MODULE 5

Options

Minimum Correct Answers for this module: 3/6

Overall Objective:
To understand the fundamentals of options. To recognise the principal classes and types, and
understand the terminology, how they are quoted in the market, how their value changes with the
price of the underlying asset and the other principal factors determining the premium, how the risk
on an option is measured and how they are delta hedged. To recognise basic option strategies and
understand their purpose.

At the end of this section, candidates will be able to:

• Define an option, and compare and contrast options with other instruments
• Define strike price, market price, the underlying, premium and expiry
• Calculate the cash value of a premium quote
• Describe how OTC and exchange-traded options are quoted, and when a premium is
conventionally paid
• Define call and put options
• Explain the terminology for specifying a currency option
• Describe the pay-out profiles of long and short positions in call and put options
• Describe the exercise rights attached to European, American, Bermudan and Asian (average
rate) styles of option
• Define the intrinsic and time values of an option, and identify the main determinants of an
option premium
• Explain what is meant by in the money, out of the money or at the money
• Define the delta, gamma, theta, rho and vega
• Interpret a delta number
• Outline what is meant by delta hedging
• Outline how to construct long and short straddles and strangles, and explain their purpose
• Outline how options can be used to synthesise a position in the underlying asset
• Define an interest rate guarantee
• Describe the function of cap and floor options, and how they are used to produce long and
short collars

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Options
On option is a contract which gives the holder (the option buyer) the rights, but not the obligations,
to transact a specific quantity of an underlying asset at a specified rate, at the agreed future date.

The underlying asset specified in the contract can be one of a wide range of underlying instruments,
such as interest rates, foreign exchange or equity.

Options can be exchange-traded or OTC, the options on futures are exchange traded while foreign
exchange options are traded over-the-counter (OTC).

When compared to forward transactions they similarly are contracts entered into today for
settlement in the future, however the distinguishing characteristic between these two contracts is
that forwards result in obligations to transact, even if it is cash settled, whereas the option contract
transfers rights to its holder and this gives them the choice as to whether they would like to exercise
the contract or not.

Rights, such as those conferred by an option contract, are not for free and an option transaction
requires the option buyer to pay the option seller a premium which for OTC options is typically
settled upfront, two business days after trade (spot).

Option terminology
Option contracts have their own set of terminology used to describe them including:

Buyer: The purchaser of an option, also referred to as the option holder.

Seller: One who sells an option, also referred to as the writer of the option.

Call: An option which gives the option buyer the right to purchase (go long) a
particular underlying asset at a specific price.

Put: An option which gives the option buyer the right to sell (go short) the
underlying instrument or asset.

Strike Price: The price at which the buyer of a call has the right to purchase and at which
the buyer of a put has the right to sell, also referred to as the exercise price.

Premium: The "cost" of the option

Exercise: The action taken by the buyer (holder) of an option who wishes to acquire a
position in the underlying at the option strike price. If the option is not
exercised, it will be left to expire

Exercise Date: The day on which an option can be exercised.

European style Option An option that can only be exercised on one date- the expiry date

American style Option An option that allows for exercise at any time before the expiry of
the option

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A more complex type is the Bermudian option, this option Average rate options:
can be exercised at certain dates during the life of the
option and usually only after a period of time has elapsed. The strike price is fixed, but the
This kind of option is usually an option embedded in a bond. market rate used to determine
whether the option has value at
Asian options or average rate options are exercised based expiry is not based on a single market
on an average of market rates established during the life of rate at expiry, but an average of
the option rather than just one price when the option is market rates during the life of the
exercised. option

An option holder will exercise their rights (to buy or sell the underlying) if the option is in-the-money
and will allow it to expire worthless if it is out-the-money.

The “money-ness” of an option strike is observed by taking the strike rate of the option in relation to
the underlying instrument.

As an example:

In-The-Money (ITM): The strike rate of the option is at a rate better than the market reference rate

Out-The-Money (OTM): The strike rate of the options is at a rate worse than the market reference
rate

At-the-Money (ATM): The strike rate of the option is at the same rate as the market reference rate

This “money-ness” is also used to describe the relationship of the strike rate compared to the
market rate at the time of the deal being struck. For example, “I have interest in the 1 month ATM
strike” is a request to buy an option where the strike price is set at the current 1 month forward
price.

The following table outlines the relationship between the strike price and the market price for both
put and call options.

Call Option Put Option

In-the-money Market price > Strike price Market price < Strike price

At-the-money Market price = Strike price Market price = Strike price

Out-the-money Market price < Strike price Market price > Strike price

Option pricing
There are various variables to consider when establishing the premium cost of an option. The
following needs to be considered when pricing options:

 The current price of the underlying instrument in the cash market

 The strike rate of the option
 How long the option is, or its time to maturity
 Volatility, expressed as an annualised percentage
 Interest Rates

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The premium is made up of two components namely time value and intrinsic value.

The Intrinsic value portion of the premium represents the current in-the money value of the option,
in other words the value you would receive, if any, if you were to exercise the option you are holding
immediately. If the option has no intrinsic value, for example and OTM or ATM option, the intrinsic
portion would simply be zero, i.e. it can only be positive. The intrinsic value therefore considers the
market and the strike price in order to determine its current “money-ness”.

A put option will have intrinsic value equal to the greater of; 0 or (Strike price – Market price)

A call option will have intrinsic value equal to the greater of; 0 or (Market Price – Strike price)

Intrinsic value is the minimum premium you will charge, over and above this one must consider the
time value portion of the premium. An option that has not yet expired and is “out of the money” is
not valueless, until expiry date is reached, the “money-ness” of the option can change i.e. it can go
from out-the-money to in-the-money and then back again. These changes have value known as time
value (not to be confused with the time value of money). Time value reflects the amount of
premium in excess of the intrinsic value that you would be prepared to pay in the hope that the
option will be worth exercising before it expires. Even out-the-money options command a price
because they may move into the money at some point during the life of the option.

Time value is determined by the current market price, the strike price, time to maturity as well as
the expected volatility of the underlying asset or instrument. Make note of the following with
regards to an options time value:

• The main determining factor for time value is volatility

• The more volatile the underlying asset, the greater the time value component of the
premium
• The longer dated the maturity of the option the greater the time value of the option
• Time value is greatest when the option is at-the money

Time decay of an option is basically the reduction in value of an options contract as reaches its
expiration date. Essentially, the value decays as time progresses, hence the term. It's vital for any
trader to know about time decay because it can play a very big part in whether trades are profitable
or not. Time value does not erode evenly over the life of the option, and the time decay at the
beginning of a long-term option is minimal, but increases faster as the option approaches expiry.

Volatility
Volatility is a measure of the risk or uncertainty of movement in the underlying asset of an option.
Volatility suggests the magnitude of the fluctuation but NOT the direction of movement. Volatility
can be distinguished as historical and implied volatility. .

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Historical Volatility
Is a measure of the actual fluctuations/ movement of the market price as experienced over a period
in the past, it is measured as the standard deviation of historical prices.

Implied volatility
An estimate of the volatility for the future fluctuations in the asset price. Implied volatility will give
you the price of an option. Higher volatility estimates reflect greater expected fluctuations (in either
direction) in underlying price levels. This expectation generally results in higher option premiums for
puts and calls alike, and is most noticeable with at-the-money options

The effect of volatility is the most subjective and perhaps the most difficult factor to quantify, but it
can have a significant impact on the time value portion of an option’s premium.

CONDITION CALL VALUE PUT VALUE

When Price of the underlying rises Rise Fall

When Price of the underlying falls Fall Rise

When Volatility increase Rise Rise

When Volatility decrease Fall Fall

Time to maturity increases Rise Rise

Time to maturity decreases Fall Fall

Interest Rates increase Rise slightly Falls slightly

Interest Rates decrease Falls slightly Rise slightly

Given that option models incorporate some form of forward price element into their workings,
interest rates also influence the premiums for many types of options. It could be that an increase in
money market interest rates relative to yield will lead to calls becoming further in-the-money
forward and puts becoming further out-of-the-money forward. The effect upon option premiums is
therefore for an increase in money market rates to cause an increase in call values and a decrease in
put values.

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The Option “Greeks”
When managing a portfolio of options, a dealer needs to know how the value of the options will
change given a change in one or more of the option price determinants, such as time to maturity or
volatility.

Delta
An option’s delta is the measure of the change in an option’s premium as a result of a small change
in the underlying spot price.

For example if a premium for a call option on the gold price is $1 when the gold price is $1500 and it
increases to $2 when the gold price moves to $1505, then the delta of the option is 1/5 or 0.2 (20%).
The delta therefore shows how sensitive the option premium is to changes in the underlying price or
rate.

Delta is expressed as a value between 0 and 1 (0 and 100%).

• Out the money options tend to have a delta which approaches zero
• At the money options have a delta of close to 0.50
• In the money options have a delta of close to 1.

Delta is also known as the hedge ratio as it is the amount by which the dealer must either go long or
short the underlying asset in order to neutralise the changes in the options value as a result of
changes in the market price.

Delta hedging
When an option dealer wants to hedge their option position they can either trade an opposite
option position and close it out, or they can delta hedge it. Delta hedging involves buying or selling
an amount of the underlying asset to offset the changes of premium resulting from a change in the
underlying asset price. For example the dealer that wrote (sold) the above gold option may be called
on to deliver the underlying asset and they are therefore essentially going short the underlying as
the option goes into the money.

The option has a -0.2 delta and a change of $5 will see the option price rise to $2, if the option dealer
has written the call for 100oz of gold they would have to buy (to offset their short position)
0.2 x 100oz = 20oz of gold (Delta x Notional amount)

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To summarise:
Position + or – Delta Delta hedge

Delta for long calls Rights to buy POSITIVE Sell Underlying

(between 0 and +1)

Delta for short calls Possible obligations NEGATIVE Buy Underlying

to sell or deliver
(between 0 and -1)

Delta for long Puts Rights to sell NEGATIVE Buy Underlying

(between 0 and -1)

Delta for short Puts Possible obligations POSITIVE Sell Underlying

to buy
(between 0 and +1)

Gamma
As the distance from the underlying prices changes to the strike price, so the delta of an option will
change. Gamma measures how delta changes as a response to a change in the underlying price and
gives an idea of how frequently a delta hedge must be adjusted. The bigger the gamma of an option
the faster its delta will change as the underlying moves. Ideally a dealer would like to be gamma
neutral so that no rebalancing of hedges is necessary when the underlying price changes. Gamma is
most sensitive to changes when an option is close to expiry and when the option is at-the-money.

Long calls POSITIVE GAMMA

Short calls NEGATIVE GAMMA

Long Puts POSITIVE GAMMA

Short Puts POSITIVE GAMMA

Vega
Vega measures the sensitivity of the option premium to changes in volatility of the underlying.

Vega is highest for at-the-money options and falls as the market price moves away from the strike
price. This was illustrated earlier when it was noted that the impact of volatility is greatest for at-the-
money options relative to deep out-the-money and in-the-money options.

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Theta
Theta measures the amount of time decay experienced by an option for a given reduction in time to
expiry (usually one day). Thus if an option is valued today at 100 and theta today is -5, then our theta
measurement is telling us that tomorrow the option value will have decreased to 95, all other things
remaining equal.

Rho
Rho measures how much the option premium responds to a change in the money market interest
rate over the life of the option. Thus rho is in fact describing the impact of a change in forward price
upon the option premium. Rho tends to be higher when the maturity of an option is longer.

Option pay-off profiles at expiry

The diagrams chart the profit or loss from an option position against the movement of the
underlying market price. The analysis assumes is graphed at expiry date and therefore only includes
the intrinsic value as time value at maturity is zero.

LONG CALL
Loss limited to premium paid
Unlimited Profit potential

SHORT CALL
Unlimited potential for loss
Profit limited to premium received

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 LONG PUT
Loss limited to premium paid
Profit limited to a maximum of
breakeven and zero

SHORT PUT
Loss limited to between breakeven
and zero
Profit limited to premium received

Note: The breakeven price takes into account the premium amount.

• A call option with a strike price of 100 with a premium of 10 will only begin to breakeven
when the market price rises above 110.

Put-Call Parity
Creating a security or portfolio that has a similar return to another security or portfolio should result
in these two assets trading at the same price, if not arbitrage will cause the market anomalies to be
exploited until such time as it corrects.

This is what is meant by put-call parity and creating a synthetic forward is a good way of showing
this. By using a combination of options we can create a payoff profile at maturity that exactly
matches that of a normal market FEC. The premium of a long call and a short put should
theoretically offset each other when the strike price is set at-the-money forward.

Long Call + Short Put = Long Forward Position

Short Call + Long Put = Short Forward position

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Trading strategies
Aside from a directional view of the underlying price the use of options enables a dealer to take a
view on changes in volatility.

A position that has positive Vega will see profitable A long ‘Vol’ position or positive Vega
results if volatility increases. is a result of a net long option position

A position that has negative Vega (generally as a result A short ‘Vol’ position or negative Vega
of a net long option position) will see profitable results is a result of a net short option
if volatility decreases. position

Long straddle
The simultaneous purchase of a call and put option at the same strike price, for the same notional
value and expiry date

• Motivation: Dealer expects

volatility to be high during the
life of the strategy

• Maximum loss = premium paid,

with unlimited upside

• Two premiums to pay therefore

expensive

Short Straddle
Simultaneous sale of both a call and put option with the same strike price, notional value, and expiry
date

• Motivation: Dealer expects very

low volatility during the life of the
strategy

• Maximum profit = premium

earned, with unlimited downside

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Long strangle
Buy a Put at and a Call at each with out-the-money strikes with same expiry date and notional
amount.

• Motivation: Dealer expects

the market to move strongly
but is unsure of which
direction
• It is a long vega trade i.e.
expect volatility to increase
• Cheaper to buy than the
straddle (OTM strikes)
• Maximum loss = premium
paid, with unlimited upside

Short strangle
Short call and short put with out-the-money strikes, the same notional and expiry date.

• This is a strategy to benefit

from low volatility.
• Dealer would have earned a
premium from both vanilla
options and will keep it if the
marker price stagnates
• Maximum profit = premium
earned, with unlimited
downside

Interest Rate Options

Interest rate options are used as insurance against the rate of interest on a floating rate loan rising
above a certain level or similarly the rate of interest on a floating rate investment falling below a
certain level.

Caps
An interest rate cap is a series of options in which each individual interest rate guarantee expires on
the fixing date on a floating rate loan. The strikes are set at the same level so that the maximum
borrowing rate for the period of the whole loan can be protected. The premium on a cap can be
paid up front or over the life of the cap depending on the terms agreed.

Floors
An interest rate floor is a series of options in which the expiry dates coincide with the fixing date on
a floating rate investment, and the option sets the minimum deposit rate for the period of the whole
investment.

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Collars
This is a structure which created from the simultaneous purchase of a cap and sale of a floor. This
reduces the premium amount payable, as the sale of the option funds the premium payable (either
all or some of it) of the option bought. The structure provides a maximum, cap, and minimum, floor,
which can be achieved at maturity date. It therefore gives the holder rights, which are limited within
a range.

Long collar – Long call (cap) and short put (floor): Protects borrower’s costs within a range Short
collar – Long put (floor) and short call (cap): Protects investor’s returns within a range

Swaptions
A swaption is an option which allows the holder to enter into an interest rate swap on the expiry
date of the swaption.

A receiver swaption is one which allows the holder to RECEIVE fixed at the strike rate of the
swaption.

A payer swaption is one which allows the holder to PAY fixed at the strike rate of the
swaption

Foreign exchange options

The following points apply as normal market convention in the currency options market:

• Currency options are traded directly between banks and their customers in the over-the-counter
market

• Currency options are usually European style i.e. only exercisable on expiry date. General market
practice in the interbank market recognises 10am New York time or 3pm Tokyo time as the
latest a holder of an option can exercise his or her rights on expiry date.

• The option price quoted in the market can be expressed in a variety of ways:
o % terms of the base currency amount
o % terms of the variable currency amount
o In the base currency per unit of the variable currency
o In the variable currency per unit of the base currency

• A USD call option traded in USD/SGD is a put on the SGD

o A call on one currency is a put on the other currency in the traded pair

• An at-the-money currency option has a strike price equal to the forward exchange rate. For
example, if the USD/ZAR spot is 11.00 and the 3-month forward rate is 11.300. A 3-month at-
the-money USD call (or ZAR put) will have a strike rate of 11.30

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Module 5: Review Questions

1. What does the rho of a currency option measure?

a) Sensitivity of the premium to changes in the remaining time to maturity
b) Sensitivity of the premium to changes in the delta
c) Sensitivity of the premium to changes in the volatility of the underlying
d) Sensitivity of the premium to changes in interest rates

2. What is the name for an option, which gives the holder the right but not the obligation to
exercise the option on any one of a number of agreed periodic dates spread over the life of an
option?
a) American option
b) European option
c) Bermuda option
d) Asian option

3. How is a short strangle position constructed?

a) Buy put and call options at the same strike price for the same maturity
b) Sell a call option and buy a put option at the same strike price for the same maturity
c) Sell call and put options with out-the money strikes for the same maturity
d) Buy call and put options with the same strike prices and different maturities

4. An option which allows the holder to enter into a receiver IRS on exercise date is
a) A receiver swaption
b) A receiver Caplet
c) A payer Interest Rate Guarantee
d) A payer swaption

5. The 1 month gold price is currently quoted at $1220. You buy a 1 month call option with a strike
price of $1250. Which of the following best describes your option?
a) In-the-money
b) Out-the-money
c) At-the-money
d) With-the money

6. The 1 month gold price is currently quoted at $1220. You buy a 1 month call option with a strike
price of $1250. What are the components of the premium charged for this option?
a) Intrinsic value & zero time value
b) Zero intrinsic value & zero time value
c) Zero intrinsic value & time value
d) Intrinsic value & time value

7. You buy a $5mio USD call option in the USD/CHF market at a strike of 1.5150 and it costs you
CHF7,500.
If you exercise at your strike price what USD/CHF rate (net) will you be long dollars at?

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8. You have sold a call option which you intend to delta hedge.
Which of the following are most correct?

a) Your position is delta positive and to hedge you will buy the underlying
b) Your position is delta negative and to hedge you will buy the underlying
c) Your position is delta negative and to hedge you will sell the underlying
d) Your position is delta positive and to hedge you will sell the underlying

9. Counterparty A sells a call option to Counterparty B with at strike of 100 and a premium cost of
10
a) A receives 10 premium and has unlimited profit potential
b) B receives 10 premium and has unlimited profit potential
c) A receives 10 premium and has limited loss potential
d) B pays 10 premium and has unlimited profit potential

10. Counterparty A sells a call option to Counterparty B with at strike of 100 and a premium cost of
10. At what market level will “B” break-even and start to make money on the option?
a) 10
b) 100
c) 90
d) 110

11. A customer is short cash and enters into an interest rate collar. Which of the following is false?
a) The collar is constructed with a simultaneous purchase of a Cap and sale of a Floor
b) The customer has reduced premium costs compared to a long cap option position
c) The customer has certainty as to their borrowing costs for the option period
d) The customer would be long a Borrower’s collar

12. The delta of an “at-the-money” long put option is:

a) Between -0.5 and -1
b) Between +0.5 and +1
c) Close to +0.5
d) Close to -0.5

13. The intrinsic value of a long call option:

a) Rises if the price of the underlying falls (and vice versa)
b) Becomes negative if the market price of the underlying falls below the strike price of the
option
c) Falls and rises with the price of the underlying when the option is in-the-money
d) Depends solely on the price volatility of the underlying

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