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A PROJECT REPORTONROLE OF OPTIONS IN HEDGING AND RISK MANAGEMENT

Project Submitted in the fulfillment of (Post Graduate Diploma inManagement/MMS)

Submitted by:MISS NEHA VILAS MORERoll No. P1209Batch 2012-2014

Under the guidance of Professor SRINJAY SENGUPTA

Declaration

I, MISS NEHA VILAS MORE solemnly declare that the project work entitled ROLE OF OPTIONS IN HEDGING AND RISK MANAGEMENT, is my original work, it is neither copied from any earlier submitted work elsewhere or not merely copied, this is specifically prepared as a part of MMS/PGDM curriculum, to be conducted in Year 2014.

Signature of the student: ________________________Name of the Student: MISS NEHA VILAS MORE

ACKNOWLEDGMENTIt gives me immense pleasure to express my deep sense of Gratitude to Prof. Srinjay Sengupta, Faculty Guide Chanakya Institute of Management Studies and Research for his valuable guidance and consistent supervision throughout the project His constructive comments and contributions had been of immense help for giving a tangible shape to this project.

I am also extremely thankful to Prof. Mahesh Narvekar and Prof. Sameer Kulkarni, for their timely guidance and support for the project. Finally I am indebted to our other faculty members, my friends who gave their full-fledged co-operation for successful completion of my project. It was an indeed a learning experience for me.

CERTIFICATE

This is to certify that the project titled ROLE OF OPTIONS IN HEDGING AND RISK MANAGEMENT has been successfully and satisfactorily completed and submitted by Mr./ Miss: NEHA VILAS MORE bearing a roll number, P1209 as a student of Chanakya Institute of Management Studies & Research as Prescribed by AICTE in fulfillment of the requirement for Post Graduate Diploma in Management (PGDM) /MMS during the year 2012 14.

Internal Guide Director Prof. SRINJAY SENGUPTA Mr. Biswas B. Das

Index

SR NOTopicPage No.

1EXECUTIVE SUMMARY7

2OBJECTIVE8

3LIMITATIONS8

4RESEARCH METHODOLOGY9

5INTRODUCTION OF OPTIONS10

5.1BASIC TERMS AND DESCRIPTIONS ABOUT EQUITY OPTIONS12

5.2WHAT ARE THE BENEFITS & RISKS?21

5.3OPTIONS PRICING23

5.4MAJOR FACTORS INFLUENCING OPTIONS PREMIUM24

6INDEX OPTIONS26

6.1BENEFITS OF LISTED INDEX OPTIONS26

6.2DIFFERENT METHODS TO CALCULATE OR MEASURE THE RELEVANT MARKET28

6.3ADJUSTMENTS & ACCURACY29

6.4EQUITY VS. INDEX OPTIONS30

7VOLATILITY & THE GREEKS35

8PUT/CALL PARITY38

9BLACK-SCHOLES FORMULA45

10RISK MANAGEMENT46

11WHY USE OPTIONS? 53

12HOW YOU CAN USE OPTIONS54

13EXITING AN OPTIONS POSITION56

14HEDGING A DETAIL STUDY57

14.1WHAT IS HEDGING?57

14.2HOW DO INVESTORS HEDGE? 58

14.3TO HEDGE OR NOT TO HEDGE?59

14.4THE COSTS OF HEDGING59

14.5THE BENEFITS OF HEDGING60

15THE PREVALENCE OF HEDGING65

15.1WHO HEDGES?65

15.2WHAT RISKS ARE MOST COMMONLY HEDGED?67

15.3DOES HEDGING INCREASE VALUE?68

16ALTERNATIVE TECHNIQUES FOR HEDGING RISK71

17PICKING THE RIGHT HEDGING TOOL78

18OPTION STRATEGIES79

18.1BUY CALL76

18.2BUYING PUTS84

18.3BUYING INDEX STRADDELES90

18.4PROTECTIVE INDEX COLLARS97

18.5BUYING INDEX PUTS TO HEDGE THE VALUE OF A PORTFOLIO103

19CURRENCY HEDGING SCENARIO'S110

19.1HEDGING AGAINST INDIAN RUPEE APPRECIATION110

19.2HEDGING AGAINST INDIAN RUPEE DEPRECIATION111

20OPTIONS STRATEGY FOR IMPORTERS112

21OPTIONS STRATEGY FOR EXPORTERS113

22CONCLUSION114

23BIBLIOGRAPHY115

1. EXECUTIVE SUMMARY

By viewing the current market scenario its been noticed that markets are falling and are in very bad state. The top notches can survive to an extent but for small companies it becomes a do or die situation wherein most do get even bankrupt. Basically situation becomes worse for both large and medium firms. So first and foremost is there any solution or a way for such firms? If yes, then what is the solution to such companies? How can such firms help themselves so that their shops dont get closed or at least minimize the risk faced? Yes, there is a solution for such companies and that is OPTIONS TRADING. To start up with options everybody needs to understand that everything in life has a risk so as options. But the best part is that it is a tool which allows assessing the risk and mitigating it at the right time and in a proper way. This of course needs an analysis to be done on a regular basis to make things work out the way the business needs. As there are two sides for everything, we have a set of investors who has genuine concerns for their business and other set of investors which rides on market sentiment. Thus it can be used for speculations as well as for hedging. Here we focus only on hedging which is a tool used maximally to mitigate the risk and to gain a profit to some extent. Before hedging its essential to understand what is the risk that options can have? And what are the factors that lead to this risk? And then how it can it can hedge? A detail study of the risk management of the factors that lead to this risk is been done through the use of various options strategies. Also a view is been provided for the Indian entrepreneurs as to how to behave when there is an rupee appreciation or depreciation? And what the importers or exporters should do when such a case arises in front of them.Hoping that the Indian entrepreneurs can take the maximum advantage of the options and enter into the exchange trading to boost their business with optimum advantage provided by the government and attain new heights

2. OBJECTIVE To have a brief understanding about options, its terms, its working. What is risk management for options How this risk can be managed through hedging How entrepreneurs who are connected globally can hedge the currency risk What are the necessary steps to be taken when a rupee appreciates or depreciates

3. LIMITATIONS

Speculation are not focused All strategies are not considered

4. Research MethodologyThe project is on role of options in hedging and risk management. Hence study has to be done on the basis of information and news available about the topic through secondary data by various modes. Secondary data was collected from the internet, company websites and. Approach of Research: this research work is designed for deductive inferences based on the empirical data available at various sites. This may not be necessarily declared for the objective described in the beginning of this research work.Sample Frame: The sample frame for this research work is strictly those firms which have any kind of risk exposure either because of import or export. The frame used for sampling is EXIM data bankSample Size: Selective convinence random sample method is adopted for sampling. The sample size is fixed to make the inferences for 90% confidence level specifically sample size is (no. of companies include).

5. INTRODUCTION OF OPTIONSAn option is a contract to buy or sell a specific financial product known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange traded fund (ETF) or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.Contracts also have an expiration date. When an option expires, it no longer has value and no longer exists.Options come in two varieties, calls and puts. You can buy or sell either type. You decide whether to buy or sell and choose a call or a put based on objectives as an options investor.http://www.optionseducation.org/content/oic/en/getting_started/options_overview/what_is_an_option.htmlOptions are financial instruments that provide flexibility in almost any investment situation. Options give you options by providing the ability to tailor your position to your situation. You can protect stock holdings from a decline in market price. You can increase income against current stock holdings. You can prepare to buy stock at a lower price. You can position yourself for a big market move, even when you don't know which way prices will move. You can benefit from a stock price's rise or fall without incurring the cost of buying the stock outright.Describing Equity Options An equity option is a contract that conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer's request.

http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_1.html

Equity option contracts usually represent 100 shares of the underlying stock. Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Do not confuse the strike price, a fixed specification of an option contract, with the premium. Premium is the price at which the contract trades. This price fluctuates daily. Equity option strike prices are listed in increments of 5, 1, 2.5, 5 or 10 points, depending on their price level. Adjustments to an equity option contract's size, deliverable and/or strike price may be made to account for stock splits or mergers. Generally, at any given time, you can purchase a particular equity option with one of at least four expiration dates. Equity option holders do not enjoy the rights due stockholders (e.g., voting rights, regular cash or special dividends). A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights. Buyers and sellers set option prices in the exchange markets. All trading is conducted in the competitive manner of an auction market.

http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_1.html

5.1. BASIC TERMS AND DESCRIPTIONS ABOUT EQUITY OPTIONSCalls and PutsThe two types of equity options are calls and puts.A call option gives its holder the right to buy 100 shares of the underlying security at the strike price, anytime before the option's expiration date. The writer (or seller) of the option has the obligation to sell the shares.The opposite of a call option is a put option, which gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime before the option's expiration date. The writer (or seller) of the option has the obligation to buy the shares.Holder (Buyer)Writer (Seller)

Call OptionRight to buyObligation to sell

Put OptionRight to sellObligation to buy

The Options PremiumAn option's price is called the premium. The option holders potential loss is limited to the initial premium paid for the contract. Alternately, the writer has unlimited potential loss. This loss is somewhat offset by the initial premium received for the contract.Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment is limited to the price of the premium.Investors can also use put and call option contracts to actively hedge against market risk. Investors can purchase a put as insurance to protect a stock holding against an unfavorable market move while maintaining stock ownership.A call option on an individual stock issue may be sold to provide a limited degree of downside protection in exchange for limited upside potential. http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_1.html

Underlying SecurityThe underlying security (such as XYZ Corporation) is the instrument that an option writer must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_1.html

Expiration ThursdayThe last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday is the options expiration day. After the option's expiration date, the contract ceases to exist. At that point, the owner of the option who does not exercise the contract has no right and the seller has no obligations as previously conveyed by the contract.SOURCE: NCFM bookLeverage & RiskOptions can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying product.Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer may face unlimited risk.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_2.htmlIn-the-money, At-the-money, Out-of-the-moneyAn options strike price, or exercise price, determines whether a contract is in-the-money, at-the-money, or out-of-the-money.If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money. This is because the holder of this call has the right to buy the stock at a price less than the price he would pay to buy the stock in the stock market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is said to be in-the-money because the holder of this put has the right to sell the stock at a price greater than the price he would receive selling the stock in the stock market.The inverse of in-the-money is out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.The amount that an option, call or put is in-the-money at any time is called intrinsic value. By definition, an at-the-money or out-of-the-money option has no intrinsic value. This does not mean investors can obtain these options at no cost.The amount that an option's total premium exceeds intrinsic value is known as the time value. Fluctuations in volatility, interest rates, dividend amounts and the passage of time all affect the time value portion of an options premium. These factors give options value and therefore affect the premium at which they are traded.Equity Call Option In-the-money = strike price less than stock price At-the-money = strike price same as stock price Out-of-the-money = strike price greater than stock priceEquity Put Option In-the-money = strike price greater than stock price At-the-money = strike price same as stock price Out-of-the-money = strike price less than stock price

Option Premium Intrinsic Value + Time ValueTime DecayThe longer the time remaining until an option's expiration, the higher its premium will be. This is because the longer an option's lifetime, the greater the possibility that the underlying share price might move the option in-the-money. Even if all other factors affecting an option's price remain the same, the time value portion of an option's premium will decrease (or decay) with the passage of time.NOTE: Time decay is a term used to describe how the theoretical value of an option reduces with the passage of time. Time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally worth only its intrinsic value.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_2.html

LongWith respect to this section's usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account.For example, if you have purchased the right to buy 100 shares of a stock and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock and are holding that right in your brokerage account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account or elsewhere, you are long 1,000 shares of stock.When you are long an equity option contract: You have the right to exercise that option at any time prior to expiration. Your potential loss is limited to the amount you paid for the option contract.ShortWith respect to this section's usage of the word, short describes a position in options in which you have written a contract (sold a contract that you did not own). As a result, you now have obligations from terms of that option contract. If the owner exercises the option, you must meet those obligations.If you have sold the right to buy 100 shares of a stock, you are short a call contract. If you have sold the right to sell 100 shares of a stock, you are short a put contract.When you write an option contract, you are creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (write) an equity option contract You can be assigned an exercise notice at any time during the life of the option contract. You should be aware that assignment prior to expiration is a distinct possibility. Your potential loss on a short call is theoretically unlimited. For a put, the fact that the stock cannot fall below $0 in price limits the risk of loss. This potential loss could still be quite large if the underlying stock declines significantly in price.

http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_2.html

Open An opening transaction is one that adds to or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both An opening purchase is a transaction in which the purchaser's intention is to create or increase a long position in a given series of options. An opening sale is a transaction in which the seller's intention is to create or increase a short position in a given series of options.Close A closing purchase is a transaction in which the purchaser's intent is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as covering a short position. A closing sale is a transaction in which the seller's intent is to reduce or eliminate a long position in a given series of options.NOTE: An investor does not close out a long call position by purchasing a put or vice versa. A closing transaction for an option involves the purchase or sale of an option contract with the same terms on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option's last trading day.ExerciseThe holder of an American-style option can exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock. They first must direct their brokerage firm to submit an exercise notice to OCC. For an option holder to ensure that they exercise the option on that particular day, the holder must notify his brokerage firm before that days cut-off time for accepting exercise instructions.The brokerage firm notifies OCC that an option holder wishes to exercise an option. OCC then randomly assigns the exercise notice to a clearing member. For an investor, this is generally his brokerage firm chosen at random from a total pool of such firms. The firm must then assign one of its customers who has written (and not covered) that particular option.Assignment to a customer is either random or on a first-in-first-out basis. This depends on the firms method. Ask your brokerage firm which method it uses for assignments.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_2.html

AssignmentThe holder of an American-style option contract can exercise the option at any time before expiration. Therefore, an option writer may be assigned an exercise notice on a short option position at any time before expiration. If an option writer is short an option that expires in-the-money, they should expect assignment on that contract, though assignment is not guaranteed as some long in-the-money option holders may elect not to exercise in-the-money options. In fact, some option writers are assigned on short contracts when they expire exactly at-the-money or even out-of-the money. This occurrence is usually not predictable.To avoid assignment on a written option contract on a given day, the position must be closed out before that day's market close. Once assignment is received, an investor has no alternative but to fulfill assignment obligations per the terms of the contract.There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners usually let them expire with no value. Although this is not always the case as post-market underlying moves may lead to out-of-the-money options being exercised and in-the-money options not being exercised.What's the Net?When an investor exercises a call option, the net price paid for the underlying stock on a per share basis is the sum of the call's strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on per share basis is the sum of the call's strike price plus the premium received from the call's initial sale.When an investor exercises a put option, the net price received for the underlying stock on per share basis is the sum of the put's strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis is the sum of the put's strike price less the premium received from the put's initial sale.Early Exercise/AssignmentFor call contracts, owners might exercise early to own the underlying stock to receive a dividend. It is extremely important to realize that assignment of exercise notices can occur early, days or weeks in advance of expiration day. Investors should expect this as expiration http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_3.htmlnears with a call considerably in-the-money and a sizeable dividend payment approaching. Call writers should be aware of dividend dates and the possibility of early assignment.When puts become deep in-the-money, most professional option traders exercise before expiration. Therefore, investors with short positions in deep in-the-money puts should be prepared for the possibility of early assignment on these contracts.VolatilityVolatility is the tendency of the underlying security's market price to fluctuate up or down. It reflects a price change's magnitude. It does not imply a bias toward price movement in one direction or the other. It is a major factor in determining an option's premium.The higher the volatility of the underlying stock, the higher the premium. This is because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase and vice versa.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option/part_3.html

Buying and SellingIf you buy a call, you have the right to buy the underlying instrument at the strike price on or before expiration. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, the option holder has the right to sell the option to another buyer during its term or to let it expire worthless.The situation is different if you write or sell to open an option. Selling to open a short option position obligates the writer to fulfill their side of the contract if the option holder wishes to exercise.When you sell a call as an opening transaction, you're obligated to sell the underlying interest at the strike price, if assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying interest, if assigned.As a writer, you have no control over whether or not a contract is exercised, and you must recognize that exercise is possible at any time before expiration. However, just as the buyer can sell an option back into the market rather than exercising it, a writer can purchase an offsetting contract to end their obligation to meet the terms of a contract provided they have not been assigned. To offset a short option position, you would enter a buy to close transaction.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option.htmlAt a PremiumWhen you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly. The premium is likely to be higher or lower today than yesterday or tomorrow. Changing prices reflect the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point of agreement becomes the price for that transaction. The process then begins again.If you buy options, you begin with a net debit. That means you've spent money you might never recover if you don't sell your option at a profit or exercise it. If you do make money on a transaction, you must subtract the cost of the premium from any income to find net profit.As a seller, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still keep the premium but are obligated to buy or sell the underlying stock if assigned.

The Value of OptionsThe worth of a particular options contract to a buyer or seller is measured by its likelihood to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration.A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option. The call option is out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price. A put option is out-of-the-money if its underlying price is above the exercise price. If an option is not in-the-money at expiration, the option is assumed worthless.An option's premium can have two parts: an intrinsic value and a time value. Intrinsic value is the amount that the option is in-the-money. Time value is the difference between the intrinsic value and the premium. In general, the longer time that market conditions work to your benefit, the greater the time value.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option.html

Options PricesSeveral factors affect the price of an option. Supply and demand in the market where the option is traded is a large factor. This is also the case with an individual stock.The status of overall markets and the economy at large are broad influences. Specific influences include the identity of the underlying instrument, the instruments traditional behavior and current behavior. The instruments volatility is also an important factor used to gauge the likelihood that an option will move in-the-money.http://www.optionseducation.org/getting_started/options_overview/what_is_an_option.html

5.2. What are the Benefits & Risks?Most strategies used by options investors have limited risk but also limited profit potential. Options strategies are not get-rich-quick schemes. Transactions generally require less capital than equivalent stock transactions. They may return smaller figures but a potentially greater percentage of the investment than equivalent stock transactions.Even investors who use options in speculative strategies such as writing uncovered calls don't usually realize dramatic returns. The potential profit is limited to the premium received for the contract. The potential loss is often unlimited. While leverage means the percentage returns can be significant, the amount of cash required is smaller than equivalent stock transactions.Although options may not be appropriate for all investors, they're among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many different kinds of investors in rising, falling and neutral markets.Reducing Your RiskFor many investors, options are useful tools of risk management. They act as insurance policies against a drop in stock prices. For example, if an investor is concerned that the price of their shares in LMN Corporation is about to drop, they can purchase puts that give the right to sell the stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option's premium, the investor has insured themselves against losses below the strike price. This type of option practice is also known as hedging. While hedging with options may help manage risk, it's important to remember that all investments carry some risk. Returns are never guaranteed. Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price. They can also profit from a rise in the value of the option's premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.Many options strategies are designed to minimize risk by hedging existing portfolios. While options act as safety nets, they're not risk free. Since transactions usually open http://www.optionseducation.org/getting_started/options_overview/what_benefits_risks.htmland close in the short term, gains can be realized quickly. Losses can mount as quickly as gains. It's important to understand risks associated with holding, writing, and trading options before you include them in your investment portfolio.Risking Your PrincipalLike other securities including stocks, bonds and mutual funds, options carry no guarantees. Be aware that it's possible to lose the entire principal invested, and sometimes more. As an options holder, you risk the entire amount of the premium you pay.But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise.Since initial options investments usually require less capital than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you'd bought the underlying stock or sold the stock short. The exception to this general rule occurs when you use options to provide leverage. Percentage returns are often high, but percentage losses can be high as well.http://www.optionseducation.org/getting_started/options_overview/what_benefits_risks.html

5.3. OPTIONS PRICINGMain Components of an Option's PremiumAn options premium has two main components: intrinsic value and time value.

Intrinsic Value (Calls)A call option is in-the-money when the underlying security's price is higher than the strike price.Intrinsic Value (Puts)A put option is in-the-money if the underlying security's price is less than the strike price. Only in-the-money options have intrinsic value. It represents the difference between the current price of the underlying security and the option's exercise price, or strike price.Time ValueTime value is any premium in excess of intrinsic value before expiration. Time value is often explained as the amount an investor is willing to pay for an option above its intrinsic value. This amount reflects hope that the options value increases before expiration due to a favorable change in the underlying securitys price. The longer the amount of time available for market conditions to work to an investor's benefit, the greater the time value.http://www.optionseducation.org/content/oic/en/getting_started/options_overview/options_pricing.html

5.4. MAJOR FACTORS INFLUENCING OPTIONS PREMIUMFactors having a significant effect on options premium include:1. Underlying price2. Strike3. Time until expiration4. Implied volatility5. Dividends6. Interest rateDividends and risk-free interest rate have a lesser effect.Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase. However, the value of a put will generally decrease in price. A decrease in the underlying security's value generally has the opposite effect.The strike price determines whether an option has intrinsic value. An option's premium (intrinsic value plus time value) generally increases as the option becomes further in-the-money. It decreases as the option becomes more deeply out-of-the-money.Time until expiration, as discussed above, affects the time value component of an option's premium. Generally, as expiration approaches, the levels of an option's time value decrease or erode for both puts and calls. This effect is most noticeable with at-the-money options.The effect of implied volatility is subjective and difficult to quantify. It can significantly affect the time value portion of an option's premium. Volatility is a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates indicate greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike. It is most noticeable with at-the-money options.The effect of an underlying security's dividends and the current risk-free interest rate has a small but measurable effect on option premiums. This effect reflects the cost to carry shares in an underlying security. Cost of carry is the potential interest paid for

http://www.optionseducation.org/content/oic/en/getting_started/options_overview/options_pricing.htmlmargin or received from alternative investments (such as a Treasury bill) and the dividends from owning shares outright. Pricing takes into account an options hedged value so dividends from stock and interest paid or received for stock positions used to hedge options are a factor.http://www.optionseducation.org/content/oic/en/getting_started/options_overview/options_pricing.html

6. INDEX OPTIONSWhat is an Index?A stock index is a compilation of several stock prices into a single number. Indexes come in various shapes and sizes. Some are broad-based and measure moves in diverse markets. Others are narrow-based and measure more specific industry sectors of the marketplace.

It is not the average number of stocks that determines if an index is broad-based or narrow-based. Rather, it is the diversity of the underlying securities and their market coverage. Different stock indexes are calculated in different ways. Even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/what_is_an_index.html

6.1. BENEFITS OF LISTED INDEX OPTIONSLike equity options, index options offer investors an opportunity either to capitalize on an expected market move or to protect holdings in the underlying instruments. The difference is that the underlying instruments of index options are indexes. These indexes can reflect the characteristics of either the broad equity market as a whole or specific industry sectors within the marketplace. 1. DiversificationIndex options enable investors to gain exposure to the market as a whole or to specific segments with one trading decision and often one transaction. An investor must make numerous decisions and transactions to obtain the same level of diversification using individual stock issues or individual equity option classes. Using index options defrays both the costs and complexities.2. Predetermined Risk for BuyerUnlike other investments with unlimited risk, index options offer a known risk to buyers. An index option buyer absolutely cannot lose more than the price of the option (the premium).3. LeverageIndex options can provide leverage. This means an index option buyer pays a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from relatively small, favorable percentage moves in the underlying index. If the index does not move as anticipated, the buyer's risk is limited to the premium paid. However, because of leverage, a small adverse move in the market can result in a substantial or complete loss of the buyer's premium. Writers of index options bear substantially greater risk, if not unlimited.4. Guaranteed Contract PerformancePrior to the existence of option exchanges and OCC, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. Furthermore, there was no convenient way to close out a position prior to the expiration of the contract. As the common clearing entity for all U.S. exchange-traded securities option transactions, OCC resolves these difficulties.As a result, rather than relying on a particular option writer, an option holder can rely on the system created by OCC's Rules and By-Laws (which includes the brokers and clearing members involved in a particular option transaction) and to certain funds held by OCC.Once OCC ensures matching orders from a buyer and a seller, it severs the link between the parties. In effect, OCC becomes the buyer to the seller and the seller to the buyer. As a result, the seller can buy back the same option they have written. This closes out the initial transaction and terminates the sellers obligation to deliver cash equal to the exercise amount of the option to OCC. This does not affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by OCC.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options.html

6.2. DIFFERENT METHODS TO CALCULATE OR MEASURE THE RELEVANT MARKET1. Capitalization-WeightedAn index can be constructed so that weightings are biased toward the securities of larger companies. This method of calculation is known as capitalization-weighted. To calculate index value, the market price of each component security is multiplied by the number of shares outstanding. This allows a security's size and capitalization to have a greater impact on the value of the index.2. Equal Dollar-WeightedAnother type of index is known as equal dollar-weighted. This index assumes an equal number of shares of each component stock. It is calculated by first establishing an aggregate market value for every component security of the index. Then, by dividing the aggregate market value by the current market price of the security. This determines the number of shares of each security. This method of calculation does not give more weight to price changes of the more highly capitalized component securities.3. Other TypesAn index can also be a simple average. It can be calculated by adding up the prices of the indexs securities and dividing by the number of securities, disregarding numbers of shares outstanding. Another type measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.

6.3. ADJUSTMENTS & ACCURACYSecurities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer considered representative of the types of stocks in the index. Securities may also be added to an index occasionally.Adjustments to indexes might be made because of substitutions or following the issuance of new stock by a component security. Such adjustments and other similar changes are within the discretion of the indexs publisher. They will not usually cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that, in the panel's determination, may cause significant discontinuity in the index level.Finally, an equity index is accurate only to the extent that: The component securities in the index are being traded. The prices of these securities are being promptly reported. The market prices of these securities, as measured by the index, reflect price movements in the relevant markets.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/what_is_an_index.html

6.4. EQUITY V/S. INDEX OPTIONSAn equity index option is a security which is intangible and whose underlying instrument is composed of equities: an equity index. The market value of an index put and call tends to rise and fall in relation to the underlying index. The price of an index call generally increases as the level of its underlying index increases. Its purchaser has unlimited profit potential tied to the strength of these increases.The price of an index put generally increases as the level of its underlying index decreases. Its purchaser has substantial profit potential tied to the strength of these decreases.RiskAs with an equity option, an index option buyer's risk is limited to the amount of the premium paid for the option. The premium received and kept by the index option writer is the maximum profit a writer can realize from the sale of the option. However, the loss potential from writing an uncovered index option is generally unlimited. Any investor considering writing index options should recognize that there are significant risks involved.Cash SettlementThe differences between equity and index options occur primarily in the underlying instrument and the method of settlement. Generally, cash changes hands when an option holder exercises an index option and when an index option writer is assigned. Only a representative amount of cash changes hands from the investor who is assigned on a written contract to the investor who exercises his purchased contract. This is known as cash settlement.Purchasing RightsPurchasing an index option does not give the investor the right to purchase or sell all of the stocks contained in the underlying index. Because an index is simply an intangible, representative number, you might view the purchase of an index option as buying a value that changes over time as market sentiment and prices fluctuate.An investor purchasing an index option obtains certain rights per the terms of the contract. In general, this includes the right to demand and receive a specified amount of cash from the writer of a contract with the same terms. http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/equity_vs_index_options.htmlOption ClassesAn option class is a term used for option contracts of the same type (call or put) and style (American or European) that cover the same underlying index. Available strike prices, expiration months and the last trading day can vary with each index option class. Strike PriceThe strike price, or exercise price, of a cash-settled option is the basis for determining the amount of cash, if any, that the option holder is entitled to receive upon exercise. In-the-money, At-the-money, Out-of-the-moneyAn index call option is: In-the-money when its strike price is less than the reported level of the underlying index. At-the-money when its strike price is the same as the level of that index. Out-of-the-money when its strike price is greater than the level of that indexAn index put option is: In-the-money when its strike price is greater than the reported level of the underlying index. At-the-money when its strike price is the same as the level of that index. Out-of-the-money when its strike price is less than the level of that indexPremiumPremiums for index options are quoted like those for equity options, in dollars and decimal amounts. An index option buyer generally pays a total of the quoted premium amount multiplied by $100 per contract. The writer, on the other hand, receives and keeps this amount.The amount by which an index option is in-the-money is called its intrinsic value. Any amount of premium in excess of intrinsic value is called an option's time value. As with equity options, changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index affect time value.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/equity_vs_index_options.html

Exercise & AssignmentThe exercise settlement value is an index value used to calculate how much money will change hands (the exercise settlement amount) when a given index option is exercised, either before or at expiration. The reporting authority designated by the market where the option is traded determines the value of every index underlying an option, including the exercise settlement value. Unless OCC directs otherwise, this value is presumed accurate and deemed final for calculating the exercise settlement amount.In order to ensure that an index option is exercised on a particular day before expiration, the holder must notify his brokerage firm before the firm's exercise cut-off time for accepting exercise instructions on that day. On expiration days, the cut-off time for exercise may be different from that for an early exercise (before expiration). Note: Different firms may have different cut-off times for accepting exercise instructions from customers. Those cut-off times may be different for different classes of options. In addition, the cut-off times for index options may be different from those for equity options.Upon receipt of an exercise notice, OCC assigns it to one or more clearing members with short positions in the same series in accordance with its established procedures. The clearing member then assigns one or more of its customers who hold short positions in that series, either randomly or on a first-in first-out basis. Upon assignment of the exercise notice, the writer of the index option has the obligation to pay a cash amount. Settlement and the resulting transfer of cash generally occur on the next business day after exercise.Note: Many firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money. Every firm should be asked to explain its exercise procedures thoroughly, including any deadline for exercise instructions on the last trading day before expiration.AM & PM SettlementReporting authorities determine the exercise settlement values of equity index options in a variety of ways. The two most common are: PM settlement - Exercise settlement values based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise. AM settlement - Exercise settlement values based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/equity_vs_index_options.htmlIf a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.When the exercise settlement value of an index option is derived from the opening prices of the component securities, investors should be aware that value might not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value.

American vs. European ExerciseAlthough equity option contracts generally have only American-style exercise, index options can have either American- or European-style.In the case of an American-style option, the holder of the option has the right to exercise it on or any business day before its expiration date. The writer of an American-style option can be assigned at any time, either when or before the option expires. Early assignment is not always predictable.An investor can only exercise a European-style option during a specified period prior to expiration. This period varies with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period.

Exercise SettlementThe amount of cash received upon exercise of an index option or at expiration depends on the closing value of the underlying index in comparison to the strike price of the index option. The amount of cash changing hands is called the exercise settlement amount. This amount is calculated as the difference between the strike price of the option and the level of the underlying index reported as its exercise settlement value (in other words, the option's intrinsic value and is generally multiplied by $100. This calculation applies whether the option is exercised before or at its expiration.In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 79.55, the holder of a long call contract with a 78 strike price would exercise and receive $155 [(79.55 - 78) x $100 = $155]. The writer of the option pays the holder this cash amount.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/equity_vs_index_options.htmlIn the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 74.88, the holder of a long put contract with a 78 strike price would exercise and receive $312 [(78 - 74.88) x $100 = $312]. The writer of the option pays the holder this cash amount.

Closing TransactionsAs with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. In order to avoid assignment and its inherent obligations, the option writer must buy this contract before the close of the market on any given day to avoid potential notification of assignment on the next business day. To close out a long position, the purchaser of an index option can either sell the contract in the marketplace or exercise it if profitable to do so.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/index_options/equity_vs_index_options.html

7. VOLATILITY & THE GREEKSVolatilityVolatility can be a very important factor in deciding what kind of options to buy or sell. Historical volatility reflects the range that a stocks price has fluctuated during a certain period. We denote the official mathematical value of volatility as "the annualized standard deviation of a stocks daily price changes."There are two types of volatility: statistical volatility and implied volatility.Statistical (Historical) Volatility is a measure of actual asset price changes over a specific period.Implied Volatility is a measure of how much the marketplace expects asset price to move for an option price. That is, the volatility that the market implies.Volatility is difficult to compute mathematically. A strategist can let the market compute the volatility using implied volatility. This is similar to an efficient market hypothesis which states that if there is enough trading interest in an option that is close to at-the-money, that option is priced fairly.The Black-Scholes FormulaThe Black-Scholes formula was the first widely used model for option pricing. A strategist can use this formula to calculate theoretical value for an option using current stock prices, expected dividends, the option's strike price, expected interest rates, time to expiration and expected stock volatility. While the Black-Scholes model does not perfectly describe real-world options markets, it is still often used in the valuation and trading of options.Variables of the Black-Scholes formula are: Stock Price Strike Price Time remaining until expiration expressed as a percent of a year Current risk-free interest rate Volatility measured by annual standard deviationhttp://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/volatility_greeks.html

The Greeks

The Greeks are a collection of statistical values that give the investor a better overall view of option premiums change given changes in pricing model inputs. These values can help decide what options strategies to use. The investor should remember that statistics show trends based on past performance. It is not guaranteed that the future performance of the stock will behave according to the historical numbers. These trends can change drastically based on new stock performance.

1. Beta Beta is a measure of how closely the movement of an individual stock tracks the movement of the entire stock market.

2. DeltaDelta is a measure of the relationship between an option premium and the underlying stock price. For a call option, a Delta of .50 means a half-point rise in premium for every dollar that the stock goes up. For a put option contract, the premium rises as stock prices fall. As options near expiration, in-the-money contracts approach a Delta of 1.00.In this example, the Delta for stock XYZ is 0.50. As the price of the stock changes by $2.00, the price of the options changes by $.50 for every $1.00. Therefore the price of the options changes by (.50 x 2) = $1.00. The call options increase by $1.00 and the put options decrease by $1.00. The Delta is not a fixed percentage. Changes in price of stock and time to expiration affect the Delta value.3. Gamma Gamma is the sensitivity of Delta to a one-unit change in the underlying. Gamma indicates an absolute change in Delta. For example, a Gamma of 0.150 indicates the Delta increases or decreases by 0.150 if the underlying price increases or decreases by $1.00. Results will usually not be exact.

4. Lambda Lambda is a measure of leverage, the expected percent change in an option premium for a 1% change in the value of the underlying product.

5. Rho Rho is the sensitivity of option value to change in interest rate. Rho indicates the absolute change in option value for a 1% change in the interest rate. For example, a Rho of .060 indicates the option's theoretical value increases by .060 if the interest rate decreases by 1.0. Results may not be exact due to rounding.

6. Theta Theta is the sensitivity of an options premium to change in time. Theta indicates an absolute change in the option value for a one-unit reduction in time until expiration. Theta may be displayed as a 1-day or 7-day measure. For example, a Theta of -.250 indicates the option's theoretical value changes by -.250 if the days to expiration reduce by seven. Results may not be exact due to rounding.

NOTE: seven day Theta will change to one day Theta if days to expiration are seven or less (see Time decay).

7. Vega Vega is the sensitivity of option value to changes in implied volatility. Vega indicates an absolute change in option value for a 1% change in volatility. For example, a Vega of .090 indicates the options theoretical value increases by .090 if the implied volatility increases by 1.0%. Alternately, the options theoretical value decreases by .090 if the implied volatility decreases by 1.0%. Results maynot be exact due to rounding.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/volatility_greeks.html

8. PUT/CALL PARITYPut/call parity is a captivating, noticeable reality arising from the options markets. By gaining an understanding of put/call parity, one can begin to better understand some mechanics that professional traders may use to value options, how supply and demand impacts option prices and how all option values (at all the available strikes and expirations) on the same underlying security are related. Prior to learning the relationships between call and put values, well review a couple of items.1. ArbitrageLet us begin by defining arbitrage and how arbitrage opportunities serve the markets. Arbitrage is, generally speaking, the opportunity to profit arising from price variances on one security in different markets. For example, if an investor can buy XYZ in one market and simultaneously sell XYZ on another market for a higher price, the trade would result in a profit with little risk.The selling pressure in the higher priced market will drive XYZs price down. Conversely, the buying of XYZ in the lower price market will drive XYZs price higher. The buying and selling pressure in the two markets will move the price difference between the markets towards equilibrium, quickly eliminating any opportunity for arbitrage. The no-arbitrage principle indicates that any rational price for a financial instrument must exclude arbitrage opportunities. That is, we can determine the value of a financial instrument if we assume arbitrage to be unavailable. Using this principle, we can value options under the assumption that no arbitrage opportunities exist.When trying to understand arbitrage as it relates to stock and options markets, we often assume no restrictions on borrowing money, no restrictions on borrowing shares of stock, and no transactions costs. In the real world, such restrictions do exist and, of course, transaction costs are present which may reduce or eliminate any perceived arbitrage opportunity for most individual investors. For investors with access to large amounts of capital, low fee structures and few restrictions on borrowing, arbitrage may be possible at times, although these opportunities are fairly rare.2. Defining DerivativesOptions are derivatives; they derive their value from other factors. In the case of stock options, the value is derived from the underlying stock, interest rates, dividends, anticipated volatility and time to expiration. There are certain factors that must hold true for options under the no arbitrage principle.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/put_call_parity.html

For example, a $50 call option on XYZ expiring June of the current year must be priced at the same or lower price than the September XYZ $50 call option for the current year. If the September call is less expensive, investors would buy the September call, sell the June call and guarantee a profit. Note that XYZ is a non-dividend paying stock, the options are American exercise style and interest rates are expected to be constant over the life of both options.Here is an example of why a longer term option premium must be equal to or greater than the premium of the short term option.Transaction 1: Buy September call for $3.00Transaction 2: Sell June call for $3.50Transaction 3: Assigned on June call, receive $50/share, short 100 XYZTransaction 4: Exercise September call, pay $50/share, flatten existing short positionResult: $0.50 per share profit*note XYZ is a non-dividend paying stock*In our interest free, commission free, hypothetical world, the timing of the assignment does not matter, however the exercise would only occur after an assignment. Note too that if XYZ falls below the $50 strike price, it does not impact the trade as a result of the $0.50 credit received when the positions were opened. If both options expire worthless, the net result is still a profit of $0.50.This example shows why a $50 XYZ call option expiring this June, must trade at the same or lower premium than a $50 call option expiring the following September. If the June premium was higher (like in the example), investors would sell the June call, causing the price to decline and buy the September, causing the price of that option to rise. These trades would continue until the price of the June option was equal to or below the price of the September option.A similar relationship can be seen between two different strike prices but the same expiration. For example, if an XYZ June $50 call was trading at $4.00 and the June $45 call was trading at $3.00, a rational investor would sell the $50 call, buy the $45 call, generating a $1 per share credit and pocket a profit.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/put_call_parity.html

3. Synthetic RelationshipsWith stock and options, there are six possible positions from three securities when dividends and interest rates are equal to zero stock, calls and puts:1. Long Stock2. Short Stock3. Long Call4. Short Call5. Long Put6. Short Put

Original Position=SyntheticEquivalent

Long Stock=Long Call+Short Put

Short Stock=Short Call+Long Put

Long Call=Long Stock+Long Put

Short Call=Short Stock+Short Put

Long Put=Short Stock+Long Call

Short Put=Long Stock+Short Call

Synthetic relationships with options occur by replicating a one part position, for example long stock, by taking a two part position in two other instruments. Similar to how synthetic oil is not extracted from the fossil fuels beneath the ground. Rather synthetic oil is manufactured with chemicals and is man-made. Similarly, synthetic positions in stocks and options are generated from positions in other instruments.To replicate the gain/loss characteristics of a long stock position, one would purchase a call and write a put simultaneously. The call and put would have the same strike price and the same expiration. By taking these two combined positions (long call and short put), we can replicate a third one (long stock). If we were to look at the gain/loss characteristics of a long stock position, the gain/loss characteristics of a combined short put/long call position would be identical. Remember the put premiums typically increase when the stock prices decline which negatively impacts the put writer; and of course the call premiums typically increase as the stock price increases, positively impacting the call holder. Therefore, as the stock rises, the synthetic position also increases in value; as the stock price falls, the synthetic position also falls.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/put_call_parity.html

Lets take a closer look at a synthetic long stock position. ABC is trading at $49 per share. The $50 put is trading at $2.00 and the $50 call is trading at $1.00 the call and the put have the same expiration - for purposes of this example the actual expiration does not matter. An investor can purchase the call and write the put. In doing so, the investor generated a $1.00 credit per share.If assigned on the short put, the put writer pays the strike price of $50 (a total of $5,000 for one put) and receives 100 shares of ABC. If the investor elects to exercise the call, they would pay $50 per share and (similar to the assigned put) receives 100 shares. But remember the investor took in a credit of $1 when they entered the synthetic position, thus the effective purchase price of the stock is $50 (paid when assignment or exercise occurs) less $1 credit from initial trade equals $49/share the price of ABC in the market.Example:ABC = $49/shareABC $50 put = $2.00ABC $50 call = $1.00The relationship of put/call parity can now be seen. In the previous example, if the relationship did not hold, rational investors would buy and sell the stock, calls and puts, driving the prices of the calls, puts and stock up or down until the relationship came back in line.Change the ABC price to $49.50 and leave the call and put premiums the same. The synthetic long stock position can be established for $49/share - $0.50 less than the market price of ABC. Rational investors would buy calls and sell puts instead of purchasing stock (and maybe even short the stock to offset the position completely and lock in a $.50 profit technically called a reversal). Eventually the buying of the calls would drive the price up and the selling of the puts would cause the put premiums to decline (and any selling of the stock would cause the stock price to decline also). This would occur until the put/call parity relationship falls back in line, thus diminishing the opportunity for arbitrage.Bid/ask spreads and other transaction costs impact the ability of investors to implement the above trades. Other factors too will change the relationship notably dividends and interest rates. Options are priced using the no arbitrage principle. The previous examples show how the markets participants would react to a potential arbitrage opportunity and what the impact may be on prices.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/put_call_parity.htmlAll this leads us to the final put/call parity equation-assuming interest rates and dividends equal zero: +stock = +call put where + is long and - is short; or stated as written: stock price equals long call premium less the put premium; any credit received or debit paid is added to or subtracted from the strike price of the options. The strike price of the call and put are the same. This assumes the strike prices and the expirations are the same on the call and put with interest rates and dividends equal to zero.

4. Impact of Dividends & Interest RatesThe next logical question is how ordinary dividends and interest rates impact the put call relationship and option prices. Interest is a cost to an investor who borrows funds to purchase stock and a benefit to investors who receive and invests funds from shorting stock (typically only large institutions receive interest on short credit balances). Higher interest rates thus tend to increase call option premiums and decrease put option premiums.For a professional trader looking to remain delta neutral and not be impacted by market movements the offset to a short call is long stock. Long stock requires capital. The cost of these funds suggests the call seller must ask for higher premiums when selling calls to offset the cost of interest on money borrowed to purchase the stock. Conversely, the offset to a short put is short stock. As a short stock position earns interest (for some large investors at least), the put seller can ask for a lower premium as the interest earned decreases the cost of funds.For example, an investor is looking to sell a one-year call option on a $75 stock at the $75 strike price. If the one-year interest rate is 5%, the cost of borrowing $7,500 for one year is: $7,500 x 5% = $375. Therefore, the call option on this non-dividend paying stock would have to be sold (at a minimum) for $3.75 just to cover the cost of carrying the position for one year.Dividends reduce the cost of borrowing if an investor borrows $7,500 (or some percentage thereof) to purchase 100 shares of a $75 stock and receives a $1/share dividend, he pays less interest on the money borrowed (assuming the $100 from the dividend is applied to the loan). This reduces the cost of carry as the cost of carrying the stock position into the future is reduced from the dividend received by holding the stock. Opposite of interest rates, higher dividends tend to reduce call option prices and increase put option prices.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/put_call_parity.html

Professional traders understand the relationships among calls, puts, interest rates and dividends, among other factors. For individual investors, understanding the early exercise feature of American style options is essential. When writing options, intuition as to when assignment may occur and when holding options understanding when to exercise at an opportunistic time is very important. For dividend paying stocks, exercise and assignment activity occurs more frequently just before (call exercises) and after (put exercises) an ex-dividend date.

Put/Call Parity Formula - Non-Dividend Paying Securityc = S + p Xer(T t)p = c - S + Xer(T t)c = call valueS = current stock pricep = put priceX = exercise price of optione = Eulers constant approximately 2.71828 (exponential function on a financial calculator)r = continuously compounded risk free interest rateT-t = term to expiration measured in years T = Expiration date t = Current value datePut-call parity: The relationship that exists between call and put prices of the same underlying, strike price and expiration month.Conversion: An investment strategy in which a long put and short call with the same strike and expiration is combined with a long stock position. This is also referred to as conversion arbitrage.Reverse Conversion: An investment strategy in which a long call and short put with the same strike and expiration is combined with a short stock position. This is also referred to as reversal arbitrage.http://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/put_call_parity.htmlArbitrage: Purchase or sale of instruments in one market versus the purchase or sale of similar instruments in another market in an effort to profit from price differences. Options arbitrage uses stock, cash and options to replicate other options. Synthetic options imitate the risk reward profile of "real" options using a combination of call and put options and the underlying stock.http://www.optionseducation.org/content/oic/en/strategies_advanced_concepts/advanced_concepts/put_call_parity.html

9. BLACK-SCHOLES FORMULAIn 1973, mathematicians Fischer Black, Myron Scholes, and Robert Merton published their formula for calculating the premium of an option. Known as the Black-Scholes model, this formula accounted for a variety of factors that affect premium: Underlying stock price Options strike price Time until expiration Implied volatility Dividend status Interest ratesAlthough the Black-Scholes formula is well known, it isnt the only method for computing an options theoretical value. American-style equity options are typically priced using a bi-nomial model due to the early exercise feature. Investors can tweak or manually adjust inputs to any pricing model to illustrate the impact of stock movement, volatility changes or other factors that influence an options actual value. For example, you could adjust the days until expirations or underlying price to see the effect on the Delta, Gamma and other Greeks.The limitation of all pricing models is that market forces determine actual premiums, not formulas, no matter how sophisticated a formula might be. Market influences can result in highly unexpected price behavior during the life of a given options contract.While no model can reliably predict what options premiums will be available in the future, some investors use pricing models to anticipate an options premium under certain future circumstances. For instance, you can calculate how an option might react to an interest rate increase or a dividend distribution to help better predict the outcomes of your options strategieshttp://www.optionseducation.org/strategies_advanced_concepts/advanced_concepts/black_scholes.html

10. RISK MANAGEMENTTo manage risk, you first have to understand the risks that you are exposed to. This process of developing a risk profile thus requires an examination of both the immediate risks from competition and product market changes as well as the more indirect effects of macroeconomic forces. Lets, begin by looking at ways in which we can develop a complete risk profile for a firm, where we outline all of the risks that a firm is exposed to and estimate the magnitude of the exposure. Later, we turn to a key question of what we should do about these risks. We can try to protect ourselves against the risk using a variety of approaches using options and futures to hedge against specific risks, modifying the way we fund assets to reduce risk exposure or buying insuranceRisk ProfileEvery business faces risks and the first step in managing risk is making an inventory of the risks that the business/organization face and getting a measure of the exposure to each risk. In this, we examine the process of developing a risk profile for a business and consider some of the potential pitfalls. There are four steps involved in this process.

http://people.stern.nyu.edu/adamodar/pdfiles/papers/hedging.pdf

Step 1: A listing of risksAssume that you run a small company in the United States, packaging and selling premium coffee beans for sale to customers. You may buy your coffee beans in Columbia, sort and package them in the California and ship them to your customers all over the world. In the process, you are approached to a multitude of risks. There is the risk of political turmoil in Columbia, compounded by the volatility in the dollar-peso exchange rates. Your packaging plant in California may sit on top of an earthquake fault line and be staffed with unionized employees, exposing you to the potential for both natural disasters and labor troubles. Your competition comes from other small businesses offering their own gourmet coffee beans and from larger companies like Starbucks that may be able to get better deals because of higher volume. On top of all of this, you have to worry about the overall demand for coffee ebbing and flowing, as customers choose between a wider array of drinks and worry about the health concerns of too much caffeine consumption.

Not surprisingly, the risks you face become more numerous and complicated as you expand your business to include new products and markets, and listing them all can be exhausting. At the same time, though, you have to be aware of the risks you face before you can begin analyzing them and deciding what to do about them.

Step 2: Categorize the risks

A listing of all risks that a firm faces can be overwhelming. One step towards making them manageable is to sort risk into broad categories. In addition to organizing risks into groups, it is a key step towards determining what to do about these risks. In general, risk can be categorized based on the following criteria:

a. Market versus Firm-specific risk:

We can categorize risk into risk that affects one or a few companies (firm-specific risk) and risk that affects many or all companies (market risk). The former can be diversified away in a portfolio but the latter will persist even in diversified portfolios; in conventional risk and return models, the former have no effect on expected returns (and discount rates) whereas the latter do.

b. Operating versus Financial Risk:

Risk can also be categorized as coming from a firms financial choices (its mix of debt and equity and the types of financing that it uses) or from its operations. An increase in interest rates or risk premiums would be an example of the former whereas an increase in the price of raw materials used in production would be an example of the latter.

c. Continuous Risks versus Event Risk: Some risks are dormant for long periods and manifest themselves as unpleasant events

http://people.stern.nyu.edu/adamodar/pdfiles/papers/hedging.pdfthat have economic consequences whereas other risks create continuous exposure. Consider again the coffee bean companys risk exposure in Columbia. A political revolution or nationalization of coffee estates in Columbia would be an example of event risk whereas the changes in exchange rates would be an illustration of continuous risk.

d. Catastrophic risk versus smaller risks:

Some risks are small and have a relatively small effect on a firms earnings and value, whereas others have a much larger impact, with the definition of small and large varying from firm to firm. Political turmoil in its Indian software operations will have a small impact on Microsoft, with is large market cap and cash reserves allowing it to find alternative sites, but will have a large impact on a small software company with the same exposure.

Some risks may not be easily categorized and the same risk can switch categories overtime, but it still pays to do the categorization.

Step 3: Measure exposure to each riskA logical follow up to categorizing risk is to measure exposure to risk. To make this measurement, though, we have to first decide what it is that risk affects. At its simplest level, we could measure the effect of risk on the earnings of a company. At its broadest level, we can capture the risk exposure by examining how the value of a firm changes as a consequence.

a. Earnings versus Value Risk Exposure

It is easier to measure earnings risk exposure than value risk exposure. There are numerous accounting rules governing how companies should record and report exchange rate and interest rate movements. Consider, for instance, how we deal with exchange rate movements. From an accounting standpoint, the risk of changing exchange rates is captured in what is called translation exposure, which is the effect of these changes on the current income statement and the balance sheet. In making translations of foreign operations from the foreign to the domestic currency, there are two issues we need to address.

The first is whether financial statement items in a foreign currency should be translated at the current exchange rate or at the rate that prevailed at the time of the transaction.

The second is whether the profit or loss created when the exchange rate adjustment is made should be treated as a profit or loss in the current period or deferred until a future period.

Accounting standards in the United States apply different rules for translation depending upon whether the foreign entity is a self-contained unit or a direct extension of the parent company. For the first group, FASB 52 requires that an entitys assets and

http://people.stern.nyu.edu/adamodar/pdfiles/papers/hedging.pdfliabilities be converted into the parents currency at the prevailing exchange rate. The increase or decrease in equity that occurs as a consequence of this translation is captured as an unrealized foreign exchange gain or loss and will not affect the income statement until the underlying assets and liabilities are sold or liquidated. (shld v delete this)

For the second group, only the monetary assets and liabilities have to be converted, based upon the prevailing exchange rate, and the net income is adjusted for unrealized translations gains or losses.

Translation exposure matters from the narrow standpoint of reported earnings and balance sheet values. The more important question, however, is whether investors view these translation changes as important in determining firm value, or whether they view them as risk that will average out across companies and across time, and the answers to this question are mixed. In fact, several studies suggest that earnings changes caused by exchange rate changes do not affect the stock prices of firms.

While translation exposure is focused on the effects of exchange rate changes on financial statements, economic exposure attempts to look more deeply at the effects of such changes on firm value. These changes, in turn, can be broken down into two types.

Transactions exposure looks at the effects of exchange rate changes on transactions and projects that have already been entered into and denominated in a foreign currency.

Operating exposure measures the effects of exchange rate changes on expected future cash flows and discount rates, and, thus, on total value.

In his book on international finance, Shapiro presents a time pattern for economic exposure, in which he notes that firms are exposed to exchange rate changes at every stage in the process from developing new products for sale abroad, to entering into contracts to sell these products to waiting for payment on these products. To illustrate, a weakening of the U.S. dollar will increase the competition among firms that depend upon export markets, such as Boeing, and increase their expected growth rates and value, while hurting those firms that need imports as inputs to their production process.

Measuring Risk Exposure

We can measure risk exposure in subjective terms by assessing whether the impact of a given risk will be large or small (but not specifying how large or small) or in quantitative terms where we attempt to provide a numerical measure of the possible effect. In this, two approaches are considered

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Qualitative approaches

When risk assessment is done for strategic analysis, the impact is usually measured in qualitative terms. Thus, a firm will be found to be vulnerable to country risk or exchange rate movements, but the potential impact will be categorized on a subjective scale. Some of these scales are simple and have only two or three levels (high, average and low impact) whereas others allow for more gradations (risk can be scaled on a 1-10 scale).No matter how these scales are structured, we will be called upon to make judgments about where individual risks fall on this scale. If the risk being assessed is one that the firm is exposed to on a regular basis, say currency movements, we can look at its impact on earnings or market value on a historical basis. If the risk being assessed is a low-probability event on which there is little history as is the case for an airline exposed to the risk of terrorism, the assessment has to be based upon the potential impact of such an incident.

While qualitative scales are useful, the subjective judgments that go into them can create problems since two analysts looking at the same risk can make very different assessments of their potential impact. In addition, the fact that the risk assessment is made by individuals, based upon their judgments, exposes it to all of the quirks (trait/habit) in risk assessment. For instance, individuals tend to weight recent history too much in making assessments, leading to an over estimation of exposure from recently manifested risks. Thus, companies over estimate the likelihood and impact of terrorist attacks, right after well publicized attacks elsewhere.

Quantitative approaches If risk manifest itself over time as changes in earnings and value, you can assess a firms exposure to risk by looking at its past history. In particular, changes in a firms earnings and value can be correlated with potential risk sources to see both whether they are affected by the risks and by how much. Alternatively, you can arrive at estimates of risk exposure by looking at firms in the sector in which you operate and their sensitivity to changes in risk measures.

1. Firm specific risk measures

Risk matters to firms because it affects their profitability and consequently their value. Thus, the simplest way of measuring risk exposure is to look at the past and examine how earnings and firm value have moved over time as a function of pre-specified risk. If we contend, for instance, that a firm is cyclical and is exposed to the risk of economic downturns, we should be able to back this contention up with evidence that it has been adversely impacted by past recessions.

Consider a simple example where we estimate how much risk Walt Disney Inc. is exposed to, from, to changes in a number of macro-economic variables, using two measures: Disneys firm value (the market value of debt and equity) and its operating

http://people.stern.nyu.edu/adamodar/pdfiles/papers/hedging.pdfincome. We begin by collecting past data on firm value, operating income and the macroeconomic variables against which we want to measure its sensitivity. In the case of the Disney, we look at four macro-economic variables the level of long term rates measured by the 10 year treasury bond rate, the growth in the economy measured by changes in real GDP, the inflation rate captured by the consumer price index and the strength of the dollar against other currencies (estimated using the trade-weighted dollar value).

The question of what to do when operating income and firm value have different results can be resolved fairly simply. The former provides a measure of earnings risk exposure and is thus narrow, whereas the latter captures the effect not only on current earnings but also on future earnings. It is possible, therefore, that a firm is exposed to earnings risk from a source but that the value risk is muted, as is the alternative where the risk to current earnings is low but the value risk is high.

2. Sector-wide or Bottom up Risk MeasuresThere are two key limitations associated with the firm-specific risk measures. First, they make sense only if the firm has been in its current business for a long time and expect to remain in it for the foreseeable future. In todays environment, in which firms find their business mixes changing from period to period as they divest some businesses and acquire new ones, it is unwise to base too many conclusions on a historical analysis. Second, the small sample sizes used tend to yield regression estimates that are not statistically significant. In such cases, we might want to look at the characteristics of the industry in which a firm plans to expand, rather than using past earnings or firm value as a basis for the analysis. To illustrate, we looked at the sector estimates for each of the sensitivity measures for the four businesses that Disney is in: movies, entertainment, theme park and consumer product businesses. Table summarizes the findings:

http://people.stern.nyu.edu/adamodar/pdfiles/papers/hedging.pdfThese bottom-up estimates suggest that firms in the business are negatively affected by higher interest rates (losing 4.71% in value for every 1% change in interest rates), and that firms in this sector are relatively unaffected by both the overall economy. Like Disney, firms in these businesses tend to be hurt by a stronger dollar, but,, unlike Disney, they do not seem have much pricing power (note the negative coefficient on inflation. The sector averages also have the advantage of more precision than the firm-specific estimates and can be relied on more.Step 4: Risk analysis

Once you have categorized and measured risk exposure, the last step in the process requires us to consider the choices we can make in dealing with each type of risk.While we will defer the full discussion of which risks should be hedged and which should not to the later section, we will prepare for that discussion by first outlining what our alternatives are when it comes to dealing with each type of risk and follow up be evaluating our expertise in dealing with that risk.

There are a whole range of choices when it comes to hedging risk. You can try to reduce or eliminate risk through your investment and financing choices, through insurance or by using derivatives. Not all choices are feasible or economical with all risks and it is worthwhile making an inventory of the available choices with each one. The risk associated with nationalization cannot be managed using derivatives and can be only partially insured against; the insurance may cover the cost of the fixed assets appropriated but not against the lost earnings from these assets. In contrast, exchange rate risk can be hedged in most markets with relative ease using market-traded derivatives contracts.

A tougher call involves making an assessment of how well you deal with different risk exposures. A hotel company may very well decide that its expertise is not in making real estate judgments but in running hotels efficiently. Consequently, it may