Investment Analysis and

Portfolio management

Investment Evaluation
Risk and Return
 His most famous investment principle is
"Know what you own, and know why you
own it", who is he?
 Paul Samuelson

Dave Ramsey

Ben Graham

Peter Lynch
 Do your homework before making a
decision. And once you've made a
decision, make sure to re-evaluate your
portfolio on a timely basis. A wise holding
today may not be a wise holding in the
future. These are the words of Peter
Lynch, an American businessman and
stock investor. Often described as a
"chameleon," Peter Lynch adapted to
whatever investment style worked at that
time.
Participants
of SECURITIES MARKET
 1. Regulators
CLB
RBI
SEBI
DEA
DCA
Participants
of Securities market cont’d….
2. Stock Exchanges
3. Depositories – NSDL and CSDL
4. Brokers
5. FII
6. Merchant Bankers
7. Primary dealers (Underwriters & Market makers of
govt. securities )
Participants
of Securities market cont’d….
 8. Custodians (back office of MFs)
 9. Bankers to an issue
 10. Debenture Trustees
 11. Credit rating agencies
 12. Transfer agents / Registrars
Settlement
 NSDL and CSDL
 Rolling settlement in T+2 basis
 T – Trade
 T+1 – custodial confirmation
 T+2 – payin and payout of funds and securities
 T+3 – Auction
 T+5 - payin and payout for auctions
Transaction costs
 1. Trading costs – a) Brokerage 3paise-
5paise per Rs100
b) Market Impact Cost
c) STT (.2% delivery &
.03% daytrade)
2. Clearing costs
3. Settlement costs – decreased from 5% to
.5%
Achievements

 ELOB –open Electronic limit order Book system

– NSE on Price –time priority
 VSATs – Very Small Aperture Terminals
 NSCC –national Securities Clearing Corporation
is the counterparty for settlement of trades
 Computerized Trading Terminals –NSE 1995
and BSE 1996
 Internet Trading – 2000
 Free float market capitalisation in 2003
 Recent Developments
Out-cry System Computerized Trading
Single Exchange Trading Multi Exchange Trading
Physical Shares Demat Shares
Long Settlement Cycle Rolling Settlement
Single Trading Floor Additional Trading Floors
Cash Market Cash & Derivative Market
Mutualised Exchanges Demutualised Exchanges
Stock Market Indices
 Price Weighted Index
 Market Value Weighted Index and
 Equal Weighted index

 ET
 Company (Previous close), open, high,low,close,
[Volume,Value,Trades] P/E,MCap, 52week high
& low
Stock Market indices
 To Measure the movement of the market
 Index= (Total Market Cap/ Base value)* base
index

 1978-79 – base year for BSE sensex

 1996 - base year for NSE Nifty
 Foreign Stock Exchange Indexes – DJIA;
S&P500; Nikkei Average of Tokyo & FTSE
(London)
 Three methods for computation of
Stock Market Indices used:
1. Price- weighted Index
2. Value- weighted Index
3. Equal- weighted Index

 Price- weighted Index: Sum of the

prices in a certain year / month / week /
day with reference to base year
 Market Value- weighted Index – each stock
affects the index in proportion to its market
value

 MV weighted index = (Total Current value /

Total Base value) * base index

 Equal- weighted Index – weights equally

assigned to each share and the weighted
average of % change in share

 Equal weighted index = BI + Total weighted

average
 The averaging procedure is adjusted for
stock splits/ dividends paid / rights issue /
bonus issue
 MV weighted method incorporates the
adjustment effectively
SEBI Initiatives
 Regulate the stock exchange business
 Regulate working of intermediaries
 Regulate working of Mutual Funds
 Prohibit Insider trading
 Prohibit unfair trade practices
 Promote investor’s education and training
SEBI Initiatives cont’d…
 Freedom in pricing instruments (Book building
process)
 Introduction of stock invest scheme
 Ban of Badla (due to excessive leverage)
 Screen based trading
 Electronic transfer
 Rolling settlement
 Registration of intermediaries
SEBI Initiatives cont’d…
 Redressal of investor grievances
 Regulation of MFs
 Introduction of Equity Derivatives
 Regulation on opening dummy trading
accounts
 Regulation on Participatory Notes
 STP –straight through processing
STP
 Straight-through processing (STP)
[November 30, 2002] enables the entire
trade process for capital markets and
payment transactions to be conducted
electronically without the need for re-
keying or manual intervention, subject to
legal and regulatory restrictions.
 a mechanism that automates the end-to-end
processing of transactions of the financial
instruments.
 It involves use of a single system to process or
control all elements of the work-flow of a
financial transaction, including what is
commonly known as the Front, Middle, and
Back office, and General Ledger.
 In other words, STP can be defined as
electronically capturing and processing
transactions in one pass, from the point of first
‘deal’ to final settlement.
 THE EVOLUTION

Derivatives Trading
On-line trading
T+1 Settlement Cycle
Free Pricing
Outcry Straight Through Processing
Dematerialisation Single Window, multi-exchange
Physical
settlement Short settlement cycle Wireless Trading

Transparent regulatory Global Exchange

framework Electronic Network Trading

Past Present Future

Future Market Direction ……….
Valuation of Securities
Introduction
 The goal of any investor or corporate
is to maximize the profit.
 The finance manager needs to have
the basic knowledge and
understanding of the framework of
security valuation.
 The concept of time value of money
provide a fundamental background for
the valuation of bonds and stocks.
25
Valuation of assets
 Valuation is the process that links risk and return to determine the
worth of an assets –bonds and stock.
 There are three key inputs required for the valuating the assets.
1. Cash flows : Value of assets is decided based on the expected
cash flow) return.
2. Timing : Timing of return is another input that is require for
valuation of asset. It is period over which returns are expected.
3. Required return : It is another and very important input needed
for valuation of asset. Expected rate of return depends on the level
of risk associated with the given investment.
 Required rate of return varies from investment to investment .
 The greater the risk, greater is the rate of return expected and vice-
versa.

26
Security
 Financial assets or securities are assets
that represent a claim to future cash flows.
 Bond: A bond is a debt security, in which
the authorized issuer owes the holders a
debt and is obliged to repay the principal
and interest at a later date.
 Equity: Capital raised from the owners by
issuing securities representing the
ownership claim to the economic unit.
27
Bond Terminology
 Par Value: Value stated on the face of the
bond that the firm promises to repay at the
time of maturity.

 Coupon Rate: It is the specific interest

rate stated on the bond and payable to the
bond holder.

 Maturity Period: The period for which

28
the bond is valid.
Cash Flows for Stockholders
 Ifyou buy a share of stock, you can
receive cash in two ways
 The company pays dividends
 You sell your shares, either to another
investor in the market or back to the
company
 As with bonds and the price of the
stock is the present value of these
expected cash flows.
29
Concept of valuation
 Valuation is the process that links risk and
return to determine the worth of assets.
 It can be applied to financial assets/securities
to determine their worth at given point of time.
 A security can be regarded simply as a series
of dividends or interest payments received
over the period of time.
 Therefore value of any security can be
defined as the present of these future cash
streams.
30
Value
 What an asset worth today in terms of its
potential benefits
 Role of EPS and P/E in valuation
 Significance of PV
 Valuation of Assets in General

 Thefollowing applies to any

financial asset:
V = Current value of the asset
Ct = Expected future cash flow in period (t)
k = Investor’s required rate of return
Note: When analyzing various assets (e.g.,
bonds, stocks), the formula below is simply
modified to fit the particular kind of asset being
evaluated. n
Ct
V0  
t 1 (1  k )
t
32
Example
 Calculatethe value of the assets if the
annual cash flow is Rs 2000 per year
for 7 years if discount rate is 18 % .

Vo = 2000 × PVIF 18 %, 7
=2000 ×3.812 =7624

33
 The value of financial assets

0 1 2 n
k ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  k) (1  k) (1  k)

34
Security valuation
 Types of security values:
1. Book Value
2. Liquidity value
3. Intrinsic value
4. Replacement value
5. Market value
Concept of Value
 Replacement of Value: is the amount that company
would be required to spend if it were to replace the
existing assets in the current condition.
 Liquidation Value: is the amount a company can be
realized if it sells its assets after having terminated
the business.
 Going concern value is the amount that company
can realized if it sells its business as an operating
one.
 Market value: of an assets or security is the current
price at which assets or security is being sold.
 Book value :assets recorded in historical cost,
depreciated over years
36
Earning Capitalization Approach
 Financial analysts have used this P/E model more frequently
than any other model. According to this model, the expected
earning per share is :
Expected PAT –Preference dividend
Number of outstanding shares
 P/ E Ratio is calculated as the price of the share divided by
earning per share.
 The reciprocal of P/E ratio is called earning price ratio or
earning yield.
 Investors in practice seem to attach a lot of importance to P/E
ratio.
 Some people use P/E multiplier to value the share of
company.

37
P/E value
 Profit Earning Capacity Value =
EPS x Capitalisation Rate
The P/E Ratio Approach
 The P/E ratio is the ratio of current market
price of the share to the earnings per share
of the firm.
 Let
 P0 = Value of Equity Share
 D1 = Dividend per share
 E1 = Earnings per share
 b = Plough-back ratio or retained earnings
 ROE = Return on Equity
39
The P/E Ratio Approach
 The value of equity share is given as
D1 g  ROE  b
P0  D1  E1 (1  b)
rg

E1 (1  b)
P0 
r  ( ROE  b)
 Where b = retention ratio
 ROE = return on Equity
 g= growth rate
Dr.P.R.Kulkarni 4/5/2019 40
Book Value Approach
 Book Value of the share is total net-worth
of the equity shareholders divided by the
number of shares outstanding.

Net  worth(equity  capital  reserves  surplus )

BV 
No.ofShares

41
Liquidation Value Approach
 The minimum value of the share in case
of liquidating the firm in its current status

LV 
Asset  liquidatio n  value  credit  prefrenceshares 
No.ofShares

42
1. Book Value = Networth
Number of Equity shares
2.Liquidity Value = Net Fixed Assets +CA – CL
Number of Equity shares

3.Replacement Value = RV of all assets

Number of Equity shares
n
4.Intrinsic value = Di + Pn
i=1 (1+i)t (1+i)n
Valuation Models
 Provide a basis to compare the relative
merits of two different shares.
 Types:
 Earnings Valuation
 Revenues Valuation
 Cashflow Valuation
 Asset Valuation
 Yield Valuation
 Member Valuation
Earnings Valuation
 Based on Net Profit and EPS
 High P/E multiplier imply that the market is
‘overvaluing’ the security & low P/E is
‘undervalued’
Revenues Valuation
 Using PSR (Price to Sales ratio)
 Or
 PSK = Market capitalisation to total
revenue (one year)
Cashflow Valuation

 Based on EBDIT
 FCF = operational cashflow – capex
Asset Valuation
 Book Value of assets = (total Assets –
long term debt) / No.of shares
 Or Equity (NW) / No.of o/s shares
 Price to BV ratio = MP / BV of shares
Yield Valuation

 Dividend Yield = DPS/ MPS

Member Valuation
 Subsciber based valuation
 Eg. Media & communication
companies; cellular and cable TV
etc.)
 Airtel has 8 lakh members in
kanpur and each uses the service
on an average of 30 months,
spending an average of Rs.1000
per month
 Member valuation = 2400 crores
Valuation of Bonds
 Bonds are negotiable promissory notes that
can be used by individuals, business firm,
government and government agencies.
 Bonds issued by the government or public
sector in India are secured.
 Private sector companies can issue secured
or unsecured bonds.
 Interest rate is fixed and known to investors.
 Expected cash flow consist of annual interest
payment and principal at time of redemption.
52
Bond Value with Maturity

n
C F
P 
t 1 1  Kd  t
1  kd  n

Holding Period of (n) Years :

C1 C2 Cn Fn
P0    ...  
(1  k d ) (1  kd) 2 (1  kd) n (1  kd) n

 P = C x PVIFA kd n +F x PVIF kd, n 53

Value of Bond
 Value of bond or any asset is equal to the
present value of the cash flows expected
from it.
 Let,
 Po = Market Price or Value of Bond
 C = Annual Coupon Payments in Rupees.
 n = number of years to maturity.
 Kd= required rate of return or discount rate
 F= Maturity Value or Par Value
 t = time period when payment is received. 54
Example
A bond whose par value is Rs 1000
bears a coupon rate of 12 %and has
maturity period of 3 years. The
required rate of return on the bond is
10 %. What is the value of this bond?

 Po= Interest ( c) x ( PVIFA Kd,n ) + F

(PVIF Kd n)

55
PV of a bond

 Vo =Rs 120 (PVIFA )

10%,3 Yrs + Rs 1000 (PVIF 10%,3 yrs )
= Rs 120 x 2.487 + 1000 x0.751
= Rs298.44 +Rs 751
= Rs 1049.44

56
Bond Value with Maturity

n
C F
P 
t 1 1  Kd  t
1  kd  n

Holding Period of (n) Years :

C1 C2 Cn Fn
P0    ...  
(1  k d ) (1  kd) 2 (1  kd) n (1  kd) n

 P = C x PVIFA kd n +F x PVIF kd, n 57

Example 2
 Consider the case where an investor
purchase a bond whose face value is
Rs 1000, maturity period is 5years,and
nominal coupon rate is 7%. The
required rate of return is 8%. What
should be he willing to pay now to
purchase the bond if it mature at par?

58
Solution
 Annual interest payable for 5 years= Rs 70
 Principle repayable amount at end of 5 yrs
=Rs 1000
 The intrinsic value or the present value of
bond
=Rs 70 (PVIFA 8%,5yrs ) + Rs 1000( PVIF 8%,5yrs )
=Rs 70 x 3.993 +Rs 1000 x 0.681
=279.51 +681 =Rs 960.51
59
Bond Value (Semi-Annual Payments)

2n
I F

/2
Po  t
 2n
t 1  Kd   kd 
1   1  
 2   2

 Po= I/2 (PVIFA Kd/2,2n)+M (PVIF Kd/2.2n )

60
Example
A bond of Rs 1000 value carries a
coupon rate of 10% and maturity
period of 6 years. Interest is payable
semi- annually. If required rate of
return is 12%.Calculate the value of
bond.

61
solution

 Value of bond =Rs50 (PVIFA 6%,12Yeaes)

+1000 PVIF 6%,12 Years.
 Rs 50 (8.384 ) +1000 (0.497)
 = Rs 419.2+ 497
 = Rs 916.20

62
Valuation of Shares
A company may issue two types of
shares:
 ordinary shares and
 preference shares
Features of Preference and Ordinary
Shares
 Claims
 Dividend
 Redemption
 Conversion

63
Dr.P.R.Kulkarni 4/5/2019
The preference share may be issued
with or without maturity period.
Redeemable preference shares are
with the maturity.
Irredeemable shares are shares
without maturity.
The holders of preference shares get
dividend at fixed rate.

Dr.P.R.Kulkarni 4/5/2019 64
 Valuation of Preference
Shares
 The value of the preference share would be the
sum of the present values of dividends and the
redemption value.
 Po = Dividend x PVIFA kp, n +Maturity Value x PVIF
kp, n

A formula similar to the valuation of bond can be

used to value preference shares with a maturity
period:
n
PDIV1 Pn
P0   
t 1 (1  k p ) (1  k p )
t n

65
Dr.P.R.Kulkarni 4/5/2019
Equity valuation Models
Equity valuation [ Dividend Capitalisation
models]

Dividend discount model

b) zero growth model
c) Gordon model or Constant growth
model
d) Multi-period growth model or
Super - normal growth model
e) h-model
Dividend discount model

P0 = PV of dividend + PV of sale price

Single period valuation model

P0 = D1 + P1 ie.,
(1+r) (1+r)
 Gordon model or
Constant (perpetual) growth
model
P0 = D1
r–g

P0 = pv of stock
g = growth rate
r = required rate of return
D1 = next year dividend
D1 = D0 (1+g)
zero growth model
P0 = D0 (1+g)
Ke - g

Where Ke = capitalisation rate or required rate of return

P0 = pv of stock
g = growth rate
D0 = dividend paid in the past
Multi-period growth model
 A) Two-stage growth
 B) Three-phase model
Two stage growth model or super-
normal growth model
P0= n D0 (1+gs)t + Dn+1 x 1

t=1 (1+ke)t (ke-gn ) (1+ ke)n

D0 = dividend of previous period

gn = normal growth rate
gs = above normal growth rate
ke = required rate of return
n = period of above normal growth
Three phase model
ga phase 1

phase 2

phase 3

gb

Time
Three phase model
P0= A D0 (1+ga)t B Dt-1 (1+gb) DB (1+gn)
+ +
t=1 (1+ke)t t=A+1 (1+ke)t r- gn (1+ ke)B
Multiple year holding period
N [(E0) dp] (1+g) n (P/E) [(E0) (1+g) N+1]
+
n=1 (1+ke)n (1+ke)N

n= growth period ; N = holding period ; E = EPS ; dp = dividend payout

0
ratio ie., DPS/EPS ; ke = required rate of return ;
P/E = Price to Earnings ratio ; g= growth rate
Risk & Return
[When probability value is given]

 E(Ri) = pi (Ri)

 σ (Ri) = Ѵ pi (Ri – E(Ri))2

 Cov(Ra,Rb) = [(Ra – E(Ra)] [((Rb - E(Rb)] x pi

 Coeff of corre = cov a,b / σa x σb

 Portfolio return and risk
 For a 2 security portfolio:-
E(Rp) = wRx + (1-w) Ry

σp2 = w2 σx2 + (1-w)2 σy2 + 2(w) (1-w) covxy

Ie.,
= w2 σx2 + (1-w)2 σy2 + 2(w) (1-w) σx σy corxy

σ p = σ p2
 Standard deviation of portfolio can
also be written as follows:
 For a two stock portfolio:

p  wA  A wB B 2wA wB  A B
  
2 2 2 2

Correlation Coefficient

Diversification can be achieved by investing in

securities that have different risk-return
characteristics. For calculations, I recommend that
you keep returns and standard deviations in
percentages
77
and proportions in decimals.
RISK, RETURN , COVARIANCE AND CORRELATION are computed
as follows:[when probability values are not given]

Return :
Rx = ∑Rx / n
Risk or σ :
σ 2= N ∑Rx 2 - (∑Rx ) 2
N2
Covariance = ∑ [ R - R ] [ R - R ]
x x y y
N
Correlation between X & Y securities:
rx,y = covx,y
σx x σy
Correlation coefficient is also calculated as
follows:[ for stock and market correlation] in Regression
model

r = n ∑XY – (∑X) (∑Y)

√n ∑X2 – (∑X)2 * √n ∑Y2 – (∑Y)2

β= n ∑XY – (∑X) (∑Y)

n ∑X2 – (∑X)2

α = Y _ βX [ where Y = Rx is dependent variable that is

stock return and X = Rm is independent variable that is
Market or Index return ]
In regression model
β measures the change in the dependent
variable (ie., stock) in response to unit
change in the independent variable.
α - measures the value of the dependent
variable even when the independent
variable has a zero value.
So the regression equation is;
Y=α+βX
Modern Portfolio Theory
 introduced by Harry Markowitz with his
paper "Portfolio Selection," which
appeared in the 1952 Journal of Finance.
 Thirty-eight years later, he shared a Nobel
Prize with Merton Miller and William
Sharpe for what has become a broad
theory for portfolio selection.
CAPM

 William Sharpe (1964) published the capital asset

pricing model (CAPM).
 Parallel work was also performed by Treynor (1961) and
Lintner (1965).
 CAPM extended Harry Markowitz's portfolio theory to
introduce the notions of systematic and specific risk.
 For his work on CAPM, Sharpe shared the 1990 Nobel
Prize in Economics with Harry Markowitz and Merton
Miller.
Assumptions -CAPM
 CAPM considers a simplified world where:
 There are no taxes or transaction costs.
 All investors have identical investment
horizons.
 All investors have identical opinions about
expected returns, volatilities and
correlations of available investments.
CAPM
 CAPM decomposes a portfolio's risk into
systematic and specific risk.
 Systematic risk is the risk of holding the market
portfolio. As the market moves, each individual
asset is more or less affected. To the extent that
any asset participates in such general market
moves, that asset entails systematic risk.
 Specific risk is the risk which is unique to an
individual asset. It represents the component of
an asset's return which is uncorrelated with
general market moves.
 According to CAPM, the marketplace
compensates investors for taking systematic risk
but not for taking specific risk.
 This is because specific risk can be diversified
away.
 When an investor holds the market portfolio,
each individual asset in that portfolio entails
specific risk, but through diversification, the
investor's net exposure is just the systematic risk
of the market portfolio.
 Systematic risk can be measured using
beta. According to CAPM, the expected
return of a stock equals the risk-free rate
plus the portfolio's beta multiplied by the
expected excess return of the market
portfolio.
 RISK

Systematic Unsystematic
(external factors/ [internal factors/
Uncontrollable, affects the market specific, unique, related
As a whole like, political,social, to a particular firm/ industry]
Economic) 1. Business risk
1. market risk 2. Financial risk (debt: equity)
2. Interest rate
3. Purchasing power
4. Inflation rate

Real ROR = 1+r / 1 + IR - 1

Where r = required rate of return ; IR = Inflation rate
Risk assessment
The riskiness of the stocks in terms of
(i) Systematic risk (market risk)
And (ii) Unsystematic risk (financial risk) is
tested through market model
Acc. To market model, the return on any
stock is related to the return on the market
index in a linear manner.
 The measure of quantifying systematic risk
is referred as ‘Beta’ / volatality analysis
 The application of Beta is done through
the use of a Regression equation ie., the
returns of stocks are regressed against the
returns of market index.
 Y = α + βX + e
 Beta is used to describe the relationship
between the stock’s return and the market
index’s return
 At an exact 45 0angle beta =+1
 The % changes in the price of the stocks
are regressed
 Eg. Scrip date Price of Index
the stock

Axis bank 28.08.2013 785 17996

Axis bank 12.09.2013 1018 19837
Axis bank 19.09.2013 1163 20505
SML – cost of equity
 a firm's cost of equity, can be estimated using the Capital
Asset Pricing Model (CAPM). According to the model,
the expected return on equity is a function of a firm's
equity beta (βE) which, in turn, is a function of both
leverage and asset risk (βA):
 where:

 KE = firm's cost of equity

 RF = risk-free rate (the rate of return on a "risk free
investment"; e.g., Treasury Bonds, G-secs, gilt edged
secs.)
 RM = return on the market portfolio or Index
What Does Beta Mean for
Investors?
 A stock with a beta of
 zero indicates no correlation with the chosen benchmark
(e.g. cash or treasury bills)

 one indicates a stock has the same volatility as the

market
 more than one indicates a stock that’s more volatile
than its benchmark
 less than one is less volatile than its benchmark
 1.3 is 30% more volatile than its benchmark
 Stocks with a beta of above one should
have returns greater than the benchmark
index, otherwise it is not regarded as a
good investment.
 If the benchmark returns 5%, then a stock
with a beta of 1.5 should return 1.5 times
5% = 7.5% or more. If not, other
investments should be considered instead.
Beta calculation
 beta of a stock, a widely used risk
management tool that describes the risk of
a single stock with respect to the risk of
the overall market. Beta is defined by the
following equation

 where rs is the return on the stock and rb is

the return on a benchmark index.
 Beta Coefficient
 Beta coefficient is a measure of sensitivity
of a share price to movement in the
market price.
 It measures systematic risk which is the
risk inherent in the whole financial system.
 Beta coefficient is an important input in
capital asset pricing model to calculate
required rate of return on a stock.
 It is the slope of the security market line.
 Formula
 Beta coefficient is calculated as covariance of a
stock's return with market returns divided by
variance of market return.
 A slight modification helps in building another
key relationship which tells that beta coefficient
equals correlation coefficient multiplied by
standard deviation of stock returns divided by
standard deviation of market returns.
 Beta coefficient is given by the following
formulas:
 β = Covariance of Market Return with Stock Return /
Variance of Market Return
 β = Correlation Coefficient × Standard Deviation of
bet. Market & stock Stock Returns /Standard
Deviation of Market Returns
Analysis
 A beta coefficient of 1 suggests that the stock carries the
same risk as the overall market and will earn market return
only.
 A coefficient below 1 suggests a below average risk and
return (where the average means the overall market) while on
the other hand a coefficient higher than 1 suggests an above
average risk and return.
Example:
 Suppose correlation coefficient between
market and share price of Company P is
0.75; standard deviation of market is 15%
and that of share price is 8%, beta can
equals 0.40 (=0.75 × 8%/15%).
THANK YOU
Futures Pricing
 1. Securities providing no income
 2. Securities providing a cash income
 3. Securities providing a known yield

 Futures price = spot price+ carry costs-

carry return
Option pricing
 An option is a contract which gives the
right, but not the obligation, to buy or sell
the underlying at a stated date and at a
stated price
Option pricing
Underlying assets

Individual stock Indices

Introduced 2.7.2001 S &P CNX Nifty
(4.6.2001)

Call option Put option

Option type Buyer (option holder) Seller (option writer)

call right to buy obligation to sell
put right to sell obligation to buy
 Exercise price/ strike price – price at
which the contract is settled
 Expiration date – date on which the
option expires
 Style of option – American (exercised at
any time prior to expiration); European
(exercised on the expiration date)
 Option premium – the price that the
holder of an option pays and the writer
of an option received for the rights
conveyed by the option
 Basis = FP – SP
 +ve basis = FP> SP
 In The Money option
 At The Money option and
 Out of The Money option
ITM option leads to a +ve cahflow
call : SP >EP
Put : SP < EP
ATM option has zero cashflow ie., SP = EP
OTM option has –ve cash flow if exercised
 Intrinsic value of option
 IV = SP - EP
 Call IV = ITM if it is ITM
 IV of call = zero if it is OTM and ATM
 Time value of an option is the difference
between its premium and its IV
 Maximum TV exists when the option is ATM