FINANCIAL DERIVATIVES AND RISK
MANAGEMENT
(MBAF0802)
Dr. Nitin Chaturvedi
Associate Professor, SFC
Galgotias University, Greater Noida (U.P.)
Options
Options are financial derivatives that give the buyer the right, but not the obligation, to buy
or sell an underlying asset at a predetermined price within a specified period. These
underlying assets can include stocks, bonds, commodities, currencies, or even other
derivatives. Options are commonly used for hedging against market risks, speculation on
price movements, or generating income.
There are two primary types of options:
Call Option: This type of option gives the buyer the right to buy the underlying asset at
a predetermined price (strike price) before the option expires. Call options are typically
used when the buyer expects the price of the underlying asset to rise.
Put Option: This type of option gives the buyer the right to sell the underlying asset at
a predetermined price before the option expires. Put options are typically used when the
buyer expects the price of the underlying asset to fall.
Example of Options
Let's say you're interested in buying a call option for Company XYZ, which is
currently trading at $50 per share. You believe that the stock price will increase in
the near future.
Current Stock Price: 50
Strike Price: 55
Expiration Date: 1 month from today
You decide to buy a call option contract for Company XYZ with the following
details:
Call Option Premium: 3 per share
Contract Size: 100 shares (standard for most options contracts)
Example of Options
Since each options contract typically represents 100 shares, buying one call
option contract will cost you 300 (3 premium * 100 shares).
Now, there are two scenarios at expiration:
1. Stock Price Increases: If, at expiration, the stock price of Company XYZ
rises above the strike price of 55, let's say it goes up to 60 per share. In this
case, your call option will be "in the money" because you have the right to buy
Company XYZ shares at 55, which is below the current market price of 60.
You can exercise your option, buy 100 shares of Company XYZ at 55 each,
and then sell them at the market price of 60 each. Your profit per share would
be 60 - 55 = 5, and since each contract represents 100 shares, your total profit
would be 5 * 100 - 300 (the premium you paid) = 200.
Example of Options
2. Stock Price Stays the Same or Decreases: If, at expiration, the stock price
of Company XYZ remains below the strike price of 55 or decreases further,
your call option will expire "out of the money."
In this case, you wouldn't exercise your option because it wouldn't be
profitable to buy shares at 55 when you could buy them for less in the market.
Your maximum loss would be limited to the premium you paid for the option,
which is 300.
Types of Options
Options can be categorized into several types based on different criteria. Here are some common types
of options:
Based on the Underlying Asset:
Stock Options: Options contracts where the underlying asset is individual stocks.
Index Options: Options contracts where the underlying asset is a stock market index, such as
the S&P 500 or NASDAQ.
ETF Options: Options contracts where the underlying asset is an exchange-traded fund
(ETF).
Based on the Right Granted:
Call Options: Give the holder the right, but not the obligation, to buy the underlying asset at
a predetermined price (strike price) before or at expiration.
Put Options: Give the holder the right, but not the obligation, to sell the underlying asset at a
predetermined price (strike price) before or at expiration.
Types of Options
Based on the Expiration Date:
European Options: Options that can only be exercised at expiration.
American Options: Options that can be exercised at any time before or at expiration.
Based on Exercise Style:
Cash-settled Options: Options where the underlying asset is not physically exchanged, and the
settlement is made in cash.
Physical Delivery Options: Options where the underlying asset is physically exchanged if the
option is exercised.
Based on the Trading Exchange:
Exchange-Traded Options: Options that are standardized contracts traded on regulated exchanges,
such as the Chicago Board Options Exchange (CBOE) or NYSE Arca.
Over-the-Counter (OTC) Options: Customized options contracts negotiated directly between two
parties and not traded on a regulated exchange.
