PRICING OF DERIVATIVES

GROUP MEMBERS:
Arzan Irani M4221

Amruta Chavan M4210

Rishikesh Surve M4252

Sandesh Sawal M4247

Tejal Rashivate M4245


FACTORS AFFECTING OPTION PRICES:
The current stock price, So

The strike price, K

The time to expiration, T

The volatility of the stock price,

The risk-free interest rate, r

The dividends expected during the life of the option.
WHAT IS STOCK PRICE & STRIKE PRICE ??
For call options, the strike price is where the security can be
bought (up to the expiration date).
For put options, the strike price is the price at which shares
can be sold.
STOCK PRICE & STRIKE PRICE:
For a call option, the payoff will be the amount by which the
stock price exceeds the strike price.
Call options therefore become more valuable as the stock
price increases and less valuable as the strike price
increases.
For a put option, the payoff on exercise is the amount by
which the strike price exceeds the stock price.
Put options therefore behave in the opposite way from call
options.
They become less valuable as the stock price increases and
more valuable as the strike price increases.
MONEYNESS
In the money: An in-the-money (ITM) option has positive
intrinsic value as well as time value.
Call option strike price < spot price
Put option strike price > spot price

At the money: An at-the-money (ATM) option has no intrinsic
value, only time value.
Call & Put option strike price = spot price

Out of the money: An out-of-the-money (OTM) option has no
intrinsic value.
Call option strike price > spot price
Put option strike price < spot price

TIME TO EXPIRATION
A specified time after which the option contract is no longer
valid is known as time to expiration.
Expiration of an option contract is the last date on which the
holder of the option may exercise it according to its terms.
The last day to trade an option is the last Thursday of the
expiration month and if that Thursday is trading holiday then it
would be the previous day.
European options cannot be exercised before the expiry of the
contract.
American options can be exercised before the expiry of the
contract.
European options may or may not become more valuable as
the time to expiration increases
American options become more valuable as the time to
expiration increases.

EXAMPLE:
Consider 2 European call options on a stock:
One with an expiration date in 1 month & the other with an
expiration date in 2 months.
Suppose that a very large dividend is expected in 6 weeks.
The dividend will cause the stock price to decline, so that the
short-life option could be worth more than the long-life option.
VOLATILITY
The owner of a call benefits from price increases but has
limited downside risk in the event of price decrease because
the most the owner can lose is the price of the option
(premium).
Similarly, the owner of a put benefits from price decreases, but
has limited downside risk in the event of price increases.
The values of both calls and puts therefore increases as
volatility increases.
INTRINSIC VALUE
The intrinsic value (or "monetary value") of an option is its
value assuming it were exercised immediately.
Thus if the spot price of the underlying security (or commodity
etc.) is above the strike price, a call has positive intrinsic value
(and is called "in the money"), while a put has zero intrinsic
value (and is "out of the money").
TIME VALUE
The time value of an option is the total value of the option,
less the intrinsic value.
It partly arises from the uncertainty of future price movements
of the underlying.
A component of the time value also arises from the unwinding
of the discount rate between now and the expiry date.
In the case of a European option, the option cannot be
exercised before the expiry date, so it is possible for the time
value to be negative;
For an American option, if the time value is ever negative, you
exercise it.
Underlying
price (Rs.)
Strike Price
(Rs.)
Premium
(Rs.)
Intrinsic
Value (Rs.)

Time Value
(Rs.)
100 90 12 10 2
101 90 13 11 2
103 90 14 13 1
88 90 1 0 1
95 90 5.50 5 0.50
INTRINSIC AND TIME VALUE FOR CALL OPTION

EXAMPLE

Underlying
price (Rs.)
Strike Price
(Rs.)
Premium
(Rs.)
Intrinsic
Value (Rs.)

Time Value
(Rs.)
100 110 12 10 2
99 110 13 11 2
97 110 14 13 1
112 110 1 0 1
105 110 5.50 5 0.50
INTRINSIC AND TIME VALUE FOR PUT OPTION

EXAMPLE
BLACK SCHOLES MODEL