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CA-FINAL-SSFFMMCHAPTER-12BOPTIONSFCA RAJESH RITOLIA8YEARS TEACHING EXPERIENCE

a)Updated notes can be downloaded free of cost from our website: cassinha.inb)Updated classes can be covered infuture at free of costc)Module covers Suggested, RTP, PM upto May 2017d)145Questions are covered in103 differentQuestionse)16Questionsof TheoryHELPING HAND INSTITUTEG-80, 2NDFLOOR, GUPTA COMPLEX, LAXMI NAGAR, DELHI-92PH: 9350171263,8447824414Email: rajeshritolia@yahoo.comWeb: cassinha.inFollow us on Facebook : https://www.facebook.com/www.correctingmyself.in/Follow us on Instagram : helpinghand_ca_ipcc_final3rdEdition

95%of Questions of May-17 was from our notes

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12A.0 INDIAN CAPITAL MARKETa)Broadly Indian Financial Market consists of Capital Market, Money Market and the Debt Marketb)The organized part of the Indian financial system can be classified from the point of view of regulatoryauthority as-RBIregulating Commercial Banks, Foreign Exchange Markets, Financial Institutions, NBFC etc.-SEBI regulating Primary Market, Secondary Market, Derivatives Market and market intermediaries likeMutual Funds, Brokers, Merchant Banks, depositories.12A.0.1 INDIAN CAPITAL MARKET(a)Role of Capital MarketiIt is the indicator of the inherent strength of the economy.iIt is the largest source of funds with long and indefinite maturity for companies and therebyenhances the capital formation in the country.iItoffers a number of investment avenues to investors.iIt helps in channeling the savings pool in the economy towards optimal allocation of capital in thecountry.

12A.0.2 STOCK MARKET AND ITS OPERATIONS1.Secondary markets are also referred to as StockExchange.2.It is a place where the securities issued by the Government, public bodies and Joint Stock Companiesare traded.3.There are 21 Stock Exchanges in the country.List of recognized stock exchangehttp://www.rushabhinfosoft.com/Webpages/COMPANY%20LAWS/HTML/Appendix-87.htm3.Leading Stock Exchanges in India:Bombay Stock Exchange (BSE ) and Natio nal StockExchange (NSE).http://www.world-stock-exchanges.net/top10.html12A.0.3 Functions of Stock Exchanges[T-1][M11-6bi-4]Write short notes on Function of Stock ExchangeFunctions of the stock exchangescan be summarized as follows:(a)Liquidity and Marketability of Securities:Investors can convert their securities into cash at any timeat the prevailing market price. Investors can change their portfolio as and when they want to change,i.e. they can at any time sell one security and purchase another.(b)Fair Price Determination:This market is almost a perfectly competitive market as there are largenumber of buyers and sellers. Due to nearly perfect information, active bidding take place from bothsides. This ensures the fair price to be determined by demand and supply forces.(c)Source for Long term Funds:Securities are traded and change hands from one investor to the otherwithout affecting the long-term availability of funds to the issuing companies.(d)Helps in Capital Formation:There are thenexusbetween the savings and the investments of thecommunity.

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(e)Reflects the General State of Economy:The performance of the stock markets reflects the boom anddepression in the economy. It indicates the general state of the economy to all those concerned, whocan take suitable steps in time.12A.1 Derivatives[T-2][M04-06][M03-06][PM-J17-17, 21] [PM-J15-17, 21]What is a "derivatives"? Briefly explainthe recommendation of the L C Gupta Committee on derivatives.[N07-5c-8](a)What are derivatives?(b)Who are the users and what are thepurposes of use?(c)Enumerate the basic differences between cash and derivatives market.[M11-7d-4] [RTP-M14-20d][PM-J17-18] [PM-J15-18]What is the meaning of underlying in relationto a derivative instrument?(a)Derivatives:It is a financial asset which derives its value from some specifiedunderlying assets.Derivativesdo not have any physical existence but emerges out of a contract between two parties.It does not have any value of its own but its value depends on the value of other physical assets.The underlying assets may be shares, debentures, tangible commodities etc.The parties to the contract of derivatives are the parties other than the issuer of the assets.The transactions in derivatives are settled by the offsetting in the samederivative. The difference invalue of the derivatives is settled in cash.There is no limit on number of units transacted in the derivative market because there is no physicalassets to be transacted.(b)Users of Derivatives market:Hedgers ;Speculators;Arbitrages;(c)Function of Derivatives MarketsThey help in transferring risk from risk averse people to risk oriented people.They help in discoveries of future prices.

Example-1Today date = 01/01/2012Today price of Flat = Rs 95000 = known asspot priceMr A wants to purchase flat on 31/03/2012, but he has fear that price of flat may go up, then how he canhedge himself from rising of prices.To hedge himself he can enter into contract on 01/01/2012 for purchase of flat on 31/03/2012Mr A hasentered into Contract for purchase of flat with Mr B. Terms of the Contract are as follows

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Date of Contract = 01/01/2012Contract price of Flat = Rs.100000 [Strike Price or Contracted Price or Forward Price, Specified Price]Date of maturity = 31/03/2012 [Strike Date, Expiry date, Maturity Date, Specified Date]Benefit of ContractBy entering into contract Mr A has fixed its purchase price of Flat at Rs.1 lacs.Even if price of flat increases/decreases, Mr A has to pay Rs.1 lac.Now suppose,Actual priceof flat increase or decrease as followsIn case of Settlement (SpeculativeTransaction)In case of Delivery (Hedging)DateActual price ofFlatLong Position ofMr AShort Position ofMr BPurchase price forMr ASale price for MrB05/01/2012Rs.1.2Lacs+0.2-0.2Rs.1 LacsRs.1 Lacs25/01/2012Rs.1.5 Lacs+0.5-0.5Rs.1 LacsRs.1 Lacs05/02/2012Rs.1.8 Lacs+0.8-0.8Rs.1 LacsRs.1 Lacs25/02/2012Rs.1.3 Lacs+0.3-0.3Rs.1 LacsRs.1 Lacs15/03/2012Rs.0.9 Lacs-0.1+0.1Rs.1 LacsRs.1 Lacs30/03/2012Rs.1.2 Lacs+0.2-0.2Rs.1 LacsRs.1 Lacs31/03/2012Rs.1.3 Lacs+0.3-0.3Rs.1 LacsRs.1 LacsWhy this gain or loss arises to each party of contractThis is because of Contract between A and BThis contract is known as Derivative InstrumentGain or loss due to contract arises due to change in prices of flat [Under lying Assets]Hence contract derives its value from Flat [Underlying Assets]Value of the derivative instrument [Contract] is equal to gain or loss to each party.The same type ofcontract can be done for shares, debenture, etc through stock exchange.

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12A.2 Option[T-3][N02-03][PM-J17-24] [PM-J15-24]Write short notes on the Option.[N97-05]Call and put option with reference to debentures.(a)Options:Options are contracts which provide the holder theright to sell or buya specified quantityof an underlying asset at a fixed price on or before the expiration of the option date.Options provide a right and not the obligation to buy or sell.The holder of the option can exercise the option at his discretion or may allow the option tolapse.

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b)Strike or Exercise Price:The specified price at which the option can be exercised is known as theStrike Price.c)Option Premium/Price:In options, the buyer pays option premium to seller.In case, the right is not exercised later, then the premium is not refunded by the option writer.d)By buying Call option Holder fixes upper limit of its purchase price but doesnot fix lower limit ofpurchase price

f)Long and short position:Buyer of an option= long positionSeller of an option = short positiong)Today 01/09/2012

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There will be maximum 3 Options on same underlying assets of 3 different maturity datesSepCall, Oct Call, Nov Call.Option is settled on last Thursday of month.h)Option is distinguished by Underlying Assets, Maturity Date and Strike Price.Today Date = 10/09/2012CMP of Share of X Ltd = Rs.100Call Option on Share"s of X Ltd may be asfollows for Sep monthSep Call 120, Sep Call 140, Sep Call 110 etc. All three Call options are different product.Example-2*** [Understanding of Call Option]On 01/01/2012 Ram enters into contract with Shyam with following terms & Conditions(a)Ram has theright but not the obligation to buy 100 shares of A Ltd on 31/03/2012 @ Rs.50 per shares.(b)If Ram does not exercise the rights of purchase, then Shyam can not sell it to Ram.(c)It means ram has purchased the [Rights of Purchase] from Shyam.(d)Ram has to pay premium [Cost of Rights of Purchase] to Shyam say Rs.5 per share.Spot price of Shares of A Ltd as on 01/01/2012 = Rs.45Price of Call Option as on 01/01/2012 = Rs.5What is the benefit and obligation of above contract to Ram and ShyamOn31/03/2012Benefit/(Loss) of Call Option to Ram and ShyamActual Market price of share on 31/03/2012Rs.35Rs.43Rs.50Rs.60Rs.70Ram has Rights to Purchase share from Shyam atstrike priceRs.50Rs.50Rs.50Rs.50Rs.50Where from Ram should buy shares (Lower of above)MarketMarketMarket orShyamShyamShyamExercise of Call option by RamNoNoNoYesYesOption-1In case of Settlement/ Speculative Gain/Loss on maturity dateGain to Ram due to exercise of Call Option000Rs.10Rs.20Loss to Shyam due to exercise of Call Option by Ram000Rs.10Rs.20Calculation of net gain/(Loss ) = G ai n on Maturity-Premium PaidNet Gain/(Loss) to Ram-Rs.5-Rs.5-Rs.5Rs.5Rs.15Net Gain or (Loss) to ShyamRs.5Rs.5Rs.5-Rs.5-Rs.15Status of OptionOutOutAtInInOption2In case of Hedging/ Actual DeliveryPurchase price of Share to Ram(MP of UA-Gain on settlement)Rs.35Rs.43Rs.50Rs.50Rs.50Sell price of Share to Shyam(MP of UA-Loss on settlement)Rs.35Rs.43Rs.50Rs.50Rs.50Example-3*** [Understanding of Put Option]On 01/01/2012 Ram enters into contract with Shyam with following terms & Conditions(a)Ram haspurchased(Right to Sell UA)(Put Option)right but not the obligation to sell 100 shares of ALtd on 31/03/2012 @ Rs.52 per shares.(b)If Ram does not exercise the rights of sale, then Shyam can not buy share from Ram.(c)It means Ram has purchased the [Rights of SaleUA] from Shyam. In other words, Ram has purchasedPut Option from Shyam(d)Ram has to pay premium [Cost of rights of sale] to Shyam say Rs.6 per share.Say Spot price of Shares of A Ltd as on 01/01/2012 = Rs.45While spot price of Put Option [Right of Sale] as on 01/01/2012 =Rs.6What is the benefit and obligation of above contract to Ram and Shyam

CHAPTER-12AOPTION DERIVATIVE12A_A.7

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On 31/03/2012Spot Price of Share as on 31/03/2012Rs.35Rs.43Rs.52Rs.60Rs.70Ram has the rights to sell share to Shyam at StrikePriceRs.52Rs.52Rs.52Rs.52Rs.52Where should Ram sell Shares[Ram should sell at higher of Spot and Strike]ShyamShyamMarketMarketMarketExercise of Put option by Ram (Holde r o f Putoption)YesYesNoNoNoOption-1In case of Settlement/ Speculative Gain/Loss on maturity dateGain to Ram due to exercise of Put Option179000Loss to Shyam due to exercise of Put Option byRam179000Calculation of net gain/(Loss) = Gain on Maturity-Premium PaidNet Gain/(Loss) to Ram113-6-6-6Net Gain or (Loss) to Shyam-11-3666Status of OptionInInAtOutOutOption-2In case of Hedging/ Actual DeliverySale price of Share to Ram(MP of UA + Gain onSettlement)5252526070Purchase price of Share to Shyam(M P o f UA +Loss on Settlement)525252607012A.3Calculation of Gain/(Loss) on Settlement of OptionQ NoExamPM-J15PM-J16PM-J17RTP1M09-O-4a-1050541AM10-O-3a-45155N12-172M06-5b-744482AM16-1d-52BN08-2c-6,N09-O-5a-6,N11-6b-8,M10-1b-447512C42453Question-1 [M09-O-4a-10][PM-J17-54][PM-J15-50]The equity share of VCC Ltd is quoted at Rs.210. A 3-month call option is available at a premium of Rs.6 pershare and a 3-month put option is available at a premium of Rs. 5 per share.The strike price in both cases in Rs. 220; andThe share price on the exercise day is Rs.200, 210, 220, 230, 240.(a)Calculate purchase price/Sale Price of Holder in case of actual delivery. [Not part of Q](b)Calculate Gain/(Loss) of Holder in case of settlement. [Not part of Q](c)Ascertain the net payoffs to the option holder of a call option and a put option.(d)Ascertain the status of Option. [Not part of Q]Also indicate the price range at which the call and the put options may be gainfully exercised.Question-1A [M10-O-3a-4][PM-J17-55][PM-J15-51] [RTP-N12-17] [SP]A call and put exist on the same stock each of which is exercisable at Rs.60. They now trade for:Market price of stock or stock indexRs.55Market price of callRs.9Market price of putRe.1Calculate the expiration date cash flow, Investment Value, and net profit from:(a)Buy 1 call(b)Write 1 call(c)Buy 1 put

CHAPTER-12AOPTION DERIVATIVE12A_A.8

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(d)Write 1 putFor expiration date stock prices is Rs.50, Rs.55, Rs.65, Rs.70Question-2 [M06-5b-7][PM-J17-48][PM-J15-44] [ICWA-J07]**The market received rumour about ABC corporation's tie-up with a multinational company. This has inducedthe market price to move up. If the rumour is false, the ABC corporation stock price will probably falldramatically. To protect from this an investor has bought the call and put options.He purchased one 3 months call with a striking price of Rs.42 for Rs.2 premium, and paid Re. 1 per sharepremium for a 3 months put with a striking price of Rs.40.(a)Determine the Investor's position if the tie up offer bids the price of ABC Corporation's stock up to Rs.43in 3 months.(b)Determine the Investor's ending position, if the tie up programme fails and the price of the stocks fallsto Rs.36 in 3 months.Question-2A [M16-1d-5] [SP]Fresh Bakery Ltd"s share price has suddenly started moving both upward and downward on a rumour thatthe company is going to have a collaboration agreement with a multinational company in bakery business. Ifthe rumour turns tobe true, then the stock price will go up but if the rumours turn to be false, then stockprice will fo down. To protect from this an investor has purchased the following call and put option:(i) One 3 months call with s striking price of Rs.52 for Rs.2 premium per share.(ii) One 3 months put with s striking price of Rs.50 for Rs.1 premium per share.Assuming a lot size of 50 shares, determine the followings:(a)Determine the Investor's ending position, if the collaboration agreement push the share price of thestocks to Rs.53 in 3 months.(b)Determine the Investor's ending position, if the collaboration agreement fails and the share price of thestocks crashes to Rs.46 in 3 months.Question-2B [N08-2c-6] [N09-O-5a-6] [N11-6b-8] [M10-1b-4][PM-J17-51][PM-J15-47] [SP]Mr. X established the following spread on the Delta Corporation's stock(i) Purchased one 3-month call option with a premium of Rs.30 and an exercise price of Rs.550.(ii) Purchased one 3-month put option with a premium of Rs. 5 and an exercise price of Rs.450.Delta Corporation's stock is currently selling at Rs.500. Determine profit or loss, if the price of DeltaCorporation's:(a) remains at Rs.500 after 3 months.(b) falls at Rs.350 after 3 months.(c) rises to Rs.600.Assume the size option is 100 shares of Delta Corporation.Question-2C[PM-J17-45][PM-J15-42][SP]Mr. A purchased a 3 months call option for 100 shares in XYZ Ltd. at a premium of Rs.30 per share, with anexercise price of Rs.550. He also purchased a 3 month put option for 100 shares of the same company at apremium of Rs.5 per share with an exercise price of Rs.450. The market price of the share on the date ofMr. A"s purchase of options, is Rs.500. Calculate the profit or loss that Mr. A would make assuming that themarket price falls to Rs.350 at the end of 3 months.Question-3 [ICWA-D08]**Rax Investments Ltd. deals in equity derivatives. Their current portfolio comprises of the followinginvestments.Infosys Rs.1,400 Call expire December 2010200 units bought at Rs.50 each (cost)Infosys Rs.1,425 Call expire December 20103,000 units bought at Rs.33 each (cost)Infosys Rs.1,350 Put expire December 20104,000 units bought at Rs.22 each (cost)What will be the profit or loss to Rax Investments Ltd. in the following situations?i)Infosys closes on the expiry day at Rs.1,550.ii)Infosys closes onthe expiry day at Rs.1,460.

CHAPTER-12AOPTION DERIVATIVE12A_A.9

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iii)Infosys closes on the expiry day at Rs.1,280.(Ignore transaction cost and taxation).12A.4 Calculation of Value of Option/Intrinsic Value of Option at expirationQ NoExamPM-J15PM-J16PM-J17RTP4N12-3a-849534AN10-1c-54852

Question-4 [N12-3a-8][PM-J17-53][PM-J15-49]***You as an investor haspurchased a 4 month call option on the equity shares of X Ltd of Rs.10, of which thecurrent market price is Rs.132 and the exercise price Rs.150. You expect the price to range between Rs.120to Rs.190. The expected share price of X Ltd and related probability is given below:Market price120140160180190Probability0.050.200.500.100.15Compute the following:(a)What is the expected value of share price 4 month hence? [Ans: Rs.160.50](b)Value of call option at the end of 4 months, if the exerciseprice prevails. [Rs.10.50](c)What is the expected value of option price at expiration. Assuming that the option is held to this time.Question-4A [N10-1c-5][PM-J17-52][PM-J15-48] [SP]Equityshare of PQR Ltd. is presently quoted at Rs.320. The market price of the share 6 months has thefollowing probability distribution:Market price180260280320400Probability0.10.20.50.10.1(a)A put option with a strike price of Rs.300 can bewritten.(b)You are required to find out expected value of option at (i.e. 6 months) [Ans: Rs.30]12A.5 Factors affecting value of OptionQ NoExamPM-J15PM-J16PM-J17RTPT-4M14-7b-430315[T-4][M14-7b-4][PM-J17-31] [PM-J15-30]Factorsaffecting value of an optionThe valuation of an option depends upon a number of factors relating to the underlying asset and thefinancial market. Some of these factors are:a)Current value of the Underlying Asset.b)Future Price: The future price level is amajor determinant of the option premium.c)Strike price of the option: The exercise of the option depends upon the difference between the strikeprice and the actual price of the underlying asset. In case of call option, the value of option will decline

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as the strike price increases, and in case of put option, the value of the option will increases as thestrike price increases.d)Expiration time of Option:The longer the time to expiry, higher would be the value of the option.e)Rate of Interest: The option holder has to pay the option premium up front, i.e., in advance to buythe option. So, there is always an opportunity cost of this premium. Increase in interest rate willincrease the value of the call option but will reduce the value of the put option.f)Income from Underlying Asset: During the life of the option, there may arise interest or dividendincome on the underlying assets. The value of the asset will decrease, as the interest or dividend ispaid. So, the value of the call option decreases and the value of the put option increases as more andmore interest and dividends are paid on the underlying assets.Summary of effect of various factors on value of optionFactorCall Option ValuePut Option ValueIncrease in value of Underlying AssetIncreasesDecreasesExtent of Volatility in Value of AssetIncreasesIncreaseIncrease in Strike PriceDecreasesIncreasesLonger Expiration TimeIncreasesIncreasesIncrease in Rate of InterestIncreasesDecreasesIncrease in Income from AssetDecreasesIncreasesQuestion-5Assume that TIC Ltd. equity is currently at Rs.500. It is now July 1. Three Call Options are quotedTIC (550) Rs.10Exp. Date29.11.2002TIC (500) Rs.50Exp. Date29.11.2002TIC (450) Rs.100Exp .Date..:..31.1.2003 (IgnoreCommissions)(a)Why thepremiumon January call (450) is so much higher than the premium on the November (500)call.(b)Suppose that you purchased 100 shares of TIC on June 1 at a cost of Rs.475 per share. You wrote (sold)one contract TIC (450) 31.01.2003 on July 1. Suppose that on 31.1.2003 TIC was at Rs.525.(i) Would the holder January Call (450) benefit from exercising the call? Why?(ii) If the call were exercised what is your tax status?(c)Suppose you do not own TIC shares. You simultaneously write one November (55 0) and buy oneNovember (500) call. What is your annualized rate of return if TIC stock closes in November at Rs.575.(Ignore commissions & dividends).12A.6 Uses of OptionQ NoExamPM-J15PM-J16PM-J17RTP678N15-1d-539910M07-2a-811M10-O-4b-81213N13-2b-83643(a)Hedging:If Holder of Option buys option for actual delivery, then such transaction is known ashedging. In this case, only Sale/Purchase is to be done through option(b)Speculative Transaction:If any person buys or sells option only for earning profit not for actualdelivery, then such transaction is known as speculative transaction. Such transaction involves risk. Itinvolves, both sale and purchase are to be done.

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(c)Arbitrage Profit:If any person buys or sells option to earn risk less profit on the basis of fair valueand actual value of option. Such transaction does not involve any risk. It involves, both sale andpurchase are to be done.Question-6 [ICWA-J04]***A portfolio manager purchased 1000 equity share's of Reliance Industries Ltd. @ Rs.510 per share. Hewants to hedge the position by writing an April call with a strike price of Rs.530 and call premium Rs.10.Alternatively, he wants to hedge by buying putoption of strike price Rs.530 and premium of Rs.10.(a)Find out his profit or loss if the share price goes up to Rs.560 or Rs.540 or 525 or 490.(b)Does the strategy of buying a stock and writing a call manage his risk effectively?(c)Under which circumstance should the portfolio manager buy a put option?12A.6.1 Hedging of Foreign Exchange receivable/ Payable through Option

Question-7***UK exporter is to receive $ 10000 in 3 Months. He wants hedging through option. How he can do so.Case-1 Strike Rate£ 1 =$ 1.5Calculate £ receivable if Spot Rate in 3 months; £ 1 = $ 1.7; £ 1 = $ 1.3Case-2 Strike Rate$ 1 = £ 0.667Calculate £ receivable if Spot Rate in 3 months; $ 1 = £ 0.6; $ 1 = £ 0.8Question-8 [N15-1d-5][PM-J17-39-FOREX]***XYZ an Indian Firm,will need to pay Yen 500000 on 30th June. In order to hedge the risk involved inForeign Currency Transaction, the firm is considering two alternative methods, i.e. Forward Market Coverand Currency Option Contract.On 1stApril, following quotations JY/INR are as follows:Spot3 months Forward1.9516/1.97111.9726/1.9923The prices for forex currency option on purchase are as follows:Strike PriceJY 2.125Call Option (June)JY 0.047Put Option (June)JY 0.098For excess or balance of JY covered, thefirm would use Forward rate as future spot rate.You are required to recommend the cheaper hedging alternative for XYZQuestion-9***A company has a receivable of $ 100 million in 3 months. A bank has offered him a put option with exerciseprice Rs.37/$.The premium payable is Rs. 1 per $. The probability of exchange rate after 3 months isProbability0.200.300.300.20Exchange rate (Rs.1 per $)35.0035.5036.0036.50In your opinion, should the company purchase put option? [Ans: Rs.0.25]

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Question-10[M07-2a-8] [SP]**XYZ Ltd. a US firm will need £3,00,000 in 180 days. In this connection, the following information isavailable:Spot rate 1 £ = $ 2.00180 days forward rate of £ as of today = $1.96Interest rates are as follows:U.K.US180 days deposit rate4.5%5%180 days borrowing rate5%5.5%A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of $ 0.04.XYZ Ltd. has forecasted the spot rates 180 days hence as below:Future rateProbability$ 1.9125%$ 1.9560%$ 2.0515%Which of the following strategies would be most preferable to XYZ Ltd.?(a)aforwardcontract(b)amoney market hedge(c)an option contract [Ans: $594900](d)no hedgingShow calculations in eachcase.Question-11[M10-O-4b-8]***A Ltd of U K has imported some chemical worth of USD 3,64,897 from one of the US suppliers. The amountis payable in six months time. The relevant spot and forward rates are:Spot RateUSD 1.5617-1.56736 months ForwardRateUSD 1.5455-1.5609The borrowing rates in UK and US are 7% and 6% respectively and the deposit rates are 5.5% and 4.5%respectively.Currency options are available under which one option contract is for GBP 12,500. The option premium forGBP at astrike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096 (put option) for 6 monthsperiodThe company has three choices:(i)Forward Cover [Ans:GBP 236102.89](ii)Money Market Cover; and [Ans: GBP 236510.10](iii)Currency Option [Ans: GBP 227923.00]Whichof the alternatives is preferable by the company?Question-12A London based firm has supplied a nuclear machine to a New York based firm for $120m, payment due in 4months time. The current spot rate is 1 £ = $ 1.58. The London firm has apprehensions that USD maydecline against British Pound. The London firm is considering the proposal of buying a put option, 4 monthsmaturity, strike Price 1 £ = $ 1.60. The option premium is $0.0002 per £. Explain the position of the Londonfirm on maturity if the Spot price of $ on maturity is £0.625; £0.65; £0.615. Also Calculate Premium Paid byLondon based firm.Question-13[N13-2b-8][PM-J17-43-FOREX] [PM-J15-36-FOREX]An American firm is under obligation to pay interest of Can$ 1010000 and Can$ 705000 on 31stJuly and30thSep respectively. The firm is risk averse and its policy is to hedge the risks involved in all foreigncurrency transactions. The finance manager of the firm is thinking of hedging the risk considering twomethods i.e. Fixed Forward or OptionContracts.It is now June 30. Following quotations regarding rates of exchange, US$ per Can$, from the firm"s bankwere obtained.Spot Rate Can$ 1 = US$0.9284-0.92881 Month Forward Rate Can$ 1 = US$0.9301

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3 Months Forward Rate Can$ 1 = US$0.9356Price for a Can$/US$ option on a US Stock exchange (cents per Can$, payable on purchase of the option,contract size Can$ 50000) are as follows:Strike Price (US$/Can$)CallsPutsJulySepJulySep0.931.562.560.881.750.941.02NANANA0.950.651.641.922.34According to the suggestion of finance manager if option areto be used, one month option should be boughtat a strike price of 94 cents and three months option at a strike price of 95 cents and for the remainderuncovered by the options the firm would bear the risk itself. For this, it would use forward rate as the bestestimate of spot. Transaction cost are ignored. Recommended, which of the above two methods would beappropriate for the American firm to hedge its foreign exchange risk on the two interest payments.12A.7 Breakeven Point for Call or Put OptionQ NoExamPM-J15PM-J16PM-J17RTP14(a)Breakeven Point for Call Option = Strike Price + Premium Paid(b)Breakeven Point for Put Option = Strike Price-Premium PaidQuestion-14[ICWA-D03]Current stock prices is Rs.100, strike price of call option Rs.100, option premium Rs.5. Find out break evenprice at which there will be no loss no profit for a call buyer.12A.8 Calculation of Value of Option at beginning(a)The value of option is the price at which it can be purchased or sold. Premium payable on option isalso known as value of option.

12A.9Calculation of Value of Option at beginning by Expected Gain ApproachQ NoExamPM-J15PM-J16PM-J17RTP15

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Question-15***A six month call option for a share has the exercise price of Rs.38 along with probabilities and price atexpiration date as below:Probabilities0.100.250.300.250.10Price of share3036404450(a)What is the expected price ofthe share after six months? [Ans: Rs.40](b)What is the value of option at expiration? [Ans: Rs.3.30](c)What is the value of option at beginning assuming interest rate to be 12% p.a.? [Ans: Rs.3.11](d)What is the value of option at beginning assuming interest rate to be 12% p.a. continuouslycompounding. [Ans: Rs.3.107]12A.10Calculation of Value of Option by Price Differential ApproachQ NoExamPM-J15PM-J16PM-J17RTP1616A1717Aa)Under price differential approach, the value ofoption is taken as equal to difference between PV ofStrike Price and Spot Price on the valuation date.

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Question-16***Given the following dataStrike Price= Rs.90Current stock Price= Rs.100-Risk free rate of interest= 10% p.a. (notcontinuous compounding)(a)Calculate theoretical current (f air) p rice of a Euro pean call opt ion expi ring after one year. [Ans:Rs.18.19](b)If the price of the call option is Rs.15, then how can arbitrageur make profit. [Ans: Min Arbitrage Profitis Rs.3.50]Question-16A [SP]Given the following dataStrike Price= Rs.180Current Price of one share= Rs.200-Risk free rate of interest= 10% p.a. (Continuous compounding)(a)Calculate theoretical current (f air) p rice of a Euro pean call opt ion expir ing after oneyear. [Ans:Rs.37.13](b)If priceof the call option is Rs.30, then how can an arbitrageur make profit.Question-17**Given the following dataStrike Price= Rs.200Current stock Price= Rs.185Time until expiration= 6 months.-Risk free rate ofinterest= 5% p.a. (not continuous compounding)(a)Calculate theoretical current (fair) price of a European put option expiring after six months.(b)If European put option price is Rs.5, then how can an arbitrageur make profit.Question-17A [SP]Given the following dataStrike Price= Rs.400Current stock Price= Rs.370Time until expiration= 6 months-Risk free rate of interest= 5% p.a. (Continuous Compounding)(a)Calculate theoretical current (fair) price of a European put option expiring after six months.(b)If European put option price is Rs.10, then how can an arbitrageur make profit.12A.11Calculation of Value of Option by Binomial Model Tree or RiskNeutralisationMethodQ NoExamPM-J15PM-J16PM-J17RTP1818A19M11-1b-54650M13-1619AM12-6a-8434619B20N15-1c-54721M13-1c-54222

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232424A2526M09-1a-8454926A27a)Assumption of BM:CMP of theshareis S and it can take two possible values at maturity, S1 or S2such that S1 > S > S2.b)The investor can borrow or lend an amount (B) at risk free rate of interest 'r'c)The strike price, K, is givend)Hedge Ratio is known as delta. Itrefers to the number of units of stock one should hold for each optionsold to create a risk-free hedge.e)The BM is based on the concept of Replicating Portfolio, which refers to a portfolio consisting of theunderlyingasset and a riskless asset, which generates the same cash flow as a specified call/putoption.Replicating Portfolio = Borrowing + Δ number of units of the underlying asset

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Question-18***The CMP of share is Rs.50. It may be either Rs.60 or Rs.40 after a year. A call option with a strike price ofRs.50 is available. The rate of interest is 12%.(a)Calculate value of Call Option.(b)Show Holding Positionafter a year.(c)If Actual price of CallOption is Rs.5 or Rs.8, whether arbitrage profit is possible under BMQuestion-18A [CS-J04] [SP]The CMP of share of BB Ltd is Rs.190. It may be either Rs.250 or Rs.140 after a year. A call option with astrike price of Rs.180 is available. The rate of interest is 9%. Rahul wants to create a replicating portfolio inorder to maintain his pay off on the Call Option for 100 shares.Find out (i) Hedge ratio (ii) Amount of borrowing (iii) fair value of call (iv) his cash flow position after a year.(f)Limitation of BMBasic assumption that there are only two possibilities for share price in future is impractical andhypothetical. Such a strategy may not work because there are more and more possibilities of shareprice.12A.11.1Risk NeutralisationMethod(a)The current price of the share is S and it can take two possible values at maturity, S1 or S2 such thatS1 > S > S2.

Question-19[M11-1b-5][PM-J15-50][PM-J15-46] [RTP-M13-16]***The CMP of an equity share of Pranchant Ltd Rs.420.Within a period of 3 months, the maximum andminimum price of it is expected to be Rs.500 and Rs.400 respectively. If the risk free rate of interest be 8%p.a. What should be the value of a 3 month call option under 'Risk Neutral Method" at the strike price ofRs.450. Given e0.02= 1.0202b)Calculation of Probability in alternative wayP1 for S1 = [SP x (1+r)/SP-LP/SP]/[HP/SP-LP/SP] = [1+r-d/u-d]Where r = PIR; u = S1/S; d = S2/Su = S1/S = 500/420 = 1.1904d = S2/S = 400/420 = 0.9523r =0.05P1 = (ert-d)/(u-d) = (1.0202-0.9523)/(1.1904-0.9523) = 0.2851

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Question-19A [M12-6a-8][PM-J17-46][PM-J15-43] [SP]Sumana wanted to buy shares of EIL which has a range of Rs.411 to Rs.592 a month later. The presentpricepershare is Rs.421. Her broker informs her that the price of these shares can store up to Rs.522within a month, so she should buy a one month CALL of EIL. In order to be prudent in buying the call, theshare price should be more than or at least Rs.522 theassurance of which could not be given by her broker.Though she understands the uncertainly of the market, she wants to know the probability of attaining theshareprice Rs.592 so that buying of a one month CALL of EIL at the executing price of Rs.522 is justified.Advice her. Take the risk free interest to be 3.60% and e0.036=1.037.Question-19B [SP]Find the value of one year European Call Option using:Spot Price = Rs.200; u = 1.4; d = 0.90; Exercise Price = Rs.220; r = 0.15Note: Value of u indicatespossible higher price; value of d indicates possible lower priceQuestion-20[N15-1c-5][PM-J17-47]**Mr Dayal is interest in purchasing Equity Shares of ABC Ltd which are currently selling at Rs.600 each. Heexpects that price of share may go upto Rs.780 or may go down to Rs.480 in 3 months. The chances ofoccurring such variations are 60% and 40% respectively. A call option on the shares of ABC Ltd can beexercised at the end of 3 months with strike price of Rs.630.(i)What combination of share and option should Mr Dayal select if he wants a Perfect hedge?(ii)What should be the value of option today (Risk Free rate is 10% p.a.)?(iii)What is the expected Rate of Return on the option?Question-21[M13-1c-5] [PM-J15-42-CB]*Ramesh owns a plot of land on which he intends to construct apartment units for sale. No. of apartmentunits to be constructed may be either 10 or 15. Total construction costs for these alternatives are estimatedto be Rs.600 lakhs or Rs.1025 lakhs respectively. Current market price for each apartment unit is Rs.80lakhs. The market price after a year for apartment units will depend upon the conditions of market. If themarket is buoyant, each apartment unit will be sold for Rs.91 lakhs, if it is sluggish, the sale price for thesame will be Rs.75 lakhs. Determine the current value of vacant plot of land. Should Ramesh startconstruction now or keep the land vacant? The yearly rental per apartment unit is Rs.7 lakhs and the riskfree interest rate is 10% p.a.Assume that the construction cost will remain unchanged.12A.11.2Calculation of S1 or S2 if TFV of Option is givenQuestion-22[SP]*Spot Price Rs.60.A one year European call Option is being quoted in the market at option premium of Rs.15with exercise price of Rs.55. Risk-free return = 12% p.a (NCC). The stock can either rise or fall after a year.It can fall by 30% by what % can it rise.12A.11.3Calculation of TFVPOunder RNMQuestion-23**Spot price of Share Euro 500. After six months either 450 or 550. Find the value of European put opinionwith a strike price of Euro 510, if risk free rate is 14% p.a. Use Risk neutral method.12A.11.4Value of Option for foreign currency under RNMa)In case of Foreign exchange transaction, interest rate is given for LHC and RHC.b)P1 = (CMP of Share*(1+PIRHC)-S2*(1+PILHC))/(S1*(1+PILHC)-S2*(1+PILHC))

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Question-24***From the following datacalculate price of a call option expiring after one year:Let spot exchange rate= Rs.50 per $Strike rate= Rs.60 per $Risk free interest rate for Rupees= 10% p.a.Risk free interest rate for Dollars= 15% p.a.Expected range of (Maximum andMinimum) spot rate on maturity of option afterone year= Rs.70-Rs.40 per$.Question-24A [SP]From the following data calculate price of a call option expiring after one year.Let spot exchange rate= Rs.60 per pound.Exercise/Strike rate= Rs.64per pound.Risk free interest rate for Rupees= 15% p.a.Risk free interest rate for pound= 20% p.a.Expected range of (Maximum and Minimum) spot rate on maturity of optionafter one year= Rs. 76.25-Rs.45 perpound.12A.11.5Value of Option under BM or RNM if Dividend is paid

Question-25***The equity share of MadhavLtd. is quoted at Rs.100 on spot. The company will pay a dividend of Rs.5 pershare after 2 months from today. After three months the price of the equity share will be either Rs.140 orRs.80. Assuming risk free rate of interest to be 12% p.a., find the option premium of three months ECOconsidering the risk strike to be Rs.110.12A.11.6Two Stage binomial methodIn this case, we will apply movements of price for two periods.(a)Calculation of 2 prices of UA at the end of 1stperiodS1= S*d1S2= S*u1(b)Calculation of 4 prices of UA at the end of 2ndperiod as followsS3= S*d1*d2Or S1*d2S4= S*d1*u2Or S1*u2S5= S*u1*d2Or S2*d2S6= S* u1*u2Or S2*u2(c)Calculation of Probabilities for S1 and S2P1= (S*(1+PIR)-S2)/(S1-S2)P2= 1-P1(d)Calculation of Probabilities for S3, S4 from S1 and Probabilities of S5, S6 from S2P3= (S1*(1+PIR)-S4)/(S3-S4)P4= 1-P3P5= (S2*(1+PIR)-S6)/(S5-S6)P6= 1-P3

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(e)Calculation of Join Probabilities S3, S4, S5, S6 from SJP1of S3= P1*P3JP2of S4= P1*P4JP3of S5= P2*P5JP4of S6= P2*P6(f)Calculate Value of Option at Maturity at S3, S4, S5and S6Expected value of ECO at maturity = JP1*S3+ JP2*S4+ JP3*S5+ JP4*S6(g)TFV of Option today = PV of ECO at maturity(h)Calculation of ACO (American Call Option)Question-26[M09-1a-8][PM-J15-49][PM-J15-45]***Consider a two year American call option with a strike price of Rs.50 on a stock the current price of which isalso Rs.50. Assume that there are two time periodsof one year and in each year the stock price can moveup or down by equal percentage of 20%. The risk free interest rate is 6%. Using binominal option model,calculate the probability of price moving up and down. Also draw a two step binomial tree showingpricesand payoffs ateach node.Question-26A [SP]Current price of a share is Rs.100. Over each of next six months periods, it is expected to go up by 10% orto go down by 10%. Risk free rate is 8% p.a. cc. What is the value of 1 year ECO with a strikeprice ofRs.100. Use RNM.Question-27[SP]The equity share of Murari Ltd. is currently selling at Rs.100. Find the value of 6 months maturity putoption, strike price Rs.101, risk free rate of interest 12% p.a. Over 3 monthsperiod, it is expected to go upby 10% or go down by 10%. Over next 3 months period, it is expected to go up by 8% or go down by 6%.

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12A.12Black Scholes ModelsQ NoExamPM-J15PM-J16PM-J17RTPT-5M15-7c-42628N06-4a-85235628AN08-1a-1253572930[T-5][M15-7c-04][PM-J17-56] [PM-J15-52]State any four assumptions of Black Scholes Model(a)The Black-Scholes model is used to calculate a theoretical price of an Option.

NoteK*e-rt*N(d2) represents this borrowing which is equivalent to the present value of the exercise pricetimes an adjustment factor of N(d2)b)The market price of the share will go down after the payment of the dividend. The value of call optionwill decrease andthe value of the put option will increase as more and more dividends are paid.

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Question-28[N06-4a-8][PM-J17-56][PM-J15-52] [ICWA-J07]***From the following data for certain stock, find the value of a call option:Price of stock now=Rs.80Exercise price= Rs.75Standard deviation of continuously compounded annual return= 0.40Maturity period= 6 monthsAnnual interest rate= 12%Givene0.12x0.5= 1.062In 1.0667 = 0.0645Question-28A [N08-1a-12] [PM-53] [SP]following information is available for X company and call option:Current share priceRs.185Option exercise priceRs.170Risk free interest rate7%Time of the expiry of option3 yearsStandard deviation0.18Calculate the value of option using black scholes formula.12A.12.1 The BSM and the dividend PaymentQuestion-29[ICWA-D06]The share of E Ltd is trading at Rs.408 and the call option exercisable in three months time has an exerciseprice of Rs.400. SD is estimated to be 22% per year. The annualized Treasury Bill rate is 5%. The companyis going to declare a dividend of Rs.10and is expected to be paid in two months time.What is the value of call option.12A.12.2 Value of Put Option under BSMQuestion-30[ICWA-D08] [SP]The share of A Ltd is trading at Rs.120 and the put option exercisable in three months time has an exerciseprice of Rs.112. SD is estimated to be 30% per year. The annualized Treasury Bill rate is 7%. What is thevalue of Put option.12A.13Different Type of Strategy for earning profit through OptionQ NoExamPM-J15PM-J16PM-J17RTP31323333A34M09-4b-8475735036373838AM12-7394041

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By adopting following strategy, we may earn certain profit in option12A.13.1 Stranglea)Buy a put and a call option with thesame expiration date but with different exercise pricesb)Strike Price of the Put (K1)< Strike Price of Call (K2)c)Expiry date of Put = Expiry date of Calld)On Maturity date(i)CMP of UA > K2, Call Option will be exercised(ii)CMP of UA < K1,Put Option will be exercised(iii)K1 < CMP of UA < K2, both option will be lapsede)Strangle is purchased when there is strong move in the market which may be up or down.Question-31What will be the payoff profile of a trader who adopts stranglestrategy under following details:OptionStrike PricePremiumPutRs.60Rs.3CallRs.65Rs.2Question-32A person purchased a call with an exercise of Rs.190 at a premium of Rs.5. He also purchased a put with anexercise price of Rs.185 at a premiumof Rs.6. Both the options have same expiration date. At what price(s) will the strangle break-even?12A.13.2 Straddlea)Buy/Sell a put and a call option with the same expiration date and same exercise pricesb)Strike Price of the Put (K) = StrikePrice of Call (K)c)Exercise price of Put = Exercise Price of Callc)On Maturity date(i)CMP of UA > K, Call Option will be exercised(ii)CMP of UA < K, Put Option will be exercised(iii)CMP of UA = K, both option will be lapsedd)Straddle ispurchased/sold when there is strong move in the market which may be up or down.Question-33Equity shares of Casio Ltd. are being currently sold for Rs.90 per share. Both the call option and the putoption for a 3 month period are available for a strike price of Rs.97 at a premium of Rs.3 per share and Rs.2per share respectively. An investor wants to create a straddle position in this share. Find out his net payoffat the expiration of the option period; if the share price on that day happens to be Rs.90 or Rs.105 orRs.97.Question-33AMr.X purchased 3-months call as well 3-months put,both at strike price of CHF 75. Premium of Call CHF 3:Premium of put-CHF 2. Prepare a table and draw a graph to show pay-offs of Mr. X if expiration prices are60,65,70,71,72,73,74,.....80,85, or 90. Do the same exercise for Y as well. Find whether the maximumamount of loss to Mr. X is equal to call premium plus put premium.

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Question-34[M09-4b-8][PM-J17-57-FOREX][PM-J15-47-FOREX]On 19h April following are the spotratesSpot rate Euro 1 = $1.20; $ 1 = Rs.44.80Following are the quotes of EuropeanOptions:Currency PairCall/PutStrike PricePremiumExpiry DateEUR/USDCall1.20$0.035July 19EUR/USDPut1.20$0.04July 19USD/INRCall44.80Rs.0.12Sep.19USD/INRPut44.80Rs.0.04Sep.19(a)A trader sells an at-the-money spot straddle expiringat three months (July 19). Calculate gain or loss ifthree months later the spot rate is Euro 1 = $1.2900(b)Which strategy gives a profit to the dealer if five months later (Sep. 19) expected spot rate is $1 =Rs.45.00. Also calculate profit for a transaction USD 1.5 million.12A.13.3 Stripsi)Buy one Call + Buy 2 Puts all with thesame exercise priceanddate of expiration.ii)Strike Price of the Put (K) = Strike Price of Call (K)iii)Expiry Date of Call = Expiry date of Putiv)On Maturity date(1)CMP of UA > K, Call Option will be exercised(2)CMP of UA < K, 2 Put Option will be exercised(3)CMP of UA = K, both option will be lapsedStrips is purchased when investor feels that decrease in the stock price is more likely than an increase.Question-35Mr. A purchases a call of 1 shares of A Ltd with 3 months expiration at a strike price of Rs.60. Call PremiumRs.1 per share. At the same time he purchases put of 2 shares of same company with same expiration,same strike price, sameoption premium per share. Find his pay off if the spot price on maturity is 55, 56,....65.12A.13.4 Strapsa)Buy 2 Call + Buy 1 Puts all with thesame exercise priceanddate of expiration.b)Strike Price of the Put (K) = Strike Price of Call (K)c)Expiry Date of Call = Expiry date of Putd)On Maturity date(i)CMP of UA > K, 2 Call Option will be exercised(ii)CMP of UA < K, 1 Put Option will be exercised(iii)CMP of UA = K, both option will be lapsedStrap is purchased when investor feelsthat increase in the stock price is more likely than decrease.12A.13.5 Butter Fliesa)It involves positions in options with three different strikes prices.b)Buying a Call at relatively low strike price = K1Buying a Call at relatively High strikeprice = K2Selling 2 Calls at average of K1 and K2 [K3 = (K1+K2)/2]c)Expiry Date of all Calls are equal

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d)It is adopted by those who expect insignificant movements in the market price.e)This strategy has limited risk and limited profit.f)Abutterfly can be created using put optionQuestion-36Current Spot Price of Share Rs.61. Call options in the market:Strike pricePremiumRs.55Rs.10Rs.60Rs.7Rs.65Rs.5Mr. X buys one call at strike price 55 and one call at strike price 65. Hesells 2 calls with strike price 60.Give pay-offs if spot price on expiry on 51, 52...7012A.13.6 Condor Spreada)It is similar to the butterfly spread but involves 4 strike prices instead of 3 strike prices, resulting in awinder profitable range. The strategy can be either call based or put based (but never with calls andputs used together in the same trade).b)Buying 1 Call Option with K1 < SSelling 1 Call Option with K = SSelling 1 Call Option with K2 > SBuying 1 Call Option K3 > K2c)Expiry Date of all Calls are equald)This strategy is adopted by those operators who expect insignificant movements in the market price ofunderlying asset. This strategy may result in small amount of profit with limited loss.Question-37Suppose spot price is Rs.100A)Buy call at a strike price of Rs.97Call premium Rs.2 per shareB)Sell call at a strike price ofRs.100Call premium Rs.1.50 per shareC)Sell call at a strike price of Rs.102Call premium Rs.1 per shareD)Buy call at a strike price of Rs.103Call premium Rs.0.70 per share12A.13.7 BULL SPREADS(a)Bull SpreadThis strategy is used by those whoexpect that the market price of the underlying assetwill go up. This trading strategy can be accomplished with either puts or calls.(b)Bull Call Spread(i)Buy 1 Call at K1 + Sell 1 Call at K2 with thesame date of expiration.(ii)K1 < K2Question-38Call market dataStrike priceCall premiumNote: Lower the strike price, higher the call premium.10051153

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Question-38A [RTP-M12-7]The current spot price of share of ABC Ltd is Rs.121 with strike price of Rs.125 and Rs.130 are trading at apremium of Rs.3.30 and Rs.1.80 respectively. Mr X a speculator is bullish about the share price over nextsix months. However, he is also of beliefthat share price could also go down. He approaches to you foradvice, you are required to:(a)Suggest a strategy that Mr X can adopt which puts limit on his gain and loss.(b)How much is maximum possible profit.(c)Draw out a rough diagram of the strategy adopted.(d)What will be break-even price of the share?[Assume-No brokerage fees and interest cost/gains](c)Bull Put Spread(i)Buy 1 Put at K1 + Sell 1 Put at K2 with thesame date of expiration.(ii)K1 < K2(iii)The options trader employing thisstrategy hopes that the price of the underlying securities goes upQuestion-39Put market dataStrike pricePut premiumNote: Lower the strike price, lower the put premium.10511151012A.13.8 Bear spread(a)It is entered by the operators whoexpect that the prices of underlying asset will decline.(b)Bear Call Spread(i)Buy 1 Call at K1 + Sell 1 Call at K2 with thesame date of expiration.(ii)K1 > K2Question-40Call market dataStrike priceCall premiumNote: Lower the strike price,higher the call premium.9581052(c)Bear Put Spread(i)Buy 1 Put at K1 + Sell 1 Put at K2 with thesame date of expiration.(ii)K1 > K2Question-41Put market dataStrike pricePut premiumNote: Lower the strike price, higher the putpremium.952105312A.13.9 CALENDER SPREAD(a)Bull calendar spread-The strategy is used by those who expect a bullish tendency in the prices. Inthis strategy the options have the same strike price but different dates of maturities. The strategy canbe either call based or put based (but never with calls and puts used together in the same trade.)

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(b)Call based strategy:, the operator buys call which long maturity period and sells the call with shortmaturity period on the same underlying asset with same strike price. Generally the option premium ofthe long term call ismore than of short term call; the strategy generally requires an initial investment.(i)Buy 1 Call at K + Sell 1 Call at K with differentdate of expiration.(ii)Maturity Period of Call 1 > Maturity Period of Call 2Example:Spot price of a share isRs.40. Mr. X purchases call option maturity 3 months at a premium ofRs.2 per share strike price Rs.45. He writes a call maturity 1 month at a premium of Re. 1 per share strikeprice Rs.45. The net cost of the strategy Re.1. Suppose the spot price on onemonth maturity call is Rs.42.The call is not exercised. Mr. X does not have to pay anything. Now suppose the spot price on the 3 monthsmaturity call is Rs.47. Net profit Re.1 per share.(c)A bear calendar Spreadis used by option traders who believe that the price of the underlyingsecurity will remain stable in the near term but will eventually fall in the long term. In this case, theoperator buys put with long maturity period and sells the put with short maturity period on the sameunderlying asset with same strike price.(i)Buy 1 Put at K + Sell 1 Put at K with differentdate of expiration.(ii)Maturity Period of Put 1 > Maturity Period of Put 2Summary of above StrategiesSlStrategiesOptionOptionMaturity DateStrike Price1StrangleBuy 1CallBuy 1 PutSameK of the Put < K of Call2StraddleBuy 1 CallBuy 1 PutSameK of the Put = K of Call3StripsBuy 1 CallBuy 2 PutSameK of the Put = K of Call4StrapsBuy 2 CallBuy 1 PutSameK of the Put = K of Call5Butter FliesBuy 1Call at K1Buy 1 Call at K2Sell 2 Call at K3SameK1 > K2 andK3 = (K1+K2)/26Condor SpreadBuy 1 Call at K1Buy 1 Call at K3Sell 1 Call at KSell 1 Call at K2SameK1 < S; K = SK2 > S; K3 > K27Bull Call SpreadBuy 1 Call at K1Sell 1 Call at K2SameK1 < K28Bear Call SpreadBuy 1 Call at K1Sell 1 Call at K2SameK1 > K29Bull Put SpreadBuy 1 Put at K1Sell 1 Put at K2SameK1 < K210Bear Put SpreadBuy 1 Put at K1Sell 1 Put at K2SameK1 > K211Bull Calendar SpreadBuy 1 Call1at KSell 1 Call1at KMP of Call1> MP of Call2Same12Bear Calendar SpreadBuy 1 Put1at KSell 1 Put1at KMP of Put1> MP of Put2Same12A.14TheoryQ NoExamPM-J15PM-J16PM-J17RTPT-6N04-5c-4,M06-2b-4[T-6][N04-5c-4]Explain the term 'intrinsic value of an option" and the 'time value of an option.[M06-2b-4]Distinguish between Intrinsic value and time value of an option.(a)Intrinsic value is the value that any given option would have if it were exercised today.Intrinsic Value of an Option at any dayIntrinsic value of Call option (to Holder) at expiration = Max [(Spot Price-Strike Price), or 0]Intrinsic value of put option (to Holder) at expiration = Max [(Strike Price-Spot Price), or 0](b)Time Value:This is the second component of an option"s price. It is defined as any value of an optionother than the intrinsic value. From the above example, if Wipro is trading at Rs.105 and the Wipro100 call option is trading at Rs.7, then we would conclude thatthis option has Rs.2 of time value (Rs.7option price-Rs.5 intrinsic value = Rs.2 time value) . Option s th at hav e ze ro intrinsi c valu e are

CHAPTER-12AOPTION DERIVATIVE12A_A.28

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comprised entirely of time value.Time value is basically the risk premium that the seller requires to provide the option buyer with theright to buy/sell the stock upto the expiration date. This component may be regarded as the Insurancepremium of the option. This is also known as "Extrinsic value." Time value decays over time.12A.15 Compounding concepts of Interest1Calculation of PV of any shares, Bonds etc. from FV, if interest rate is compounding yearlyPV = FV/(1+PIR)PV = FV*PVF(1 Period, PIR)PIR is interest rate of 1 periodExample-1FV of Share at the end of 6 months =Rs.110Period = 6 monthsInterest Rate = 12% p.a. [Compounding Yearly]PIR of 6 months = 6%PV of Share at t0= FV/(1+PIR of 6 months) = 110/1.06 = Rs.103.77 ORPV of Share at t0= FV*PVF(1 Period, 6%)= Rs.110*0.943 = Rs.103.732Calculation of PV of any shares, Bonds etc. fromFV, if interest rate is compounding periodicallyPeriod, Future Value and Interest Rate should be given with period of compoundingPV = FV/(1+PIR)nPV = FV*PVF(n Period, PIR)PIR is interest rate for each compounding periodn = No ofCompounding in Period GivenExample-2FV of Share at the end of 6 months =Rs.110Period = 6 monthsInterest Rate = 12% p.a. [Compounding Half Yearly, Quarterly, Monnthly]CompoundingHalf yearlyQuarterlyMonthlyPIR6% for 6 months3% for 3 months1%for 1 monthNo of Compounding in Year126PV of Share at t0FV/(1+PIR of 6 months)nFV/(1+PIR of 3 months)nFV/(1+PIR of 1 months)nPV of Share at t0Rs.110/1.06110/(1.03)2110/(1.01)6PV of Share at t0Rs.103.77Rs.103.68Rs.103.625AlternativePV of Share at t0FV*PVF(1 Period, 6%)FV*PVF(2 Period, 3%)FV*PVF(6 Period, 1%)PV of Share at t0Rs.110*0.943Rs.110*0.9425Rs.110*0.9420PV of Share at t0Rs.103.73Rs.103.675Rs.103.624Calculation of PV of any shares, Bonds etc. from FV, ifinterest rate is compounding continuouslyPeriod, Future Value and Interest Rate should be givenPV = FV/ertPV = FV*e-rtt = Period in Months /12 or Period in days/365

CHAPTER-12AOPTION DERIVATIVE12A_A.29

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Example-3FV of Share at the end of 6 months =Rs.110Period = 6 monthsInterest Rate (r) = 12% p.a. [Continuously Compounding]t = 6/12 = 0.5 yearsPV of Share at t0= FV/ert= 110/e0.12*0.5= Rs.110/e0.06= Rs.110/1.0618 = Rs.103.5977 ORPV of Share at t0= FV*e-rt= Rs.110*e-0.12*0.5= Rs.110*e-0.06= Rs.110*0.9417 = Rs.103.5875Calculation of FV of any shares, Bonds etc. from PV, if interest rate is compounding yearlyPeriod, Current Value and Interest Rate should be givenFV = CV*(1+PIR)FV = CV/PVF(1 Period, PIR)PIR is interest rate of 1 periodExample-4CVof Share = Rs.105Period = 6 monthsInterest Rate = 12% p.a. [Compounding Yearly]PIR of 6 months = 6%FV of Share at end of 6 months = CV*(1+PIR of 6 months) = 105*1.06 = Rs.111.30 ORFV of Share at end of 6 months = CV/FVF(1 Period, 6%)= Rs.105/0.9433 = Rs.111.316Calculation of FV of any shares, Bonds etc. from CV, if interest rate is compounding periodicallyPeriod, Current Value and Interest Rate should be given with period of compoundingFV = CV*(1+PIR)nFV = CV/PVF(nPeriod, PIR)PIR is interest rate for each compounding periodn = No of Compounding in Period GivenExample-5CV of Share = Rs.105Period = 6 monthsInterest Rate = 12% p.a. [Compounding Half Yearly, Quarterly, Monthly]CompoundingHalf yearlyQuarterlyMonthlyPIR6% for 6 months3% for 3 months1% for 1 monthNo of Compounding in Year126FV of Share at six monthsCV*(1+PIR of 6 months)nCV*(1+PIR of 3 months)nCV*(1+PIR of 1 months)nFV of Share at six monthsRs.105*1.06105*(1.03)2105*(1.01)6FV of Share at six monthsRs.111.30Rs.111.39Rs.111.45AlternativeFV of Share at six monthsCV/PVF(1 Period, 6%)CV/PVF(2 Period, 3%)CV/PVF(6 Period, 1%)FV of Share at six monthsRs.105/0.943Rs.105/0.9425Rs.105/0.9420FV of Shareat six monthsRs.111.31Rs.111.40Rs.111.4657Calculation of FV of any shares, Bonds etc. from CV, if interest rate is compounding continuouslyPeriod, Future Value and Interest Rate should be given

CHAPTER-12AOPTION DERIVATIVE12A_A.30

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FV = CV*ertFV = CV/e-rtt = Period in Months/12 or Period in days/365Example-6CV of Share = Rs.105Period = 6 monthsInterest Rate (r) = 12% p.a. [Continuously Compounding]t = 6/12 = 0.5 yearsFV of Share at end of 6 months = CV*ert= 105*e0.12*0.5= Rs.105*e0.06= Rs.105*1.0618 = Rs.111.489ORFV of Share at end of 6 months = CV/e-rt= Rs.105/e-0.12*0.5= Rs.105/e-0.06= Rs.105/0.9417 = Rs.111.5005Summary of aboveParticularsCalculation of PVCalculation of FVIR is Compounding YearlyPV = FV/(1+PIR)FV = CV*(1+PIR)PV = FV*PVF(1Period, PIR)FV = CV/PVF(1 Period, PIR)IR is Compounding PeriodicallyPV = FV/(1+PIR)nFV = CV*(1+PIR)nPV = FV*PVF(n Period, PIR)FV = CV/PVF(n Period, PIR)IR is Continuously CompoundingPV = FV/ertFV = CV*ertPV = FV*e-rtFV = CV/e-rt

CHAPTER-12AOPTION DERIVATIVE-SOLUTION12A_B.1

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Solution-1Call OptionShare price on the exercise dateRs.200Rs.210Rs.220Rs.230Rs.240Strike Price of call OptionRs.220Rs.220Rs.220Rs.220Rs.220Where from Holder should buy shares [Lower]From MarketFrom MarketFrom MarketFrom WriterFromWriterWhether Holder would exercise Call optionNoNoNoYesYes(a) Purchase of Share to HolderRs.200Rs.210Rs.220Rs.220Rs.220(b) Gain to Holder due to Call Option000Rs.10Rs.20Maximum loss to Holder is premium paid-Rs.6-Rs.6-Rs.6-Rs.6-Rs.6(c) Net Gain or (Loss) to Holder-Rs.6-Rs.6-Rs.6Rs.4Rs.14(d) Status of OptionOutOutAtInInPut OptionShare price on the exercise dateRs.200Rs.210Rs.220Rs.230Rs.240Strike PriceRs.220Rs.220Rs.220Rs.220Rs.220Where shouldholder sell shares [Higher]To WriterTo WriterTo MarketTo MarketTo MarketWhether holder would exercise Put optionYesYesNoNoNo(a) Sale Price of Share to HolderRs.220Rs.220Rs.220Rs.230Rs.240(b) Gain to Holder due to Put OptionRs.20Rs.10000Maximum loss to Holder is premium paid-Rs.5-Rs.5-Rs.5-Rs.5-Rs.5(c) Net Gain or (Loss) to HolderRs.15Rs.5-Rs.5-Rs.5-Rs.5(d) Status of OptionInInAtOutOut(ii)price range at which the call and the put options may be gainfullyexercised.In case of Call Option, If Share Price on exercise date is more than Rs.220In case of Put Option, If Share Price on exercise date is Less than Rs.220Solution-1APremium of call option = Rs.9Premium of put option = Rs.1(i)Expiration date cash flows [Means purchase price or sale price on Exercise of Option]Stock pricesRs.50Rs.55Rs.60Rs.65Rs.70Strike PriceRs.60Rs.60Rs.60Rs.60Rs.60Buy 1 Call [Purchase price for Holder on Exercise of Call Option i.e [Lower]000Rs.60Rs.60Write 1 Call [Sale price for Writer on Exercise of Call Option by Holder]000Rs.60Rs.60Buy 1 Put [Sale price for Holder on Exercise of Put Option] [Higher]Rs.60Rs.60000Write 1 Put [Purchase price for writer on Exercise of PutOption]Rs.60Rs.60000(ii)Investment value = Expiration value of Option = Gain on exercise of OptionStock pricesRs.50Rs.55Rs.60Rs.65Rs.70Strike PriceRs.60Rs.60Rs.60Rs.60Rs.60Buy 1 Call [Gain to Holder of Call Option] = Value of CallOption000510Write 1 Call [Loss to Writer of Call Option]000-5-10Buy 1 Put [Gain to Holder of Put Option] = Value of Put Option105000Write 1 Put [Loss to Writer of Put Option]-10-5000(iii) Calculation of net profit/ LossStockpricesRs.50Rs.55Rs.60Rs.65Rs.70Strike PriceRs.60Rs.60Rs.60Rs.60Rs.60Buy 1 call [Gain/(Loss)-Premium Paid]-9-9-9-41Write 1 call [Gain/(Loss)-Premium Paid]9994-1Buy 1 put [Gain/(Loss)-Premium Paid]94-1-1-1Write 1 put[Gain/(Loss)-Premium Paid]-9-4111

CHAPTER-12AOPTION DERIVATIVE-SOLUTION12A_B.2

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Solution-2(a) If share price goes to Rs.43 at expiryParticularsCall OptionPut OptionTotalInvestor Buy11Premium PaidRs.2Rs.1Rs.3Strike PriceRs.42Rs.40If market Price of share at expiryRs.43Rs.43Exercise of OptionYesNoValue of OptionRs.1NilGain101Premium Paid-2-1-3Net Gain/ (Loss)-1-1-2(c) If share price goes to Rs.36 at expiryParticularsCall OptionPut OptionTotalInvestor Buy11Premium PaidRs.2Rs.1Rs.3Strike PriceRs.42Rs.40If market Price of share at expiryRs.36Rs.36Exercise of OptionNoYesValue of Option04Gain044Premium Paid-2-1-3Net Gain/ (Loss)-231This can be done with 100 sharesSolution-2A(a) If share pricegoes to Rs.53 at expiryParticularsCall OptionPut OptionTotalInvestor Buy11Premium PaidRs.2Rs.1Rs.3Strike PriceRs.52Rs.50If market Price of share at expiryRs.53Rs.53Exercise of OptionYesNoValue of OptionRs.1NilGain101Premium Paid-2-1-3Net Gain/ (Loss)-1-1-2No of Shares5050Total-50-50-100(c) If share price goes to Rs.36 at expiryParticularsCall OptionPut OptionTotalInvestor Buy11Premium PaidRs.2Rs.1Rs.3Strike PriceRs.52Rs.50Ifmarket Price of share at expiryRs.46Rs.46Exercise of OptionNoYesValue of Option04Gain044Premium Paid-2-1-3Net Gain/ (Loss)-231

CHAPTER-12AOPTION DERIVATIVE-SOLUTION12A_B.3

HELPING HAND INSTITUTE| FCA, RAJESH RITOLIA| 9350171263,8447824414| WEBSITE:CASSINHA.IN

No of Share5050Total Gain/(Loss)-100+15050This can be done with 100 sharesSolution-2B(a)If share price = Rs.500 at expiryParticularsCall OptionPut OptionTotalMr X Buy11Premium PaidRs.30Rs.5No of Shares in One Option100100Total Premium PaidRs.3000Rs.500Rs.3500Strike PriceRs.550Rs.450If market Price of shareat expiryRs.500Rs.500Exercise of Option by Mr XNoNoValue of Option00Gain000Premium Paid-3000-500-3500Net Gain/ (Loss)-3000-500-3500(b)If share price = Rs.350 at expiryParticularsCall OptionPut OptionTotalMr X Buy11Premium PaidRs.30Rs.5No of Shares in One Option100100Total Premium PaidRs.3000Rs.500Rs.3500Strike PriceRs.550Rs.450If market Price of share at expiryRs.35quotesdbs_dbs6.pdfusesText_12

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