Options

and
Embedded
Options

Ramamoorthi Srinivasan ICMA RVO – Bangalore

BSc FCA, FAFD, RV & RP 08-Dec-2019
 • An option provides the holder with:
• the right to buy or sell a specified quantity of an
underlying asset (“Underlying”)
• at a fixed price (called a strike price or an exercise
price)
• at or before the specific (“expiration”) date.
• Since it is a right and not an obligation, the holder can
Option choose not to exercise the right and allow the option
to expire.
-General • Whether buy or sell, the BUYER PAYS premium and
Principles - SELLER RECEIVES PREMIUM.
• An option may also be viewed as an asset which is:
• (a) Whose value is based entirely on the value of
underlying asset
• (b) Whose cash flow is dependent on the
happening/ non happening of contingent events.
 • A “Short” means selling the option and
• A “Long” means buying the option.
• European Option (*): When an option can be
exercised only on the maturity date.
• American Option: When an option can be
Option exercised any time before its maturity date.
-Definitions - • The seller of an option is known as the “Writer”.
Writing an option means selling an option.

(*) India follows European Option.

  A call option gives the buyer of the option:
• The right to buy the underlying asset at a fixed price,
called the strike price,
• At any time prior to the expiration date of the option.
• The buyer pays a price “Premium” for this right.
• If at expiration, the value of the asset is:
• less than the strike price, the option is not exercised
and expires worthless.
• greater than the strike price, the option is exercised
Call Option by the buyer at the exercise price.
• The difference between the then asset value and
the exercise price comprises the gross profit on
the option investment.
• The net profit on the investment is the difference
between the gross profit and the price paid for
the call initially. (“Pay Off”).
 Share of Comp A
Spot Price 1000
Date 1-Jan-18
Strike Premiu
Call Options price Date m
  1050 31-Jan-18 50
 Scenarios 1 2 3 4 5 6
Actual Price 800 900 1000 1100 1200 1300
Net Pay off -50 -50 -50 50 150 250
300

Call Option 200

250

150

100
Actual Price
50
Net Pay off
0
1 2 3 4 5 6
-50 -50 -50
 • Put option gives the buyer of the option:
• The right to sell the underlying asset at a fixed
price, again called the strike price,
• At any time prior to the expiration date of the
option.
• The buyer pays a price for this right.
• If the price of the underlying asset is :
• Greater than the strike price, the option will not
Put Option be exercised and will expire worthless.
• Less than the strike price, the owner of the put
option will exercise the option and sell the stock
at the strike price, claiming the difference
between the strike price and the market value
of the asset as the gross profit.
• In theory, a call option has unlimited upside
potential for profits (infinity) but a put
option has limited potential because value
of the underlying asset cannot be negative.
 Share of Co A
Spot Price 1000
Date 1-Jan-18
Put Options Strike price Date Premium
  1050 31-Jan-18 50
 Scenario 1 2 3 4 5 6
Actual Price 800 900 1000 1100 1200 1300
Net Pay off 150 50 -50 -50 -50 -50
250

Put Option 200 200

150

100 100
Net Pay off

50

0
1 2 3 4 5 6

-50 -50 -50 -50 -50

-100
 The fair value of an option is based on the following
principles.
• Price Movement of the Underlying:
Event Call Put
Stock Price goes up Gain Loss
Stock Price goes down Loss Gain

Determinants • Time till expiry: If days pass without any significant

of Option change in the stock price, there is a decline in the
value of the option.
Value Also, the value of an option declines more rapidly as the
option approaches the expiration day.
• Volatility in Stock Prices: Volatility can be
understood via a measure called statistical
(sometimes called historical) volatility, or SV for
short. SV is a statistical measure of the past price
movements of the stock; it tells you how volatile
the stock has actually been over a given period of
time.
Higher the volatility, higher the value of option
 • Interest Rate- Another feature which
affects the value of an Option is the
time value of money. The greater the
interest rates, the present value of
the future exercise price are less.
• Strike Price- Value of call option
decreases with every increase in
Strike Price.
Determinants For put options, the value of the
of Option option increases with increase in Strike
Price.
Value • Dividends- The dividends, if declared
are not received by the option holder
but by the writer (if he holds the
underlying asset). So, when the price
falls upon turning ex dividend, the
value of a call falls and value of put
increases.
 Parameter Incr/ Call Put Option
Decr Option
Stock Price Increase Increase Decrease
Strike Price Increase Decrease Increase
Variance (β) Increase Increase Increase
Time to Increase Increase Increase
expiration
Risk free rate Increase Increase Decrease
Dividends Increase Decrease Increase
Option –Value
Determinants Parameter Incr/ Decr Call Put Option
Stock Price Decreases Decrease Increase
Strike Price Decreases Increase Decrease
Variance (β) Decreases Increase Increase
Time to Decreases Increase Increase
expiration
Risk free rate Decreases Decrease Increase
Dividends Decreases Increase Decrease
 Option values - When an option holder
exercises his right to buy or sell it may have
three possibilities.
a. An option is in the money when it is
advantageous to exercise it.
b. When exercise is not advantageous it is called
Option – out of the money.
Possible c. When option holder does not gain or lose it is
Outcomes called at the money
  Call Option Put Option
In the Money S>K S<K
Out of the S<K S>K
money
At the money S=K S=K
 • Option Value= Intrinsic Value + Time Value
• The intrinsic value is the difference between
the price of the underlying asset and
the strike price.
• The intrinsic value for a call option is equal to
the underlying price minus the strike price;
Option -Values • the intrinsic value for a put option is equal to
the strike price minus the underlying price.
• Thus intrinsic value is :
• the amount in-the-money, when the option is in-
the-money.
• Is Zero, If the option is at-the-money or out-of-
money.
 • Time value refers to the portion of an
option's premium that is attributable to the amount of
time remaining until the expiration of the option
contract.Time Value :
• Is positive when a call that is out of -the-money or at-
the-money.
• Is greater, longer the time to expiration..
• Is Zero at expiration.
Option -Values Time value of a call = C- [Max (0,S-K)]
Time value of a put = P- [Max(0,K-S)]
• In general, an option loses one-third of its time value
during the first half of its life, and the remaining two-
thirds of its time value during the second half.
• Time value decreases over time at an accelerating pace, a
phenomenon known as time decay or time-value decay.
• TV of American option cannot be negative (because the
option value is never lower than IV)
 Another factor can influence an option's time
value is implied volatility.

It is the amount an underlying asset is likely to

move over a specified time period. If the
implied volatility increases, the time value will
also rise.

Option -Values For example, if an investor purchases a call

option with an annualized implied volatility of
30 percent and the implied volatility jumps to
45 percent the next day, the option's time value
would increase.

Investors would figure that dramatic moves

bode well for their chances for the asset to
move their way.
 • Put-Call Parity Relationship -If the price of
put and call are out of sync, then there will be
arbitrage and market players will make easy
money. This never happens in actual practice.
Call + PV(K)= Put + Spot
(Assumptions- European, no dividend and small
Option -Terms time lag). Does not hold good for American
options. Example
If Then
Call Put
Spot Strike is will be Reason
60 55 7 2 60-7=53, 55-2=53
60 55 9 4 60-9=51, 55-4=51
 • The Binomial model is used to calculate the price of an
American option.
• It is based on the premise that the price of an asset can move
only in one of the two possible prices in a given time period.
• The overall time interval of the option is divided into a large
number of smaller time intervals of ∆T, over the life of the
option.
Option – • In each of these time intervals, the price of the underlying
asset moves from its initial value of S to one of the two new
Pricing- values, Su and Sd.
• The movement from S to Su is an ‘up’ movement and the
Binomial movement from S to Sd is a ‘down’ movement.
Model • The probability of an up movement is denoted by ‘p’ and the
probability of a down movement is denoted by ‘1-p’.
• At each node, the top number shows the stock price at the
node and the lower one shows the value of option at the
node.
• The option prices at the penultimate node are calculated from
the option prices at the final nodes.
 • Other than the six key variables, we also need
the following to build a binomial model:
• Size of two possible changes
• Probabilities of changes occurring
Option – • The model thus establishes a tree of stock
Pricing- prices that represent all possible paths that the
stock price could take during the life of the
Binomial option.
Model • In such a situation a hedged position can be
established by buying the stock and by writing
Options. The pricing of the Options should be
such that the return equals the risk free rate.
 Today Date 01-Jan-19
Expiration Date 31-Jan-19
Variation 10%
Spot Price 100
Option – 31-Jan-19
133.1
Pricing- On 10-Jan-19 20-Jan-19
Binomial 121 108.9

Model 99 108.9
110
100
89.1

90 81 72.9
 Formula
P = (probability) of price increase / Decrease , r= Risk Free interest
Rate
U= Upper Prob, D= Lower Prob, S= Spot Price, C= Call Premium,
K= Strike Price, R=1+r, Type= European, Stage =1

Option – C= P * (Max(0, ((U*S)-K) +((1-P) (D*S)-K)) / (1+(R/100))

Where P=(R-d)/ (U-d)
Pricing- Illustration
Binomial S=300, U=1.1, D=0.95, R=5% (0.05), K=300

Model P= 1.05-0.95 / 1.1-0.95=0.1/ 0.15=0.66

C= 0.66 *(Max(0,((1.1*300)-300))+ ((1-.66) *.95*300)-300)/
(1+.05), C= 0.66* 30 + 0/ 1.05 =19.8/1.05 =19.05
 The BS model is used to calculate the value of an
European option.
BS model assumes the lognormal property of stock
prices, which means that changes in stock prices are
normally distributed, with value between zero and
infinity.
The Black-Scholes model makes certain assumptions:
Option – • The option is European.
Pricing-Black • No dividends during the life of the option.
Sholes • Markets are efficient (i.e., market movements
cannot be predicted).
• There are no transaction costs.
• The risk-free rate and volatility of the underlying
are known and constant.
• The returns on the underlying are normally
distributed.
 Formula
C= S*Nd1 – K e-rt Nd2, where d1= In(S /K
e-rt)+ β √t /( β√t) d2= d1- β√t
Illustration
Option – S=92, K=95, t=50 days (0.137), r=7.12
Pricing-Black %,β=0.35
Sholes K *e-rt =95*(.0712*.137)=94.08
d1= In(92/94.08)+(0.5*0.137)/
0.35*.137 = -0.1077
d2= -0.2372, N(-0.1077)=0.4571, N(-
0.2372)=0.4063 (From table)
C=3.84
 Monte Carlo simulation is often used to benchmark or
cross-check the value obtained from BSM Model or
Binomial Model.

In terms of theory, Monte Carlo valuation relies on risk

neutral valuation.  The technique applied then is:

a. To generate a large number of possible, but random

(“Brownian”), price paths for the underlying (or

Monte Carlo underlying) via simulation, and

b. To then calculate the associated exercise value (i.e.
Simulation "payoff") of the option for each path.
c. These payoffs are then averaged and discounted to
today. This result is the value of the option.
d. In Excel, NORMSINV is the inverse cumulative
function for the standard normal distribution.
NORMSINV(RAND()) gives a random sample
from a standard normal distribution.
 A normal bond or debt which has additional feature
like a call or put option by virtue of its terms of issue
is said to be issued with an embedded option.

Embedded The option may be exercised either by the issuer or

the holder at the time specified in the terms of issue.
Options
An embedded option is integral to the instrument
and does not trade by itsef.
Each investor has a unique set of income needs, risk tolerances, tax
rates, liquidity needs and time horizons.
Embedded options provide solutions to fit the needs of all participants.
RISKS

There are two dimensions of risk for investors.

(a) Re-investment risk- when market
Embedded circumstances necessitate the exercise the
Options-Need embedded option, the party receiving the proceeds
may not be able to profitably reinvest.
(b) They almost always limit a security's
potential price appreciation because when
market circumstances change, the price of the
affected security may be capped or bound by a
specific conversion rate or call price.
 Bonds with Call Option- A company issuing bonds at
times of high prevailing interest rates, anticipating (or
hoping) that interest rates may fall in future reserves an
option  to redeem the issued bonds at some time in the
future.
This a great tool for issuer both parties and does not
require a separate option contract.

Call and Put b. Bonds with Put Option- Bonds with a put option
(allowing investors to exit) are not as common.
Bonds
They provide more control of the outcome in the hands of
the bondholder.

Puttable bond are typically more expensive than normal

bonds because it allows the investor to exit if rates rise
and invest their proceeds in higher-yielding instruments.
 The pricing of callable and puttable bonds (given
similar maturities, credit risk, etc., tend to move in
opposite directions with passage of time.
Price of call = price of normal bond – price of call
option
Price of put = price of normal bond + price of put
option
Call and Put c. Convertible Bond- A convertible bond is a
Bonds normal bond bearing interest until the
predetermined date allowing the conversion of the
bonds into shares of company at a predetermined
ratio.
The bondholder benefits as the price of the bond
has the potential to rise as the underlying stock
rises. But downside is that the price of the bond
 Definition- Interest rate derivative (IRD) is an instrument
based on an underlying asset, the value of which is impacted
by any change in the interest rates.
Types of IRD

OTC Derivatives Over-the-counter - OTC derivatives are

private, bilateral contracts in which two parties agree on how
a particular trade or agreement is to be settled in the future,
Interest Rate usually designed under the framework of International Swaps
and Derivatives Association (ISDA) agreement.
Derivative
Products Forwards -A forward contract is a private (OTC) agreement
between two parties in which one party (the buyer) agrees to
buy from other party (the seller) an underlying asset on a
future date at a price established at the start of the contract.

Example: A farmer expects to grow 50,000 apples next year. He can of course sell his apples for whatever the price is when
he harvests it, or he could lock in a price now by selling a forward contract that obligates him to sell 50,000 apples after the
harvest for a fixed price. By locking in the price now, he eliminates the risk of falling apple prices. On the other hand, if
prices rise later, he will not gain but will get only what his contract entitles him to.
 FRA is a forward contract in which one party agrees to lend to
another party a specified amount at a future date for a
specific period of time at an interest rate agreed upon today.
FRAs are used more frequently by banks for hedging their
interest rate exposures.
Example: A company learns that it will need to borrow
10,00,000 in six months' time for a 6-month period. The
interest rate at which it can borrow today is 8%. Company’s
Interest Rate treasurer thinks it might rise as high as 10% over the
forthcoming months. The treasurer will therefore buy FRA in
Derivative order to cover the period of 6 months starting 6 months from

Products now. He receives a quote of 9% from his bank and buys the
FRA for a notional of 10,00,000.
Interest rate swap One counterparty A pays a fixed rate (the
swap rate) to counterparty B, while receiving a floating rate
(usually pegged to a reference rate such as LIBOR). Note that
there is no exchange of the principal amounts and that the
interest rates are on a ‘notional’ (i.e. imaginary) principal
amount. Also note that the interest payments are settled in
net. This kind of swap is called a Plain Vanilla Swap.
 Futures - Futures are same as forward contracts in substance
but are traded on a recognized Stock Exchange. All the terms,
other than the price, are set by the Stock Exchange.
Also, both the buyer and the seller of the futures contracts
are protected against the counter party risk by an entity
called the Clearing Corporation.
NSE contracts have been standardised to expire on the last
Thursday of every month. At any date there are 3 options
available viz, for the month, next month and the month
Futures and following. Lot sizes are fixed by the exchange and margins are
payable.
Options Options -Options are derivative instruments that provide the
opportunity to buy or sell an underlying asset on a future
date. In return for granting the option, the party granting the
option collects a payment from the other party. This payment
collected is called the “premium” or price of the option.
 MCQ
1. Suppose the stock price of Intel is $63, and the call price is $4 with a strike price of $65. If you
write a covered call option, and Intel stock rises to $71, the profit or loss of your strategy is: 
($6), ($2), $6, $4,$8
2. Suppose you buy a Merck put for $2.50 which matures in September with a strike price of $50.
Merck is currently trading at $51.75. If the stock price of Merck falls to $46, the rate of return of
your put option is: 
30%, 160%,100%,90%,60%
3. A put option with an exercise price of $60 was priced at $3. At expiration, the underlying stock
is selling for $64. If you wrote this put for $3, your profit or loss at expiration would be: 
($3), $1, -$1,$4,$3
4. A call option with an exercise price of $45 was priced at $4. If the underlying stock at
expiration is $51, your profit or loss at expiration would be:
$2 , -$2,$-4,$3,$4
 MCQ
5. An at-the-money protective put position (comprised of owning the stock
and the put):
a. has limited profit potential when the stock price rises
b. protects against loss at any stock price below the strike price of the put
c. is equivalent to selling short the stock
d. provides a pattern of returns at the current stock price
e. returns an increase in the stock's value, less the cost of the put

7. Which of the following statements is wrong?

a), For both calls and puts, there is an upper and lower boundary
b), Due to limited liability of an option, the option price cannot be negative.
c), A call option is always worth less than the underlying security on which the
option
d), All is
ofwritten.
the above statements are correct.
e), Both a and b
 MCQ
8. According to the Black-Scholes option pricing model:
the most difficult parameter to estimate is the risk-free interest rate
short selling of the stock is not allowed
the option price does not depend on the risk-free interest rate
an at-the-money call is worth the same as an at-the-money put
the option price does not depend on the expected return of the underlying stock

Which of the following statements about the Black-Scholes option pricing model
9.
(BSOPM) is correct?
The BSOPM assumes that the volatility of the stock is stochastic.
Most of the known mispricings by the BSOPM are consistent across time.
The BSOPM performs well for short-term options and in-the money options.
The BSOPM tends to overprice options with high variance and under
price options with low variance.
MCQ
10 . The Black-Scholes option pricing model can be applied to:
a), valuing portfolio insurance
b), valuing warrants
c), valuing convertible bonds
d), all of the above
e), only b and c
In the Black-Scholes option pricing model, the value of a call is inversely
11 .
related to:
its strike price
the risk-free interest stock
the volatility of the stock
its time to expiration date
its stock price
According to put-call parity, the sum of the call value and the present value
12 .
of the exercise price minus the stock price is equal to:
time value
option premium
put price
call price minus put price
intrinsic value
 MCQ
A dollar increase in stock price would lead to __________in the put option's
14 .
value of _____than one dollar.
a decrease, less
an increase, more
an increase, either less or more
an increase, less
a decrease, more
15. Consider buying of put option, probability that a buyer would have negative
payoff increases with the
increase in stock price
decrease in stock price
increase in maturity duration
decrease in maturity duration
16. When price of underlying asset increases then good option is
buy the call option
sell the call option
buy the put option
sell the put option