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Sunil Parameswaran

The following week, everybody was present well in advance except the MD. He walked in at the last moment apologizing profusely. “Sorry everyone! I am coming straight from the airport. Hope that I have not missed anything.”

“No Sir. We have been waiting for you,” said Goatee.

“What are you guys chatting about?” he asked the two new recruits. “You guys are always in animated discussions.”

“They are both Bengalis Sir,” said Ganguly. “And we love to talk.”

“I guess that is why you are called Chatterjees,” said Goatee.

Everybody burst out laughing. The MD almost spilt his coffee over his shirt.

“Let us continue with our discussion on options,” said Goatee.

“When will an options contract be exercised?” asked Balaji.

“Call and put options will both be exercised only if they are in-the-money. Let me explain what the term means. A call option is said to be in-the-money if the current price of the underlying asset is greater than the exercise price. Thus if we denote the stock price by S, and the exercise price by X, the call option will be in-the-money if S > X. For put options it is the reverse. A put will be said to be in-the-money if S < X.”

“Will an option always be in-the-money?” asked Curd Rice.

“No Sir! It can be out-of-the-money. A call will be said to be out-of-the-money if S < X, while a put will be said to be out-of-the-money if S > X. At times the exercise price of an option may be exactly equal to the price of the underlying asset. That is, S may be equal to X. In such cases both call and put options are said to be at the money.”

“I feel that a call option should be exercised only if the price of the underlying asset is greater than the sum of the exercise price and the premium paid for the option. That is, if S > X + C, where C is the option premium. Am I right?” asked Ganguly.

“Not really,” said Goatee. “The option premium is a sunk cost. And, sunk costs ought not to be factored in while taking an investment decision. Let me illustrate. Assume that a premium of Rs 10 was paid for a call option. Let the stock price be Rs 405 and the exercise price Rs 400. Obviously the option is in-the-money although S < X + C. If the option is exercised the profit for the holder will be 405 – 400 – 10 = -5. That is, there will be a loss of Rs 5. However if the option is not exercised, the entire premium of Rs 10 will be lost. Clearly, although there is a loss in both cases, it is better to lose Rs 5 rather than Rs 10. This is a manifestation of the principle that sunk costs ought not to be factored in while taking a decision.”

“Can the option premium be negative?” asked Balaji.

“Never” said Goatee. “Let me explain why. A negative premium would mean that someone is prepared to pay you to buy an option. If so you could buy it and simply forget about it. If it ends up in-the-money you will get an additional positive payoff. Else, if it ends up out-of-the-money, you need not exercise. Thus, in no case, will you have to confront the spectre of a negative cash flow. This is clearly an arbitrage opportunity.”

“But if an option is out-of-the-money, the option premium can be negative can it not?” persisted Balaji.

“No. An option premium consists of two components, the intrinsic value and the time value. The intrinsic value is equal to the extent by which the option is in-the-money if it is in-the-money, else it is equal to zero. That is, I.V. = Max [0,S-X] for calls and Max [0,X-S] for puts.

“What the expression Max [0,S-X] means is the following: If S-X is positive, that is, if the call option is in-the-money, then the intrinsic value will be S-X. Else, if S-X is negative, that is, the call option is out-of-the-money, then the intrinsic value will be zero. A similar logic applies to puts. Thus, the intrinsic value can never be negative.

“The difference between the option premium and the intrinsic value is referred to as the time value or the speculative value of the option. The time value may be negative for certain deep out-of-the-money European options. However, it will be non-negative for all other options. The sum of the two components will never be negative.”

“Last time you mentioned that an Asian option is based on the average price of the asset. Can such options be useful for a company like ours?” asked the MD.

“They can. For instance, if we are receiving cash flows every month, we may wish to hedge the average cash flow rather than the cash flow for a particular month.”

“What are the variables that influence the option price?” asked the MD.

“In addition to the stock price and the exercise price, the other variables that determine the option premium are the riskless rate of interest, the time to expiration of the option, the volatility of the stock return, and any dividend payouts from the asset.”

“I read somewhere that options are not payout protected.” “What does this mean?” asked Ganguly.

“On many exchanges, the terms of the option contract will not be amended if the underlying stock were to pay a cash dividend. On the other hand, the exercise price and the size of the contract will be changed in the event of other corporate actions such as stock splits, stock dividends and rights issues.”

“What about India?” asked Curd Rice.

“On the National Stock Exchange the terms of the contract are amended if the dividend is perceived as extraordinary. An extraordinary dividend is defined as one in excess of 10 per cent of the current market value of the security. Thus if the current stock price were to be Rs 120, a dividend in excess of Rs 12 per share would be perceived as extraordinary.”

“Let’s break off Gentlemen” said the MD. “I would like to understand corporate actions and their influence on options contracts more clearly. Rahul you can commence next week’s discussion from there.”

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