FINANCE COMPENDIUM

CAPITAL MARKETS

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TEAM NIVESHAK
Contents

What Are Capital Markets?....................................................................................................................1

Stocks
- Equity vs Debt…………………………………………………………………………………………..2
- Preferred Stock………………………………………………………………………………..…….....2
- Dividends………………………………………………………………………………………………..3
- Stock Splits……………………………………………………………………………...….…………..3
- Stock Buybacks………………………………………………………………………………………...3
- New Stock Issues………………………………………………………………………………………4
- Different Classes of Stock…………………………………………………………………………..…4
- The Bulls, the Bears, and the Farm…………………………………………………………………..4
- Trading Platforms……………………………………………………………………………………….5
- Stock Indices…………………………………………………………………………………………….5
- Types of Market Participants…………………………………………………………………………..6
- Long/Short Positions……………………………………………………………………………………6
- Speculation/Hedging/Arbitrage………………………………………………………………………...7
- Types of Analysis………………………………………………………………………………………..7

Bonds
- How Big is the Market and Who Buys……………………………………………………………….. 8
- Benefits of investing in corporate bonds………………………………………………………………8
- Types of issuers………………………………………………………………………………………… 9
- Basic Terms of Bonds………………………………………………………………………………….. 9

Derivatives
- Benefits of Derivatives………………………………………………………………………….……….10
- What are Futures and Options?………………………………………………………………………..10
- Important Terminology for Options……………………………………………………………………..11
- 'In the Money', 'At the Money' & Out of the money' Options…………………………………..…….11
- Intrinsic Value of an option……………………………………………….…………….……………….12
- Other Valuation Techniques…………………………………………………….………………………14
 CAPITAL MARKETS
What Are Capital Markets?

Capital markets are venues where savings and investments are channeled between the suppliers who
have capital and those who are in need of capital. The entities that have capital include retail and
institutional investors while those who seek capital are businesses, governments, and people. Capital
markets are composed of primary and secondary markets. The most common capital markets are the
stock market and the bond market. Capital markets seek to improve transactional efficiencies. These
markets bring those who hold capital and those who require it.

Types of Capital Markets

Capital markets primarily feature two types of securities – equity securities and debt securities. Both are
forms of investments that provide investors with different returns and risks and provide users with capital
with different obligations.

1. Equity Securities

Equity securities are traded on the stock market and are essentially ownership shares of a business or
venture. When you own equity securities of a company, you essentially own a portion of that company and
are entitled to any future earnings that the company brings in. However, the money that you invest in equity
securities is not required to be paid back by the business.

2. Debt Securities

Debt securities are traded on the bond market and are IOUs that can come in the form of bonds or notes.
They essentially represent the borrowing of money that will be paid back at a later date with interest.
Interest is the required compensation that entices lenders to lend their money. The borrowers will take the
money today, use it to finance their operations, and pay back the money in addition to a prescribed rate of
interest at a later date. The securities can be bought and sold on two types of markets:

The primary market is when a company directly issues the securities in exchange for capital.
The secondary market is when the security holders trade with other investors in a transaction that is
separate from the issuing company.

Capital markets feature trading of other securities as well, including Foreign exchange (forex),
Commodities, Derivatives and so on

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Stocks

What does the "Inc." after the names of many companies, mean? Not surprisingly, it means that a company
is incorporated. There are many forms of incorporation from which a company can choose. The
incorporation of a company can be regarded as its birth. And when a company is born, it has "equity." This
equity is also referred to as stock, and refers to ownership in a company. Most people unfamiliar with the
finance world equate stock with the running tickers in the "pits" of Wall Street trading floors, and other
symbols of publicly traded stock. But we should realize that companies do not have to be publicly traded
in order to have stock - they just have to be incorporated and owned.

Equity vs Debt

Equity, or ownership stake, is the volatile part of the firm's assets. The equity of a company is represented
by securities called stocks. Here, when we refer to stock, we are actually referring to common stock. Equity
has a book value - this is a strictly defined value that can be calculated from the company's Balance Sheet.
It also has a market value. The market value of equity or stock for a publicly traded firm can be found in
The Wall Street Journal or any of the stock quote services available today. Market value of a company's
equity can be understood with the simple formula:

stock price x number of shares outstanding [or common stock outstanding = market value of equity

Investors make lots of money - and lose lots, too - because of their decisions on which stocks to invest in,
and what happened to the value of those stocks after they were bought.

The other component of the asset value of a company comes from its debt, which is represented by
securities called bonds (these are issued when investors loan money to a company at a given interest
rate). Typically, banks and large financial institutions invest in debt. The returns for debt investors are
assured in the form of interest on the debt. Sometimes, the market value of the debt changes (see section
on bond pricing), but bond prices usually do not change as drastically as stock prices can. On the
downside, bonds also have lower expected returns than stocks. U.S. Treasury bonds, for example, can
provide returns of 5 to 7% a year or so, while a Tesla stock may rise 10% in a single day. On the other
hand, bonds usually have less downside risk than stock. Though they won't post big gains, U.S. Treasury
bonds won't lose 10% of their value in a single day, either. A simple example of how debt and equity make
up assets is to consider how most people buy homes. Homebuyers generally start with a down payment,
which is a payment on the equity of the house. Then, the homebuyer makes mortgage payments that are
a combination of debt (the interest on the mortgage) and equity (the principal payments). Initially, a
homebuyer generally pays primarily interest (debt), before gradually buying larger and large portions of
the principal (equity).

Preferred Stock

Common stock and debt are the two extremes in the continuum of the forms of investment in a company.
Enter preferred stock, which is a security in the middle of the continuum. One type of preferred stock is
referred to as "convertible" preferred. If the preferred stock is convertible, it can be converted into common
stock as prescribed in the initial issuance of the preferred stock. Like bondholders, holders of preferred
stock are assured an interest-like return - also referred to as the preferred stock's "dividend.” The other
key difference between preferred and common stock comes into play when a company goes bankrupt. In

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what is referred to as the "seniority" of creditors, the debt holders have first claim on the assets of the firm
if the company becomes insolvent. Preferred shareholders are next in line, while the common stock
shareholders bring up the rear. This isn't just a matter of having to wait in line longer if you are a common
stock shareholder. If the bondholders and owners of preferred stock have claims that exceed the value of
the assets of a bankrupt company, the common stock shareholders won't see a dime. There is a tax
advantage for corporations to invest in preferred stock rather than in bonds for other companies. Corporate
investors are taxed for only 30% of the dividends they receive on preferred stock. On the other hand, 100%
of the interest payments on bonds paid to corporate investors are taxed. This tax rule comes in handy
when structuring mergers.

Seniority of Creditors
1. Bondholders
2. Preferred stockholders
3. Common stockholders

Dividends

Dividends are paid to many shareholders of common stock (and preferred stock). However, the directors
cannot pay any dividends to the common stock shareholders until they have paid all outstanding dividends
to the preferred stockholders. The incentive for company directors to issue dividends is that companies in
industries that are particularly "dividend sensitive" have better market valuations if they regularly issue
dividends. Issuing regular dividends is a signal to the market that the company is doing well. Unlike with
bonds, however, the company directors decide when to pay the dividend on preferred stock. In contrast, if
a company fails to meet a few bond payments as scheduled, the bondholders can force the company into
bankruptcy.

Stock Splits

As a company grows in value, it usually splits its stock so that the price does not become absurdly high.
This enables the company to maintain the liquidity of the stock. If the Coca-Cola Company had never split
its stock, the price of one share bought when the company's stock was first offered would be worth millions
of dollars. If that were the case, buying and selling one share would be a very crucial decision. This would
adversely affect a stock's liquidity (that is, its ability to be freely traded on the market).

Stock buybacks

Often you will hear that a company has announced that it will buy back its own stock. Such an
announcement is usually followed by an increase in the stock price. Why does a company buy back its
stock? And why does its price increase after that? The reason behind the price increase is fairly complex,
and involves three major reasons. The first has to do with the influence of earnings per share on market
valuation. Many investors believe that if a company buys back shares, and the number of outstanding
shares decreases, the company's earnings per share goes up. If the P/E (price to earnings-per-share ratio)
stays stable, investors reason, the price should go up. Thus, investors drive the stock price up in
anticipation of increased earnings per share.

The second reason has to do with the "signaling effect." This reason is simple to understand, and largely
explains why a company buys back stock. No one understands the health of the company better than its

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senior managers. No one is in a better position to judge what will happen to the future performance of the
company. So, if a company decides to buy back stock (i.e., decides to invest in its own stock), these
managers must believe that the stock price is undervalued and will rise (or so most observers would
believe). This is the signal company management sends to the market, and the market pushes the stock
up in anticipation. The other reason the stock price goes up after a buyback can be understood in terms
of the "debt tax shield" (a concept used in valuation methods). When a company buys back stock, its net
debt goes up (net debt = debt - cash).

New Stock Issues

The reverse of a stock buyback is when a company issues new stock, which usually is followed by a drop
in the company's stock price. As with stock buybacks, there are three main reasons for this movement.
First, investors believe that issuing new shares "dilutes" earnings. That is, issuing new stock increases the
number of outstanding shares, which decreases earnings per share, which - given a stable P/E ratio -
decreases the share price. (Of course, the issuing of new stock will presumably be used in a way that will
increase earnings, and thus the earnings per share figure won't necessarily decrease, but because
investors believe in earnings dilution, they often drive stock prices down.) There is also the signaling effect.
In other words, investors may ask why the company's senior managers decided to issue equity rather than
debt to meet their financing requirements. Surely, investors may believe management must believe that
the valuation of their stock is high (possibly inflated) and that by issuing stock they can take advantage of
this high price. Finally, if the company believes that the project for which they need money will definitely
be successful, it would have issued debt, thus keeping all of the upside of the investment within the firm
rather than distributing it away in the form of additional equity. The stock price also drops because of debt
tax shield reasons. Because cash is flushed into the firm through the sale of equity, the net debt decreases.
As net debt decreases, so does the associated debt tax shield.

Different Classes of Stock

Common and preferred are the two main forms of stock; however, it's also possible for companies to
customize different classes of stock in any way they want. The most common reason for this is the
company wanting the voting power to remain with a certain group; hence, different classes of shares are
given different voting rights. For example, one class of shares would be held by a select group who are
given ten votes per share while a second class would be issued to the majority of investors who are given
one vote per share. When there is more than one class of stock, the classes are traditionally designated
as Class A and Class B. Berkshire Hathaway (ticker: BRK), the company of Warren Buffett (one of the
greatest investors of all time), has two classes of stock. The different forms are represented by placing the
letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".

The Bulls, the Bears, and the Farm

On Wall Street, the bulls and bears are in a constant struggle. If you haven't heard of these terms already,
you undoubtedly will as you begin to invest.

• A bull market is when everything in the economy is great, people are finding jobs, GDP is growing,
and stocks are rising. Things are just plain rosy! Picking stocks during a bull market is easier
because everything is going up. Bull markets cannot last forever though, and sometimes they can

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lead to dangerous situations if stocks become overvalued. If a person is optimistic, believing that
stocks will go up, he or she is called a "bull" and said to have a "bullish outlook."

• A bear market is when the economy is bad, recession is looming, and stock prices are falling. Bear
markets make it tough for investors to pick profitable stocks. One solution to this is to make money
when stocks are falling using a technique called short selling. Another strategy is to wait on the
sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of
a bull market. If a person is pessimistic, believing that stocks are going to drop, he or she is called
a "bear" and said to have a "bearish outlook."

• Chickens are afraid to lose anything. Their fear overrides their need to make profits and so they
turn only to money-market securities or get out of the markets all together. While it's true that you
should never invest into something over which you lose sleep, you are also guaranteed never to
see any return if you avoid the market completely and never take any risk.

• Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy on hot
tips and invest in companies without doing their due diligence. They get impatient, greedy, and
emotional about their investments, and they are drawn to high-risk securities without putting in the
proper time or money to learn about these investment vehicles. Professional traders love the pigs,
as it's often from their losses that the bulls and bears reap their profits.

Trading Platforms

An exchange is a place where financial instruments are bought/ sold in an efficient and organized manner.
The place may be physical or electronic (with the spread of technology, the majority of exchange takes
place through the electronic medium). The financial instruments may include stocks, options, futures,
commodities, securities, foreign currencies and so on. The transactions in an exchange are usually done
with the benefit of a clearing-house (which offers some protection against defaults) as opposed to over-
the-counter (OTC) trading which has a greater risk because of the associated uncertainty regarding
defaults. A company which wants to trade securities through an exchange has to fulfill certain listing
requirements (the rigidity of which varies across exchanges) like timely disclosures including audited
financial reports.

Stock Indices

A Stock Market Index regularly measures the price performance of a basket of stock from the entire listed
stocks on the exchange. Further, it shows the performance of the overall market or a certain segment of
the market depending upon the selection of the basket. Often, indices serve as benchmarks against which
to evaluate the performance of a portfolio's returns. The Sensex and Nifty-50 are two popular benchmark
indices that largely reflect the performance of Bombay Stock Exchange (BSE) and National Stock
Exchange (NSE). To understand how each sector of the stock market is doing, there are sectoral indices
such as Nifty Bank. Nifty Auto etc.

The two most common kinds of indices are – Price-weighted and Free Float Market Capitalization-
weighted Index.

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Price Weighting based indices weight constituent stocks by their share price. However, a stock split for
any constituent stock of the index would cause the weight in the index of the stock that split to decrease,
even in the absence of any meaningful change in the fundamentals of that stock. This feature makes price-
weighted indices unattractive as benchmarks for passive investment strategies and portfolio managers.
Nonetheless, many price-weighted indices, such as the Dow Jones Industrial Average and the Nikkei 225,
are followed widely as visible indicators of day-to-day market movements.

Free-float Market-Capitalization Weighting calculates the market capitalization of the company after
taking into consideration only those shares of a company that are actively traded in the open market and
are not held by the promoters or is locked-in shares in nature. Free float are those shares that are issued
by the company which are readily available and are actively traded in the market. Some of the widely used
indices include S&P 500, NASDAQ Composite, FTSE 100, NIFTY 50, Sensex, and Hang Seng Index.

Types of Market Participants

The two-basic classification of Financial Market participants are: Investor vs. Speculator and Institutional
vs. Retail.

Investors - Investors seek to profit through ownership of an instrument by placing greater significance on
the underlying fundamental factors such as value, growth and size of a firm. An investor is typically distinct
from a trader. An investor typically puts capital to use for long-term gain, while a trader seeks to generate
short-term profits.

Speculators - Speculation refers to the activity where one takes a position to profit from fluctuations in the
market value of a tradable financial instrument—rather than attempting to profit from the underlying
financial attributes embodied in the instrument such as value addition, return on investment, growth or
dividends. Many speculators pay little attention to the fundamental value of a security and instead focus
purely on price movements.

Institutional - An institutional investor is an entity which pools money to purchase securities, real property,
or other investment assets. In other words, an institutional investor is an organization that invests on behalf
of its members and it manages assets based on the interests and goals of its clients. Institutional investors
include banks, insurance companies, pension funds, hedge funds, private equity funds, REITs,
endowment funds, sovereign wealth funds, and mutual funds. Each class of Institutional investors differ in
their investment horizon time and risk profile.

Retail - A retail investor is an individual who purchases securities for their own personal account rather
than for an organization. Retail investors typically trade in much smaller amounts and exert less influence
over corporate decisions than the institutional shareholders. Retail investing generally occurs through
three channels: individual investors, retail brokers (who act at the direction of these individuals), managed
accounts (whereby the account manager makes the financial decisions for the individual).

Long/Short Positions

Every trade has a long and a short position. Simply put, a long position in a product means that the position
holder will benefit if the price of the product or the underlying product (in case of derivatives) increases
and vice versa. The opposite is the case for the short position holder Example Buying any product is

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equivalent to taking a long position. Some examples of long positions include buying stocks, bonds, gold,
etc. Similarly, selling any product is equivalent to taking a short position. Apart from the above mentioned,
other examples include issuing debt, entering into a contract (forward contract) of selling gold at some
fixed price, etc.

Speculation/Hedging/Arbitrage

• Speculation refers to the activity where one takes a position in the market with an expectation of
the direction and/or magnitude in the movement of the underlying instrument’s price.

• Hedging is the practice of limiting/minimizing one’s risks. It can serve as an effective tool to
stabilize the returns one earns on their investments and limits the losses occurring in an
unexpected turn of events. It usually involves some cost or giving up some return in exchange for
more safety.

• Arbitrage is a trade where an investor makes risk free profits by entering into multiple transactions.
It takes place due to some mis-pricing existing in the market. There can be multiple ways of buying
an asset (directly or indirect). Arbitrage occurs when there is a pricing mismatch between different
routes taken. Investors thus can go long using one route and short using the other as described in
the example below.
Example: Consider an investor with £10 million and the following rates:
£1 = $1.5
$1 = ¥80
£1 = ¥100
Long Side: He can buy $15 million from these. With these dollars he can buy ¥1200 million.
Short Side: He can sell ¥1200 million to get £12 million.
This set of transactions creates an overall risk-free profit of £2 million purely due to pricing
anomalies existing in the market.

Types of Analysis

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value
of a stock. Fundamental analysts’ study everything from the overall economy, industry conditions,
competitive position, company’s quality of management, corporate governance standards, and the
financial condition of the company. Earnings, expenses, assets, and liabilities are all important
characteristics to fundamental analysts.

Technical analysis is a method of evaluating securities by analyzing the statistics generated by market
activity, such as past prices and volume. Technical analysts do not attempt to measure an instrument’s
intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
The field of technical analysis is based on three assumptions – the market discounts everything (at any
given time, an instrument’s price fully reflects everything that has or could affect the instrument), price
moves in trends, history tends to repeat itself.

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Bonds

Corporate bonds (also called corporates) are debt obligations, or IOUs, issued by private and public
corporations. They are typically issued in multiples of $1,000 and/or $5,000. Companies use the funds
they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to
expanding the business.

When you buy a bond, you are lending money to the corporation that issued it, which promises to return
your money, or principal, on a specified maturity date. Until that time, it also pays you a stated rate of
interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike
stocks, bonds do not give you an ownership interest in the issuing corporation.

How Big Is the Market and Who Buys

The corporate bond market is large and liquid, with daily trading volume estimated at $15 billion. Issuance
for 2000 was an estimated $626.2 billion. The total market value of outstanding corporate bonds in the
United States at the end of 2000 was approximately $3.4 trillion.

Most corporate bonds trade in the over-the-counter (OTC) market, which does not exist in a central
location. It is made up of bond dealers and brokers from around the country who trade debt securities over
the phone or electronically. Market participants are increasingly utilizing electronic transaction systems to
assist in the trade execution process. Some bonds trade in the centralized environment of the New York
Stock Exchange (NYSE) and American Stock Exchange (AMEX), but the bond trading volume on the
exchanges is small. The OTC market is much larger than the exchange markets, and the vast majority of
bond transactions, even those involving exchange-listed issues, take place in this market. Investors in
corporate bonds include large financial institutions, such as pension funds, endowments, mutual funds,
insurance companies and banks. Individuals, from the very wealthy to people of modest means, also invest
in corporates because of the many attractions these securities offer.

Benefits of Investing in Corporate Bonds

Investors buy corporates for a variety of reasons:

• Attractive yields. Corporates usually offer higher yields than comparable-maturity government
bonds or CDs. This high-yield potential is generally accomplished by higher risks

• Dependable income. People who want steady income from their investments, while preserving
their principal, include corporates in their portfolios.

• Safety. Corporate bonds are evaluated and assigned a rating based on credit history and ability to
repay obligations. The higher the rating, the safer the investment.

• Diversity. Corporate bonds provide the opportunity to choose from a variety of sectors, structures
and credit-quality characteristics to meet your investment objectives.

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• Marketability. If you must sell a bond before maturity, in most instances you can do so easily and
quickly because of the size and liquidity of the market.

Types of Issuers

There are five main classifications of issuers representing various sectors that issue corporate bonds:

(1) public utilities;

(2) transportation companies;
(3) industrial corporations;
(4) financial services companies;
(5) conglomerates.

Basic Terms of Bonds

Maturity

One of the key investment features of any bond is its maturity. A bond’s maturity tells you when you should
expect to get your principal back and how long you can expect to receive interest payments. (However,
some corporates have “call,” or redemption, features that can affect the date when your principal is
returned.

Corporate bonds, in general, are divided into three groups:

Short-term notes: Maturities of up to 5 years

Medium-term notes/bonds: Maturities of 5–12 years
Long-term bonds: Maturities greater than 12 years

Structure

Another important fact to know about a bond before you buy is its structure. With traditional debt securities,
the investor lends the issuer a specified amount of money for a specified time. In exchange, the investor
receives fixed payments of interest on a regular schedule for the life of the bonds, with the full principal
returned at maturity. In recent years, how- ever, the standard, fixed interest rate has been joined by other
varieties. The three types of rates you are most likely to be offered are these:

• Fixed-rate- Most bonds are still the traditional fixed-rate securities described above.
• Floating-rate- These are bonds that have variable interest rates that are adjusted periodically
according to an index tied to short-term Treasury bills or money markets. While such bonds offer
protection against increases in interest rates, their yields are typically lower than those of fixed-rate
securities with the same maturity.
• Zero-coupon- These are bonds that have no periodic interest payments. Instead, they are sold at
a deep discount to face value and redeemed for the full-face value at maturity. (One point to keep
in mind: Even though you receive no cash interest payments, you must pay income tax on the
interest accrued each year on most zero-coupon bonds. For this reason, zeros may be most
suitable for IRAs and other tax- sheltered retirement accounts.

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Derivatives

In recent years, derivatives have become increasingly important in the field of finance. Futures and options,
the most popular derivatives are now actively traded on many exchanges. Forward contracts, swaps, and
many other derivative instruments are regularly traded both in the exchanges and in the over-the-counter
markets. Derivatives have probably been around for as long as people have been trading with one another.
Forward contracting dates back at least to the 12th century, and may well have been around before then.

Benefits of Derivatives

Derivatives reduce market risk and increase the willingness to trade in stock market. Trading in derivatives
involves lower cost of trading and it also leads to increased volume in the stock market.

What are Futures and Options?

Futures and Options are forms of exchange-regulated forward trading in which you enter into a transaction
today, the settlement of which is scheduled to take place at a future date. The settlement date is called
the expiry date of the contract.

A Futures contract is an agreement between the buyer and a seller for the purchase and sale of a
particular asset at a specific future date. The price at which the asset would change hands in the future is
agreed upon at the time of entering into the contract. The actual purchase or sale of the underlying
involving payment of cash and delivery of the instrument does not take place until the contracted date of
delivery. A futures contract involves an obligation on both the parties to fulfill the terms of the contract.

An Option is a contract that goes a step further and provides the buyer of the option (also called the
holder) the right, without the obligation, to buy (call) or sell (put) a specified asset at an agreed price on or
up to a particular date. For acquiring this right, the buyer has to pay a premium to the seller. The seller on
the other hand, has the obligation to buy or sell that specified asset at that agreed price. The premium is
determined taking into account a number of factors such as the underlying's current market price, the
number of days to expiration, the strike price of the option, the volatility of the underlying asset, and the
risk- less rate of return. Specifications of the options contract like the strike price, the expiration date and
regular lot, are specified by the exchange.

An option contract may be of two kinds, viz., a Call option or a Put option. An option that provides the
buyer the right to buy is a Call option. The buyer of the call option can call upon the seller of the option
and buy from him, the underlying at any point on or before the expiry date by exercising his option at the
agreed price.

The seller of the option has to fulfill the obligation on exercise of the option.
The right to sell is called a Put option. Here, the buyer of the option can exercise his right to sell the
underlying to the seller of the option at the agreed price.

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Important Terminology for Options

• Underlying: The specific security / asset on which an options contract is based.

• Option Premium: Premium is the price paid by the buyer to the seller to acquire the right to buy
or sell
• Strike Price or Exercise Price: The strike or exercise price of an option is the specified/ pre-
determined price of the underlying asset at which the same can be bought or sold if the option
buyer exercises his right to buy/ sell on or before the expiration day.
• Expiration date: The date on which the option expires is known as Expiration Date. On Expiration
date, either the option is exercised or it expires worthless.
• Exercise Date: is the date on which the option is actually exercised. In case of European Options,
the exercise date is same as the expiration date while in case of American Options, the options
contract may be exercised any day between the purchase of the contract & its expiration date (see
European/ American Option)
• Open Interest: The total number of options contracts outstanding in the market at any given point
of time.
• Option Holder: is the one who buys an option which can be a call or a put option. He enjoys the
right to buy or sell the underlying asset at a specified price on or before specified time. His upside
potential is unlimited while losses are limited to the Premium paid by him to the option writer.
• Option seller/ writer: is the one who is obligated to buy (in case of Put option) or to sell (in case
of call option), the underlying asset in case the buyer of the option decides to exercise his option.
His profits are limited to the premium received from the buyer while his downside is unlimited.
• Option Class: All listed options of a particular type (i.e., call or put) on a particular underlying
instrument, e.g., all Sensex Call Options (or) all Sensex Put Options
• Option Series: An option series consists of all the options of a given class with the same expiration
date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call
options that are traded with Strike Price of 3600 & Expiry in May.

'In the Money', 'At the Money' & Out of the money' Options

An option is said to be ‘at-the-money’, when the option's strike price is equal to the underlying asset price.
This is true for both puts and calls. A call option is said to be in-the-money when the strike price of the
option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is ‘in-
the- money’, when the spot Sensex is at 4100 as the call option has value. The call holder has the right to
buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at
4100, a profit can be made by selling Sensex at this higher price.

On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying
asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no
longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when
the current price is at 3700.

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A put option is in-the-money when the strike price of the option is greater than the spot price of the
underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100.
When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an
amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the
strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put
option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.
Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant
variance with the underlying asset price.

Intrinsic Value of an option

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the
immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be a positive number or 0. It can't be negative. For a call option, the
strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater
than 0. For a put option, the strike price must be greater than the underlying asset price for it to have
intrinsic value.

There are two types of factors that affect the value of the option premium:

Quantifiable Factors:
· underlying stock price,
· the strike price of the option,
· the volatility of the underlying stock,
· the time to expiration and
· the risk-free interest rates.

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Non- Quantifiable Factors
· Market participants’ varying estimates of the underlying asset's future volatility
· Individuals’ varying estimates of future performance of the underlying asset, based on
fundamental or technical analysis
· The effect of supply & demand- both in the options marketplace and in the market for the
underlying asset
· The "depth" of the market for that option - the number of transactions and the contract's trading
volume on any given day.

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