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1. Learning Outcomes
After studying this module, you shall be able to

Know what are Options contracts

Learn what are call and Put Options
Know the various types of Option strategies
Know what are swaps and its features

2. Introduction

2.1 Options

A search for a contract which provides better hedging facility has resulted into the discovery of an
instrument which provides the right but not the obligation known as Option contracts. In Option
contract, buyer has the right but not the obligation, to buy or sell securities of the underlying
security at a specified price on or before a given date.

There are two types of options, Call Options and Put Options.

A call option provides to the holder a right to buy an asset at a specific price on or before an

A Put option on the other hand gives the holder the right to sell l (go short) an asset at a specific
price on or before the expiration date.

used in Options contracts.

Underlying Security: The stock or asset on which an option contract is based is called as the
underlying security. Options are called as derivative securities because their value is derived from
the value of the underlying security. For example, stock options have a unit of trade of 100 shares
i.e. one option contract represents the right to buy or sell 100 shares of the underlying stock.
Underlying security include shares, stocks, stock indices, foreign currencies, bonds, commodities,
futures contracts, etc.

Strike Price: The strike price, or exercise price is that price of underlying at which the shares of
stock can be bought or sold by the holder, or buyer, of the option contract if he exercises his right
against a writer, or seller, of the option.

Premium: is the price which buyer pays to the seller of the option for availing the right. It is
nonrefundable one time which is out of pocket expense of entering into the option contract.

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In the money- When on exercising an option, the option buyer makes profit, the option is said to
be in the money. Puts with a strike price above the underlying asset price and calls with a strike
price below the underlying asset

Out of the money- When the call buyer makes losses, he is said to be having an option which is
out of the money. Puts with a strike price above the underlying asset and calls with a strike price

At the money- when both the strike price and stock price are same or when the option holder breaks
even.

There are two categories of Options:

American Option
European Option

In the case of an American option: The holder of an option has the right to exercise his option on
or before the expiration date of the option; otherwise, the option will expired.

A European option: is an option which can only be exercised only on the date of the expiry of the
contract.

The person who acquires the right is known as the option buyer or option holder, while the other
person (who confers the right) is known as option seller or option writer.

Example: Suppose the current price of TATA motors share is 550 per share. X owns 1000 shares
of TATA MOTORS Ltd. and estimated in the decline in price of share. The option (put) contract
available at BSE is of 600, in next two-month delivery. Premium cost is 10 per share. X will buy a
put option at 10 per share premium at a strike price of 600. In this way X has hedged his risk of
price fall of stock. X will exercise the put option if the price of stock goes down below 600 and
will not exercise the option if price is more than 600, on the exercise date. In case of options, buyer
has a limited loss and unlimited profit potential. For example. If the stock goes up X shall not lose
because of the fact that he shall not exercise his right to sell.

Following are the features of the options contracts:

Option contract gives the holder the right to buy or sell.

The holder may exercise his option or may not.
The holder can execute the contract based on the situation i.e. he will exercise only if it
is profitable to him.
Buyer of the option contract is not under obligation to exercise the option i.e. if on
exercising he loses, he will not exercise the option.

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3. Pay off
Payoff Profile for Buyer of Call Options: Long Call

In call option, buyer has a right to buy the underlying asset at the strike price mentioned in the
option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If at point of time before the expiry or at the time of expiry, the spot price of the
underlying is less than the strike price, buyer can let his option lapse unexercised. His loss in this
case is only the premium he paid for buying option.

Payoff Profile for writer of Call Options: Short Call

loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option.
Hence as the spot price increases the writer of the option starts making losses. If upon expiration
the or at any time before the expiry spot price of the underlying is less than the strike price, the
buyer will not exercise his option and the writer gets the premium which he earns for carrying the
risk of loss.

4. Various Option Strategies

Option Strategies

1. Covered Call
2. Protective Put
3. Straddle
4. Strangle

4.1. Protective Put

This is one of important hedging instrument available resulting from buying the underlying asset
and buying put options. A Protective Put strategy has a very similar pay off profile to the Long
Call. The maximum loss is limited to the premium paid and can have unlimited profit potential.
Protective Puts are ideal for investors who are concerned about stock market fluctuations and are
risk averse, so in case of market going down, the value of the put options that the trader holds will
increase and the value of the stock will go down. If the combined position is hedged by the
protective put then the profits of the put options will offset the losses of the stock and the investor
will lose only the premium paid by him for the put option.

However, if the market rises substantially then the trader will not exercise put option and on the
other hand value of stock increases. Loss from put option will be limited to the premium paid and
profits from the increase in the stock will be unlimited. The profits gained from the increase in the
stock outweigh the loss from the put option premium being paid.
Maximum Loss In this case shall be limited to the premium paid for the put option.
Maximum Gain: Unlimited
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When to use: When the investor is long on stock and wants to protect against a market declines.

Fig 1: Protective Put

4.2. Covered Call

In a state when investor is holding the stock but is expecting a mild decline in the stock price he
can sell call. The strategy is called as covered call writing. This is the result of buying underlying
asset and selling call options. This strategy is used by many investors who hold stock. The idea
behind a Covered Call is to hold stock over a long period of time and every month or so sell out-
of-the-money call options. Even though the payoff shows an unlimited loss potential, we must
consider this type of strategy when investor have bought the stock long ago and hence the call
option's strike price may be a long way from the purchase price of the stock.
Example: We hold Tata steel last year at 925 and today it is trading at 940. We might decide selling
945 call option. Even if the market falls temporarily it will have to wait to start seeing losses on the
underlying. Meanwhile, the call option expires worthless and we earn the premium received from
the spread.
Maximum Loss: Unlimited on the downside.
Maximum Gain: Limited to the premium received from the sold call option.
When to use: When we own the underlying stock (or futures contract) and wish to lock in profits.

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4.2. Straddle

It is an investment strategy involving two transactions, purchasing both call and put or selling call
and put of the same security, same strike price and same expiration date. This involves the
simultaneous holding of the two following positions:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.

Straddle allows the holder to book profit based on the price movements. It is appropriate for those
investor who expects a large movement in the index and unaware of the direction.

Example: An investor who feels that the index which currently stands at 1,252 could move
significantly in three months. The investor could create a straddle by buying both a put and a call
with a strike close to 1,252 and an expiration date in three months. Suppose a three-month call at a
strike of 1,250 costs 95.00 and a three month put at the same strike cost 57.00. To enter into this
position, the investor faces a cost of 152.00. If at the end of three months, the index remains at
1,252, the strategy costs the investor 150. (An up-front payment of 152, the put expires worthless
and the call expires worth 2). If at expiration the index settles around 1,252, the investor incurs
losses. However, if as expected by the investors, the index jumps or falls significantly, he profits.
If the price goes up, he uses call option and does not exercise put options. Risk is limited to the
extent of paying premiums but profits are unlimited in long straddle.

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Long Straddle: This is formed by buy one call option and buys one put option at the same strike
price.

Short Straddle: If a trader expects the price fluctuations to remain in a narrow range the strategy
of shorting a call as well as an option can help the trader to earn the premium on call as well as put.
This is formed by shorting one call option and shorting one put option at the same strike price.

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4.3. Strangle

A strangle is an options strategy similar to a straddle, but with different strike prices on the call and
put options. Investor may go for long strangle if he thinks the underlying security is volatile with
an upward bias.

The trader in the example above might enter into a strangle, if he believes that XYZ's financial
results will probably be positive, but he is not certain and still wants to hedge some of the risk of a
negative results (and is willing to pay for this privilege).

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5. Swap

A Swap is an agreement wherein one asset is exchanged in future with another, or exchange of a
stream of payments for another. A swap is a private agreement between two parties where both
parties are forced to share some specified cash flows at regular intervals over a period of time but
want a different stream of flows. Swap contract usually involves several futures exchange cash
flows. The cash flows of a swap can be determined in advance, or customized for each settlement
with reference to a specific market interest rate, such as LIBOR (London interbank offer rate) or
MIBOR (Mumbai interbank offer rate). At the time of settlement, a difference is to be paid by the
party who is obligated to pay more at the settlement.

Terminology of SWAP Agreement

1. Two Parties are involved in a swap deal. For example, in an interest rate swap, the first
party could be a fixed rate payer/receiver and the second party could be a floating rate
receiver/payer.
2. Swap Banks/Facilitator- Swap facilitators are referred to as 'Swap Banks' There are two
kinds of swaps facilitators i.e., Swap Broker and Swap Dealer.
3. Swap Broker act as an intermediary who charges the commission and identifies the
potential counterparties in a swap deal.
4. Swap Dealer: Swap dealer also known as 'market maker'; associates himself with the swap
deal and often involved as a financial intermediary for earning a profit.

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5. Notional Principal: The amount on which swap deal takes place is the notional principal.
This amount is notional as it does not get changed. For example: In Interest rate swap, only
interest rate gets exchanged which is based on notional principal.
6. Trade Date: Commencement of Swap deal is the trade date.
7. Effective Date: It is also known as Value Date: This is the date when the initial cash flows
in a swap contract begin (e.g. initial fixed and floating payments, for interest rate swaps).
The maturity of a swap contract is calculated from this date.
8. Reset Date: Reset date is that date on which the interest rate/LIBOR/MIBOR rate is
determined. The first reset date will be two days before the first payment date and the
second reset date will be two days before the second payment date and so on.
9. Maturity Date: Date of Maturity on which the outstanding cash flows stop in the swap
contract is referred to as the maturity date.

Swap is the form of derivative contract by two parties in order to take advantage of fluctuations in
the market. It can be currency or interest rate swap.

The following are the important features of a swap:

1. Another Form of forward contract

2. Two parties: Swap is executed between two parties with equal and opposite needs.

3. Credit Advantage: Borrowers enjoying credit advantage in floating rate will enter into a swap
agreement to exchange with the borrowers enjoying comparative advantage in fixed interest rate.

4. Flexibility: In short-term, market and lenders have the flexibility to adjust the floating interest
rate (short-term rate) according to the conditions prevailing in the market as well as the current
financial position of the borrower. Hence, the short-term floating interest rate is cheaper to the
borrower with low credit rating when compared with fixed rate of interest

5. Intermediary: Swap requires the existence of two counter parties with opposite but matching
needs. By arranging swaps among two, these intermediaries earn income too.

6. Settlements: No exchange of principle is involved. On the other hand, a stream of fixed rate
interest is exchanged for a floating rate of interest, and thus, there are streams of cash flows are
involved.

7. Long-term agreement: Swaps are long term agreement not like forward contracts. The
exchange of a fixed rate for a floating rate requires a comparatively longer period.

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5. Summary

1. A search for a contract which provides better hedging facility has resulted into the
discovery of an instrument which provides the right but not the obligation known as
Option contracts
2. There are two types of Options contract- Call and Put. Both the options have right but not
the obligation to buy in case of call or sell in case of put.
3. Different strategies make option contracts more attractive as one can take advantage of
these strategies depending upon the market expectations.
4. Swap is an agreement wherein one asset is exchanged in future with another, or exchange
of a stream of payments for another.

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ECONOMICS MODULE No. 6: DERIVATIVES II: OPTIONS AND SWAPS