OPTION

Option Market:
Option is a product, traded in option market.

Over the Exchange Over the Organized market

counter product traded product counter market

Option:
Option is a contract/ agreement enforceable at law. It is a right (not obligation) to buy or to sell.
It is a contract between two parties (option buyer and option seller), which is made in order to buy
or to sell a particular asset at a strike/definite/specific/preferred price on a certain date in the future.

Features of Option:
• It is a contract.
• Between two parties (Option buyer and option seller).
• For a particular asset.
• Exercised at a strike/definite/specific/prefixed price.
• On a certain date in the future.
• It provides rights to option buyer.
• Option buyer buys right for payment of premium to the option seller.
• Option buyer cannot be compelled to exercise option rather option buyer exercise option.

Types of Option:
Option

In order In order
to buy to sell
Call option Put option
Oblig
ation
Right Option Option to Option Option
to buyer seller sell buyer seller
buy

Buye Selle Selle Buye

r of r of r of r of
asset asset asset asset

Position: Long Short Short Long

Option can be of following two kinds as well:

• European Option: European Option allows option buyer to exercise option on the last date
of the contract.

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 • American Option: American Option allows option buyer to exercise any day with in the
contract period.

On What Assets Option is Made?

• Financial assets — Stock
- Currency
- Debt instrument (T-bond/T-bill/T-certificate/T-notes/Corporate
bond/Corporate debenture/Money market security/Commercial paper).
• Goods or commodity (Spices, wheat etc.)
• Option on stock index.
• Portfolio. Ex: ICB 14. (Strike price determine by stock index.

Problem 1:
Kim is bearish on the stock of the Chittagong Cement. Therefore, Kim purchases four put option
contracts of 100 shares each of Chittagong Cement for a premium of $3 per share. The option
striking price is $40 and it has a maturity of 3 months. Chittagong Cement has a current market
price of $38. If Chittagong Cement’s price falls to $30, how much profit will he earn over the 3-
month period? What is Kim’s gain or loss if the ending price of Chittagong Cement’s stock is $42?

Straddle:
Straddle is the combination of call and put options.

Problem 2:
Rumors that the City Corporation is going to tender a hostile offer for a controlling interest in the
Morris Corporation. The price of Morris’s stock has started moving up. However, if a hostile
takeover attempt fails, Morris’s stock price will probably fall dramatically. To profit from this,
Frank has established the following straddle position with the stock of the Morris Corporation:
a) Purchased one 3-month call with a striking price of $40 for a $2 premium.
b) Paid a $1 per share premium for a 3- month put with a striking price of $40.
Requirements:
1) Determine Frank’s ending position if the takeover offer bids the price of Morris’s stock up
to $41 in 3 months.
2) Determine Frank’s ending position if the takeover fails and the price of the stock falls to
$35 in 3 months.

Spread:
It is the combinations of both call and put option:
• On the same stock
• For the same duration
• With different exercise price
• With different premium.

Spread is of two types. They are

• Bull Spread: share price increase highly
• Bear Spread: share price decrease

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Problem 3:
Freda established the following spread on the Glaxo’s stock:
a) Purchased one 3-month call option with a premium of $3 and an exercise price of $55.
b) Purchased one 3-month put option with a premium of $0.50 and an exercise price of $45.
The current price of Glaxo is $50.
Determine Freda’s profit or loss if,
i. The price of Glaxo stays at $50 after 3 months.
ii. The price of Glaxo falls to $35 after 3 months and
iii. The price of Glaxo rises to $60.

Black & Shocles (B/S) Model:

The Black-Scholes formulas for the prices at time 0 of a European call on a non-dividend-paying
stock and a European put option on a non-dividend-paying stock are:
c = S0 N (d1 ) − Ke− rT N (d 2 )
and p = Ke− rT N (−d 2 ) − So N (d1 )
ln( S0 / K ) + (r +  2 / 2)T
d1 =
where,  T
d 2 = d1 −  T
The variables c and p are the European call and European put price, S0 is the stock price at time
zero, K is the strike price, r is the continuously compounded risk-free rate, σ is the price volatility,
and T is the time to maturity of the option.

Problem 4:
Determine the value of a call option with the B/S model for the following inputs:
σ = 0.3, r = 0.10, S0 = $25, T = 0.3 years, and Striking/exercising price, K = $28. Also determine
the investor’s hedge ratio or delta.

Problem 5:
The following input information exists for the call options on the Roberts Corporation’s common
stock:
σ = 0.52, r = 0.10, S0 = $35, T = 0.25 years, and K = $30.
Requirements:
a) Determine the value of a call option with the B/S Model.
b) Determine the value of a put option.
=$1.21
Problem 6:
The stock price 6 months from the expiration of an option is $42, the exercise price of the option
is $40, the risk free interest rate is 10% per annum, and the volatility is 20% per annum.
a) Determine the value of a call option with the B/S Model.
b) Determine the value of a put option with the B/S Model.

Problem 7:
A put and call will expire in 3 months and both have a striking price of $25. The risk free rate is
10 percent.

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 a) Determine the price of the put if the call has a price of $4 and the stock has a price of
$22.
b) b) If the put has a price of $5 and the stock price is $20, determine the price of the call.

Problem 8:
The Benson Corporation’s stock is currently selling for $45.
a) Determine the call premium on Benson’s stock for the following inputs:
σ = 0.35, T = 0.5, K = $41, r = 0.10, and zero cash dividend.
b) Determine the call premium for Benson’s stock if the annual dividend yield (D) is 6%.
c) Why do these premiums differ?
d) Determine the value of a put option on the Benson’s stock without dividend.
e) Determine the value of a put for Benson’s stock if the annual dividend yield (D) is 6%.

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