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LEARNING OBJECTIVES
2
Explain
Options
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An
The
The
Options
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The
The
American
Possibilities of option
holder exercising his right
There are three possibilities:
In-the-money: A put or a call option is said to in- the- money
when it is advantageous for the investor to exercise it.
Out-of-the-money: A put or a call option is out-of-the-money
if it is not advantageous for the investor to exercise it.
At-the-money: When the holder of a put or a call option does
not lose or gain whether or not he exercises his option, the
option is said to be at-the- money.
Call Option
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Buy
a call option
The
Call Premium
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The
The
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Put Option
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Buy
a put option
The
[Exercise price
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Example
The Put Option Holder's Pay-off at
Expiration
Example
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The
Index Options
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Index
In
Index Options
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Combinations of Put,
Call and Share
A
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Example
Current share
price
Share price
Protective Put
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Current share
price
Exerci se price
Share price
The
At
Put-call Parity
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Suppose you buy a share (long position), buy a put (long position) and sell
a call (short). The current share price is Rs 100 and the exercise price of
put and call options is the same, that is, Rs 100. Both put and call options
are European type options and they will expire after three months. Let us
further assume that there are two possible share prices after three months:
Rs 110 or Rs 90. What is the value of your portfolio?
Covered Call
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Combinations of Put,
Call and Share
Straddle:
Straddle Buyer
Straddle Seller
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Strips
Straps
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Exercise
A strangle is a Prices
portfolio of a put and a call with the
same expiration date but with different exercise
prices. The investor will combine an out-of-themoney call with an out-of-the-money put.
Example
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Spreads
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Types of Spreads
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Bullish spread
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An
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Bearish spread
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Collars
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A collar
Pay-off to a collar
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Factors Determining
Option Value
1.
2.
3.
4.
The value of the options will lie between Max and Min lines
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Volatility of an
Underlying Asset
The
Example
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The figure below shows graphically the effect of the volatility of the underlying
asset on the value of a call option. The underlying assets in the example are share
of two companiesBrightways and Jyotipath. Both shares have same exercise
price and same expected value at expiration. However, Jyotipaths share has more
risk since its prices have large variation. It also has higher chances of having
higher prices over a large area as compared to Brightways share. The greater is the
risk of the underlying asset, the greater is the value of an option.
Interest Rate
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The value of a call option will increase with the rising interest
rate since the present value of the exercise price will fall.
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Time to Option
The present value of the exercise price will be less if time to
Expiration
expiration is longer and consequently, the value of the option
will be higher.
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Limitation of DCF
Approach
The DCF approach does not work for options
because of the difficulty in determining the
required rate of return of an option. Options are
derivative securities. Their risk is derived from the
risk of the underlying security. The market value of
a share continuously changes. Consequently, the
required rate of return to a stock option is also
continuously changing. Therefore, it is not feasible
to value options using the DCF technique.
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The
Risk Neutrality
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Investors are risk-neutral. They would simply expect a riskfree rate of return.
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Assumptions
The rates of return on a share are log normally
distributed.
The value of the share (the underlying asset) and the
risk-free rate are constant during the life of the
option.
The market is efficient and there are no transaction
costs and taxes.
There is no dividend to be paid on the share during
the life of the option.
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rf t
N (d 2 )
where
C0 = the current value of call option
S0 = the current market value of the share
E
= the exercise price
e
= 2.7183, the exponential constant
rf
= the risk-free rate of interest
t
= the time to expiration (in years)
N(d1) = the cumulative normal probability density
function
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ln ( S / E ) rf 2 / 2 t
d 2 d1 t
where
ln = the natural logarithm;
= the standard deviation;
2 = variance of the continuously
compounded annual return on the share.
Features of BS Model
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BlackScholes
The
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A call option has a positive hedge ratio and a put option has a
negative hedge ratio.
Example
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Example
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Implied Volatility
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Implied
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Dividend-Paying
Option
Share
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Ordinary Share as an
Option
The
Example
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Example
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