Financial Derivatives

Unit-III-Options

Introduction
The options are important financial derivatives where the instruments have additional
features of exercising an option which is a right and not an obligation. Hence, options
provide better scope for risk coverage and making profit at any time within the expiration
date. The price of the underlying is derived from the underlying asset. Options are of
different types. Some are related to stock index, some with currency and interest rates.
During the last three decades the option trading gained momentum though the first option
in commodity was launched in 1860in USA. Based on the sale and purchase there are two
types of options: put and call. The exercise-time of adoption makes it in American or
European. The other category of options includes- over the counter (OTC) or exchange
traded. Options can be valued either with the help of intrinsic value or with time value.
There are two positions in option trading- long and short position.

An option may be defined as a contract between two parties where one gives the other the
right (not the obligation) to buy or sell an underlying asset as a specified price within or on
a specific time. The underlying may be commodity, index, currency, or any other asset. As
an example, the party has 1000 shares of Satyam Computer whose current price is Rs.
4000per share and other party agrees to buy these 1000 shares on or before a fixed date
(i.e. suppose after4month) at a particular price say it is become Rs.4100 per share. In future
within that specific time period he will definitely purchase the shares because by exercising
the option, he gets Rs. 100 profit from purchase of a single share.

In the reverse case suppose that the price goes below Rs. 4000 and declines to Rs. 3900 per
share, he will not exercise at all the option to purchase a share already available at a lower
rate. Thus option gives the holder the right to exercise or not to exercise a particular deal.
In present time options are of different varieties like- foreign exchange, bank term deposits,
treasury securities, stock indices, commodity, metal etc. Similarly the example can be
explained in case of selling right of an underlying asset.

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The Structure of Option

The structure of constitutes option buyer , option seller and financial intermedaitory

Features of options

The following features are common in all types of options.

• Contract:

Option is an agreement to buy or sell an asset obligatory on the parties.

• Premium:

In case of option a premium in cash is to be paid by one party (buyer) to the other party
(seller).

• Pay off:

From an option in case of buyer is the loss in option price and the maximum profit a seller
can have in the options price.and writer

Holder of an option is the buyer while the writer is known as seller of the option. The writer
grants the holder a right to buy or sell a particular underlying asset in exchange for a certain
money for the obligation taken by him in the option contract.

• Exercise price

There is call strike price or exercise price at which the option holder buys (call) or sells
(put) an underlying asset.

• Variety of underlying asset

The underlying asset traded as option may be variety of instruments such as commodities,
metals, stocks, stock indices, currencies etc.

• Tool for risk management

Options are a versatile and flexible risk management tools which can mitigate the risk
arising from interest rate, hedging of commodity price risk. Hence options provide custom-
tailored strategies to fight against risks.
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Types of options

There are various types of options depending upon the time, nature and exchange of
trading. The following is a brief description of different types of options:

• Put and call option

• American and European option

• Exchange traded and OTC options.

Put option

It is an option which confers the buyer the right to sell an underlying asset against another
underlying at a specified time on or before predetermined date. The writer of a put must
take delivery if this option is exercised. In other words put is an option contract where the
buyer has the right to sell the underlying to the writer of the option at a specified time on
or before the option‟s maturity date.

Call option

It is an option which grants the buyer (holder) the right to buy an underlying asset at a
specific date from the writer (seller) a particular quantity of underlying asset on a specified
price within a specified expiration/maturity date. The call option holder pays premium to
the writer for the right taken in the option.

Dual option

It is an option the right to both purchase and sell of an option.

American option provides the holder or writer to buy or sell an expiry of the option. On the
other hand a European option can be exercised only on the date of expiry or maturity. is
clear that American options are more popular because there is timing flexibility to exercise
the same. But in India, European options are prevalent and permitted.

Exchange traded options can be traded on recognized exchanges like the futures contracts.
Over the counter options are custom tailored agreement traded directly by the dealer
without the involvement of any organized exchange. Generally large commercial bankers

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and investment banks trade in OTC options. Exchange traded options have specific
expiration date, quantity of underlying asset but in OTC traded option trading there is no
such parties. Hence OTC traded options are not bound by strict expiration date, specific
limited strike price and uniform underlying asset. Since exchange traded options are
guaranteed by the exchanges, hence they have less risk of default because the deals are
cleared by clearing houses.

On the other side OTC options have higher risk element of default due to non-involvement
of any third party like clearing houses. Offsetting the position by buyer or seller in
exchange traded option is quite possible because the buyer sells or the seller buys another
option with identical terms and conditions., the rights are transferred to another option
holder. But due to unstandardized money is required by the writer of option but there are
no such requirement for margin funds in OTC optioning. In exchange traded option
contracts, there is low cost of transactions because the creditworthiness of the buyer of
options is influencing factor in OTC- traded options.

Distinction between futures and options

Though both futures and options are contracts or agreements between two parties, the relies
some point of difference between the two. Futures contracts are obligatory in nature where
both parties have to oblige the performance of the contracts, but in options, the parties have
the right and not the obligation to perform the contract. In option one party has to pay a
cash premium (option price) to the other party (seller) and this amount is not returned to
the buyer whether no insists for actual performance of the contract or not.

In future contract no such cash premium is transferred by either of the two parties. In
futures contract the buyer of contract realizes the gains/profit if price increases and incurs
losses if the price falls and the opposite in case of vice-versa. But the risk/rewards
relationship in options is different. Option price (premium) is the maximum price that seller
of adoption realizes. There is a process of closing out a position causing causation of
contracts but the option contract maybe any number in existence.

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Option Pricing Model

There are two types of Option pricing models viz Binomial and Black Scholes

Binomial Model

An investor knows the current stock price at any given moment. They will try to guess the
stock price movements in the future. Under this model, we split the time to expiration of
the option into equal periods (weeks, months, quarters). Then the model follows an iterative
method to evaluate each period, considering either an up or down movement and the
respective probabilities. Effectively, the model creates a binomial distribution of possible
stock prices.

It’s mostly useful for American-style options, which investors can exercise at any given
time. The model also assumes there’s no arbitrage, meaning there’s no buying while selling
at a higher price. Having no-arbitrage ensures the value of the asset remains the same,
which is a requirement for the Binomial Option Pricing model to work.

Assumptions

When setting up a binomial option pricing model, we need to be aware of the underlying
assumptions, to understand the limitations of this approach better.

• At every point in time, the price can go to only two possible new prices, one up and
one down (this is in the name, binomial);

• The underlying asset pays no dividends;

• The interest rate (discount factor) is a constant throughout the period;

• The market is frictionless, and there are no transaction costs and no taxes;

• Investors are risk-neutral, indifferent to risk;

• The risk-free rate remains constant.

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Advantages and disadvantages

(+) The model is mathematically simple to calculate;

(+) Binomial Option Pricing is useful for American options, where the holder has the right
to exercise at any time up until expiration.

(-) A significant advantage is a multi-period view the model provides for the underlying
asset’s price and the transparency of the option’s value over time.

(-) A notable disadvantage is that the computational complexity rises a lot in multi-period
models.

(-) The most significant limitation of the model is the inherent necessity to predict future
prices.

Black-Scholes Model

In 1973, economists Fischer Black and Myron Scholes published an article named "The
Pricing of Options and Corporate Liabilities" that developed the idea of a risk-neutral
pricing of financial assets. Economist Robert Merton then expanded on these ideas and
refined them for the pricing of options in particular, leading to the publication of an
academic paper which enshrined what was deemed the Black-Scholes model. Oftentimes,
Merton's name is added to the formula as well for his role in the process.

Scholes and Merton would share a Nobel prize in 1997 for the development of the Black-
Scholes model; Black was ineligible since he had passed away prior to the awarding of the
prize but he was also acknowledged for his role in helping create the model.

How the Black-Scholes Model Works

The Black-Scholes model is a complete formula used to calculate the price of an option or
other financial derivative. With all the financial inputs in place, the model produces a price
for the option. This also allows traders to figure out the impact of changing other variables
in the formula and see the potential impact that would have on the price of the option in
question.

BSM Model Variables

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The Black-Scholes model uses many data points that are obtained from observable features
of the financial markets to operate. These include:

• Stock Price: Current price of the stock

• Option Strike: The strike price of the option

• Expiry: The amount of time until the option expires

• Risk-Free Rate: What investors can earn on cash or short-term government bonds.

• Volatility: The amount of volatility investors expect in a stock.

Presumptions of the BSM Model

The Black-Scholes model uses a variety of principles to reach its pricing outcome. These
assumptions include:

• A Riskless Asset: The Black-Scholes model works by comparing a risky asset to a

risk-free asset such as treasury bills.

• No Dividend: The financial asset won't pay out dividends during the life of the
option contract.

• Random Walk: Prices behave in a random manner, and are not correlated from one
period to the next.

• No Transaction Limits: Market participants can buy or sell as many securities at

one time as they wish without limits.

• No Transaction Fees: The model assumes market participants aren't limited by

brokerage fees.

• No Arbitrage: The model assumes there is no way to benefit from differing prices
for the same financial asset.

• Option Is European Format: The Black-Scholes model is for options which can't be
exercised prior to the expiration date.

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Black-Scholes Formula

The Black Scholes formula can be written out as follows below:

Black-Scholes Formula (Author's work)

The above holds using the following parameters:

C: Call Option price

•
• S: Current stock price

• K: The option's strike price

• r: The risk-free rate of return

• t: Time remaining until contract expiry

• N: Normal distribution

From that basic formula, there are other more specific variations. There's the call—or
European call formula—for determining the price of call options in particular. There's also
a put option version for dealing with the put side of the option ledger.

Important: This model is for European-style options, that is to say options which cannot
be exercised until the time that they expire. Adjustments must be made for American-style
options which can be exercised prior to expiration.

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Benefits of the Black-Scholes Model

• Simplifies Option Pricing: By making the other variables of option pricing

constants, it puts the emphasis on the effects of time and volatility in relation to an
asset price. This simplification, while at times general, allows for easy and quick
pricing of options which might otherwise be harder to value.

• Easy For Hedging: Due to the set of assumptions made in the model, a Black-
Scholes practitioner can easily hedge between the options market and the other
financial instruments involved (namely the underlying stock and the risk-free cash
instrument).

• Widely Used And Accepted: The Black-Scholes is the most prevalent options
pricing framework out there and thus using it is likely to result in options pricing
close to what other market participants have in their own spreadsheets.

• Speed: The simplifications within the model make it possible to calculate a vast
number of options prices quickly. Other more sophisticated methods may be
slightly more accurate but take longer to output results.

Limitations of the Black-Scholes Model

• Volatility Isn't Constant: Newer research shows volatility tends to vary over time
and also over strike price. Arguably, the 1987 crash, in part, was due to mispriced
options thanks to the so-called volatility smile and market makers not pricing out-
of-the-money options at sufficiently high premiums.

• Liquidity Isn't Infinite: The Black-Scholes model assumes that market participants
can transact as much stock as they want without changing market prices. During
market crashes, liquidity often disappears, temporarily invalidating this premise.

• Risk-Free Rate Isn't Constant: While interest rates are generally stable, sometimes,
such as in 2022, they move at a rapid clip, causing long-term options priced at one
interest rate to become significantly mispriced.

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• Assumes Price Changes Are Normally Distributed: Some critics of the Black
Scholes model, such as Nassim Taleb, argue that stocks do not follow a standard
distribution of returns and that they experience outsized moves more frequently
than the model would predict. This has serious implications for the pricing of out-
of-the-money options.

• Assumes Prices Are A Completely Random Walk: The model works on the basis
that price changes are completely random. However, academic research has shown
that prices may have some momentum; that is to say stocks going up have a
tendency to keep going up in the intermediate term and vice versa.

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