OPTIONS

Let's say that on May 1, the stock price of Abc Co. is Rs 67 and the premium (Cost) is Rs 3.15 for a July 70 call, which indicates that the expiration is the third Friday of July and the strike price is Rs 70. The total price of the contract is Rs 3.15 x 100 = Rs 315. In reality, you would also have to take commissions into account, but we will ignore them for this example. Example: How Options Work?

Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of Rs 70 means that the stock price must rise above Rs 70 before the call option is worth anything; furthermore, because the contract is Rs 3.15 per share, the break-even price would be Rs When the stock price is Rs 67, it's less than the Rs 70 strike price, so the option is worthless. But don't forget that you've paid Rs 315 for the option, so you are currently down by this amount.

Three weeks later the stock price is Rs 78. The options contract has increased along with the stock price and is now worth: Rs 8.00 x 100 = Rs 800. Subtract what you paid for the contract, and your profit is: (Rs 8.00 – Rs 3.15) x 100 = Rs 485. You almost doubled our money in just three weeks! You could sell your options, which is called "Closing Your Position“ If the price drops, is less than our Rs.70 strike price and there is no time left, but you have to consider your cost.

An investor buys 20 options on shares of XYZ Ltd at a price of Rs 500 (per share). Each option consists of 100 shares and premium paid is Rs. 5/- per share. What will happen if, at the expiry of option, the share price is i) 516 or ii) 490? Example: Exercising Option

i) Share Price of Rs 516 Per Share: If, at expiry the share price is Rs 516 per share, then the option is In-the-Money and will be exercised. It means the investor could buy the shares at a strike price of Rs 500 per share and then can sell immediately in the market at a price of Rs 516 per share. In this case investor will make profit. The net gain on this deal can be calculated as under:

For Option Holder: Total Gains 20 x 100 x ( )Rs. 32,000 Total Options Cost 20 x 100 x5Rs. 10,000 Net GainsRs. 22,000

For Option Seller: Option Premium Earned 20 x 100 x 5Rs. 10,000 Loss on Option 20 x 100 x ( )Rs. 32,000 Net Loss Rs. 22,000

ii) Share Price of Rs. 490 Per Share: If the share price is less than strike price Rs 490 per share, the option is out-of-money and will not be exercised. The option holder will loose the cost of option Rs 10,000. The option seller will profit the premium received Rs 10,000. Gain of one party is the loss of other party.

Currency Options

The structure of currency option is the same as of equity options. A C.O. is a contract which confers right to the buyer to buy or sell (but not obligation): –Fixed amount of underlying currency –At a fixed price (Strike Price) –On a fixed date (Expiry) Amount of underlying currency is governed by the contract size as determined in each currency. Currency Options

A buyer of a call option has a right but not the obligation to buy the underlying currency. A buyer of a put option has a right but not the obligation to sell the underlying currency. Premium is charged by option writer from option holder.

Hedging With Currency Option: To construct a hedge with currency option, one needs to consider the following: –The extent of exposure and the currency involved. –Consider the hedging tool (A call or put option will serve the purpose). –Calculate the most Suitable strike price. –Option will be only exercised if it is In-the-Money.

Assuming it is end of June. The PKR/US $ spot rate is $ A Pakistan importer is required to make US$ to a foreign exporter in the amount of US $ 100,000 in September and has decided to hedge through currency option. The company can hedge it either by buying a call option on dollars or sell put options on PKR. A bank is willing to sell put option at strike price of $ / PKR for a premium of Rs. 9,175. Example: Currency Option

The company will buy $ 100,000 in September and can do this by buying a put option on Pak Rupees at a strike price of $ /PKR. It will need to have a put option on: (100,000/ )= Rs Million Pak Rupees The cost of option will be Rs 9,175. The result of this hedge will be dependent upon the spot ex rate in September. Example: Currency Option

If the spot rate in September are $ per Re. 1. The dollar has weakened and therefore, the option will not be exercised. The cost of option in this case will only be Rs. 9,175. Now let’s assume that dollar has strengthened in September.

The Spot Rate in September is $ : The dollar strengthened and the option is In-the-Money and should be exercised. Cost of us$ Rs. 6,049,972 At (Reverse Rate is Rs ) Cost of Option Rs. 9,175 Total Cost Rs. 6,059,147 Effective Ex Rate = 100,000 / 6,059,147 = $

Calculating the Benefit of this Hedge: If transaction was not hedged, then The cost would have been: US $ 100,000 / = Rs. 6,153,089 Cost Under Hedge = Rs. 6,059,147 Net Saving = Rs. 93,942

Interest Rate Option

Interest rate options is an option to borrow or lend “Notional” amount for a specified period starting on or before a future date (expiry date) at a fixed rate of interest (exercise price). Interest rate options resemble to forward rate agreements. Interest rate options are exchange traded. If the option is exercised, it is cash-settled. Interest Rate Options

At expiry, the benchmark rate (like KIBOR) is higher than the strike Rate, for borrower the option is in-the-money, and he will exercise the option. On the other hand, if at expiry the benchmark (KIBOR) is lower than the strike rate, then the borrower’s option is out-of-money and will not exercise it. The option will lapse. In this case the company will borrow the money on the prevalent rate of interest (KIBOR). Option for lender follows the same mechanism.

A company intends to borrow Rs. 5 million in two month’s time for a period of 6 months. The company anticipates that 6 months KIBOR rate will increase, which is currently staying at 8%. The company can borrow at KIBOR plus 2%. The company has decided to hedge this exposure through borrower’s option. The company buys an option at a strike rate of 8.50%. The option cost will be Rs. 12,000. Example: Interest Rate Option

The Notional amount is Rs. 5 million, notional period is 6 months and expiry date is set in two months. Assuming that at expiry, the 6 months KIBOR rate is 9.50%. The option is In-the-Money and it will be exercised. What happens then?