Unit 3

MBA/BBA/B.com/UGC Net

By
Dr. Anand Vyas
Introduction to Options, Hedging with
Currency Options
• An option is a financial contract that gives an investor the right, but not the
obligation, to either buy or sell an asset at a pre-determined price (known
as the strike price) by a specified date (known as the expiration date).

• Options are derivative instruments, meaning that their prices are derived
from the price of their underlying security, which could be almost anything:
stocks, bonds, currencies, indexes, commodities, etc. Many options are
created in a standardized form and traded on an options exchange like the
Chicago Board Options Exchange (CBOE), although it is possible for the two
parties to an options contract to agree to create options with completely
customized terms.
• Call Option: Option to purchase the underlying asset.
• Put Option: Option to sell the underlying asset.
• Options Contract: The agreement between the writer and the buyer.
• Expiration Date: The last day an options contract can be exercised.
• Strike Price: The pre-determined price the underlying asset can be
bought/sold for.
• Intrinsic Value: The current value of the option’s underlying asset.
• Time Value: The additional amount that traders are willing to pay for an
option.
• Vanilla Option: A normal option with no special features, terms or
conditions.
• American Option: Option that can be exercised any time before the
expiration date.
• European Option: Option that can be exercised only on the expiration date.
• Exotic Option: Any option with a complex structure or payoff calculation.
Speculation and Arbitrage with Options, Pricing Options
• Arbitrage and speculation are two very different financial strategies, with differing
degrees of risk.
• Arbitrage involves the simultaneous buying and selling of an asset in order to profit from
small differences in price. Often, arbitrageurs buy stock on one market (for example, a
financial market in the United States like the New York Stock Exchange) while
simultaneously selling the same stock on a different market (such as the London Stock
Exchange). In the United States, the stock would be traded in U.S. dollars, while in
London, the stock would be traded in pounds.
• As each market for the same stock moves, market inefficiencies, pricing mismatches, and
even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not
limited to identical instruments; arbitrageurs can also take advantage of predictable
relationships between similar financial instruments, such as gold futures and the
underlying price of physical gold.
• Speculation, on the other hand, is a type of financial strategy that involves a significant
amount of risk. Financial speculation can involve the trading of instruments such as
bonds, commodities, currencies, and derivatives. Speculators attempt to profit from
rising and falling prices. A trader, for example, may open a long (buy) position in a stock
index futures contract with the expectation of profiting from rising prices. If the value of
the index rises, the trader may close the trade for a profit. Conversely, if the value of the
index falls, the trade might be closed for a loss.
Pricing Options
• Option pricing refers to the amount per share at which an option is traded.
Options are derivative contracts that give the holder (the “buyer”) the right, but
not the obligation, to buy or sell the underlying instrument at an agreed-upon
price on or before a specified future date. Although the holder of the option is
not obligated to exercise the option, the option writer (the “seller”) has an
obligation to buy or sell the underlying instrument if the option is exercised.
• Depending on the strategy, options trading can provide a variety of benefits,
including the security of limited risk and the advantage of leverage. Another
benefit is that options can protect or enhance your portfolio in rising, falling and
neutral markets. Regardless of why you trade options – or the strategy you use –
it’s important to understand how options are priced. In this tutorial, we’ll take a
look at various factors that influence options pricing, as well as several popular
options-pricing models that are used to determine the theoretical value of
options.
• Top three influencing factors affecting options prices:
• the underlying equity price in relation to the strike price (intrinsic
value)
• the length of time until the option expires (time value)
• and how much the price fluctuates (volatility value)

Other factors that influence option prices (premiums) including:

• the quality of the underlying equity
• the dividend rate of the underlying equity
• prevailing market conditions
• supply and demand for options involving the underlying equity
• prevailing interest rates
General Principles of Pricing:
Black Scholes option pricing Model, Index Options
• The Black Scholes Model is one of the most important concepts in
modern financial theory. The Black Scholes Model is considered the
standard model for valuing options. A model of price variation over
time of financial instruments such as stocks that can, among other
things, be used to determine the price of a European call option. The
model assumes that the price of heavily traded assets follow a
geometric Brownian motion with constant drift and volatility. When
applied to a stock option, the model incorporates the constant price
variation of the stock, the time value of money, the option’s strike
price and the time to the option’s expiry. Fortunately one does not
have to know calculus to use the Black Scholes model.
•
Black-Scholes Model Assumptions
• There are several assumptions underlying the Black-Scholes model of calculating
options pricing..

• The exact 6 assumptions of the Black-Scholes Model are :

• Stock pays no dividends.

• Option can only be exercised upon expiration.
• Market direction cannot be predicted, hence “Random Walk.”
• No commissions are charged in the transaction.
• Interest rates remain constant.
• Stock returns are normally distributed, thus volatility is constant over time.
Limitations of the Black Scholes Model
• The Black–Scholes model disagrees with reality in a number of ways, some
significant. It is widely used as a useful approximation, but proper use requires
understanding its limitations – blindly following the model exposes the user to
unexpected risk.
• Among the most significant limitations are:
• The Black-Scholes Model assumes that the risk-free rate and the stock’s volatility
are constant.
• The Black-Scholes Model assumes that stock prices are continuous and that large
changes (such as those seen after a merger announcement) don’t occur.
• The Black-Scholes Model assumes a stock pays no dividends until after expiration.
• Analysts can only estimate a stock’s volatility instead of directly observing it, as
they can for the other inputs.
• Variants of the Black Scholes Model
• There are a number of variants of the original Black-Scholes model. As
the Black-Scholes Model does not take into consideration dividend
payments as well as the possibilities of early exercising, it frequently
under-values Amercian style options.

• As the Black-Scholes model was initially invented for the purpose of

pricing European style options a new options pricing model called the
Cox-Rubinstein binomial model is also used. It is commonly known as
the Binomial Option Pricing Model or more simply, the Binomial
Model, which was invented in 1979
Hedging with Index Options
• An alternative to selling index futures to hedge a portfolio is to sell index
calls while simultaneously buying an equal number of index puts. Doing so
will lock in the value of the portfolio to guard against any adverse market
movements. This strategy is also known as a protective index collar.
• The idea behind the index collar is to finance the purchase of the
protective index puts using the premium collected from selling the index
calls. However, as a result of selling the index calls, in the event that the
fund manager’s expectation of a falling market is wrong, his portfolio will
not benefit from the rising market.
• After determining the index to use, we calculate how many put and call
contracts to buy and sell to fully hedge the portfolio using the following
formula.
• No. Index Options Required = Value of Holding / (Index Level x Contract
Multiplier)
• Speculation:
• Future contracts are extremely attractive for speculators as they provide tremendous leverage. By paying a
small margin amount, speculators can take higher exposure of the underlying, thereby increasing their
reward potential as well as the risk. A person who is bullish on the price of the underlying can BUY a future
contract while a person who is bearish would SELL the future contract.

• Hedging:
• Hedging is an act of protecting or guarding the investment against an undesired price movement. Suppose a
long term investor owns a portfolio of stocks worth Rs 10 lacs. Although he is optimistic about the stocks he
has in the portfolio, he is not very comfortable with the overall movement of the market. The price
movement of a stock is dependent both on the micro (profitability of the company, its growth potential,
business model, management competency etc) and the macro factors (GDP growth of the country, interest
rates, overall state of economy etc). Such an investor can hedge his portfolio by selling Index Futures (like
Nifty future) and thereby removing the risk of macro variables from his portfolio.
• Another way to hedge using future contracts is by buying the futures of an index/stock when the cash to buy
the underlying would be available on a future date. Say a person is sure to receive cash inflows of Rs 5 lacs in
2 months’ time, which he wants to, invest in stocks. However, he is very bullish on the markets and wants to
invest as early as possible. What can he do? He can simply pay the margin amount and take the relevant
LONG exposure in future contracts. This will hedge him from the risk of losing out on the profits if market
were to go up in the next 2 months. It must be noted here that hedging does not necessarily mean reduced
possibility of losses. Like the long term investor we discussed above might lose on both cash and futures
positions if market moved up while his stocks fell.

• Arbitrage:
• An arbitrageur gains by buying the stock and going short in its future contract when the price of the future
contract is higher than its theoretical price. When the price of the future contract is less than what it should
be, the arbitrageur gains by going long in the future contract and selling the underlying in cash market.
Index Options Market in Indian Stock Market
• Index Options Market in Indian Stock Market
• Futures contract based on an index i.e. the underlying asset is the
index, are known as Index Futures Contracts. For example, futures
contract on NIFTY Index and BSE-30 Index. These contracts derive
their value from the value of the underlying index.
• Similarly, the options contracts, which are based on some index, are
known as Index options contract. However, unlike Index Futures, the
buyer of Index Option Contracts has only the right but not the
obligation to buy / sell the underlying index on expiry. Index Option
Contracts are generally European Style options i.e. they can be
exercised / assigned only on the expiry date.
Use of different option strategies to mitigate the risk
• Many investors mistakenly believe that options are always riskier
investments than stocks because they may not fully understand the
concept of leverage. However, if used properly, options may carry less risk
than an equivalent stock position. Read on to learn how to calculate the
potential risk of options positions and how the power of leverage can work
in your favor.
• Leverage has two basic definitions applicable to options trading. The first
defines leverage as the use of the same amount of money to capture a
larger position. This is the definition that gets investors into the most
trouble. A dollar invested in a stock and the same dollar invested in an
option do not equate to the same risk.
• The second definition characterizes leverage as maintaining the same sized
position, but spending less money doing so. This is the definition of
leverage that a consistently successful trader or investor incorporates into
his or her frame of reference.