQVXUH

performance. There is little performance. There is little

RUQROLTXLGLW\ULVN

Options: Advantages and Disadvantages

Feature

Cost

Advantage
2SWLRQVDUHDQ
LQH[SHQVLYHZD\WRJDLQ
DFFHVVWRWKHXQGHUO\LQJ
LQYHVWPHQWZLWKRXW

having to buy stock

Disadvantage

Effect on Holder/Writer

H[SLUHZRUWKOHVV7KLVULVN

+ROGHUPD\EH
GLVDGYDQWDJHGGXHWR
H[SLU\:ULWHUZRXOGEH
DGYDQWDJHGDVVKH
QHHGQRWPDNHGHOLYHU\

As a form of insurance,
an option contract may

increases the greater the

H[WHQWWRZKLFKWKHRS

tion is out of the money

DQGWKHVKRUWHUWKHWLPH
XQWLOH[SLUDWLRQ

7.66 I ADVANCED FINANCIAL MANAGEMENT

once the option has

H[SLUHG

Leverage

to stump up less money

,QYHVWRUVVKRXOGUHDOL]H
WKDWRSWLRQVOHYHUDJH

gain.

RQWKHGRZQVLGHDVZHOO

2SWLRQVHQDEOHLQYHVWRUV
DQGREWDLQDGGLWLRQDO

Marketability
+HGJLQJ

can impact performance

2SWLRQWHUPVWUDGHRQDQ 5HJXODWRU\LQWHUYHQWLRQ
H[FKDQJHDQGDVVXFK
FDQSUHYHQWH[HUFLVH
DUHVWDQGDUGL]HG
ZKLFKPD\QRWEHGHVLU

Both parties to an options

2SWLRQVPD\EHXVHGWR

%RWKWKHKROGHUDQG
WKHZULWHUPD\EHGLV
DGYDQWDJHGGHSHQGLQJ
XSRQZKLFKVLGHRIWKH
WUDGHWKH\DVVXPHDQG
WKHXOWLPDWHGLUHFWLRQRI
WKHXQGHUO\LQJVHFXULW\

limit losses.

able.

7KHLQYHVWRUPD\HQGXS

being incorrect as to the

GLUHFWLRQDQGWLPLQJRI
DVWRFNVSULFHDQGPD\

implement a less than

SHUIHFWKHGJH
5HWXUQ

enhancement

'LYHUVLFDWLRQ

5HJXODWLRQ

:ULWHUVRIQDNHGFDOOVDUH
H[SRVHGWRXQOLPLWHGULVN

2SWLRQVPD\EHXVHGWR
HQKDQFHDSRUWIROLRV

return.

WUDQVDFWLRQEHQHWIURP
VWDQGDUGL]HGDQGHQ

forceable terms.

%RWKWKHKROGHUDQG
WKHZULWHUPD\EHGLV
GLUHFWLRQDQGWLPLQJRID DGYDQWDJHGGHSHQGLQJ
XSRQZKLFKVLGHRIWKH
VWRFNVSULFHUHQGHULQJ
WKHDWWHPSWDWHQKDQFHG WUDGHWKH\DVVXPHDQG
SRUWIROLRUHWXUQZRUWKOHVV WKHXOWLPDWHGLUHFWLRQRI
WKHXQGHUO\LQJVHFXULW\
7KHLQYHVWRUPD\HQGXS

being incorrect as to the

2QHFDQUHSOLFDWHDQ
'LYHUVLFDWLRQFDQQRW
DFWXDOVWRFNSRUWIROLRZLWK eliminate systematic risk.

the options on those very

stocks.

7HUPVRIOLVWHGRSWLRQVDUH 5HVWULFWLRQVXSRQH[HUFLVH :KLOHLQVRPHFDVHV

UHJXODWHG
may occur by regulatory QHFHVVDU\UHJXODWRU\DW
FDQGLVUXSWZKDWPD\
DW2&&6(&FRXUW
other regulatory agency). EHDSURWDEOHWUDGH
DIIHFWLQJKROGHUDQG
ZULWHUDOLNH

The Terms Used In Relation To Options Contract:

(a) Strike Price / Exercise Price:

6WULNH 3ULFH  ([HUFLVH 3ULFH LV WKH SULFH DW ZKLFK WKH RSWLRQ FDQ EH H[HUFLVHG LH WKH SULFH DW
ZKLFKWKHXQGHUO\LQJDVVHWFDQEHERXJKWRUVROGRQWKHH[SLU\GDWH(XURSHDQ2SWLRQRUEHIRUH
WKH H[SLU\ GDWH LQ FDVH RI $PHULFDQ 2SWLRQ 6WULNH 3ULFH  ([HUFLVH 3ULFH LV [HG E\ WKH 6WRFN
([FKDQJHDQGQRWE\WKH:ULWHURU+ROGHURIDQRSWLRQ7KH6WRFN([FKDQJH[HVDVHULHVRISULFHV
VSDFHGDWDSSURSULDWHSULFHLQWHUYDOVIRUDQXQGHUO\LQJDVVHW$QLQYHVWRUFDQFKRRVHKLVSUHIHUUHG
6WULNH3ULFHIURPVXFKDUDQJHRISULFHV
Example: 6WULNH3ULFHIRU'HFHPEHU2SWLRQV&RQWUDFWRQ6KDUHVRI:LSURH[SLULQJRQ
ZLOOEH`1900, ``1950, `1975, `HWF$QLQYHVWRUFDQFKRRVHWREX\DQRSWLRQZLWKDQ
([HUFLVH3ULFHRI`ZKLOHDQRWKHUPLJKWFKRRVH`1950.
(b) Premium


3UHPLXP LV WKH SULFH DW ZKLFK WKH RSWLRQV FRQWUDFW IRU DQ DVVHW ZLWK D JLYHQ H[SLU\ GDWH DQG
VWULNHSULFHLVWUDGHG,WLVSDLGE\WKH%X\HUWRWKH:ULWHU6HOOHURIWKHRSWLRQ7KHZULWHUNHHSVWKH
SUHPLXPZKHWKHURUQRWWKHRSWLRQLVH[HUFLVHG,WLVWKHFRQVLGHUDWLRQSDLGWRWKH:ULWHU6HOOHUIRU
XQGHUWDNLQJWRGHOLYHUEX\WKH XQGHUO\LQJVHFXULW\LIWKHRSWLRQLVH[HUFLVHG2SWLRQ3UHPLXPLV

ADVANCED FINANCIAL MANAGEMENT I 7.67

Financial Derivatives as a Tool for Risk Management

PDUNHWGHWHUPLQHGLHEDVHGRQWKHGHPDQGIRU WKH RSWLRQV ZLWK D JLYHQ VWULNH SULFH 3UHPLXP
SD\DEOHRQDQ2SWLRQV&RQWUDFWGHSHQGVXSRQYDULRXVIDFWRUVOLNH 6WULNH 3ULFH ([SLU\ 'DWH

etc.


2SWLRQ3UHPLXPFRQVLVWVRIWZRFRPSRQHQWVL,QWULQVLF9DOXHDQGLL

7LPH9DOXH

(c) Expiry Date:






,WLVWKHODVWGD\LQWKHFDVHRI$PHULFDQVW\OHRUWKHRQO\GD\LQWKHFDVHRI(XURSHDQVW\OHRQ

ZKLFKDQRSWLRQPD\EHH[HUFLVHG*HQHUDOO\2SWLRQVFRQWUDFWRQDQ\VHFXULW\LVWUDGHGEDVHG
RQLWVVWULNHSULFHDQGWKHH[SLU\GDWH
Example: ,Q1RYHPEHUWKHIROORZLQJRSWLRQVRQ7&66KDUHVFDQEHWUDGHG
x

x


  'HFHPEHU 7&6 6HULHV RI 2SWLRQV &RQWUDFW ZLWK 6WULNH 3ULFHV RI `
` 1975, ` HWF

 -DQXDU\7&66HULHVRI2SWLRQV&RQWUDFWZLWK6WULNH3ULFHV`
` HWF

1900, `  ` 1950,

1,950, ` 1,975, ` ` 

(d) Contract Size:



&RQWUDFW VL]H LV WKH QXPEHU RI XQLWV RI WKH XQGHUO\LQJ DVVHW FRYHUHG E\ DQ RSWLRQV FRQWUDFW
&RQWUDFWVL]HLV[HGE\WKH([FKDQJH
Example: 6KDUHVRI:LSUR.JVRI:KHDWHWF

In-the-Money, At-the-Money, and Out-of-Money, with reference to Options:

(a) 7KHVHWHUPVGHVFULEHWKHSRVLWLRQRIRSWLRQVFRQWUDFWIURPWKHWUDGHUVSHUVSHFWLYHERWK%X\HU
DQG6HOOHURIDQRSWLRQ
(i) In the Money: ,WLVDVLWXDWLRQZKHQH[HUFLVLQJWKHRSWLRQZRXOGEHDGYDQWDJHRXVDQGUHVXOWLQ
JDLQRUSURWWRWKHRSWLRQKROGHU
(ii)

At the Money: ([HUFLVHRIRSWLRQLQWKLVSRVLWLRQZRXOGQHLWKHUUHVXOWLQDJDLQRUORVVWRWKH

RSWLRQKROGHU$WWKLVVWDJHWKH&XUUHQW0DUNHW3ULFH&03DQGWKH([HUFLVH3ULFH(3DUH
HTXDO

(iii) Out of Money: ([HUFLVHRIRSWLRQLQWKLVVLWXDWLRQZRXOGUHVXOWLQDORVVWRWKH2SWLRQ+ROGHU

(b) Call Option and Put Option: $QRSWLRQKROGHUZLOOH[HUFLVHKLVRSWLRQRQO\ZKHQLWLVDGYDQWDJHRXV
WR H[HUFLVH LW EDVHG RQ WKH 6WULNH 3ULFH DQG WKH 0DUNHW 3ULFH RQ WKH GDWH RI H[SLU\ $FWLRQ RQ
2SWLRQVDUHDVIROORZVEDVHGRQWKHPDUNHWSULFHRQWKHGDWHRIH[SLU\
Situation
&03< (3

&03= (3
&03> (3

Call Option

Put Option

Position

Action

Position

Action

2XWRI

/DSVH%X\LQJDW(3ZLOOQRW
EH DGYDQWDJHRXV 'R QRW
H[HUFLVHWKH2SWLRQ

In the Money

([HUFLVH 6HOOLQJ DW (3

ZRXOG EH DGYDQWDJHRXV
([HUFLVHWKH2SWLRQ

At the
Money.
In the
Money

,QGLIIHUHQFH3RLQW

At the
Money.

,QGLIIHUHQFH3RLQW

Money

([HUFLVH%X\LQJDW(3ZRXOG
EHDGYDQWDJHRXV([HUFLVH
WKH2SWLRQ

2XWRI

Money

/DSVH6HOOLQJDW(3ZLOOQRW
EH DGYDQWDJHRXV 'R QRW
H[HUFLVHWKH2SWLRQ

Note: &03 &XUUHQW0DUNHW3ULFHRQ([HUFLVH([SLU\'DWH(3 ([HUFLVH3ULFH

7.68 I ADVANCED FINANCIAL MANAGEMENT

Types of Options:
(a) Based on Nature of Activity:
Call Option

Put Option

2SWLRQZKLFKJLYHVWKHKROGHUWKHright to BUY

an asset, but not an obligation to buy.

2SWLRQZKLFKJLYHVWKHKROGHUWKHright to SELL

an asset, but not an obligation to sell.

&DOO 2SWLRQ ZLOO EH H[HUFLVHG RQO\ ZKHQ WKH 3XW 2SWLRQ ZLOO EH H[HUFLVHG RQO\ ZKHQ WKH
([HUFLVH3ULFHLVORZHUWKDQWKH0DUNHW3ULFH>2QO\ ([HUFLVH 3ULFH LV KLJKHU WKDQ WKH 0DUNHW 3ULFH
>2QO\WKHQLWZLOOEHDGYDQWDJHRXVWRWKH+ROGHU@
WKHQLWZLOOEHDGYDQWDJHRXVWRWKH+ROGHU@
6HOOHU  :ULWHU LV XQGHU DQ REOLJDWLRQ WR VHOO WKH 6HOOHU  :ULWHU LV XQGHU DQ REOLJDWLRQ WR EX\ WKH
XQGHUO\LQJ DVVHW LI WKH %X\HU H[HUFLVHV KLV RSWLRQ XQGHUO\LQJ DVVHW LI WKH %X\HU H[HUFLVHV KLV RSWLRQ
WREX\WKHVKDUHVVWRFN
WRVHOOKLVVKDUHVVWRFN
(b) Based on Exercising the Option:
American Option

European Option

2SWLRQXQGHUZKLFKKROGHUFDQH[HUFLVHKLVULJKW 2SWLRQXQGHUZKLFKKROGHUFDQH[HUFLVHKLVULJKW
DWDQ\WLPHEHIRUHH[SLU\GDWH
RQO\RQWKHH[SLU\GDWH
Buying a Call Option (Long Call)
$ FDOO RSWLRQ SURYLGHV WKH KROGHU WKH ULJKW EXW QRW WKH REOLJDWLRQ WR EX\ D FHUWDLQ VHFXULW\ DW D
VSHFLHGSULFHRQDVSHFLHGGDWH&DOOPHDQVWRUHGHHPRUHIIHFWDFODLP,IDQLQYHVWRUH[SHFWVWKH
FRPSDQ\$VKDUHWRULVHIURPWKHSUHVHQWSULFHRI` KHFDQEX\DFDOORSWLRQRQFRPSDQ\$
HJZLWKDVWULNHSULFHRI` 7KLVFDOORSWLRQJLYHVWKHLQYHVWRUWKHULJKWEXWQRWWKHREOLJDWLRQWREX\
FRPSDQ\$VKDUHVDWDSULFHRI` DWDQ\WLPHXSWRWKHH[SLU\GDWH(DFKRSWLRQFRQWUDFWLV
QRUPDOO\RIXQGHUO\LQJVKDUHV
:LWK DQ RSWLRQ SUHPLXP RI  SHU XQGHUO\LQJ VKDUH DQG D SULFH RI  XSRQ WKH H[SLU\ RI WKH FDOO
RSWLRQWKHLQYHVWRUVFDSLWDOJDLQPD\EHFDOFXODWHGDVIROORZV

4,000

([SLUDWLRQJDLQ[

2SWLRQSUHPLXP[

` 

Net gain (4,000 - 2,000)

` 2,000

,IWKHH[SLU\SULFHLVLQVWHDGWKHJDLQXSRQH[SLUDWLRQLVPHDQLQJWKDWWKHLQYHVWRUKDVVXIIHUHGD
loss of ` RULQRWKHUZRUGVWKHRSWLRQSUHPLXPRUWKHSULFHRIWKHRSWLRQ
/RVVJDLQ

40



10
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ADVANCED FINANCIAL MANAGEMENT I 7.69

Financial Derivatives as a Tool for Risk Management

7KHJXUHVKRZVWKHSRWHQWLDOFDSLWDOJDLQDQGORVVXSRQH[SLU\RIWKHFDOORSWLRQ1RWHWKDWWKHORVVLV
OLPLWHGWRWKHSUHPLXPZKLFKKDVDOUHDG\EHHQSDLGZKHUHDVWKHFDSLWDOJDLQLVXQOLPLWHG7KHJXUH
DOVRVKRZVWKHSD\RIIIRUDFDOORSWLRQZKHQWKHRSWLRQLVLQDWRURXWRIWKHPRQH\$FDOORSWLRQ
LVVDLGWREHDWWKHPRQH\ZKHQWKHVWULNHSULFHHTXDOVWKHSULFHRIWKHXQGHUO\LQJDVVHW,IWKHSULFHLV
OHVVWKDQRUDERYHWKHVWULNHSULFHWKHFDOORSWLRQLVRXWRIWKHPRQH\DQGLQWKHPRQH\UHVSHFWLYHO\
7KHJXUHDOVRVKRZVWKDWWKHLQYHVWRUZLOOEUHDNHYHQ%(DWDSULFHOHYHORI
,QYHVWPHQW LQ RSWLRQV FDQ DFKLHYH FRQVLGHUDEOH FDSLWDO JDLQV /HW XV SUHVXPH RQFH PRUH WKDW WKH
SULFH RI WKH VKDUH LQFUHDVHV IURP  WR  ,I \RX LQYHVW LQ WKH VKDUH \RXU LQYHVWPHQW ZLOO \LHOG D
SHUFHQWDJHJDLQRI
 
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DQGKDVDSUHPLXPRI+HUHWKH\LHOGDPRXQWVWR
 
Writing or Selling a Call Option (Short Call):
:ULWLQJRU6HOOLQJD&DOO2SWLRQLVZKHQ\RXJLYHWKHEX\HURIWKHFDOORSWLRQWKHULJKWWREX\DVWRFN
IURP\RXDWDFHUWDLQSULFHE\DFHUWDLQGDWH,QRWKHUZRUGVWKHVHOOHUDOVRNQRZQDVWKHZULWHURIWKH
FDOORSWLRQFDQEHIRUFHGWRVHOODVWRFNDWWKHVWULNHSULFH7KHVHOOHURIWKHFDOOUHFHLYHVWKHSUHPLXP
WKDWWKHEX\HURIWKHFDOORSWLRQSD\V,IWKHVHOOHURIWKHFDOORZQVWKHXQGHUO\LQJVWRFNWKHQLWLVFDOOHG
ZULWLQJDFRYHUHGFDOO,IWKHVHOOHURIWKHFDOOGRHV127RZQWKHXQGHUO\LQJVWRFNWKHQLWLVFDOOHG
ZULWLQJ D QDNHG FDOO 2EYLRXVO\ LQ WKLV LQVWDQFH LW LV QDNHG EHFDXVH WKH VHOOHU GRHV QRW RZQ WKH
XQGHUO\LQJVWRFN7KHEHVWZD\WRXQGHUVWDQGWKHZULWLQJRIDFDOOLVWRUHDGWKHIROORZLQJH[DPSOH
3URW

Increasing

3URW
/LPLWHG

8QGHUO\LQJ6WRFN
3ULFH

0
Loss

/RVV
8QOLPLWHG
Short Call

Example of Writing / Selling a Call Option:

,WV-DQXDU\VWDQG0U3HVVLPLVWRZQVVKDUHVRI*22*VWRFNWKDWKHERXJKW\HDUVDJRDW
7KHVWRFNLVQRZDWEXW0U3HVVLPLVWWKLQNVWKDWWKHSULFHRI*22*LVJRLQJWRVWD\WKHVDPHRU
GURSLQWKHQH[WPRQWKEXWKHZDQWVWRFRQWLQXHWRRZQWKHVWRFNIRUWKHORQJWHUP$WWKHVDPHWLPH
0U%XOOMXVWUHDGDQDUWLFOHRQ*22*DQGWKLQNV*22*LVJRLQJWRJRXSLQWKHQH[WIHZZHHNV
EHFDXVH *22* LV DERXW WR KDYH D SUHVV UHOHDVH VD\LQJ WKH\ H[SHFW WKHLU &KLQD WUDIF WR EH YHU\

strong for the year.

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+HSODFHVDQRUGHUWR6(//*22*-DQXDU\FDOODVDPDUNHWRUGHU0U%XOODOVRSODFHVD
PDUNHWRUGHUWR%8<WKHYHU\VDPH*22*RSWLRQFRQWUDFW0U3HVVLPLVWVRUGHULPPHGLDWHO\JHWVOOHG
DWVRKHUHFHLYHVUHPHPEHUHDFKRSWLRQFRQWUDFWFRYHUVVKDUHVEXWLVSULFHGRQDSHU
VKDUHEDVLVLQKLVDFFRXQWIRUVHOOLQJWKHFDOORSWLRQ0U%XOOLPPHGLDWHO\JHWVOOHGDWDQGSD\V
IRUWKH*22*-DQXDU\FDOO7KHPDUNHWPDNHUJHWVWKHVSUHDG

7.70 I ADVANCED FINANCIAL MANAGEMENT

2QFH WKH WUDGH LV PDGH 0U 3HVVLPLVW KRSHV WKDW *22* VWD\V EHORZ  XQWLO WKH WKLUG )ULGD\ LQ
-DQXDU\0HDQZKLOH0U%XOOLVKRSLQJWKDW*22*FORVHVZHOODERYHE\WKHWKLUG)ULGD\LQ-DQXDU\
,I*22*FORVHVDWRUEHORZWKHQWKHFDOORSWLRQZLOOH[SLUHZRUWKOHVVDQG0U3HVVLPLVWSURWVWKH
KHUHFHLYHGIRUZULWLQJVHOOLQJWKHFDOODQG0U%XOOORVHVKLV,I*22*FORVHVDWWKHQ
0U%XOOZRXOGH[HUFLVHWKHFDOORSWLRQDQGEX\WKHVKDUHVRI*22*IURP0U3HVVLPLVWDW0U
3HVVLPLVWKDVQRZUHFHLYHGIRUZULWLQJWKHFDOORSWLRQEXWKHKDVDOVRORVWEHFDXVHKHKDG
WRVHOODVWRFNWKDWZDVZRUWKIRU0U%XOOZRXOGEHKDSS\LQWKDWKHVSHQWEXWKHPDGH
RQWKHVWRFNEHFDXVHKHHQGHGXSSD\LQJIRUDVWRFNWKDWZDVZRUWK
, QRWHG HDUOLHU WKDW  RI RSWLRQ EX\HUV ORVH PRQH\ DQG WKDW  RI RSWLRQ VHOOHUV PDNH PRQH\
7KHUHLVDYHU\VLPSOHH[SODQDWLRQIRUWKLVIDFW6LQFHVWRFNSULFHVFDQPRYHLQGLUHFWLRQVXSGRZQ
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RIWKHVWRFNRUWKHEX\HURIWKHSXWZDQWV7KHUHIRUHRIWKHWLPHWKHVHOOHURIWKHRSWLRQLVWKHRQH

making the money!

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WKHUDEELWVWKDWDUHJHQHUDOO\ORRNLQJIRUDTXLFNPRYHLQVWRFNSULFHVDQGWKHRSWLRQVHOOHUVZULWHUVDUH
WKHWXUWOHVWKDWDUHORRNLQJWRPDNHDIHZGROODUVHDFKGD\
Buying a Put (Long Put)
$QLQYHVWRULVVDLGWREHORQJDSXWRSWLRQZKHQKHKDVSXUFKDVHGDSXWRSWLRQDQGFXUUHQWO\RZQVWKH
SXW7KHWHUPJRLQJORQJUHIHUVWREX\LQJDVHFXULW\DQGDSSOLHVWREHLQJORQJDVWRFNORQJDFDOO
DQGORQJDSXW:KHQ\RXDUHORQJDSXW\RXDUHKRSLQJWKDWWKHSULFHRIWKHXQGHUO\LQJVWRFNRULQGH[
IDOOVEHORZWKHVWULNHSULFHRIWKHSXWRSWLRQ:KHQWKHVWRFNSULFHLVDERYHWKHVWULNHSULFHWKHORQJ
SXWRSWLRQLVRXWRIWKHPRQH\:KHQWKHVWRFNSULFHLVDWWKHVWULNHSULFHWKHORQJSXWRSWLRQLVDW
WKHPRQH\$QGZKHQWKHVWRFNSULFHLVEHORZWKHVWULNHSULFHWKHORQJSXWRSWLRQLVLQWKHPRQH\
3URW

or Loss

LONG PUT

6WRFN3ULFH
DW([SLUDWLRQ


`

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DORQJSRVLWLRQEXWWKHSHUVRQWKDWVROGRUZURWHWKHSXWLVVKRUWDSXW
7KHSHUVRQWKDWLVORQJDSXWZDQWVWKHVWRFNSULFHWRIDOOWR` VRWKDWKLVSURWLVPD[LPL]HG7KH
SHUVRQWKDWLVVROGRUZURWHWKHSXWDQGLVVKRUWDSXWZDQWVWKHVWRFNSULFHWRVWD\DWRUJRDERYHWKH
VWULNHSULFHVRWKDWWKHSXWRSWLRQH[SLUHVZRUWKOHVV
Writing a Put (Short Put)
*RLQJVKRUWE\ZULWLQJDSXWLVJHQHUDOO\FRQVLGHUHGPRUHULVN\WKDQJRLQJORQJVLQFH\RXUHREOLJDWHG
WRKRQRU\RXUVLGHRIWKHFRQWUDFWVKRXOGWKHKROGHUGHFLGHWRH[HUFLVH,QJHQHUDO\RXZRXOGFKRRVH
WKLVVWUDWHJ\EHFDXVH\RXEHOLHYHWKHVWRFNVSULFHZLOOULVHDERYHWKHVWULNHSULFHOHDYLQJWKHRSWLRQ
ZLWKRXWDQ\YDOXHDWH[SLUDWLRQDQG\RXZLWKWKHSUHPLXP
$PRUHFRQVHUYDWLYHUHDVRQWRVHOODSXWLVLI\RXKDYHDWDUJHWSULFHDWZKLFK\RXGOLNHWREX\VKDUHV
RI D VWRFN 6KRXOG WKH RSWLRQ EH H[HUFLVHG \RXOO EH IRUFHG WR SD\ IRU WKH VWRFN 7KH SUHPLXP \RX
UHFHLYHGZLOOUHGXFH\RXUQHWSULFHSDLGRQWKRVHVKDUHV

ADVANCED FINANCIAL MANAGEMENT I 7.71

Financial Derivatives as a Tool for Risk Management

)RUH[DPSOHVD\\RXZULWHDSXWZLWKDVWULNHSULFHRIDQGDSUHPLXPRI,IWKHVWRFNVSULFHGURSV
WR\RXOOOLNHO\EHDVVLJQHGWKHRSWLRQ<RXOOKDYHWRSD\IRUWKHVKDUHVEXWWKH\RX
UHFHLYHGDWWKHRXWVHWPHDQV\RXUQHWSULFHIRUWKHVKDUHVLVRUSHUVKDUH,IWKHVWRFNVSULFH
ULVHVDJDLQLQWKHIXWXUH\RXFRXOGUHDOL]HFRQVLGHUDEOHJDLQV

3URW

Short Put
Y

3URW3RWHQWLDO
Limited

Break -Even Point

(strike + Premium)

Strike
Price

Loss Potential :
Substantial

Loss

Underlying Stock Price

Lower
Higher

,Q WKH JUDSK VKRZQ KHUH WKH YHUWLFDO <D[LV UHSUHVHQWV SURW DQG ORVV ZKLOH WKH KRUL]RQWDO ;D[LV
VKRZVWKHSULFHRIWKHXQGHUO\LQJVWRFN7KHEOXHOLQHVKRZV\RXUSRWHQWLDOSURWRUORVVJLYHQWKHSULFH
RIWKHXQGHUO\LQJ
Determination of Option Premium :
7KHIDFWRUVRQZKLFKWKHOHYHORISUHPLXPGHSHQGDUH
(a) Exercise Price: ([HUFLVH3ULFHRU6WULNH3ULFHUHIHUVWRWKHSULFHDWZKLFKWKHFRQWUDFWLVDJUHHGXSRQ
:KHQEX\LQJDQ2SWLRQDQLQYHVWRUFDQFKRRVHIURPDVHWRI6WULNH3ULFHVIRUZKLFK2SWLRQVFDQ
EHERXJKWVROG%DVHGRQ6WULNH3ULFHFKRVHQWKH2SWLRQ3UHPLXPZLOOYDU\DVIROORZV
Exercise
Price
High

Call Option Premium is

Put Option Premium is

LOW. $V WKH ([HUFLVH 3ULFH JRHV XS WKH HIGH. $V WKH ([HUFLVH 3ULFH JRHV XS WKH
YDOXH RI 2SWLRQ LH &03 Less (3 JRHV YDOXHRI2SWLRQLH(3Less &03JRHVXS
GRZQ7KHUHIRUHLWEHFRPHVOHVVYDOXDEOH Therefore, it becomes more valuable. The

value of obligation to perform is also high

IURPKROGHUVSHUVSHFWLYH

Low

HIGH. $VWKH([HUFLVH3ULFHJRHVGRZQWKH LOW. $VWKH([HUFLVH3ULFHJRHVXSWKHYDOXH

YDOXH RI 2SWLRQ LH &03 Less (3 JRHV RI 2SWLRQ LH (3 Less &03 JRHV GRZQ

up. Therefore, it becomes more valuable. Therefore, it becomes less valuable.

Value of obligation to perform is also high
IURPKROGHUVSHUVSHFWLYH

(b) Current Price of the Underlying Asset: 2WKHUWKLQJVUHPDLQLQJFRQVWDQWLIWKHFXUUHQWPDUNHWSULFH

RIWKHDVVHWJRHVXSYDOXHRIWKHFDOORSWLRQLQFUHDVHVVLQFHWKHSRVVLELOLW\RIH[HUFLVLQJWKHFDOO
DOVR LQFUHDVHV DQG SXW RSWLRQ GHFUHDVHV ,I WKH &XUUHQW 0DUNHW 3ULFH GHFUHDVHV YDOXH RI SXW
RSWLRQLQFUHDVHVDVWKHSRVVLELOLW\RIH[HUFLVLQJWKHSXWRSWLRQDOVRLQFUHDVHVDQGYDOXHRIFDOO
RSWLRQGHFUHDVHV

I ADVANCED FINANCIAL MANAGEMENT

(c) Maturity or Expiry Date: /RQJHUWKHWLPHWRPDWXULW\KLJKHUWKHSHULRGRIXQFHUWDLQW\DQGKHQFH

KLJKHU WKH 2SWLRQ 3UHPLXP 7KHUHIRUH DQ RSWLRQ ZLWK  PRQWKV WR PDWXULW\ ZLOO KDYH D KLJKHU
SUHPLXPWKDQDQRSWLRQZLWKPRQWKWRPDWXULW\

(d) Volatility of Stock Prices: Volatility of stock price in the spot market (Cash Market) also contributes
WR SUHPLXP +LJKHU YRODWLOLW\ ZRXOG PHDQ SULFHV KLWWLQJ WKH H[WUHPHV DQG WKH EX\HU RI RSWLRQ
ZRXOGH[HUFLVHKLVRSWLRQZKLFKZRXOGUHVXOWLQDKLJKHUREOLJDWLRQRQWKHSDUWRIWKHVHOOHURIWKH
RSWLRQ7KHUHIRUHWKHYDOXHVRIERWKFDOOVDQGSXWVLQFUHDVHDVYRODWLOLW\LQFUHDVHV*UHDWHUWKH
YRODWLOLW\KLJKHUZLOOEHWKHSUHPLXPDQGYLFHYHUVD
(e) Interest Rate Movement:$VLQWHUHVWUDWHVLQFUHDVHVWKHH[SHFWHGUHWXUQUHTXLUHGE\WKHLQYHVWRUV
RQ WKH VWRFN DOVR LQFUHDVHV 7KHUHIRUH WKH SUHVHQW YDOXH RI WKH IXWXUH UHWXUQV GHFUHDVHV ,I WKH
LQWHUHVWUDWHGHFUHDVHVWKHH[SHFWDWLRQVDOVRJRGRZQ
(f)

Market Factors:

L

LL 'LYLGHQGH[SHFWDWLRQVLHLIDODUJHGLYLGHQGLVH[SHFWHGIURPDVWRFNWKHFDOORSWLRQZLOO
EHSULFHGOHVVVLQFHGLYLGHQGZKHQGHFODUHGDQGGLVWULEXWHGWKHSULFHVZLOOIDOOGRZQ:KHQ
FDVKPDUNHWSULFHVIDOOWKHYDOXHRIDFDOORSWLRQDOVRJRHVGRZQ

/LTXLGLW\LQWKHPDUNHWLHH[WHQWRIPRQH\DYDLODEOHIRULQYHVWPHQW

Intrinsic Value of an Option And Time Value of an Option:

,QWULQVLFYDOXHDQGWLPHYDOXHDUHWZRRIWKHSULPDU\GHWHUPLQDQWVRIDQRSWLRQVSULFH,QWULQVLFYDOXH
FDQEHGHQHGDVWKHDPRXQWE\ZKLFKWKHVWULNHSULFHRIDQRSWLRQLVLQWKHPRQH\,WLVDFWXDOO\WKH
SRUWLRQRIDQRSWLRQVSULFHWKDWLVQRWORVWGXHWRWKHSDVVDJHRIWLPH7KHIROORZLQJHTXDWLRQVZLOODOORZ
\RXWRFDOFXODWHWKHLQWULQVLFYDOXHRIFDOODQGSXWRSWLRQV
x

x

Call Options,QWULQVLFYDOXH 8QGHUO\LQJ6WRFNV&XUUHQW3ULFH&DOO6WULNH3ULFH7LPH9DOXH &DOO

3UHPLXP,QWULQVLF9DOXH
Put Options ,QWULQVLF YDOXH  3XW 6WULNH 3ULFH  8QGHUO\LQJ 6WRFNV &XUUHQW 3ULFH 7LPH 9DOXH  3XW
3UHPLXP,QWULQVLF9DOXH

$70DQG270RSWLRQVGRQWKDYHDQ\LQWULQVLFYDOXHEHFDXVHWKH\GRQRWKDYHDQ\UHDOYDOXH<RX
DUHVLPSO\EX\LQJWLPHYDOXHZKLFKGHFUHDVHVDVDQRSWLRQDSSURDFKHVH[SLUDWLRQ7KHLQWULQVLFYDOXH
RIDQRSWLRQLVQRWGHSHQGHQWRQWKHWLPHOHIWXQWLOH[SLUDWLRQ,WLVVLPSO\DQRSWLRQVPLQLPXPYDOXH
LWWHOOV\RXWKHPLQLPXPDPRXQWDQRSWLRQLVZRUWK7LPHYDOXHLVWKHDPRXQWE\ZKLFKWKHSULFHRI
DQRSWLRQH[FHHGVLWVLQWULQVLFYDOXH$OVRUHIHUUHGWRDVH[WULQVLFYDOXHWLPHYDOXHGHFD\VRYHUWLPH
,QRWKHUZRUGVWKHWLPHYDOXHRIDQRSWLRQLVGLUHFWO\UHODWHGWRKRZPXFKWLPHDQRSWLRQKDVXQWLO
H[SLUDWLRQ7KHPRUHWLPHDQRSWLRQKDVXQWLOH[SLUDWLRQWKHJUHDWHUWKHRSWLRQVFKDQFHRIHQGLQJ
XSLQWKHPRQH\7LPHYDOXHKDVDVQRZEDOOHIIHFW,I\RXKDYHHYHUERXJKWRSWLRQV\RXPD\KDYH
QRWLFHGWKDWDWDFHUWDLQSRLQWFORVHWRH[SLUDWLRQWKHPDUNHWVHHPVWRVWRSPRYLQJDQ\ZKHUH7KDWV
EHFDXVHRSWLRQSULFHVDUHH[SRQHQWLDOWKHFORVHU\RXJHWWRH[SLUDWLRQWKHPRUHPRQH\\RXUHJRLQJ
WRORVHLIWKHPDUNHWGRHVQWPRYH2QWKHH[SLUDWLRQGD\DOODQRSWLRQLVZRUWKLVLWVLQWULQVLFYDOXH,WV
HLWKHULQWKHPRQH\RULWLVQW
Example:/HWVXVHWKHWDEOHEHORZWRFDOFXODWHWKHLQWULQVLFYDOXHDQGWLPHYDOXHRIDIHZFDOORSWLRQV
35,&(2),%0 
CALL STRIKE PRICE

75
80
85

JAN




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DIHZFDOORSWLRQSUHPLXPV

ADVANCED FINANCIAL MANAGEMENT I 7.

Financial Derivatives as a Tool for Risk Management

1.

Strike Price = 75

,QWULQVLFYDOXH 8QGHUO\LQJSULFH6WULNHSULFH  

7LPHYDOXH &DOOSUHPLXP,QWULQVLFYDOXH  

2.

Strike Price = 80

,QWULQVLFYDOXH 8QGHUO\LQJSULFH6WULNHSULFH  

7LPHYDOXH &DOOSUHPLXP,QWULQVLFYDOXH  

3.

Strike Price = 85

,QWULQVLFYDOXH 8QGHUO\LQJSULFH6WULNHSULFH   =HUR,QWULQVLF9DOXH

7LPHYDOXH &DOOSUHPLXP,QWULQVLFYDOXH   $OO7LPH9DOXH

7KHLQWULQVLFYDOXHRIDQRSWLRQLVWKHVDPHUHJDUGOHVVRIKRZPXFKWLPHLVOHIWXQWLOH[SLUDWLRQ+RZHYHU
VLQFH WKHRUHWLFDOO\ DQ RSWLRQ ZLWK  PRQWKV WLOO H[SLUDWLRQ KDV D EHWWHU FKDQFH RI HQGLQJ XS LQWKH
PRQH\ WKDQ DQ RSWLRQ H[SLULQJ LQ WKH SUHVHQW PRQWK LW LV ZRUWK PRUH EHFDXVH RI WKH WLPH YDOXH
FRPSRQHQW7KDWVZK\DQ270RSWLRQFRQVLVWVRIQRWKLQJEXWWLPHYDOXHDQGWKHPRUHRXWRIWKH
PRQH\DQRSWLRQLVWKHOHVVLWFRVWVLH270RSWLRQVDUHFKHDSDQGJHWHYHQFKHDSHUIXUWKHURXW7R
PDQ\WUDGHUVWKLVORRNVJRRGEHFDXVHRIWKHLQH[SHQVLYHSULFHRQHKDVWROD\RXWLQRUGHUWREX\VXFK
DQRSWLRQ+RZHYHUWKHSUREDELOLW\WKDWDQH[WUHPHO\270RSWLRQZLOOWXUQSURWDEOHLVUHDOO\TXLWHVOLP
7KHIROORZLQJWDEOHKHOSVWRGHPRQVWUDWHWKHFKDQFHDQRSWLRQKDVRIWXUQLQJDSURWE\H[SLUDWLRQ
35,&(2),%0 
STRIKE

65
70
75
80
85

JAN

17



10
6


Intrinsic

16
11
6
1
0

Value Time

Value



4
5



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WREUHDNHYHQ ,I\RXZHUHWREX\D-DQXDU\FDOODQGSD\IRULW,%0ZRXOGRQO\KDYH
WREHDWLQRUGHUWREUHDNHYHQ $V\RXFDQVHHWKHIXUWKHURXWDQ270RSWLRQLVWKH
OHVVFKDQFHLWKDVRIWXUQLQJDSURW
7KHGHHSHULQWKHPRQH\DQRSWLRQLVWKHOHVVWLPHYDOXHDQGPRUHLQWULQVLFYDOXHLWKDV7KDWVEHFDXVH
WKHRSWLRQKDVPRUHUHDOYDOXHDQG\RXSD\OHVVIRUWLPH7KHUHIRUHWKHRSWLRQPRYHVPRUHOLNHWKH
XQGHUO\LQJDVVHW7KLVYHU\LPSRUWDQWFRQFHSWKHOSVWRGHVFULEHWKHGHOWDRIDQRSWLRQ8QGHUVWDQGLQJ
GHOWDLVWKHNH\WRFUHDWLQJGHOWDQHXWUDOVWUDWHJLHVRQHRIWKHPDLQDSSURDFKHVWRQRQGLUHFWLRQDO
2SWLRQHWLFVWUDGLQJ2QHRIWKHUHDVRQVLWVLPSRUWDQWWRNQRZWKHPLQLPXPYDOXHRIDQRSWLRQLVWR
FRQUPKRZPXFKUHDOYDOXHDQGKRZPXFKWLPHYDOXH\RXDUHSD\LQJIRULQDSUHPLXP6LQFH\RX
FDQH[HUFLVHDQ$PHULFDQVW\OHFDOORUSXWDQ\WLPH\RXZDQWLWVSULFHVKRXOGQRWEHOHVVWKDQLWVLQWULQVLF
YDOXH,IDQRSWLRQVSULFHLVOHVVWKDQLWVH[HUFLVHYDOXHDQLQYHVWRUFRXOGEX\WKHFDOODQGH[HUFLVHLW
PDNLQJDJXDUDQWHHGDUELWUDJHSURWEHIRUHFRPPLVVLRQV

7.74 I ADVANCED FINANCIAL MANAGEMENT

EXPECTATION, REWARD AND RISK OF BUYER AND WRITER OF A CALL OPTION

&DOO2SWLRQ

%X\HURU+ROGHU

6HOOHURU:ULWHU

going long

going short

Expectation +H H[SHFWV WKH ULVH RI

PDUNHWSULFHRIWKHXQGHUO\LQJVWRFN

Expectation +HH[SHFWVWKHPDUNHWSULFH
RIWKHXQGHUO\LQJVWRFNWRVWD\DW

Reward :KHQ WKH SULFH RI XQGHUO\LQJ

VWRFN DSSUHFLDWHV WKHUH ZRXOG EH
SRWHQWLDOIRUXQOLPLWHGJDLQ

Reward +LVJDLQLVOLPLWHGWRWKHH[WHQWRI
WRWDOSUHPLXPUHFHLYHGZKHQRSWLRQZDV
ZULWWHQDQGKHNHHSVWKHSUHPLXPZKHQ
WKHPDUNHWSULFHRIWKHXQGHUO\LQJVWRFN
VWD\VDWRUGHFOLQH

Risk :KHQ WKH PDUNHW SULFH RI

XQGHUO\LQJVWRFNGHFOLQHVKLVORVVLVRQO\
WRWKHH[WHQWRIWRWDOSUHPLXPSDLGIRU

the call option.

Figure :

Risk :KHQWKHPDUNHWSULFHRIXQGHUO\LQJ
VWRFNULVHVKLVSRWHQWLDOORVVLVXQOLPLWHG

RIGHTS AND OBLIGATIONS OF THE HOLDER AND WRITER OF A PUT OPTION

3XW2SWLRQ

%X\HURU+ROGHU

6HOOHURU:ULWHU

3D\VWRWDOSUHPLXP

5HFHLYHVWRWDOpremium

going long

+HKDVWKHULJKWEXWQRWWKHREOLJDWLRQ
WRVHOOVKDUHVRIWKHXQGHUO\LQJVWRFN

at strike price.

going short

+H LV REOLJDWHG WR EX\ RQ GHPDQG WKH

XQGHUO\LQJ VWRFN RI  VKDUHV DW VWULNH
SULFH ZKHQ WKH EX\HUKROGHU H[HUFLVHV

put option.

Covered options and Naked options:

Covered Option: ,W LV DQ RSWLRQ WKDW LV FRPELQHG ZLWK DQ RIIVHWWLQJ SRVLWLRQ LQ WKH XQGHUO\LQJ VWRFN
&RYHUHG 2SWLRQ LPSOLHV WKDW LQ FDVH RI &DOO 2SWLRQV WKH 6HOOHU KDV WKH XQGHUO\LQJ VWRFN LQ WKHLU
SRVVHVVLRQZKLFKFDQEHWUDQVIHUUHGDWWKHWLPHRIH[SLU\LQFDVHRI3XW2SWLRQWKH6HOOHUKDVVROGWKH

shares in the Cash Market.

(a) Covered Calls:


+HUHWKH6HOOHU:ULWHURID&DOO2SWLRQRZQVWKHXQGHUO\LQJVWRFN

,IWKHRSWLRQLVH[HUFLVHGE\WKH2SWLRQ+ROGHUWKH6HOOHUZRXOGVLPSO\GHOLYHUWKHVWRFNKH
DOUHDG\RZQVDQGUHFHLYHVWKHVDOHSULFHRIWKHVWRFNHTXDOWRWKH6WULNH3ULFH

ADVANCED FINANCIAL MANAGEMENT I 7.75

Financial Derivatives as a Tool for Risk Management

(b) Covered Puts:


+HUHWKH6HOOHU:ULWHURID3XW2SWLRQKDVVROGWKHVWRFNLQWKH&DVK0DUNHWREWDLQHGXQGHU
6WRFN/HQGLQJ6FKHPHRUKLVRZQVWRFN


,I WKH RSWLRQ LV H[HUFLVHG E\ WKH 2SWLRQ +ROGHU WKH VHOOHU ZRXOG EX\ WKH VWRFN DQG DW WKH
([HUFLVH 3ULFH DQG GHOLYHUV LW EDFN WR WKH SHUVRQ IURP ZKRP KH KDG ERUURZHG WKH 6WRFN
XQGHU6WRFN/HQGLQJ6FKHPH,IKHKDGVROGKLVRZQVWRFNHDUOLHUKLVSRUWIROLRZRXOGRQFH
DJDLQLQFOXGHWKHVWRFNERXJKWXQGHUWKH3XW2SWLRQ
Naked Options: ,WLVDQRSWLRQWKDWLVQRWFRPELQHGZLWKDQRIIVHWWLQJSRVLWLRQLQWKHXQGHUO\LQJVWRFN
:KHQWKHLQYHVWRUZULWHURID&DOODQGZULWHURID3XWGRHVQRWKDYHDQ\VWRFNLQKLVKDQGRULVQRWVKRUW
VHOOSRVLWLRQLQWKHFDVKPDUNHWDWWKHWLPHRIHQWHULQJLQWRRSWLRQVFRQWUDFWLWLVFDOOHG8QFRYHUHG
2SWLRQV
(a) Uncovered Calls:


+HUHWKH6HOOHU:ULWHURIWKH&DOO2SWLRQGRHVQRWRZQWKHXQGHUO\LQJVWRFN

,I WKH SULFH RI WKH XQGHUO\LQJ DVVHW ULVHV WKH &DOO :ULWHU KDV QR SURWHFWLRQ DQG ZRXOG EH
UHTXLUHGWREX\LQWKHRSHQPDUNHWDQGGHOLYHUWKHDVVHWWRWKH2SWLRQ+ROGHU

,IWKH&DOO:ULWHUGRHVQRWRZQWKHVWRFNDQGWKHRSWLRQLVH[HUFLVHGWKHSRWHQWLDOORVVRQKLV
KHDGLVXQOLPLWHG

(b) Uncovered Puts:



+HUHWKH:ULWHU6HOOHURIWKH3XW2SWLRQGRHVQRWVHOOWKHXQGHUO\LQJDVVHWLQWKH&DVK0DUNHW
HLWKHUKLVRZQVWRFNRUERUURZHGXQGHU6WRFN/HQGLQJ

,IWKHSULFHRIWKHXQGHUO\LQJDVVHWIDOOVWKH3XW:ULWHUZLOOQRWKDYHDQ\SURWHFWLRQEXWWREX\

the stock at a very high price.

Spread strategy- Types of spread strategies:

,QRSWLRQVWUDGLQJDQRSWLRQVSUHDGLVFUHDWHGE\WKHVLPXOWDQHRXVSXUFKDVHDQGVDOHRIRSWLRQVRI
the same class on the same XQGHUO\LQJVHFXULW\EXWZLWKGLIIHUHQWstrike pricesDQGRUH[SLUDWLRQGDWHV.

$Q\VSUHDGWKDWLVFRQVWUXFWHGXVLQJcallsFDQEHUHIHUUHGWRDVDFDOOVSUHDG6LPLODUO\SXWVSUHDGV are
VSUHDGVFUHDWHGXVLQJput options.

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Vertical, Horizontal & Diagonal Spreads
7KH WKUHH EDVLF FODVVHV RI VSUHDGV DUH WKH YHUWLFDO VSUHDG WKH KRUL]RQWDO VSUHDG DQG WKH GLDJRQDO
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DQGH[SLUDWLRQGDWHV
Bull Spread- its variants:
%XOO 6SUHDG LV WKH DFW RI EX\LQJ DQG VHOOLQJ RSWLRQV ZLWK GLIIHUHQW VWULNH SULFHV ZLWK WKH VDPH H[SLU\
GDWHV&DOO2SWLRQSXUFKDVHGKDVD/RZHU([HUFLVH3ULFHWKDQ&DOO2SWLRQZULWWHQ6LPLODUO\SXW2SWLRQ
3XUFKDVHGKDVD+LJKHU([HUFLVH3ULFHWKDQ3XW2SWLRQVROG

7.76 I ADVANCED FINANCIAL MANAGEMENT

Basis:
D ,QYHVWRUH[SHFWVWKDWWKHSULFHRIWKHXQGHUO\LQJDVVHWZLOOULVHLHRXWORRNLVEXOOLVK
E ,QYHVWRUGRHVQRWZDQWWRWDNHXQGXHULVNVRQVXFKH[SHFWDWLRQ
Types: 7KHUHDUHWZRW\SHVRI%XOO6SUHDGV%XOO&DOO6SUHDGDQG%XOO3XW6SUHDG
Areas

Bull Call Spread

Bull Put Spread

6LWXDWLRQ

%X\ DQG :ULWH D &DOO 2SWLRQ ZLWK GLIIHUHQW %X\DQG:ULWHD3XW2SWLRQZLWKGLIIHUHQW

H[HUFLVHSULFHVEXWVDPHH[SLU\GDWH
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Loss

Bear Spread and its variants- When will an investor choose to enter into a Bear Spread:
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Condition Prevalent and Outlook:
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E ,QYHVWRUGRHVQRWZDQWWRWDNHXQGXHULVNVRQVXFKH[SHFWDWLRQE\HQWHULQJLQWRVDOHFRQWUDFWV
Types: 7KHUHDUHWZRW\SHVRI%HDU6SUHDGV%HDU&DOO6SUHDGDQG%HDU3XW6SUHDG
Areas

Bear Call Spread

Bear Put Spread

6LWXDWLRQ

%X\DQG:ULWHD&DOO2SWLRQZLWKGLIIHUHQW %X\DQG:ULWHD3XW2SWLRQZLWKGLIIHUHQW
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Loss

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ADVANCED FINANCIAL MANAGEMENT I 7.77

Financial Derivatives as a Tool for Risk Management

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DQGWKHUHLVQRWJRLQJWREHDVXEVWDQWLDOULVHRUIDOOLQLWVSULFHV
Features:
(a) Risk: 5LVNLVOLPLWHG
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SULFHRIWKHZULWWHQRSWLRQV
(c) Costs: Commission Costs are high.
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%HDU6SUHDG

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:KHUH(31,(3DQG(3UHSUHVHQWWKHWKUHH([HUFLVH3ULFHV
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Basis

/RQJ%XWWHU\6SUHDG

6KRUW%XWWHU\6SUHDG

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Box Spread (Long Box)

7KHER[VSUHDGRUORQJER[LVDFRPPRQarbitrage strategy that involves buying a bull call spread
WRJHWKHUZLWKWKHFRUUHVSRQGLQJbear put spreadZLWKERWKYHUWLFDOVSUHDGVKDYLQJWKHVDPHVWULNH
SULFHVDQGH[SLUDWLRQGDWHV7KHORQJER[LVXVHGZKHQWKHVSUHDGVDUHXQGHUSULFHGLQUHODWLRQWRWKHLU
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Box Spread Construction

Buy

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or Loss

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HTXDOO\DSSOLFDEOHXVLQJ(7)RSWLRQVLQGH[RSWLRQVDVZHOODVoptions on futures.

ADVANCED FINANCIAL MANAGEMENT I 7.79

Financial Derivatives as a Tool for Risk Management

7KHER[VSUHDGLVSURWDEOHZKHQWKHFRPSRQHQWVSUHDGVDUHXQGHUSULFHG&RQYHUVHO\ZKHQWKHER[
LVRYHUSULFHG\RXFDQVHOOWKHER[IRUDSURW7KLVVWUDWHJ\LVNQRZQDVDVKRUWER[.
Combination Trading Strategy- its variants:
&RPELQDWLRQLVD7UDGLQJ6WUDWHJ\WKDWLQYROYHVWDNLQJDSRVLWLRQLQERWKFDOOVDQGSXWVRQWKHVDPH

stock.

Types:
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(b) Strangle: 6WUDQJOHLQYROYHVEX\LQJDSXWDQGFDOOZLWKWKHGLIIHUHQWVWULNHSULFHDQGVDPHH[SLU\
GDWH
(c) Strips: 6WULSLQYROYHVVHOOLQJRQHFDOODQGWZRSXWVZLWKWKHVDPHVWULNHSULFHDQGVDPHH[SLU\GDWH
(d) Straps: 6WUDS LQYROYHV VHOOLQJ WZR FDOOV DQG RQH SXW ZLWK WKH VDPH VWULNH SULFH DQG VDPH H[SLU\
GDWH
Straddle:
,Q WUDGLQJ WKHUH DUH QXPHURXV VRSKLVWLFDWHG WUDGLQJ VWUDWHJLHV GHVLJQHG WR KHOS WUDGHUV VXFFHHG
UHJDUGOHVVRIZKHWKHUWKHPDUNHWPRYHVXSRUGRZQ6RPHRIWKHPRUHVRSKLVWLFDWHGVWUDWHJLHVVXFK
DV LURQ FRQGRUV DQG LURQ EXWWHULHV DUH OHJHQGDU\ LQ WKH ZRUOG RI RSWLRQV 7KH\ UHTXLUH D FRPSOH[
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LVDEOHWRSURWQRPDWWHUZKHUHWKHXQGHUO\LQJSULFHRIWKHVWRFNFXUUHQF\RUFRPPRGLW\HQGVXS
+RZHYHURQHRIWKHOHDVWVRSKLVWLFDWHGRSWLRQVWUDWHJLHVFDQDFFRPSOLVKWKHVDPHPDUNHWQHXWUDO
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ORRNDWGLIIHUHQWWKHW\SHVRIVWUDGGOHVDQGWKHEHQHWVDQGSLWIDOOVRIHDFK
Types of Straddles
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x

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The Long Straddle
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7.80 I ADVANCED FINANCIAL MANAGEMENT



7KHWUDGHUFDQKHGJHKLVRUKHUEHWVDQGSLFNERWKVLGHVVLPXOWDQHRXVO\7KDWVZKHUHWKHORQJ
VWUDGGOHFRPHVLQ

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DQG

Source: TradeNavigator.com
:KLOH WKH PDUNHW ORRNV OLNH LW PD\ EUHDNWKURXJK WKH  SULFH WKHUH LV QR JXDUDQWHH WKDW LW ZLOO
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Drawbacks to the Long Straddle
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so may not match the amount at risk.

ADVANCED FINANCIAL MANAGEMENT I 7.81

Financial Derivatives as a Tool for Risk Management

,Q)LJXUHEHORZZHVHHWKDWWKHPDUNHWEUHDNVWRWKHXSVLGHVWUDLJKWWKURXJK

Source: TradeNavigator.com
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money.

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I ADVANCED FINANCIAL MANAGEMENT

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ADVANCED FINANCIAL MANAGEMENT I 7.

Financial Derivatives as a Tool for Risk Management

3URW
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LONG STRANGLE






Stock Price
at Expiration

Long Strangle Payoff Diagram

Limited Risk
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Breakeven Point(s)
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LVHTXDOO\DSSOLFDEOHXVLQJ(7)RSWLRQVLQGH[RSWLRQVDVZHOODVoptions on futures.

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The converse strategy to the long strangle is the short strangle.6KRUWVWUDQJOHVSUHDGVDUHXVHGZKHQ

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ADVANCED FINANCIAL MANAGEMENT I 7.85

Financial Derivatives as a Tool for Risk Management

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7.86 I ADVANCED FINANCIAL MANAGEMENT

3URW
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STRAP



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Financial Derivatives as a Tool for Risk Management

Put-Call Parity Theory:
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Option Valuation
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(ii)

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7.88 I ADVANCED FINANCIAL MANAGEMENT

Value of an Option: (a) Formula Method:

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XI
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3UHVHQW9DOXHRI

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Value of option at
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Factor

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Financial Derivatives as a Tool for Risk Management

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6SRW3ULFH)3E\HTXDWLQJWKHSUHVHQWYDOXHRIH[SHFWHG)XWXUH6SRW3ULFHWRWKH&XUUHQW
6SRW3ULFH60).

Nominal Value of an Option: $SSO\WKHSUREDELOLWLHVVRLGHQWLHGRQWKHYDOXHRIWKHRSWLRQ

DWWKHWZR)XWXUH6SRW3ULFHVWRJHWWKHH[SHFWHGYDOXHRIRSWLRQRQH[SLU\

Present Value: 'LVFRXQWWKHH[SHFWHGYDOXHRIRSWLRQQRPLQDOYDOXHWRSUHVHQWYDOXHWR

LGHQWLI\WKHYDOXHRIDQRSWLRQ

Basis for Risk Neutral Valuation Approach: 9DOXDWLRQRIRSWLRQVLVEDVHGRQDUELWUDJHSRVVLELOLWLHVDQGLV

WKHUHIRUHLQGHSHQGHQWRIULVNSUHIHUHQFHV7KHUHIRUHYDOXHRIRSWLRQVVKRXOGEHWKHVDPHIRUDQ\VHW

of risk preferences.

Factors Considered:
D &XUUHQW6SRW3ULFH630),

E ([SHFWHG)XWXUH6SRW3ULFHV)31DQG)3),
F ([HUFLVH3ULFH(3
G 5LVN)UHH5DWHRI5HWXUQDQG
H 3HULRGWR([SLU\
Approach:
D ,GHQWLFDWLRQRI3UREDELOLW\RI/RZHU3ULFH/LPLW31RU8SSHU3ULFH/LPLW3E\VROYLQJWKHIROORZLQJ
HTXDWLRQ


630

3UHVHQW9DOXHRI>31)313)3@ZKHUH313 
Hrt[>31[)313[)3@

ert[630

31)313)3

E 9DOXHRI2SWLRQ 39RI>9DOXHDW)31319DOXHDW)33@

Note: 9DOXHRI2SWLRQXQGHU%LQRPLDO0RGHODQGWKH5LVN1HXWUDO9DOXDWLRQ0RGHOZLOOEHWKHVDPH

7.90 I ADVANCED FINANCIAL MANAGEMENT

Black and Scholes Model of option valuation:

Pricing Model: 8QGHUWKH%600RGHORI2SWLRQ3ULFLQJYDOXHRIDQRSWLRQLVWKHGLIIHUHQFHEHWZHHQ
WKHH[SHFWHGEHQHWIURPDFTXLULQJDVWRFNDQGWKHSUHVHQWYDOXHRIWKHH[HUFLVHSULFH
Development of BSM Model:
(a)

Stage I: Value of Option of a Riskless Stock

Basic Formula: >2QWKHDVVXPSWLRQWKDWWKHVWRFNLVYLUWXDOO\ULVNOHVV@

L

LL 9DOXHRI&DOO7RGD\ 3UHVHQW9DOXHRI)3(3RUHrt)3(3

LLL )XWXUH6SRW3ULFH)3 )XWXUH9DOXHRI&XUUHQW6SRW3ULFHFRPSRXQGHGFRQWLQXRXVO\DW5LVN

)UHH5DWH 630;Hrt

(iv)

9DOXHRI&DOORQ([SLU\ 3D\2IIRQ([SLU\ 6SRW3ULFHRQ([SLU\'DWHLess ([HUFLVH3ULFHLH

>)3(3@>$VVXPSWLRQ6WRFNLVYLUWXDOO\ULVNIUHH@

Value of Call Today:

&DOO


Hrt)3(3
Hrt630;Hrt(3
Hrt;630;HrtHrt;(3
630Hrt;(3LH&XUUHQW6WRFN3ULFHLess 39RI([HUFLVH3ULFH

(b) Stage II: Introduction of Probability Factor and Risk Factors:



7RWKHDERYHEDVLFIRUPXODFRQWDLQLQJWZRFRPSRQHQWVSUREDELOLWLHVDUHDVVLJQHGDVIROORZV

)RU630 3UREDELOLW\WKDWWKHVWRFNSULFHZLOOPRYHDWWKHULVNIUHHUDWHLH)XWXUH6SRW3ULFHLV
DIDFWRURI&XUUHQW6WRFN3ULFHDQG5LVN)UHH5DWHRI5HWXUQRUWKHH[WHQWWRZKLFK5LVN)UHH
5DWHDIIHFWVWKH)XWXUH6SRW3ULFH

)RU 3UHVHQW 9DOXH RI ([HUFLVH 3ULFH  3UREDELOLW\ WKDW WKH RSWLRQ ZLOO EH H[HUFLVHG GXH WR

uncertainty in the stock price movement.

0RGLHG)RUPXOD3 630 Less 3 (3Hrt

:KHUH 31 3UREDELOLW\RI6WRFN3ULFHPRYLQJLQDFFRUGDQFHZLWK5LVN)UHH5DWH

3 3UREDELOLW\WKDWWKHRSWLRQZLOOEHH[HUFLVHGDQGVWULNHSULFHSDLG

(c) Stage III: Calculation of Probability Factor:

P1 and P2 6WDQGDUG1RUPDO'LVWULEXWLRQ7DEOH9DOXHRIDYDULDEOHZKLFKLVDIXQFWLRQRIWLPHSHULRG
RIRSWLRQLHSHULRGWRH[SLU\WULVNDVVRFLDWHGZLWKWKHVWRFNUHWXUQFXUUHQW6WRFN
3ULFH630DQG([HUFLVH3ULFH(3


31LVGHQRWHGE\1'1DQG3LVGHQRWHGE\1')

0RGLHG)RUPXOD1'1;630 Less N(D) ;(3;Hrt

(d) Computation of Variables for Probability:



L

'O9DULDEOH$WWDFKHGZLWK0RYHPHQWLQ6WRFN3ULFH
Ln _ SP0 /EP i + 8_r + 0.50v2 i tB
v t

ADVANCED FINANCIAL MANAGEMENT I 7.91

Financial Derivatives as a Tool for Risk Management



LL '9DULDEOH$WWDFKHGZLWK([HUFLVHRI2SWLRQ

Ln _ SP0 /EP i + 8_r + 0.50v2 i B

= D1

v t

RU

1RWH/QUHIHUVWR1DWXUDO/RJDULWKP
Assumptions of the Black and Scholes Model:
D 5DWHVRIUHWXUQRQDVKDUHVWRFNDUHORJQRUPDOO\GLVWULEXWHG
E 9DOXHRIWKHVKDUHDQGWKHULVNIUHHUDWHDUHFRQVWDQWGXULQJWKHOLIHRIWKHRSWLRQ
F 0DUNHWLVHIFLHQWDQGWKHUHDUHQRWUDQVDFWLRQFRVWVDQGWD[HV
G 1RGLYLGHQGVDUHSDLGRQWKHVKDUHGXULQJWKHOLIHRIWKHRSWLRQ

(e) No restrictions or penalties for short selling.

I 2SWLRQFDQEHH[HUFLVHGRQO\RQWKH([SLU\'DWHLHRSWLRQVDUHDOO(XURSHDQ2SWLRQV
The Greeks
,QRSWLRQVWUDGLQJ\RXPD\QRWLFHWKHXVHRIFHUWDLQJUHHNDOSKDEHWVZKHQGHVFULELQJULVNVDVVRFLDWHG
ZLWKYDULRXVSRVLWLRQV7KH\DUHNQRZQDVWKHJUHHNVDQGZHVKDOOGLVFXVVWKHIRXUPRVWFRPPRQO\
XVHGRQHV7KH\DUHGHOWDJDPPDWKHWDDQGYHJD
Delta:
'HOWDRID6WRFN2SWLRQLVWKHUDWLRRIWKHFKDQJHLQWKHSULFHRIWKHVWRFNRSWLRQWRWKHFKDQJHLQWKH
SULFHRIWKHXQGHUO\LQJVWRFN,WPHDVXUHVWKHVHQVLWLYLW\RI2SWLRQV3ULFHWRWKHPRYHPHQWLQWKHSULFHV
RIWKHXQGHUO\LQJDVVHW
Deltas of Call Option and Put Option:
D 'HOWDRID&DOO2SWLRQLVDOZD\VSRVLWLYH
E 'HOWDRID3XW2SWLRQLVDOZD\VQHJDWLYH
Formula:
Delta _T i =

Change in Option Price i.e. Option Premium

Change in Stock Price

Example: 2QZKHQWKHWUDGHRSHQVWKHVWRFNSULFHRI$PLWHFK&DVWLQJVLV` ,WULVHVWR

` 7KH'HFHPEHU&DOO2SWLRQRQ$PLWHFK&DVWLQJVVWDUWHGDW` ,WPRYHGWR` 
'HOWDRI&DOO2SWLRQVRI$PLWHFK&DVWLQJVLVFRPSXWHGDVXQGHU
Delta _T i =

Close Option Price `23 - Opening Option Price `20

`3.00
=
= 0.30
Clo sin g Stock Price `250 - Option Stock Price `240 `10.00

Application: 9DOXHRI'HOWDLVWKHQXPEHURIXQLWVRIWKHXQGHUO\LQJVWRFNZKLFKDQLQYHVWRUVKRXOGKROG
IRUHDFKRSWLRQVROGLQRUGHUWRFUHDWHDULVNOHVVKHGJH
Delta Hedging:
&UHDWLQJD5LVNOHVV+HGJHXVLQJ2SWLRQVDQG8QGHUO\LQJ6WRFNLVFDOOHG'HOWD+HGJLQJ
Rebalancing: 6LQFH'HOWDFKDQJHVWKHLQYHVWRUVSRVLWLRQUHPDLQVGHOWDKHGJHGRUGHOWDQHXWUDOIRU
RQO\DUHODWLYHO\VKRUWSHULRG7KHKHGJHVKRXOGEHDGMXVWHGSHULRGLFDOO\7KLVLVFDOOHGUHEDODQFLQJ

I ADVANCED FINANCIAL MANAGEMENT

Delta Values:
Option Position is
,QWKH0RQH\>([WUHPHEHQHFLDO&03@

At the Money

2XWRI0RQH\>([WUHPHEHQHFLDO&03@

Value of Delta
$OPRVW(TXDOWR >1HYHUEH\RQGWKDQ@
$SSUR[LPDWHO\HTXDOWR
1HDUWR=HUR

Gamma :
7KHJDPPDRIDQRSWLRQLVGHQHGDVWKHUDWHRIFKDQJHRIWKHRSWLRQVGHOWDZLWKUHVSHFWWRWKHSULFH
RIWKHXQGHUO\LQJZKHQDOOHOVHUHPDLQVWKHVDPH,WVWKHVHFRQGSDUWLDOGHULYDWLYHRIWKHRSWLRQSULFH
ZLWKUHVSHFWWRWKHXQGHUO\LQJSULFH,QRWKHUZRUGVJDPPDLVWKHUDWHDWZKLFKGHOWDZLOOFKDQJH
7KHGHOWDFDSWXUHVWKHH[WHQWRIFKDQJHDQGWKHJDPPDPHDVXUHVWKHSDFHRIWKHFKDQJH,WLVDOVR
FDOOHGDs Curvature.
*DPPDLVDOVRFDOOHGDVWKH6HFRQG'HULYDWLYHRIDQ2SWLRQ3UHPLXPVLQFHLWPHDVXUHVWKHVHQVLWLYLW\
RI'HOWDZKLFKLVWKHUVWPHDVXUHRIVHQVLWLYLW\RI2SWLRQV3ULFHWR0DUNHW3ULFHRIWKH8QGHUO\LQJ$VVHW
Evaluation based on Gamma Values:
D ,I*DPPDLVVPDOOGHOWDFKDQJHVVORZO\DQGUHEDODQFLQJDFWLHDGMXVWPHQWVWRNHHSDSRUWIROLR
GHOWDQHXWUDOQHHGVQRWEHGRQHRQDIUHTXHQWEDVLV
E ,I*DPPDYDOXHLVKLJKGHOWDLVKLJKO\VHQVLWLYHWRWKHSULFHRIWKHXQGHUO\LQJDVVHW7KLVVLWXDWLRQ
UHTXLUHVWKHUHEDODQFLQJWREHGRQHRQDIUHTXHQWEDVLV
Vega or Lambda:
9HJDRIWKHRSWLRQPHDVXUHVWKHVHQVLWLYLW\RIRSWLRQSULFHZLWKUHVSHFWWRWKHYRODWLOLW\RIWKHSULFHRI
WKHXQGHUO\LQJDVVHW,WFRQVLGHUVERWKPRYHPHQWLQSULFHDQGDOVRGHFUHDVHLQSHULRGWRH[SLU\RIDQ
RSWLRQ,WLVFDOFXODWHGDVFKDQJHLQWKHRSWLRQSUHPLXPIRUDXQLWFKDQJHLQWKHYRODWLOLW\RIWKHSULFH
RI WKH XQGHUO\LQJ DVVHW )RU ERWK FDOO DQG SXW RSWLRQV 9HJD OLHV EHWZHHQ ]HUR DQG LQQLW\ 9HJD LV
PD[LPXPIRUDWWKHPRQH\RSWLRQVZLWKORQJWHUPWRH[SLUDWLRQ+LJK9HJDUHHFWVWKHKLJKHUFKDQFHV
RIDQRSWLRQJRLQJ,QWKHPRQH\DWDQ\SRLQWLQWLPHGXULQJWKHFXUUHQF\RIWKHFRQWUDFW6RRSWLRQV
ZLWKKLJK9HJDDUHDWWUDFWLYHWRWKHRSWLRQEX\HU9HJDLVSRVLWLYHIRU2SWLRQ%X\HUDQGQHJDWLYHIRU
2SWLRQ6HOOHU
Theta:
7KHWDPHDVXUHVWKHVHQVLWLYLW\RIWKHRSWLRQVSULFHZLWKUHVSHFWWRLWVWLPHWRH[SLU\LH7LPH9DOXHRIDQ
2SWLRQ,WPHDVXUHVWKHFKDQJHRIWKHSULFHRIWKHRSWLRQZLWKWKHSDVVDJHRIWLPH,WLVDOVRUHIHUUHG
WRDVWKHWLPHGHFD\RIWKHVWRFNRUSRUWIROLR7KHWD9DOXHVIRUERWKWKH&DOODQGWKH3XW2SWLRQOLHV
EHWZHHQ=HURDQGWKH7RWDO9DOXHRIWKH2SWLRQ,WZLOOEHSRVLWLYHRUQHJDWLYHEDVHGRQWKHQDWXUHRI
WKHLQYHVWRUKROGHURUZULWHU9DOXHRI7KHWDLVJHQHUDOO\PHDVXUHGRQSHUGD\EDVLVDQGWKHUHIRUH
YDOXHRI7KHWDZRXOGYDU\IRUHYHU\WUDGLQJGD\EDVHGRQWKHPRYHPHQWLQ6WRFN3ULFHV:KHQ2SWLRQ
&RQWUDFWDSSURDFKHVWKHH[SLU\GDWHRSWLRQWHQGVWREHFRPHOHVVYDOXDEOH6LQFHWKH6WRFN3ULFH
DQGWKHRSWLRQSULFHPRYHLQWDQGHPWKHYDOXHRIWKHWDUHPDLQVVDPHRUXQLIRUPWRZDUGVWKHHQGRI

the options contract.

Rho

5KRLVWKHODVWDQGWKHOHDVWXVHG*UHHN5KRKHOSVXVWRXQGHUVWDQGWKHFKDQJHLQRSWLRQSUHPLXP
ZKLFKDUHQRWOLQNHGWRWKHXQGHUO\LQJVWRFNPRYHPHQW)RULQVWDQFHLQWHUHVWUDWHVFKDQJHVPD\FDXVH

a change in option premium.

5KRLQGLFDWHVWKHFKDQJHLQRSWLRQYDOXHIRUDRQHSHUFHQWDJHFKDQJHLQWKHLQWHUHVWUDWH
Example: D5KRRILQGLFDWHVWKHRSWLRQVWKHRUHWLFDOYDOXHZLOOLQFUHDVHE\LIWKHLQWHUHVWUDWH
LVGHFUHDVHGE\
$QLQFUHDVHLQLQWHUHVWUDWHVLQFUHDVHVWKHYDOXHRIFDOOVDQGGHFUHDVHVWKHYDOXHRISXWV$GHFUHDVHLQ
LQWHUHVWUDWHVGHFUHDVHVWKHYDOXHRIFDOOVDQGLQFUHDVHVWKHYDOXHRISXWV7KHUDQJHRIWKH5KR9DOXH
DOVRGHSHQGVRQWKHSRVLWLRQWKDWDSHUVRQKROGVLQWKH2SWLRQ/RQJFDOOVDQGVKRUWSXWVKDYHSRVLWLYH
5KR6KRUWFDOOVDQGORQJSXWVKDYHQHJDWLYH5KR

ADVANCED FINANCIAL MANAGEMENT I 7.