The Hindu Business Line : Taking a call on options

On Friday, the two new recruits, Vijay and Rajeev, were the first to enter the conference room. Their objective was to impress the MD and they appeared to have succeeded for he gave them an approving look as he entered.

“Morning gentlemen! Hope you have been enjoying the discussion,” said the MD.

“Very much Sir,” said Vijay. “We did not have a tutor who was qualified to teach derivatives at our business school and our finance faculty tried to do the best they could. Fortunately we had access to a good library and we managed to tool up by ourselves.”

“That is very common in India,” said the MD. “Most people do well despite the faculty and not because of the faculty.”

“I must say that Rahul is very knowledgeable,” said Rajeev.

“Oh! His pedigree is impeccable. One does not go to Xaviers and then Dartmouth for nothing.”

By then everyone else had arrived.

Asian options?

“Okay folks let me reignite our discussion on options,” said Goatee. “Last time Balaji we signed off with a definition of European and American options.”

“By the way is there anything called an Asian option?” asked the MD.

“Yes Sir. It is an option that is based on the average price taken by the underlying asset from the time the contract is initiated till it expires. Such options fall into the category of what are called exotic options.”

“I do not want to go deeper into the issue for such options are relatively more complex,” said Goatee.

“I have a question,” said Curd Rice. “Are options traded on exchanges or are they OTC products.”

“Originally the only way options could be traded was over-the-counter,” said Goatee. “Exchange traded options were introduced by the Chicago Board Options Exchange (CBOE) only in 1973.”

“So does that mean that there is no longer a demand for OTC options,” asked Curd Rice.

“No Sir,” said Goatee. “For many institutional investors the types of options contracts offered by exchanges are inadequate from their standpoint and they seek the freedom to design their own contracts.”

“What is it that could make exchange traded options inadequate from the point of view of institutions,” asked the MD.

“Let me explain Sir. Every options contract has an exercise price and expiration date associated with it. In the case of exchange traded contracts each contract must necessarily incorporate one of the allowable exercise prices and expiration dates.”

“What do you mean by allowable exercise prices and expiration dates,” asked Curd Rice.

“Well Sir for each product on which options contracts can be traded, the exchange will specify a list of allowable exercise prices. Each contract must incorporate one of these prices. Besides, one cannot enter into a contract for any duration. Currently in India the maximum time to expiration of an option on the exchanges is three months.

“Today is September 10. If you go on the NSE you will find that contracts are trading with expiration dates in September, October and November. A December contract will be introduced only when the September contract expires.”

Expiration of contracts

“When do options contracts expire?” asked Balaji.

“In India contracts expire on the last Thursday of the expiration month. If the last Thursday happens to be a holiday then they will expire on the previous business day. In the US, stock options contracts expire on the Saturday following the third Friday of the expiration month.”

“What a funny expression! Is it not the same as saying that the contracts will expire on the third Saturday?” asked Balaji.

“Not quite. The Saturday following the third Friday of the month will be the fourth Saturday of the month if the first day of the month is a Saturday. Otherwise it will be the third Saturday.”

“I must say that options sound quite morbid. Everyone is talking of expiration all the time. Reminds me of an undertaker,” said Ganguly.

“Or a midwife,” said the MD. “The other word that is always bandied about in derivatives is delivery.”

Everyone burst out laughing.

“If the exchange is going to set the price of the option then what is the role of the buyer and the seller?” asked Balaji.

“The exchange sets the exercise price of the option and not the price of the option” exclaimed an exasperated Goatee.

“What is the difference between the two?”

“Unlike in the case of a forward or a futures contract where neither party has to pay the other to enter into the contract, in the case of an options contract the buyer has to pay the seller at the outset. This is because the seller is giving a right to the buyer and rights are never given free. This price that is paid by the buyer at the beginning is called the option price or option premium.”

“Is it refundable?” asked Balaji.

Exercise price

“No! Now let me turn to the exercise price. It is the price payable per unit of the underlying asset if a call option is exercised and the price receivable per unit of the underlying asset if a put option is exercised. An option may or may not be exercised. Consequently the exercise price may or may not enter the picture.”

“So how is this premium determined? Can it also be deduced by ruling out cash and carry and reverse cash and carry strategies like in the case of futures? asked Ganguly.

“Arbitrage free arguments are invoked to price options. However valuation of options is considerably more complex than the valuation of futures.

“To value an option we have to postulate a process for the evolution of the price of the underlying asset. For each hypothesis about the price process we will get a different model. Thus option prices are model dependent.”

“What is this Black-Scholes model?” asked Balaji.

“It is the most widely used model for the valuation of European options on non-dividend-paying stocks.”

“Why should anybody buy a stock which never pays dividends?” asked Balaji.

“Non-dividend paying does not mean that it will never pay dividends. What we mean is that it will not pay a dividend during the life of the option.”

“Are American options always more expensive than European options?” asked Ganguly.

“For a given expiration date and exercise price an American option is usually priced higher. This is because it affords the option holder greater flexibility.”

“Just curious. What are Flex and E-Flex options?” asked Vijay.

“These are options where the trader gets to pick his exercise price and expiration date. However, unlike OTC options they are cleared by the clearinghouse associated with the derivatives exchange.”

“Gentlemen, time,” said the MD. “In Star Trek they said that space was the final frontier. For us time appears to be the final frontier.”

“By the way what do they call women who deal in call options” he said.

“Wilma!” exclaimed Goatee. Wilma was blushing. She had a phenomenal memory for phone numbers and Goatee and the MD had nicknamed her as ‘Call Girl’.

Racy@TheHindu.co.in

http://Racycases.blogspot.com

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