How do derivatives minimize risks?

Forwards, futures and swaps involve firm commitments to exchanges of cash flows in the future at prices or rates determined in the present. An option provides the right, but not the obligation,to a future exchange at a price or rate determined in the present.

Options
As we have learned, the holder of a forward contract is obliged to trade at maturity. Unless the position is closed before maturity the holder must take possession of the asset, regardless of whether the underlying asset has risen or fallen in price. Wouldnt it be nice if we only had to take possession of the asset if it had risen? To address this ,derivatives known as options are traded. The two most common ones are call options and put options.

Call Vs Put Option

Call Option Put Option A call option gives the A Put Option gives the investor the right (not holder the right (but not the obligation!) to buy the obligation!) to sell an an underlying asset at underlying asset at an an agreed upon price agreeduponprice (the (the strike price) at a strike price) at a date in date in the future (the the future (the expiration date) expiration date T).

Option Terminology.
Premium the amount paid to the seller for buying an option(call or Put) at the time of agreement. Strike price (K) The price at which the option holder may buy or sell the underlying as defined in the option contract.Also known as exercise price. Exercise Action taken by the option holder to exercise his right. Time to expiration (T) time units (a time unit has the length t) until expiration European Option the holder can exercise this option only at expiry American Option the holder can exercise this option at any time during the life of the option (The right to exercise at any time is clearly valuable. Therefore the value of an American option cannot be less than an equivalent European option) Market Price, or Spot Price (S) the current price you have to pay in the market for the underlying.

Premium
Why does the buyer of an option(call or put), have to pay a premium? The buyer of an option has potential for profit without the risk of a loss. For this situation the buyer of an option has to pay a premium. What is the maximum loss ,that a buyer of an option can incur?

Call option
If the market price of the underlying is higher than the strike price, it is profitable to exercise the option. If market price is lower, the option holder (buyer) is not obliged to exercise it since he would incur a loss. The option would automatically expire on its last date(expiry date)

Important-Selling an option.
The seller of an option has a limited upside,( ie limited to the premium received), but an unlimited downside depending on price movement. Selling an option is risky.

Call option
A call option gives the investor the right (not the obligation!) to buy an underlying asset at an agreed upon price (the strike price) at a date in the future (the expiration date) The holder of a call option wants the underlying asset to rise as much as possible so that he can buy the asset for a relatively small amount, then sell it and make money. The value of a purchased call option is given by the expression max{S K, 0} .The value cannot be negative

Value of an option
Option Price = Intrinsic Value + Time Value. Intrinsic Value: For a call option, it is the greater of,(a) Spot price minus Strike Price (b) Zero. : For a put option, it is the greater of,(a) Strike price minus Spot Price (b) Zero. Time Value is the value of an option arising from time left to maturity/expiry.

Moneyness of an option
In the case of a call option if the spot price is greater than the strike price it is IntheMoney. If strike price is more than the spot price, it is Out-of-the-Money . In the case of a put option if the strike price is greater than the spot price it is In-the-Money .If spot price is more than strike price, it is Out of the Money

Determinants of Option Price/Premium

1. 2. 3. 4. 5. Spot/Market Price Strike Price. Risk free Interest rate r Time to expiry. Volatality(Standard Deviation)

Selling a call option

The call option we have discussed so far is a purchased call option. But we can sell a call option also. When we sell a call option we receive a premium. Then we speak of a written call option.

The payoff and the profit of a written call option are just the mirror images of the corresponding purchased option.

Put Option
A Put Option gives the holder the right (but not the obligation!) to sell an underlying asset at an agreeduponprice (the strike price) at a date in the future (the expiration date T).
The holder of a put option wants the underlying asset to fall as much as possible The payoff function of a Purchased Put Option is max{ K S, 0},Cannot be negative.

Call option Payoff for Buyer/Seller

Spot price Strike price Premium Buyers Profit 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 -2 -2 -2 -2 -2 -2 -2 -2 -1 0 1 2 3 4 5 6 29 27 2 Sellers Profit 2 2 2 2 2 2 2 2 1 0 -1 -2 -3 -4 -5 -6
8 6 4 2
Profit 0

Price

Buyers Profit
20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 Sellers Profit

-2
Spot price Strike price Premium Buyers Profit 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 -2 -2 -2 -2 -2 -2 -2 -2 -1 0 1 2 3 4 5 6 25 27 2 Sellers Profit 2 2 2 2 2 2 2 2 1 0 -1 -2 -3 -4 -5 -6
8 6 4 2
Profit 0

Price

Buyers Profit
20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 Sellers Profit

-2 -4
-6

-8

Spot price Strike price Premium

25 27 2 Buyers Profit Sellers Profit -2 -2 -2 -2 -2 -2 -2 -2 -1 0 1 2 3 4 5 6 2 2 2 2 2 2 2 2 1 0 -1 -2 -3 -4 -5 -6

Price

-4
-6

Price 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

2
Profit 0

Buyers Profit Sellers Profit

-2 -4 -6 -8 Price

-8

Price

Put option Payoff for Buyer/Seller

Spot price Strike price Premium Buyers Profit 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 5 4 3 2 1 0 -1 -2 -2 -2 -2 -2 -2 -2 -2 -2 25 27 2 Sellers Profit -5 -4 -3 -2 -1 0 1 2 2 2 2 2 2 2 2 2
6 4 2
Profit 0

Price

Buyers Profit
20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 Sellers Profit

-2 -4 -6

Price

Call Vs Put
CALL OPTION
8 6
4

PUT OPTION
6

2
Profit 0

Buyers Profit 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 Sellers Profit

Profit 0 -2 -4 -6

Buyers Profit 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 Sellers Profit

-2
-4

-6
-8 Price

Price

-rt

C=S.N(d1)-Ke

.N(d2)

It may not look like much, but it is the most dangerous equation since E=MC squared.Just as Albert Einsteins equation eventually led to Hiroshima and Nagasaki, this one has had the financial impact of a nuclear bomb. It contributed to stock market booms and busts, to a succession of financial crises and to economic slumps that lost millions of people their livlihood.It is the Black Scholes formula.

Black Scholes Option Pricing Model

-rt

C=S.N(d1)-Ke
C=Call option Price S=Current price of stock

.N(d2)

K=Strike price of the stock N(d1) /N(d2) = Probabilities(Cumulative Normal Distribution Function) e=2.71828 t=time to expiry in years r=risk free annualised interest rate as a decimal

Black Scholes Option Pricing Model

d1= ln(S/K)+rt + 0.5 t t d2= ln(S/K)+rt - 0.5 t t