Executive Programme In Management And Insurance

Investment Analysis

Class Notes 9

2009

Prof P. Sen
Indian Institute of Management Calcutta
 Options Markets

 OTC Markets

 Exchanges

 Options Clearing Corporation : National Securities

Clearing Corporation Limited (NSCCL) – as a middle
layer between buyer and seller
 Options Trading

 OTC Markets
 Customized
 Comparative low volumes
 Higher costs

 Exchanges
 Most of the trading
 High degree of standardization – market
participants trade in a limited and uniform set of
securities
 Contracts involve buying and selling of 100 shares
 Adjustments take place for stock dividends and
stock splits
 Quotations show both “in the money” and “out of
money” contracts
 Adjustments

 Bonus issue (stock dividend)

If ratio is m:n,
new strike price = p * n / (n+m)

 Rights issue
Ration = m:n
Issue price = R
Old exercise price = X
New exercise price = (nX + mR) / (m + n)
 Options Trading – Continued

 Exchanges (contd)
 Normal to see offsetting quotes: higher price for
puts would mean lower price for calls.
 Discrepancies may occur because of trades taking
place at different times
 Maturities tend to be relatively short – THREE
months. However, for example in the US there can be longer
term options too – typically based on larger company
securities or indexes – LEAPS (Long Term Equity
Anticipation Securities)

 Option Types
 Options traded in India are European Options.
In the US most of the traded options in the US are American
Options, though there are some exceptions – Foreign
Currency options and Stock Index options
 NSE NIFTY Options

• European Style

• Trading Cycle: 3 month trading cycle – the near month (one), the next
month (two) and the far month (three)

• Expiry Day: Last Thursday of the expiry month. If the last Thursday is
a trading holiday, then the previous trading day.

• Permitted Lot Size: 200

• Strike Price Interval: 10

Options Trading – Option Clearing Corporation

1. Clearinghouse for options trading –owned by the exchanges

(NSCCL owned by NSE)

3. After deal is struck, OCC places itself between the two traders
– positioning itself as the effective buyer and seller.

5. All individuals therefore have to deal only with the OCC

7. OCC guarantees contract performance.

9. Margin requirements for writer. The extent is determined by :

 Whether and to what extent the option is trading “in money”.

The extent determines the margin needed.

 Extent of margin is influenced by other securities in the

investor’s portfolio. For example if the call option writer has
the underlying stock then that can be held as part of the
brokerage account
 Options Trading – Type of Options

 Index Options http://online.wsj.com/documents/inions.htm

 Futures Options

 Foreign Currency Options

 Interest Rate Options

Reference : http://online.wsj.com/documents/mktindex.htm
 Options Trading– Type of Options (contd)
“Exotic Options”
 Asian Options – (also called an average option) is an option whose
payoff is linked to the average value of the underlier on a specific set of
dates during the life of the option
 Barrier Options – depend not only on some asset price at expiration but
also that it falls below a barrier price
• Knock in : exists after a barrier has been achieved
• Knock out : ceases to exist after a barrier has been achieved
 Lookback Options – depends on the maximum or minimum prices
during the life of the asset
 European Call Payoff : amount by which the final price exceeds
the minimum price achieved during life of option
 European Put Payoff : amount by which the maximum price
achieved during the life of the option exceeds the final price
 Currency Translated Options – derivative where the payoff is defined
in variables in one currency and paid in another
 Quanto - fix in advance the exchange rate at which an
investment in foreign currency will be converted
 Binary Options – Discontinuous payoff eg. “All or nothing” – pays
nothing if below strike price at time T and pays fixed amount Q if above
strike price
 Stock Options
Microsft ( MSFT ) Underlying stock price*: 25.61
Call Put
Expiration Strike Last Volume Open Interest Last Volume Open Interest
Oct 5.00 20.60 160.00 110.00 ... ... ...
Jul 15.00 10.50 20.00 285.00 ... ... ...
Jul 17.50 8.00 250.00 1,515.00 ... ... 20.00
Jul 20.00 5.50 126.00 4,827.00 ... ... 22,396.00
Oct 20.00 5.77 3.00 1,420.00 ... ... 6,845.00
Jan 22.00 4.03 99.00 76,960.00 0.20 150.00 120,060.00
Jul 22.50 3.10 297.00 13,002.00 ... ... 71,417.00
Aug 22.50 3.10 1,446.00 3,976.00 0.05 390.00 2,026.00
Oct 22.50 3.30 188.00 18,422.00 0.15 15.00 6,910.00
Jan 22.50 3.60 21.00 654.00 ... ... 15,572.00
Jan 24.50 1.95 165.00 112,060.00 0.60 422.00 187,034.00
Jul 25.00 0.55 24,015.00 137,827.00 0.05 1,955.00 100,129.00
Oct 25.00 1.25 1,671.00 94,499.00 0.55 179.00 39,988.00
Jan 25.00 1.65 1,460.00 40,161.00 0.85 97.00 14,938.00
Jan 27.00 0.75 1,413.00 285,606.00 1.85 25.00 115,325.00
Jul 27.50 0.05 121.00 129,998.00 1.95 746.00 7,520.00
Aug 27.50 0.10 1,092.00 6,127.00 1.95 817.00 6,009.00
Oct 27.50 0.25 1,536.00 185,820.00 2.10 200.00 12,105.00
Jan 27.50 0.55 516.00 17,946.00 2.20 22.00 4,371.00
Jan 29.50 0.25 22.00 72,628.00 4.40 1.00 24,228.00
Jul 30.00 0.05 10.00 12,129.00 4.50 775.00 2,991.00
Oct 30.00 0.05 40.00 9,204.00 4.50 31.00 459.00
Jan 30.00 0.15 260.00 29,466.00 ... ... 681.00
Jan 32.00 0.10 209.00 142,123.00 6.50 100.00 14,940.00
Jul 32.50 ... ... 2,290.00 7.00 750.00 203.00
Aug 37.50 0.05 50.00 ... ... ... ...
*Underlying stock price represents listed exchange price only. It may not match the composite
closing price.
 Options Strategies -1
 Comparisons (of Stock Only (A), Call Only (B) and Combination of Call &
Bill (C) )
 B provides much higher sensitivity to price increases and would
benefit the investor with certain beliefs about price increases
 C provides a level of insurance

 Protective Put (buy stock + buy put)

 Provides a form of portfolio insurance. However during price
increases profits curtailed by cost of put

 Covered Call ( buy stock + sell call → as compared to “Naked Call” which
is just the call)
 Profit when decision to sell at a certain price – Sell Discipline

 Straddle (buy put +buy call)

 Apparently payoff always positive – however both a call and put have
to be purchased. There is a region of losses
 Variations – Strips (2 puts + 1 call), Straps (1 put + 2 calls)
 Options Strategies -2

 Spreads (Two or more calls (or puts) on the same stock with differing
exercise prices or maturity dates –with a combination of buying and
selling)
 Money Spread – purchase of one option and the simultaneous
sale of another with a different expiration date
 Time Spread – sale and purchase of options with differing
expiration dates
 Three price regions. (example of “Bullish Spread” provided in
excel sheet – payoff either increases or unaffected by price
increase)
 Pricing “anomalies” may be a motivation for spreads
 Collars (protective put + write call option)
 brackets value of portfolio between two bounds
 Appropriate for investors who have a wealth goal but are
unwilling to suffer a loss beyond a certain level
 Some financially engineered products like “equity linked note”
are similar to Collars
 Put-Call Parity Relationship
ST ≤ X ST > X

Payoff for Call 0 ST - X

Owned

Payoff for Put ST – X 0

Written

Total Payoff (C-P) ST – X ST - X

Payoff of Long Call & Short Put

Payoff
Combined = Long Call
Leveraged Equity

Stock Price

Short Put
 Arbitrage & Put Call Parity

Since the payoff on a combination of a long call and a short put are equivalent to
leveraged equity, the prices must be equal.

C - P = S0 - X / (1 + rf)T

If the prices are not equal arbitrage will be possible

If the stock pays dividend, then the general formula becomes :

C - P = S0 - X / (1 + rf)T + PV (dividends)
 Put Call Parity – Disequilibrium Example

Stock Price = 110

Call Price = 17
Put Price = 5
Risk Free = 10.25% (annual), 5% (semi-annual)
Maturity = .5 yr
X = 105

Write Call & Buy Put

C - P > S0 - X / (1 + rf)T
17- 5 > 110 - (105/1.05)
12 > 10
Since the leveraged equity is less expensive, acquire the low cost alternative and sell
the high cost alternative.
 Put-Call Parity Arbitrage

Cash Flow in 6
Months
Position Immediate ST < 105 ST ≥ 105
Cashflow
Buy Stockd -110 ST ST

Borrowa X/(1-r)T=100 +100 -105 -105

Sell Callb +17 0 -(ST-105)

Buy Putc -5 105-ST 0

Total +2 0 0

Notes : a. r= 5 % semi annual T = 6 months

b. Exercise Price = 105, Sale Price of Option = 17
c. Exercise Price = 105, Cost of Option = 2
d. Stock price now = 110
 Option-like Securities

• Callable Bonds
• Convertible Securities
• Warrants
• Collateralized Loans
 Futures and Forwards

• Forward - an agreement calling for a future delivery of an asset at an

agreed-upon price

• Futures - similar to forward but feature formalized and standardized

characteristics
• Key difference in futures
– Secondary trading - liquidity
– Marked to market
– Standardized contract units
– Clearinghouse warrants performance
 Forward Contracts vs Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
 Key Terms for Futures Contracts

• Futures price - agreed-upon price at maturity

• Long position - agree to purchase
• Short position - agree to sell
• Profits on positions at maturity
Long = spot minus original futures price
Short = original futures price minus spot

Types of Contracts
• Agricultural commodities
• Metals and minerals (including energy contracts)
• Foreign currencies
• Financial futures
– Interest rate futures
– Stock index futures
 Trading Mechanics

• Clearinghouse - acts as a party to all buyers and sellers.

– Obligated to deliver or supply delivery
• Closing out positions
– Reversing the trade
– Take or make delivery
– Most trades are reversed and do not involve actual delivery
 Margin and Trading Arrangements

• Similar to trading in Stocks, there is an Initial Margin - funds deposited to

provide capital to absorb losses and a Maintenance (or Variation) Margin – an
established value below which a trader’s margin may not fall. In addition there is
a Margin call - when the maintenance margin is reached, broker will ask for
additional margin funds

• Marking to Market - each day the profits or losses from the new futures price are
reflected in the account.

• Convergence of Price - as maturity approaches the spot and futures price

converge

• Delivery - Actual commodity of a certain grade with a delivery location or for

some contracts cash settlement
 Marking to Market
Futures Prices over 5 days :

Day Price Remark

0 5.10 Today
1 5.20
2 5.25
3 5.18
4 5.18
5 5.21 Delivery

Daily Mark to Market

Day Profit Daily Proceeds (5,000 X Profit/Loss)

1 0.10 500
2 0.05 250
3 -0.07 -350
4 0.00 0
5 0.03 150

550
 Cash Vs Actual Delivery

 Most Futures contract call for actual delivery

 Warehouse receipts
 May be settled with higher or lower grade commodities in
case of supply constraints – premiums/discounts applicable
in such cases
 Cash Delivery for Financial Futures
 For example a contract involving delivery of $250 times the
value of the index

Regulations & Taxation

• Inter alia limits of price variations

• Because of marking to market – current tax rather than deferred tax

 Trading Strategies

• Speculation -
– short - believe price will fall
– long - believe price will rise
• Hedging -
– long hedge - protecting against a rise in price
– short hedge - protecting against a fall in price
 Speculation

No. of T-Bonds 2,000

Current (November) Spot Price 100.00

Futures price for December 99.50

Speculator's Exp Spot Price in December 98.50

Margin for trading 10.00%

Contract Size 200,000

Margin 20,000

Profit if expected price comes true 2,000

ROI 10.0% in ONE month!

Price Variation 1.0%
 Hedging
T-Bond Prices in December
98.50 99.50 100.50

Short Hedge (for sellers of assets/ commodities/

services)

Bond holdings (value = 2000 * PT) 197,000 199,000 201,000

Futures Profit or Loss (short) 2,000 0 -2,000 (Sell Future Now Buy in December)
Total 199,000 199,000 199,000

Long Hedge (for purchasers of assets / commodities/

services)

Cash Outflow for Purchase -197,000 -199,000 -201,000

Futures Profit or Loss (Long) -2,000 0 2,000 (Buy Future Now Sell in December)
Total -199,000 -199,000 -199,000
 Types of Hedging

 Cross Hedge - Hedging a position using futures on

another commodity eg., hedging for bauxite using
aluminum. Risk : Is relationship between aluminum and
bauxite stable?

 Portfolio Hedge
 Commodity Futures return have been observed to
have a negative correlation with stock returns. Some
studies have estimated this at -.24.
 These future contracts can thus be used for portfolio
diversification. Increase of commodity prices will be
hedged by a long position on that commodity and
would thus be an inflation hedge
 Basis and Basis Risk
• Basis - the difference between the futures price and the spot price
– over time the basis will likely change and will eventually converge
• Basis Risk - the variability in the basis that will affect profits and/or hedging
performance

A long-short futures position will profit when basis narrows

Now
Spot price : $291
Futures Price (3 months away) : $296
Basis = $5
Tomorrow
Spot price : $294
Futures Price : $298.50
Basis = $4.50
Gain on holding : $3
Loss on short futures : $2.50
Net Gain : $0.50
 Types of Hedging (contd)

Calendar Hedge
Investor takes a long position in a futures contract of one
maturity and a short position in the same commodity – but
with a different maturity

Example :
September Maturity Contract (Long) + August Maturity Contract Short
September Price increases by $.05 August price increases by $.04
Net Position : 5 – 4 = $.01 profit