Q1. What is an option? What is the difference between a call option and a put option? Illustrate your answer with the help of position diagrams. A1 In a broad sense, an option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions. Thus, an option is a contingent claim. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. A call option on a share (or any asset) is a right to buy the share at an agreed exercise (strike) price. The following diagram (see Problem 1) depicts the call option pay-off.
4 Call Value
3 2 1 0 0 47 50 51 54 Share Price
A put option is a contract that gives the holder a right to sell a specified share (or any other asset) at an agreed exercise price on or before a given maturity period. The following diagram (see Problem 5) depicts the put option pay-off.
0 97 100 101 104
Q2. Show by the payoff graphs of an investor at expiration with the following portfolios: (i) One share and a put (long) (ii) One share and a put (short) (iii) One share and a call (short) (iv) One share and two call (short) (v) Two shares and a call (short) (vi) A call (long) and a put (short) A2 Here are two examples of pay-off graphs (for the remaining See Chapter 7 in the book for payoff graphs).
One share and a put (short)
Value of Put to Seller
10
Value of Put 5 0 -5 60 65 70 75
-10 Share Price
A call (long) and a put (short)
Value of Portfolio of Put & Call
15 Pay-off
10
0 90 97 100 110 Share Price
Q3. Explain the difference between selling a call option and buying a put option. Illustrate your answer. A3 The selling of a call option (short position) means that the buyer of the call option will have the option to exercise it. The buyer will exercise the option only when the market price the underlying asset is higher than the exercise price. Thus, the seller of a call option will be loser. The following example illustrates this point
6-month call option (short): Pay-off
Exercise price, E 100 Current share price, S0 100 Share price, St 110 -10 90 0 The selling of a put option (short position) means that the buyer of the put option will have the option to exercise it. The buyer will exercise the option only when the market price the underlying asset is less than the exercise price. Thus, the seller of a call option will be loser. The following example illustrates this point
6-month put option (short): Pay-off
Exercise price, E 100 Current share price, S0 100 Share price at maturity, St 110 -10 90 0
Q4. Explain when a call option and a put option are in-the-money, at-the-money and out-of-the-money. A4 In-the-money A put or a call option is said to be in-the-money when it is advantageous for the investor to exercise it. In the case of in-the-money call options, the exercise price is less than the current value of the underlying asset, while in the case of the in-the-money put options; the exercise price is higher than the current value of the underlying asset 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. In the case of the out-of-the -money call options, the exercise price is higher than the current value of the underlying asset, while in the case of the out-of-the -money put options, the exercise price is lower than the current value of the underlying asset. 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. In the case of the out-of-the-money options the exercise price is equal to the current value of the underlying asset
Q5. What are the factors that influence the prices of options on share? Explain how increase in the risk-free rate and decrease in volatility can make an American put attractive if it is exercised early? A5 The value of an option depends on the following factors: • Exercise price and the share (underlying asset) price • Volatility of returns on share: The greater is the risk of the share (underlying asset), the greater is the value of an option. As the option value cannot be less than zero, the probability of a higher price of the share causes the option to be worth more. • Time to expiration • Interest rate: The exercise price is paid at the time the option is exercised. The present value of the exercise price will depend on the interest rate. The value of a call option will increase with the rising interest rate since the present value of the exercise price will fall. The effect is reversed in the case of a put option.
Q6. What will be lower and upper bounds for the price of a call option? Explain the reasons. A6 It is difficult to say what the price of a share at expiration will be. However, we can draw up a probabilistic distribution of the future share prices. The call option buyer will be utmost prepared to pay for holding the option a price equal to the value of the share. Instead of paying more for the option, he will prefer to buy the share at present. Thus, the maximum value that an option can approach is the price of the share (the underlying asset). This is possible only when the present value of the exercise price is zero. The exercise price can approach to zero under two conditions: (1) the time to expiration is very long (almost infinity) and (2) the option will not be exercised in the near future. The minimum value of an option will be zero until share price rises above the exercise price. At maturity, the value of the option either will be zero or the excess of the share price over the exercise price. Most often, the value of the options will lie between upper and lower bounds.
Q7. Why isn’t it beneficial to exercise an American call option early? Give reasons. A7 There is always a possibility that the value of the underlying asset may increase in the future. Hence, an American option will be exercised on maturity.
Q8. What is a protective put? What position in call option is similar to a protective put? A8 Put option at-the-money is called a protective put. The value of the portfolio of a share and a put at expiration will always be greater than the value of a call at expiration by the exercise price. The investor can also protect herself by taking a covered position. A covered call position is an investment in a share plus the sale of a call on that share. The position is covered because the investor holds a share against a possible obligation to deliver the share. The total value or payoff of a covered call at expiration is the share price minus the value (payoff) of the call.
Q9 How can a spread be created? What is a straddle? What is a strangle? Draw
payoff graphs to explain the implications of a spread, a straddle and a strangle. A9 A spread is a combination of a put and a call with different exercise prices. A straddle is a combined position created by the simultaneous purchase (or sale) of a put and a call with the same expiration date and the same exercise price. A strangle is a portfolio of a put and a call with the same expiration date but with different exercise prices. (Refer to the chapter in the book for graphs.)
Q10 How and why a collar is created? What are its implications for an investor? A10 A collar involves a strategy of limiting a portfolio’s value between two bounds. Suppose you are holding a large number of Infosys shares currently selling at Rs 4,000 per share. You can design a strategy that would let your payoff to range within a band, irrespective of the price fluctuations in Infosys share. If you do not want your payoff to go below Rs 3,900, you can buy a protective put with an exercise price of Rs 3,900. Your outlay will be the premium that will be required to pay for buying the put. You can sell a call option with an exercise price of, say, Rs 4,100 at a premium equal to the put premium. Thus, your net outlay would be zero. The short call limits your portfolio’s upside potential. Even if the price of Infosys share increases beyond Rs 4,100, your payoff would not exceed Rs 4,100 because the buyer of the call will exercise his option at the share price higher than the exercise price. 4200 Payoff 4100 4000 3900 3800 Share 3700 Price 3800 3900 4000 4100 4200 4300
Q11 Explain and illustrate a one-step binomial approach to value a European option. A 11 Suppose you own a share that has a current price of Rs 150. Its price at the end of one year has two possibilities: either Rs 100 or Rs 300. Assume that you buy a call option on the share with an exercise price of Rs 200. At the end of the year, you will exercise your option if the share price is Rs 300 and the value of the option will be: Rs 300 – Rs 200 = Rs 100. You will forgo your call option if the share price is Rs 100, and the value of option will be zero. Instead of buying a call option, you sell a call option on the share. You can create a portfolio of certain number of shares (let us call it delta, ∆) and one call option in such a way that there is no uncertainty of the value of portfolio at the end of one year. You can do so if you combine a long position (buying) in the share and a short position (selling) in the call option. Let us assume that you create a portfolio of shares and an option by buying ∆ (delta) shares and selling a call option. Suppose if the price goes up to Rs 300, the buyer of the option will exercise his option and you will lose Rs 100. If the price turns out to be Rs 100 the option buyer will not exercise his option and you do not gain or lose. Your portfolio will be risk-less if the value of the portfolio is same whether the price of the share increases to Rs 300 or falls to Rs 100. That is:
Difference in option values
Option delta (∆) = Difference in share prices 100 − 0 100 = = = 0.5 300 − 100 200 The option delta is the measure of the sensitivity of the option value vis-à-vis the change in the share price. You will have a risk-less portfolio if you combine a long position in 0.5 shares with a short position in one call option. If the price increases to Rs 300, the value of the portfolio is: 0.5 × Rs 300 – Rs 100 = Rs 50 And if the share price falls to Rs 50, then the value of portfolio is: 0.5 × Rs 100 = Rs 50 The value of portfolio at the end of one year remains Rs 50 irrespective of the increase or decrease in the share price. What is the present value of the portfolio? Since it is a risk- less portfolio, we can use the risk-free rate as the discount rate. Suppose the risk-free rate is 10 per cent, the present value of the portfolio is: Rs 50 PV of portfolio = = Rs 45.45 (1.10) 1 Since the current price of share is Rs 150, the value of the call option can be found out as follows: Rs 150∆ − value of a call option = Rs 45.45 Rs 150 × 0.50 − Value of a call option = Rs 45.45 Value of a call option = Rs 75 − Rs 45.45 = Rs 29.55
Q12 What is a risk-neutral valuation approach to valuing a European option? Give an
example. A12 We can assume that investors are risk-neutral. Therefore, for their investment in share, they would simply expect a risk-free rate of return. In our example, the share price could rise by 100 per cent (from Rs 150 to Rs 300) or it could fall by 33.3 per cent (from Rs 150 to Rs 100). Under these situations, a risk-neutral investor’s return from the investment in the share is given as follows: Expected return = (probability of price increase) × percentage increase in price +(1 − probability of price increase) × percentage decrease in price = risk - free rate = p × 100 + (1 − p) × (−33.33) = 10 p = 0.325
We can utilise this information to determine the value of the call option at the end of the year. The call option is worth Rs 100 when the share price increases to Rs 300, and its worth is zero if the share price declines. We can thus calculate the value of the call option at the end of one year as given below: = 0.325 100 + (1 – 0.325) 0 = Rs 32.50 The current (present) value of the call option is = 32.5/1.1 = Rs 29.55
Q13 What are the assumptions of the Black-Scholes model for option pricing? What are the attributes of the model? A13 The B–S model is based on the following assumptions: 1. The rates of return on a share are log normally distributed. 2. The value of the share (the underlying asset) and the risk-free rate are constant during the life of the option. 3. The market is efficient and there are no transaction costs and taxes. 4. There is no dividend to be paid on the share during the life of the option. The B–S model is as follows: C 0 = S 0 N(d 1 ) − Ee − 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 d1 = [ ] ln(S / E) + rf + σ 2 / 2 t σ t d 2 = d1 − σ t where ln = the natural logarithm; = the standard deviation and 2 = variance of the continuously compounded annual return on the share. The Black–Scholes model has two features. First, the parameters of the model, except the share price volatility, are contained in the agreement between the option buyer and seller. Second, in spite of its unrealistic assumptions, the model is able to predict the true price of option reasonably well. The model is applicable to both European and American options with a few adjustments.
Q14 Illustrate the concept of put–call parity.
A14 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. The value of portfolio at expiration is given in the following table.
Rs110, 90, Exercise Price (E) Rs100 Exercise Price (E) Rs100 St > E Payoff St < E Payoff Value of share (long) St 110 St 90 at expiration Plus: Value of put + 0 +0 + (E – St) + (100 – 90) (long) at expiration = [Max (E - St,, 0)] + 10 Less: Value of Call – (St – E) – (110 – 100) 0 0 (short) at expiration = [Max (St – E), 0] – 10 Total value (payoff) St – (St – E) = 100 St + (E – St) 90 + 10 = 100 E =E
You may notice that whether share price rises or falls, the value of the portfolio at expiration is equal to the exercise price (E). It is a risk-free portfolio since the outcome will be the same whatever happens to the share price. The present value of the portfolio can be calculated using a risk-free rate of return (rf). Let us assume that the risk-free rate is 10 percent. Thus the present value of portfolio is: PV of portfolio = S 0 + P0 − C 0 = Ee − rf t = 100e − 0.1×0.25 = 100 × 0.9573 = Rs 97.53 We can rewrite above Equation as follows: S + P = C + Ee − rf t This relationship is called put-call parity. We can also obtain the following expressions from above Equation C 0 = P0 + S 0 − Ee − rf t P = C − S + Ee − rf t
Q15 What is a hedge ratio or a call option delta? How is it determined?
A15 The hedge ratio is commonly called the option’s delta. Difference in option values Option delta (∆ ) = Difference in share prices The hedge ratio is a tool that enables us to summarise the overall exposure of portfolios of options with various exercise prices and maturity periods. An option’s hedge ratio is the change in the option price for an Rs 1 increase in the share price. A call option has a positive hedge ratio and a put option has a negative hedge ratio. Under the Black-Scholes option valuation formula, the hedge ratio of a call option is N (d1) and the hedge ratio for a put is N (d1) – 1. N (d) stands for the area under the standard normal curve up to d. Therefore, the call option hedge ratio must be positive and the put option hedge ratio is negative and of smaller absolute value than 1.0.
Q16 Why is ordinary share an option? Explain.
A16 One distinguishing feature of ordinary share is that it has limited liability. The limited liability feature provides an opportunity to the shareholders to default on a debt. If a firm has incurred a debt, each time a payment is due, the shareholders can decide to make payment or to default. If the firm’s value is more than the payment that is due, the shareholders will make payment since they shall be left with a positive value of their equity and keep the firm. If the payment that is due is more than the value of the firm, the shareholders will default and let the debt- holders keep the firm. Since the shareholders have a hidden right to default on debt without any liability, the debt contract gives them a call option on the firm. The debt-holders are the sellers of call option to the shareholders. The amount of debt to be repaid is the exercise price and the maturity of debt is the time to expiration. There is an alternate way of looking at ordinary share as an option. The shareholders’ option can be interpreted as a put option. The shareholders can sell (hand-over) the firm to the debt-holders at zero exercise price if they do not want to make the payment that is due.
