Submitted to: Muhammad Usman Yusuf Submitted by: Fatima Amin L1S12MSMG0007

MS Management Studies University of Central Punjab, Lahore

Option contract is the right to buy or sell specific securities at a determined price on some future date. Option is the right not the obligation to buy /sell the securities at strike price on the maturity date. Value of an option is calculated by subtracting the exercise price from the value of stock on maturity date. E.g. the stock of Unilever is trading at 20 Rs on 2 March 2011, X and Y contracted that the X will buy the stock at Rs 25 on 2 April 2011 and pays him a premium of 2 Rs. If the strike price on 2 April is: 30 Rs Value of option = 30 25=5 = 15-25 =0 15 Rs

If stock value is less then exercise price the option value would be zero. X at Rs 25 buys back the stock but in the market price is Rs 30. So, X is in profit whereas Y suffers the lose because he is selling his stock of market value of Rs 30 at Rs 25. The price of the option is called premium. Option value would be zero if the stock value is equal to or less than the exercise price, and it would be positive when the stock price is greater than the exercise price. We can estimate the option value by multiplying the probabilities of changing stock value with the expected fluctuated stock value and then taking the summation of all the results. The value of option remains zero until the point of exercise price after that the value of option increases with the increase of stock value. Option value depends on the expiration time. The highest value of option would only be possible if the expiration time is long enough and expiration is not possible until the long time ends. The present value of the exercise price would be zero in such a long time. So that the stock price = value of option. The value of option varies from zero up to the exercise price to the value of stock greater than exercise price. Boundaries of option values are: When the present value of exercise price becomes equals to zero there is maximum option value. When the exercise price is less than the stock value there is an increase in the option value. Stock price < exercise price......... trading out of money Stock price > exercise price..........trading in the money Stock price = exercise price.........trading at the money X have to buy back the stock at Rs 25 but in the market the price is Rs 15. So, X is in loss. Y sell the stock back at Rs 25 but if he sell it in market it is of Rs 15. So, he is in profit.

Time of expiration is directly related with the value of option, greater the time of expiration greater would be the value of option the reason behind is that the option has more time to get the value and longer the expiration time lesser the present value of the exercise price, other things remains constant. There is a convex relationship between the option value and the stock value when the expiration time is closer. It is not suitable for the holder to exercise the option earlier because he would not be able to generate the maximum value of the option and only earn the theoretical value of the option; same is the case with American option holder. Time value of money is also including in option valuation. Longer the expiration time, lesser will be the present value exercise price and higher would be the market interest rate. The higher the volatility of the stock prices the higher the value of option. If the stock prices changes rapidly the value of the option increases. If the stock price does not change the option will be of less value. Two stocks of same expiration time but of different volatilities of the stock price, the stock with greater volatility would be of higher option value. Greater the dispersion of stock prices in that stock greater will be the possible option values. Greater the volatility greater the dispersion higher would be the option value because of the long expiration time to generate the higher value. The higher option value is not based upon the greater future returns but it is the volatility of returns that confirms the high option value. Two related financial assets like the stock and the option on that stock. The price movements in one of the assets equalize by the fluctuations in the prices of the other asset. If the transaction cost and the dividend is zero, the opportunity cost is essential to maintain hedged position, it is the risk free rate on the treasury securities. Buying the stock holding it and write the other options is called hedged position. Option delta is the ratio of stock to option: Option delta = spread of option prices / spread of stock prices = u Vo d Vo / u Vs d Vs = 10 0 / 60-45 = 2/3 It tells us to purchase 2 shares of stock and write 3 options to create the hedged position. It depicts that how much stock and option off-set the price movements to be fixed at the hedged position at which both have the same returns. Return earned on the hedged position depends on the value of option or premium at the beginning of the option. The investment in hedging is less than the amount of premium received on the writing of two options. In short the investment in the stock is long form and it includes the outflow of the cash whereas the short form includes the inflow of cash in the form of premium. In hedged position the investor will earn the risk-free rate of return as in the market equilibrium. Call option, put option and the shares of stocks are called call-put parity in market equilibrium. Black-Scholes option model states that the option pricing concepts are also used to evaluate the other contingent claims. Assumptions of this model include: European options No transaction cost, transparent information, divisible stocks Zero dividends

No imperfections in holding an option Interest rate remains constant Stock prices vary as usual Normal probability distribution Transparent information about the volatility of returns

Approximation of hedge includes: if the stock price increases the slope between the stock price and option value increases and less options have to be written for hedged position or if the stock price decreases the slope reduces and the option value will be less and more options have to be written for hedging. Greater the stock price as compared to exercise price less risky the option is. With the passage of time the changes in stock prices are adjusted to maintain the hedge position. Black Scholes gives the formula for the option value as: Option value = [share price * option delta] loan adjusted The value of option includes the interest rate, variance, expiration time and stock price but it does not include the expected return on the stock. An increase in these factors gives higher value of option and higher stock value. The formula is sensitive because the standard deviation used in it, vigilance is required in depicting that option may be overvalued or undervalued. Hedge ratio gives the proportion at which the prices of the two financial assets adjust. Hedge position is only an approximate position because in reality transaction cost and execution time is required. Emphasis is on the delta option that equalizes the stock price and option value. Other parameters of Black Scholes are: Gamma = derivative with respect to stock price Theta = derivative with respect to expiration time Vega = derivative with respect to volatility Rho = derivative with respect to interest rate American option is the one that is exercisable at any point in time before the expiration date, in case of non dividend stock American and European stock are same. The difference is only between the European and dividend paying American stock. As the dividend increases the value of option decreases other things remains the same. Cash dividend shows the partial liquidation of the company whereas the liquidating dividend reduces the stock price and the option value to zero. Higher the ex-dividend paid before the maturity date lower will be the value of option, other things remains the same. Cash dividend has an effect on the maturity time of the option because it is better to buy the stock at the time of receiving the dividend but at the same time investor have to bear the opportunity cost i.e. the interest on exercise price. Investors have to choose either the interest or the dividend. Dividends are adjusted by the Black Scholes i.e. by subtracting all the present values of the expected future dividend from the sock value to get the adjusted stock price. Wholey give the modified Black Scholes model having the prediction error less than that of Black

Scholes. It includes the adjustment of dividend, ex-dividend time and decline in stock price at ex dividend date. But still it overestimates the high volatility stock and in the money options and underestimates the low volatility stock and out of money options. Index option is written on large portfolio of securities e.g. NYSE index. Debt option is an actual debt or future contract that protects the investor from interest rate fluctuations. Foreign currency options are written on the foreign currency units e.g. USD, Yen, pounds etc.