Derivatives Options, Futures

From an investment perspective

Why derivatives
Risk return framework expanded
ability to modify the risk and expected return
characteristics of existing investment portfolios.
That is, options and futures allow investors to hedge
(or even increase) the risk of a collection of stocks in
ways that go far beyond the diversification results
Replication of cash flow patterns that already
exist in other forms, arbitrage if two otherwise
identical series of cash flows do not carry the
same current price
Impact of Futures
Generally, a dollar-for-dollar relationship exists between the
changes in the price of the underlying security and the price of the
corresponding futures contract.
In effect, being long (short) in futures is identical to subtracting
(adding) cash from (to) the portfolio.
Long futures positions have the effect of increasing the exposure of
the portfolio to the asset; Long positions in futures on the
portfolios underlying asset increase the portfolios exposure (or
sensitivity) to price changes of the asset
Shorting futures decreases the portfolios exposure - effect of
decreasing the portfolios sensitivity to the underlying asset.
Long is always the buyer here with a time lag. Short is always the
seller again with a time lag

Forward Contract
Definition: A forward contract is a commitment to purchase at a future date a given amount of a
commodity or an asset at a price agreed on today.






The price fixed now for future exchange is the forward price.
The party with a long position will be the buyer of the underlying asset or commodity.

Features of forward contracts:
custom tailored
traded over the counter (not on exchanges)
no money changes hands until maturity
non-trivial counter-party risk.

Example. Consider a 3-month forward contract for 1,000 tons of soybean at a forward price of Rs.
16500/ton. The long side is committed to buy 1,000 tons of soybean from the short side in three
months at the price of Rs.16500/ton.
Futures Contract
Forward contracts have two limitations:
(a) illiquidity
(b) counter-party risk.

Futures contracts are designed to address these two limitations.
Definition: A futures contract is an exchange-traded, standardized, forward-like
contract that is marked to the market daily. This contract can be used to establish a
long (or short) position in the underlying asset.

Features of futures contracts:
Standardized contracts:
(1) underlying commodity or asset
(2) quantity
(3) maturity.
Exchange traded
Guaranteed by the clearing house no counter-party risk
Gains/losses settled daily
Margin account required as collateral to cover losses
Futures Terminology
Spot price: The price at which an asset trades in the spot market.

Futures price: The price at which the futures contract trades in the futures market.

Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-months
and three months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires
on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the
Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of
which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.

Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different
basis for each delivery month for each contract. In a normal market, basis will be positive. This reflect that futures prices
normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost
of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the
asset.

Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is
known as Initial margin.

Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's
gain or loss depending upon the futures closing price. This is called marking-to-market.

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account
never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a
margin call and is expected to top up the margin account to the initial margin level before trading commences on the next
day.
Participants in Derivates markets
Based on the applications that derivatives are
put to, these investors can be broadly
classified into three groups:
Hedgers
Speculators, and
Arbitrageurs
Hedgers
These investors have a position (i.e., have bought
stocks) in the underlying market but are worried about
a potential loss arising out of a change in the asset
price in the future. Hedgers try to avoid price risk
through holding a position in the derivatives market.
For Example: Investor has a target buy price for Wipro
@ 250 in three months time. However, the investor is
worried may increase above Rs.250 and hence is keen
to hedge this risk of price rise. Assuming that there is a
futures contract that is trading at Rs. 250 he can lock in
the price purchase price now.
Possible payoff of long hedging
Expiry day spot
price
Rs. 300 Rs.250 Rs.200
Investor Payoff Rs. 50 Rs. 0 Rs.-50
Cost of investing Rs.250 Rs.250 Rs.250
Commodity hedging
Hedging on Commodities





If I have 100 tonnes of coconut Oil, I want to lock in the price. I am
Long on the commodity. A short position in a forward contract
based on the same commodity would provide the desired negative
price correlation.
By virtue of holding a short forward position against the long
position in the commodity, the investor has entered into a short
hedge.
Speculators
A Speculator is one who bets on the derivatives market based on his views on the potential
movement of the underlying stock price. Speculators take large, calculated risks as they trade
based on anticipated future price movements. They hope to make quick, large gains;

For Example: Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market and
also at Rs.500 in the futures market (assumed values for the example only). A speculator feels
that post the RBIs policy announcement, the share price of ICICI will go up. The speculator
can buy the stock in the spot market or in the derivatives market. If the derivatives contract
size of ICICI is 1000 and if the speculator buys one futures contract of ICICI, he is buying ICICI
futures worth Rs 500 X 1000 = Rs. 5,00,000. For this he will have to pay a margin of say 20%
of the contract value to the exchange. The margin that the speculator needs to pay to the
exchange is 20% of Rs. 5,00,000 = Rs. 1,00,000. This Rs. 1,00,000 is his total investment for
the futures contract.

If the speculator would have invested Rs. 1,00,000 in the spot market, he could purchase only
1,00,000 / 500 = 200 shares.

Let us assume that post RBI announcement price of ICICI share moves to Rs. 520. With one
lakh investment each in the futures and the cash market, the profits would be:
(520 500) X 1,000 = Rs. 20,000 in case of futures market and
(520 500) X 200 = Rs. 4000 in the case of cash mark
The opposite holds with wrong calculations!
Arbitrageurs
Arbitrageurs attempt to profit from pricing inefficiencies in the
market by making simultaneous trades that offset each other and
capture a risk-free profit. An arbitrageur may also seek to make
profit in case there is price discrepancy between the stock price in
the cash and the derivatives markets.
For example, if on 1st August the SBI share is trading at Rs. 1780 in
the cash market and the futures contract of SBI is trading at Rs.
1790 (fair value), the arbitrageur would buy the SBI shares (i.e.
make an investment of Rs. 1780) in the spot market and sell the
same number of SBI futures contracts and book a profit of Rs. 10.
Expiry Date Price 2000 1780 1500
Payoff in Spot 220 0 -280
Payoff in Futures -210 10 290
Total 10 10 10
Spot future parity
The future value discounted is equal to present value
F
0
T
= S0(1 + cost of carry)
T
Works fine in case there is no dividend, or cost of
storage. Else need to adjust for these.
Cost of carry = storage cost + foregone interest income
from holding
The spot price of XYZ today is $50, and the annual risk-
free rate of return is Rf = 5%. It is known that XYZ does
not pay dividends during the next year. What is the
forward price of XYZ for delivery 1 year from today?
Fair Forward price for delivery 1 year from today = F
0
1
=
50(1 + 0.05) = $52.50
Risk Less Arbitrage Strategy: Spot
futures Parity relationship
Arbitrage Strategy
Action Initial Cash
Flow
Cash flow in 1
year
Borrow So
funds
So -So (1+rf)
Buy Stock for So -So St+D
Enter short
Futures position
0 Fo-St
With Div 0 Fo So(1+rf)+D
Cost of Carry Relationship
Fo = So (1+rf) D
For Multi period
Fo = So ((1+rf)-D)
t
For continuous compounding rate



Where:
F = Futures price
S = Spot price of the underlying asset
r = Cost of financing (using continuously
compounded interest rate)
T = Time till expiration in years
e = 2.71828
D = dividend
Real World Fair Value Calculation
Cost of carry model where futures fair value FV
t

should be FV
t
= S
t
(1+i)
T
. where S
t
is the spot price
for the same time stamp and i is the cost of carry
and T is the time period. For estimate i and T we
use the normal overnight borrowing rate in India
(3.5% p.a or 1.035*(1/365) -1 = 0.009425%) T =
days left for expiry. For instance if the spot price
of a stock is Rs. 786 and the number of days
before expiry are 25 days then the fair value of
the futures price should be 786*(1+0.009425)^25
= 787.85.
Arbitragers will have different thresholds of
reaction : say more than 1% deviation

Settlement Procedure
Initial Margin + Mark to Market Margin
Let us say, Initial Futures Price = Rs. 1000; Initial Margin requirement = Rs. 500;
Maintenance Margin Requirement = Rs. 300; Contract size = 10 (that is, one futures
contract has 10 shares of XYZ. How the end of day margin balance of the holder of (i)
a long position of a contract and (ii) a short position of a contract, varies with the
changes in settlement price from day to day is given below.

Contract Specification for S&P CNX Nifty
Contract Specification for Stock Futures
Index Arbitrage
If Futures Price > Spot Price - Short futures and buy
stocks (Negative Arbitrage)
If Futures Price< Spot price Long Futures and sell
stock (Positive Arbitrage)
Stock current price is $100, one year rf is 6%, One
year future price is 104. How would you
arbitrage?
Not easy : you need to perfectly hedge!
There are some benefits of program trading.
How about short sales restrictions?

Hedging using Futures
Basis and basis risk
Perfect hedge does not always exist
The asset we are trying to hedge may not be
exactly the same as the asset underlying the
futures.
The time at which we sell the asset (which
could be random)might not be exactly be the
same as the delivery date of the futures.
Basis Risk - Intuition
At time of origination of contract (initial basis)
B
0,T
= S
0
F
0,T

At time of Closure of contract (cover basis)
B
t,T
= S
t
F
t,T

Price risk is S
t-
S
0

Basis risk is B
t,T
B
0,T
= (S
t
F
t,T
) (S
0
F
0,T
)

The investor is swapping the price risk for the basis risk. So
pure price risk should be greater than basis risk for the
future/forward market to be efficient

Intuition
Intuition
Notice, however, that only the cover basis is unknown at Date 0,
and so real exposure is to the correlation between future changes in the
spot and forward contract prices.
If these movements are highly correlated, the basis risk will be quite small
Minimum Variance hedge
Profit from the hedge



Calculations on MV hedge
Using Index futures for Hedging
Let us consider an example. Suppose you own a portfolio of Rs 3 million which has
a beta of 0.9. How would I hedge this portfolio? By selling Rs 2.7 million of index
futures.

The portfolio beta is computed as the weighted average of the stock betas.
Suppose the above portfolio is composed of Rs 1 million in ITC, which has a beta of
1.2 and Rs 2 million in Hindustan lever, which has a beta of 0.8, the portfolio beta
in this case is equal to ( 1*1.2 + 2*0.8)/3 or approximately 0.9. Now to obtain a
complete hedge which would remove the hidden index exposure, I would have to
take a short position of portfolio value times portfolio beta which as we
mentioned is approximately Rs 2.7 million.

So if the Nifty is at 1500 and the market lot on NSE's futures market is 200, each
market lot of Nifty would cost 3,00,000. Hence I would have to sell 9 market lots to
obtain a position:
Long Portfolio: Rs 3,000,000
Short S&P CNX Nifty: Rs 2,700,000

This position will essentially be immune to any fluctuation of the index. If the index
goes up, the portfolio gains and the futures lose. If the index goes down, the
portfolio loses but the futures gain. In either case, the investor is hedged against
market fluctuations.

38
Risk-Minimization Hedging
Soybeans Case
Suppose that you are a soybean meal processor. You hold soybeans
for regular use in your business. From this inventory, you purchase
soybeans and sell soybeans to your customers.
You have an ongoing inventory of 1,000,000 bushel of soybeans.
Suppose the cash price of soybeans is currently Rs.7.19 . As such,
the inventory is currently valued at Rs.7,190,000.
You wish to minimize the price risk associated with holding the
inventory. You realize that if the price of soybeans were to drop
substantially, you would experience a loss in value on the soybeans
that you have in inventory. Such a loss would be devastating to
your profits. You wish to hedge the price risk of the inventory that
you hold.
Because the inventory is an ongoing asset, the processor does not
have a specified horizon. As such, the processor wishes to engage in
a risk-minimizing hedge.

39
Risk-Minimization Hedging
Soybeans Case
Step 1: estimate the price change and percentage price changes for the
soybean using the previous 60 days daily data of soybean prices.
Day Cash (S) Future (F) Chg (S) Chg (F)
1 890327 755
2 890328 749.5 1 -5.5
3 890329 747.5 1 -2
4 890330 725 1 -22.5
5 890331 723 1 -2
6 890403 697.5 72 -25.5
7 890404 702 1 4.5
8 890405 702 1 0
9 890406 701 1 -1
10 890407 699 1 -2
11 890410 707 3 8
12 890411 708 1 1
13 890412 715.5 1 7.5
14 890413 716 1 0.5
15 890414 722.5 1 6.5
16 890417 736 3 13.5
17 890418 738.5 1 2.5
18 890419 737.5 1 -1
19 890420 741 1 3.5
20 890421 754.5 1 13.5
. . . . .
. . . . .
59 890616 717.5 1 0
60 890619 733 3 15.5
Where :
Chg (S) = change in cash price
Chg (F) = change in futures price
40
Risk-Minimization Hedging
Soybeans Case
Step 2: run a regression analysis in Excel (recall that to do this in
Excel you need to go to Tools, Data Analysis, Regression. The
Y variable will be the change in the commodity price. The X variable
will be the change in the futures price.
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.11726695
R Square 0.013751537
Adjusted R Square -0.003551067
Standard Error 15.62544125
Observations 59
ANOVA
df SS MS F Significance F
Regression 1 194.0458 194.0458 0.794767 0.376411
Residual 57 13916.8 244.1544
Total 58 14110.85
Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%
Intercept 4.879820628 2.035745 2.397068 0.019828 0.803311 8.95633 0.803311 8.95633
X Variable 1 -0.185935589 0.208566 -0.891497 0.376411 -0.603581 0.23171 -0.603581 0.23171
41
Risk-Minimization Hedging
Soybeans Case
Step 3: interpret the results.
From the above regression, we have:
0103 . 0 = o
5159 . 0 = |
Results: in order to complete the risk-minimizing hedge, we should sell 0.5159 bushel
of soybean futures contracts for each bushel that we have in inventory. Since we have
1,000,000 bushel of soybeans in inventory, we should sell:

0.5159 X 1,000,000 = 515,900 bushel of soybeans in the futures market.
4758 . 0
2
= R
42
Risk-Minimization Hedging
Soybeans Case
Soybeans are traded in 5,000 bushel futures contracts, we should sell:
Quantity Contract
Hedged Be To Amount
# = Contracts
You should sell 103 Soybean Contracts.
18 . 103
5000
900 , 515
# = = Contracts
Bond Hedges
From the modified duration, we find that


Optimal Hedge ratio is given by

Bond Hedges



Find Yield Beta by correlating the 10 year yield to the 15 year
yield. If it follows expectations hypothesis, the yield beta = 1.
Find Modified Durations of A and B and current price
(Modified Duration and prices are 6.4036 years and 87.71 for
Security A and 8.2009 years and 117.12 for Security B)

A T-Bond/T-Note (NOB) Futures
Spread
speculators in the bond market will have a clear
view on a change in the overall shape of the yield
curve but be less certain as to the actual direction
in future rate movements.
One way to mitigate this unwanted risk while
investing (based on your view) is to go both long
and short in contracts representing different
points on the yield curve.
This is known as the Treasury Notes over Bond
spread (or NOB spread) strategy. rate
movements
NOB
Mid feb prices for a june expiry



You expect a flattening yield curve the existing 27 bp
yield difference will disappear
Strategy
Go long in one Treasury bond futures.
Go short in one Treasury note futures
Note over Bond (NOB futures)
Make use of Liquidity premiums disappearing over time

Contract Settlement price Implied Yield
20 yr, 6% T bond 103.0625 5.74
10 yr 6% T note 104.0625 5.47
NOB
Profit from strategy



OPTIONS

Economic Benefits of Options
Help bring about a more efficient allocation
and management of risk
Save transactions costs
Permit investment strategies that would not
be possible otherwise.
Uses
1. Suppose we are given a financial derivative.
What is the fair" price for such a contract?
[Pricing]
2. Suppose we are managing a large portfolio.
How can we control the exposure to financial
risks? [Hedging]
3. Suppose that you have to achieve some
financial targets with your portfolio (e.g., think of
yourself being the manager of a pension fund.
How can I minimize the risk and the costs of
missing the target? [Risk Management]
Underlying assets
Options are written on almost anything one
can think of. I.e., possible underlyings can be
such things as stocks, foreign exchange rates,
interest rates, gold, pork bellies, et cetera.
Here we discuss primarily options on stocks.
Option contracts
Options
Instruments that grant their owners (holders) the right, but not
the obligation, to buy or sell an underlying asset at a specific
price (or exercise or strike price), either on a specific date or any
time up to a specific date (or expiration date).

Options fall into two broad categories
Call options: Give holder the right (but not the obligation) to buy
an underlying asset at a specified price on or before a specified
date.
Put options: Give holder the right (but not the obligation) to sell
an underlying asset at a specified price on or before a specified
date.
53
Options can be either sold (written) or purchased, thus
giving rise to four possible basic option positions
Long call position (holder of a call option)
Short call position (writer or seller of a call option)
Long put position (holder of a put option)
Short put position (writer or seller of a put option)

Options also referred to: American and European options
American options: can be exercised any time before expiration
date.
European options: can be exercised only at expiration date.


54
Other key definitions used in option trading
Exercise (strike) price: Pre-determined price at which the
underlying asset may be purchased (in the case of a call) or sold to
a seller or writer (in the case of a put).
Expiration date: Last date at which an option can be exercised.
Option premium: Price paid by the option buyer to the seller of
the option, whether put or call.
In-the-money option: The option has intrinsic value, and would
be exercised if it were expiring
Out-of-the-money option: The option has no intrinsic value,
would not be exercised if expiring
If not expiring, could still have value since it could later
become in-the-money
At-the-money option: If the spot market price of the underlying
asset is equal to the exercise price.

55
Example: Call options
Suppose you own a call option (long call position) with an
exercise (strike) price of Rs.30.

If the current stock price is Rs.40 (in-the-money):
Your option has an intrinsic value of Rs.10.
You have the right to buy at Rs.30, and you can exercise
your right and then sell the stock in the market for
Rs.40.

If the current stock price is Rs.20 (out-of-the-money):
Your option has no intrinsic value.
You would not exercise your right to buy the stock for
Rs.30 as you can buy the stock for Rs.20 in the stock
market.

56
Example: Put options
Suppose you own a put option (long put position) with an
exercise (strike) price of Rs.30.

If the current stock price is Rs.20 (in-the-money):
Your option has an intrinsic value of Rs.10.
You have the right to sell at Rs.30, so you can buy the
stock at Rs.20 and then exercise and sell for Rs.30.

If the current stock price is Rs.40 (out-of-the-money):
Your option has no intrinsic value.
You would not exercise your right to sell the stock for
Rs.30 as you can sell the stock for Rs.40 in the stock
market.

57
Long call position (buying a call option)
Position taken in the expectation that price will
rise.
Example:
For a call buyer with
an exercise price = Rs.70
option premium (option price) paid by the call buyer =
Rs.6.13
The following diagram shows different total dollar profits for
buying a call option with a strike price of Rs.70 and a premium
of Rs.6.13

58
Long call position (Buying call option)
59
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise price = Rs.70
Call premium = Rs.6.13
Stock Price at Expiration
Profit from Strategy
Limited loss
Call premium
Break-even price
unlimited profit
Example (Cont)
For a call buyer with an exercise price = Rs.70.
If current share price > exercise price (Rs.80); call option is in the
money.
If current share price = exercise price (Rs.70); call option is at the money
If current share price < exercise price (Rs.60); call option is out of the
money
Call premium (option price) paid by the call buyer = Rs.6.13
Breakeven point = Exercise price + Premium
= Rs.70 + Rs.6.13 = Rs.76.13
Profit realised, if the share price rises above Rs.76.13
Profit = Spot rate (Exercise price + Premium)
e.g. spot rate = Rs.80
Profit = 80 (70+6.13)
Note payoff = profit - Profits on an option strategy include
option payoffs and the premium paid for the option

60
Short call position (selling a call option)
Position taken in the expectation that price will remain
steady or decline
Example:
For a call seller (writer) with
an exercise price = Rs.70
option premium (option price) earned by the call seller =
Rs.6.13
The following diagram shows different total dollar profits for
selling a call option with a strike price of Rs.70 and a premium
of Rs.6.13

61
Short call position (selling a call option)
62
40 50 60 70 80 90 100
(500)
(1,000)
0
500
1,000
1,500
(2,000)
(1,500)
Exercise price = Rs.70
Call premium = Rs.6.13
Profit from Strategy
Stock Price at Expiration
Profit limited to call
premium
Call premium
Unlimited loss
Long put position (buying a put option)
Position taken in the expectation that price will decline.

Example:
For a put buyer with
an exercise price = Rs.70
option premium (option price) paid by the put buyer =
Rs.6.13
The following diagram shows different total dollar profits for
buying a put option with a strike price of Rs.70 and a premium
of Rs.6.13

63
Long put position (buying a put option)
64
40 50 60 70 80 90 100
1,000
500
0
1,500
2,000
2,500
3,000
(500)
(1,000)
Exercise price = Rs.70
Put premium = Rs.6.13
Profit from Strategy
Stock Price at Expiration
Profit up to Rs.6,387
[100x(Rs.70-Rs.6.13)]
Limited loss
Break-even price
Put premium
Example (Cont)
For a put buyer with an exercise price = Rs.70.
If current share price < exercise price (Rs.60); put option is in the
money.
If current share price = exercise price (Rs.70); put option is at the money
If current share price > exercise price (Rs.80); put option is out of the
money
Put premium (option price) paid by the put buyer = Rs.6.13
(thus maximum loss Rs.6.13 up to exercise price of Rs.70)
Breakeven point = Exercise price - Premium
= Rs.70 Rs.6.13 = Rs.63.87
Profit realised, if the share price drop below Rs.63.87
Profit = Exercise price (Spot rate + Premium)
e.g. spot price = Rs.60
Profit = 70 (60+6.13)

65
Short put position (selling a put option)
The put writer bets that the price will not decline greatly
collects premium income with no payoff
The payoff for the buyer is the amount owed by the writer
(payoff loss limited to the strike price since the stocks value
cannot fall below zero)
Example:
For a put seller with
an exercise price = Rs.70
option premium (option price) earned by the put seller =
Rs.6.13
The following diagram shows different total dollar profits for
selling a put option with a strike price of Rs.70 and a premium
of Rs.6.13


66
Short put position (selling a put option)
67
40 50 60 70 80 90 100
(500)
(1,000)
0
500
1,000
1,500
(2,000)
(1,500)
Exercise price = Rs.70
Call premium = Rs.6.13
Profit from Strategy
Stock Price at Expiration
Call premium
Limited profit (put premium)
Loss up to Rs.6,387
[100x(Rs.70-Rs.6.13)]
Option Strategies
Single Option and Stock
Covered Call
Protective puts
Spreads : multiple options
of same or different types
Bull spread
Bear Spread
Box Spread
Butterfly spread
Calendar Spreads
Diagonal Spread

Combinations
Straddle
Strip , Strap
Strangle
Focus not on replicating
all payoffs, but general
understanding of these
strategies
Technical Trading using options
Contrary-opinion technicians use put options, which give
the holder the right to sell stock at a specified price for a
given time period, as signals of a bearish attitude.
A higher put/call ratio indicates a pervasive bearish
attitude, which technicians consider a bullish indicator.
This ratio fluctuates between .60 and .40, and it has
typically been substantially less than 1 because investors
tend to be bullish and avoid selling short or buying puts.
The current decision rule states that a put/call ratio above
.60sixty puts are traded for every 100 callsis
considered bullish, while a relatively low put/call ratio of
.40 or less is considered a bearish sign
Protective Puts
( C ) protective Put strategy : the investment strategy involves buying a put option on
a stock and the stock itself.
(D) a short position in a put option is combined with a short position in the stock. This
is the reverse of a protective put.
Protective Puts
Strike Price X = Rs. 100; Stock Price S = Rs. 97 (at the expiration
date)
Value of Put = X-St = 100 97 = 3
Protective Put means holding stock and put options. If the
price of the stock moves down you have protection on value
loss. Used as a simple portfolio insurance strategy

ST <= X ST > X
Stock ST ST
+Put X-ST 0
Total X ST
Covered Calls
(A) the portfolio consists of a long position in a stock plus a short position in a call option. This is
known as writing a covered call. The long stock position "covers" or protects the investor
from the payoff on the short call that becomes necessary if there is a sharp rise in the stock
price.
(B) A short position in a stock is combined with a long position in a call option. This is the reverse
of writing a covered call
Covered Calls
Purchase of a stock and simultaneous sale of a call on the stock (the sales
is covered as you own the stock). Writing without owning stock is
naked position.
Fund Manager has a target sell price (for an owned stock) say: Rs. 110.
And the fund owns 1000 shares of the stock. The current price is Rs. 100.
Fund manager writes a call at Rs. 110 say for Rs. 5. If the price goes up
fund manager gets Rs. 110 and if the price goes down then the fund
manager gets Rs. 5000. When the fund manager owns lot of stocks and is
clear with the target sell prices then it is a simple disciplined strategy to
boost income.
ST <= X ST > X
Stock ST ST
+Written Call -0 -(ST-X)
Total ST X
Using Options instead of stocks
Suppose you have a choice of two investment strategies. The first is to
invest Rs.100 in a stock. The second strategy involves investing Rs.90 in
6 month T-bills and Rs.10 in 6 month calls. If the call is priced at Rs.5,
then you are able to buy 2 calls.
The payoffs for this strategy are outlined below.



.

Put Call Parity
Consider a combination of Call plus bond (where the value of
the bond is equal to the strike price of the stock) payoff




The Payoff is similar to Protective put! Hence:
C+X/(1+Rf)
T
= So +P
P = C + PV(k) - S

ST <= X ST > X
Call 0 St-X
Bond X X
Total X ST
Synthetic T bills
Put Call Parity - Example
Stock Price Rs.110
Call Price (1 year expiration, X =Rs. 105) Rs.17
Put Price (1 year expiration, X =Rs. 105)

Rs.5
Risk Free interest rate 5%
Put Call Parity
Is Parity Violated?
17+105/(1.05) = 110 +5 = 2 YES!
Arbitrage Strategy

Position Cash Flow
Now
ST< 105 ST>105
Buy Stock -110 ST ST
Borrow
(equals to the
exercise price
= 105/1.05
100 -105 -105
Sell Call 17 0 -(ST-105)
Buy Put -5 105-ST 0
Total 2 0 0
Pricing of Options: Arbitrage Bounds
Options are priced based on arbitrage principle
(as they are redundant securities)
For example: Suppose that an American call option on
Mahindra Satyam with an exercise price of Rs.70 is selling for Rs.3
and that the Mahindra Satyam stock price is Rs.75. An arbitrage can
be executed by buying the option and exercising it immediately,
yielding an immediate profit of Rs.2 per share. Hence the lower
bound for the option can be written as:
C
A
>= max(0, S-X) here A represents American Option

Arbitrage Bounds
Lower Bound on an American Put Option
P
A
>= max(0, X-S)
Lower Bound on a European Call Option
C
E
>= max(0, S-X(1+r)
-T
)
Lower Bound on a European Put Option
P
E
>= max[0, X(1+r)
-T
- S]
However, Exercise Price is set based on an
unknown future stock price! Hence, pricing is
not simple. We have relay on probability of
future prices.

Option Valuation: A simple example
A stock is currently priced at Rs.40 per share.
In 1 month, the stock price may
go up by 25%, or
go down by 12.5%.
A simple example
Stock price dynamics:
Rs.40
Rs.40x(1+.25) = Rs.50
Rs.40x(1-.125) = Rs.35
t = now t = now + 1 month
up state
down state
Call option
A call option on this stock has a strike price of
Rs.45
t=0 t=1
Stock Price=Rs.40;
Call Value=Rs.c
Stock Price=Rs.50;
Call Value=Rs.5
Stock Price=Rs.35;
Call Value=Rs.0
A replicating portfolio
Consider a portfolio containing A shares of the
stock and $B invested in risk-free bonds.
The present value (price) of this portfolio is AS + B
= Rs.40 A + B
Portfolio value

t=0 t=1
Rs.50 A + (1+r/12)B
Rs.35 A + (1+r/12)B
Rs.40 A + B
up state
down state
A replicating portfolio
This portfolio will replicate the option if we
can find a A and a B such that
Rs.50 A + (1+r/12) B = Rs.5
Rs.35 A + (1+r/12) B = Rs.0
and
Portfolio payoff
=
Option payoff
Up state
Down state
The replicating portfolio
Solution:
A = 1/3
B = -35/(3(1+r/12)).
Eg, if r = 5%, then the portfolio contains
1/3 share of stock (current value Rs.40/3 =
Rs.13.33)
partially financed by borrowing Rs.35/(3x1.00417)
= Rs.11.62
The replicating portfolio
Since the replicating portfolio has the same
payoff in all states as the call, the two must
also have the same price.
The present value (price) of the replicating
portfolio is Rs.13.33 Rs.11.62 = Rs.1.71.
Therefore, c = Rs.1.71
A general (1-period) formula

A =
C
u
C
d
S
u
S
d
B =
S
u
C
d
S
d
C
u
1 + r ( ) S
u
S
d
( )
p =
r d
u d
c = AS+ B =
pC
u
+ 1 p ( )C
d
1+ r
Two Periods
Suppose two price changes are possible during
the life of the option
At each change point, the stock may go up by
R
u
% or down by R
d
%
Two-Period Stock Price Dynamics
For example, suppose that in each of two
periods, a stocks price may rise by 3.25% or
fall by 2.5%
The stock is currently trading at Rs.47
At the end of two periods it may be worth as
much as Rs.50.10 or as little as Rs.44.68
Two-Period Stock Price Dynamics

Rs.
47
Rs.48.53
Rs.45.83
Rs.50.10
Rs.47.31
Rs.44.68
Terminal Call Values

Rs.C
0
Rs.C
u
Rs.C
d
C
uu
=Rs.5.10
C
ud
=Rs.2.31
C
dd
=Rs.0
At expiration, a call with a strike price of
Rs.45 will be worth:
Two Periods
The two-period Binomial model formula for a
European call is
C =
p
2
C
UU
+ 2p(1 p)C
UD
+ (1 p)
2
C
DD
1+ r ( )
2
Black-Scholes (1973) Model (BSM)
Using stochastic calculus and the heat exchange equation from
physics, Black and Scholes developed the following model.

2 / 1
1 2
2 / 1
2
1
2 1 0
) (
) (
) 5 . 0 ( ) / ( 1
) ( ) ( ) (
T d d
T
T r X S n
d
d N e X d SN C
rT
o
o
o
=
(

+ +
=
=

( ) ( )
( ) ( )
0 5 . 0 1
0 5 . 0 ) (
/ 351 83 / 281 2 /
/ 351 83 / 281 2 /
2
2
>
< ~
+

d if e
d if e d N
d d
d d
96
Where
C
0
= the call price;
S = current market price of underlying ordinary shares;
X = exercise price of call option;
T = time to expiration (fraction of year);
r = current annualised market interest rate for prime
commercial paper;
o = standard deviation of annual return on underlying
asset (volatility)
N(d
1
) = cumulative density function of d
1
as defined earlier
e = base of natural logarithms (approx 2.71828);
N(d
2
) = cumulative density function of d
2
as defined earlier;
ln( S/X) = natural log of ( C/X)
97
Example:
From the following information, calculate the
price of call option
S = Rs.40
X = Rs.40
r = 9%
T = 1 year
o = 0.3


98
2 / 1
1 2
2 / 1
2
1
2 1 0
) (
) (
) 5 . 0 ( ) / ( 1
) ( ) ( ) (
T d d
T
T r X S n
d
d N e X d SN C
rT
o
o
o
=
(

+ +
=
=

15 . 0 ) 1 ( 3 . 0 45 . 0
45 . 0
) 1 ( 3 . 0
1 ) ) 3 . 0 ( 5 . 0 09 . 0 ( ) 40 / 40 ( 1
2 / 1
2
2 / 1
2
1
= =
=
(

+ +
=
d
x n
d
6736 . 0 ) (
1
~ d N
5596 . 0 ) (
2
= ~ d N
49 . 6 $ ) 5596 . 0 )( ( 40 ) 6736 . 0 )( 40 (
) 1 ( 09 . 0
0
= =

e C
99
Options Strategies
Strategy 1: Vertical
Spread (So = Rs. 40
and LOT SIZE 100)
Cost ST = 46 ST = 38
Buy Call ITM @40 -200 600 0
Sell Call OTM @45

+100 100 0
Net Position@ ST -100 00 -100
Strategy 2: Long
Strangle(So = Rs. 40
and LOT SIZE 100)
Cost ST = 50 ST = 40
Buy Put OTM @35 -100 0 0
Buy Call OTM @45 -100 500 0
Net Position@ ST -200 300 -200
Options Strategies
Strategy 3: Long
Straddle (So = Rs.
40 and LOT SIZE
100)
Cost ST = 50 ST = 40
Buy Put ATM @40 -100 0 0
Buy Call ATM @40 -100 1000 0
Net Position@ ST -200 800 -200
Strategy 4:
STRAP(So = Rs. 40
and LOT SIZE 100)
Cost ST = 30 ST = 50
Buy 2 Calls ATM
@40
-400 0 2000
Buy Put ATM @40 -200 1000 0
Net Position@ ST -600 400 1400
Options Strategies
Strategy 5: STRIP
(So = Rs. 40 and
LOT SIZE 100)
Cost ST = 50 ST = 30
Buy 2 Puts ATM
@40
-400 0 2000
Buy 1Call ATM @40 -200 1000 0
Net Position@ ST -600 800 1400
Strategy 6:
Butterfly Spread(So
= Rs. 40 and LOT
SIZE 100)
Cost ST = 40 ST = 30
Buy Call ITM @30 -1100
Sell 2 calls ATM
@40
+800
Buy Call OTM @50 -100
Net Position@ ST -400