Chapter 4

Options
3.1 Concept & Meaning of Options,
3.2 Types of Options,
3.3 Pricing of Options: Black and Scholes Model, Binomial Model,
3.4 Trading Strategies involving Options.

An option is a unique instrument that confers a right without an obligation to buy or sell
another asset, called the underlying asset. Like forwards and futures it is a derivative
instrument because the value of the right so conferred would depend on the price of the
underlying asset. As such options derive their values inter alia from the price of the
underlying asset. For easier comprehension of the concept of an option, an example from
the stocks as underlying asset is most apt.

Consider an option on the share of a firm, say ITC Ltd. It would confer a right to the holder
to either buy or sell a share of ITC. Naturally, this right would be available at a price, which
in turn is derived from the price of the share of ITC? Hence, an option on ITC would be
priced according to the price of ITC shares prevailing in the market. Of course this right can
be made available at a specific predetermined price and remains valid for a certain period of
time rather than extending indefinitely in time.

The unique feature of an option is that while it confers the right to buy or sell the underlying
asset, the holder is not obligated to perform. The holder of the option can force the
counterparty to honors the commitment made. Obligations of the holder would arise only
when he decides to exercise the right. Therefore, an option may be defined as a contract
that gives the owner the right but no obligation to buy or sell at a predetermined price
within a given time frame. It is the absence of obligation to perform for one of the parties
that makes the option contract a substantially different derivative product from forwards
and futures, where there is equal and binding obligation on both the parties to the contract.
This unique feature of an option makes several applications possible that may not be
feasible with other derivative products.

Terminology of Options
Before we discuss how an option contract works it would be useful to familiarize with the
basic terms that are often used in describing and using options. These basic terms are
described below.
Call Option
A right to BUY the underlying asset at predetermined price within specified interval of time
is called a CALL option.
Put Option
A right to SELL the underlying asset at predetermined price within a specified interval of
time is called a PUT option.
Buyer or Holder
The person who obtains the right to buy or sell but has no obligation to perform is called the
owner/holder of the option. One who buys an option has to pay a premium to obtain the
right.
Writer or Seller
One who confers the right and undertakes the obligation to the holder is called seller/writer
of an option.
Premium
While conferring a right to the holder, who is under no obligation to perform, the writer is
entitled to charge a fee upfront. This upfront amount is called the premium. This is paid by
the holder to the writer and is also called the price of the option.
Strike Price
The predetermined price at the time of buying/writing of an option at which it can be
exercised is called the strike price. It is the price at which the holder of an option buys/ sells
the asset.
Strike Date/Maturity Date
The right to exercise the option is valid for a limited period of time. The latest time when the
option can be exercised is called the time to maturity. It is also referred to as
expiry/maturity date.

Types of Options
Options have several features, certainly more than forwards and futures making several
differentiations possible in the basis products of calls and puts. Based on several
considerations the options can be categorized in a number of ways, such as:
➢➢ Based on nature of exercise of options
➢➢ Based on how are they generated, traded, and settled
➢➢ Based on the underlying asset on which options are created

Nature of Exercise: American Versus European

Based on the timing of exercise the options can be either American or European. American
options can be exercised at any point of time before the expiry date of the option, while
European options are exercisable only upon maturity.
Nature of Markets: OTC Versus Exchange Traded
Options can also be categorized as OTC or exchange traded depending upon where and how
they are created, traded, and settled. Options may be like it forward contracts, which are
specific and negotiated by two contracting parties mutually with direct negotiations, known
as OTC, or they can be like futures which may be bought and sold on the specific exchanges
where the two contracting parties may not be known to each other but instead enter into a
contract on the floor/screen of an exchange. In the exchange-traded options the contracts
need to be standardized, while an OTC product is tailor-made to the requirements of the
parties concerned.
The standardization of option contract would be in at the discretion of the exchange and is
done in terms of Quantity of Underlying Asset Only specific quantity of the underlying asset
could be traded on the exchange and need to be predetermined.

Naked (Uncovered) and Covered Option

Naked or uncovered options are those which do not have offsetting positions, and
therefore, are more risky. On the other hand, where the writer has corresponding offsetting
position in the asset underlying (he option is called covered option. Writing a simple
uncovered (or naked) call option indicates toward exposure of the option writer to
unlimited potential losses. The basic aim is to earn the premium. In period of stable or
declining prices, call option writing may result in attractive profits by capturing the time
value of an option. The strategy of writing uncovered calls reflects an investor’s
expectations and tolerance for risk.

Stock Options
Options on individual shares of common stock have been traded for many years. Trading on
standardized call options on equity shares started in 1973 on CBOE whereas on put options
began in 1977. Stock options on a number of over-the-counter stocks are also available.
While strike prices are not because of cash dividends paid to common stock holders, the
strike price is adjusted for stock splits, stock dividends, reorganization, recapitalizations, etc.
which affect the value of the underlying stock.

Foreign Currency Options

Foreign currency is another important asset, which is traded on various exchanges. One
among these is the Philadelphia Stock Exchange. It offers both European as well as American
option contracts. Major currencies which are traded in the option markets are US dollar,
Australian dollar, British pound, Canadian dollar, German mark, French franc, Japanese yen,
Swiss franc, etc. The size of the contract differs currency to currency. This has been
explained in more detail in the chapter on currency option.

Index Options
Many different index options are currently traded on different exchanges in different
countries. For example, the S&P 100 index at CBOE and Major Market Index at AMEX are
traded in the US options markets. Similarly, in India, such index options have been started
on National Stock Exchange and Bombay Stock Exchange. Like stock option, index option’s
strike price is the index value at which the buyer of the option can buy or sell the underlying
stock index. The strike index is converted into dollar (rupee) value by multiplying the strike
index by the multiple for the contract. If the buyer of the stock index option intends to
exercise the option then the stock must be delivered. It would be complicated to settle a
stock index option by delivering all the stocks that make up that particular index. Hence,
instead, stock index options are cash settlement contracts. In other words, if the option is
exercised, the exchange assigned option writer pays cash to the option buyer, and there will
be no delivery of any share.

The money value of the stock index underlying an index option is equal to the current cash
index value multiplied by the contracts multiple. This is calculated as:
Rupee value of the underlying index = Cash index value x Contract multiples. For example,
the contract multiple for the S&P 100 is $100. So, assume, the cash index value for the S&P
100 is 750 then the dollar value of the S&P 100 contracts is 750x
100 = $75,000.

Futures Options
In a futures option (or options on futures), the underlying asset is a futures contract. An
option contract on futures contract gives the buyer the rights to buy from or sell to the
writer a specified future contract at a designated price at a time during the life of the
options. If the futures option is a call option, the buyer has the right to acquire a long
futures position.

Similarly, a put option on a futures contract grants the buyer the right to sell one particular
future contracts to the writer at the exercise price. It is observed that the futures contract
normally matures shortly after the expiration of the option. Futures options are now
available for most of the assets on which futures contracts are on the Euro dollar at CME
and the Treasury bond at the CBOT.

Interest Rate Options

They are another important options contract, which are popular in the international
financial markets. Interest rate options can be written on cash instruments or futures. There
are various debt instruments, which are used as underlying instruments for interest rate
options on different exchanges. These contracts are referred to as options on physicals.

Recently, these interest rate options have also gained popularity on the over-the-counter
markets like on treasury bonds, agency debentures and mortgage backed securities. There
are governments, large banking firms and mortgage-backed-securities dealers who make a
market in such options on specific securities.

B-S Model Assumptions and Limitations

Just as with most other models in finance, BSOPM is also based on some assumptions,
which are as follows:
(a) Frictionless markets. More precisely it means there are no transaction costs, short
selling is permitted, existence of similar borrowing and lending rates and infinitely divisible
assets. This is not a severely restrictive assumption since the intention is to separate the
effect of market forces on option prices.
(b) The asset pays zero dividends. This is also not an implausible assumption at least in the
short run. But subsequent models in the literature proposed some adjustments to the basic
BSOPM to incorporate dividend/intermediate income.
(c) The option is European style.
(d) Asset prices follow a geometric Brownian motion. In other words, asset returns are
normal and stationary. Many critics called this assumption as the biggest hole in the B-S
formula, including its inventor Prof. Fisher Black in an influential article in the. Journal of
Applied Corporate Finance in 1989.
But this way of making simplifying assumptions to describe the complex real world more
well-mannered is followed in many disciplines of Sciences and also in economics and finance
from ages, and in that spirit this model is not an exception. More importantly, despite these
seemingly deficient assumptions, the model does a reasonable job in pricing a variety of
derivative instruments.

THEORY QUESTIONS

Question 1: Since a forward market already existed, why was it necessary to establish
currency futures and currency option contracts?
(AJ-7 Marks Winter-13)
Question 2: What is option price? State the factors affecting option prices.
(AJ-7 Marks Winter-13)
Question 3: What is a call option and put option? What are the six determinants of a
currency option value?
(AJ-7 Marks Winter-13)
Question 4: What is the relevance of Block Scholes option Model? State its underlying
assumptions.
(AH-7 Marks Winter-12)
Question 5: State the relevance and underlying assumptions of Binomial option Model in
present market situation
(AH-7 Marks Winter-12)
Question 6: What are the features of an option contract? Explain with suitable examples.
(AE-7 Marks Summer-11)
Question 7: Explain the strategies involving options.
(AE-7 Marks Summer-11)
Question 8: Black schools option model is one of the important Models for pricing the
option. Discuss the statement in the light of various models for option pricing.
(AD-14 Marks Winter-10)
Question 9: What is Binomial pricing model? What are its various assumptions? Also discuss
one-step binomial model with hypothetical examples.
(AD-14 Marks Winter-10)
Question 10: Define the term option and option contract. What are features of an option
contract?
(AD-7 Marks Winter-10)
Question 11: What is naïve hedging model? How it is different from price sensitivity model?
Explain.
(AD-7 Marks Winter-10)
Question 12: Explain the properties of stock option.
(AD-7 Marks Winter-10)
Question 13: What is an option derivative? Give a detailed classification of option
derivative.
(AD-7 Marks Winter-10)
Question 14: What is Block-Scholes model? What are its underlying assumptions?
(AD-7 Marks Winter-10)
Question 15: Explain different trading strategies involving one option and one stock.
(AD-7 Marks Winter-10)
Question 16: Explain the nature and characteristics of option contract. Discuss different
types of option contracts.
(JSD-14 Marks Summer-09)
Question 17: What is a calendar spread strategy? Explain different types of calendar spread
strategies.
(JSD-7 Marks Summer-09)

PRACTICAL QUESTIONS

Question 1: The current stock price for ACC Ltd. Is Rs. 85/-. European call option with
exercise price of Rs. 85/- will expire in 160 days. The yield on a 160 day T-bill is 5.18%. The
standard deviation of annual return on the stock is 44%. Compute the premium for a call
option on this stock.
(AM-14 Marks Summer-15)
Question 2: The stock price 6 months from the expiration of an option is Rs. 42. The stock
price is Rs. 40, the risk free interest rate is 10% per annum and the volatility is 20% per
annum. Determine (using, Black-Sholes model)
(i) European call option.
(ii) European put option.
(AK-14 Marks Summer-14)
Question 3: An American call option with strike price 20 and maturity period of 5 month is
worth Rs. 150. Suppose that current price of stack is 19 and risk free rate of return is 10%
p.a. What is the price of put-option?
(AJ-7 Marks Winter-13)
Question 4:
(A) What is the value of a European call option on U.S. dollar with an exercise price of ¥
100/$ and a maturity date six month from now if the current spot rate of exchange is ¥ 80/$
and the risk free rate in both Japan and the United States is 5%?
(B) Suppose that in the above question (5 (A)) the currency markets are undergoing a period
of unusually high volatility. If the true standard deviation of the Yen/Dollar pot rate is 20%;
by how much have you under or overestimated the value of the Dollar call option? Use
Black Sholes option Model.
(AJ-14 Marks Winter-13)
Question 5: What could be the price of a two month European put option on a non dividend
pay stock, when stock price is 15 and strike price is 18 and risk free rate of interest is 6% p.a.
(AH-7 Marks Winter-12)
Question 6: A stock price is currently Rs. 90/- It is known that at the end of the month the
stock price will be either Rs. 95/- or Rs. 85/-. The risk free rate of interest is 12% p.a. with
continuous compounding. Calculate the value of one month European call option with a
strike price at Rs. 88/-.
(AH-7 Marks Winter-12)
Question 7: The current market price of ABC stock is Rs. 210/-. It is expected that in next six
month it may go up to Rs. 231 or down to Rs. 192. Calculate the value of six month
European call option with strike price of Rs. 200. The risk free rate of return is 12% p.a.
(AH-7 Marks Winter-12)
Question 8: Calculate the call option price of the stock as per Block-Scholes option Model
from the following details.
Option on ABC 500
Stock price Rs. 120
Exercise date Rs. 100
Estimated standard deviation 6 months
Current standard deviation 30%
Current market price Rs. 28
Risk free return 8% p.a.
Given N(d1) = 0.8770 N(d2) = 0.8289

(AE-7 Marks Summer-11)

Question 9: From the following details,
(i) Calculate the value of European put options and
(ii) Calculate the price of a three month European put option.
A non-dividend paying stock with a strike price of Rs. 50 when the current stock price is 50.
The risk free interest rate is 10% per annum and assumes that volatility is 30% per annum. A
dividend of Rs. 1.50 is expected from three months.
(AE-7 Marks Summer-11)
Question 10: Consider the following data and calculate value of call options as per Block
schools model.
Stock price RS. 50
Month of expiration 3 months
Risk free sale of interest 10% p.a.
Standard deviation of stock 40%
Exercise price Rs. 55
Option type European call

(AD-7 Marks Winter-10)

Question 11:
(A) Consider a four month European call option on UK pound. Suppose current exchange
rate is ($/£) 1.69, strike price is ($/£) 16,000, the risk free interest rate in USA is 8% p.a.
risk free interest rate in UK is 11% p.a. and option price is 4.3 cents.
Calculate the implied volatility.
(B) From the following information, draw a strategy.
Spot price of the time of buying put options Rs. 48/$
Strike price X Rs. 50/$
Premium P Rs. 2/$
The gain/lose profile of put option.
Spot price (S1) (per Dollar) Gain (+)/Loss (-)
Rs. 45 +Rs. 7
Rs. 46 +Rs. 6
Rs. 47 +Rs. 5
Rs. 48 +Rs. 4
Rs. 49 +Rs. 3
Rs. 50 +Rs. 2
Rs. 52 0.00
Rs. 54 -Rs. 2
Rs. 60 -Rs. 8
Rs. 62 -Rs. 8

(AD-14 Marks Winter-10)

Question 12: An investor holds an option to buy 1000 securities at a price of Rs. 37.90
currently. Show the impact of this option on the investor.
(AD-7 Marks Winter-10)
Question 13: A stock index is at 5000 points. There is a 50% probability that it will change
either up by 20 points or down 10 points, in each month. Consider a European call option on
this index with an exercise price of 5020 points, which will expire in 3 months. Find the value
of the European call
(AD-7 Marks Winter-10)
Question 14: A stock is currently placed at Rs. 215. At the end of two months. The stock
price will be either Rs. 230 or Rs. 205. Calculate the value of a European call option to buy
this stock for Rs. 222.
(JSD-14 Marks Summer-09)
Question 15: A stock price is currently Rs. 90. It is known that at the end of one month the
stock price will be either Rs. 95 or Rs. 85. The risk free rate of interest is 12% per annum
with continuous compounding. Calculate the value of one month European call option with
a strike price of Rs. 88.
(JSD-7 Marks Summer-09)
Question 16: The current stock price is Rs. 210. Over next 6 - month period it is expected to
go up to Rs. 231 or down to Rs 192. Calculate the value of 6 – months European call option
with strike price of Rs. 200, given further that the risk free rate of interest is 12% per annum.
 (JSD-7 Marks Summer-09)
Question 17: Following data are given:
Current price of a share Rs. 68.125
Exercise price of the call option Rs. 60
Continuously compounded
Annual Risk free rate of interest 13.25% per annum
Maturity period of the call option 2 months
volatility 20%
N(0.91) 0.8186
N(0.72) 0.7642
Calculate the value of the call option.
(JSD-14 Marks Summer-
09)