3. Simplifying Call Option
-
Upload
rohit-gupta -
Category
Documents
-
view
218 -
download
0
Transcript of 3. Simplifying Call Option
![Page 1: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/1.jpg)
Simplifying Call Option – By Prof. Simply Simple TM
I hope the last lesson on „Options‟ helped you in getting
to understand the concept.
In continuation of that, we also discussed the „Put‟
option for your clarity on the subject.
Having explained the „Put‟ option, quite naturally, you‟ll
want to know about the „Call‟ option.
Let me try & explain it in the next few slides…
![Page 2: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/2.jpg)
Let‟s look at the same example
for the farmer & bread
manufacturer as we did in our
earlier lessons on „Futures‟ &
on „Options‟.
![Page 3: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/3.jpg)
So going back to our farmer
who cultivates wheat…
![Page 4: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/4.jpg)
And a bread manufacturer
who needs wheat as an
input for making bread…
![Page 5: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/5.jpg)
• The farmer thinks that the price of wheat which is
currently trading at Rs. 100 could fall to Rs. 90 in 3
months.
• The bread manufacturer on the other hand feels that the
price of wheat on the other hand might become Rs. 120 in
3 months.
![Page 6: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/6.jpg)
• In such a case, both of them get together & sign a contract
which says that at the end of 3 months the bread manufacturer
would buy wheat from the farmer at Rs. 110.
• Thus the bread manufacturer is protected against a possible
rise in prices.
• And the farmer is protected against any drop in the price of
wheat in the near future.
![Page 7: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/7.jpg)
Such a contract is called a
Futures contract as we saw in
our lesson on „Futures‟.
![Page 8: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/8.jpg)
• In a Futures contract both parties are obliged to honor the contract
and there is no escape route for either party.
• But what if the contract gives the bread manufacturer the “option”
of (either)
– Buying the wheat from the farmer at the pre-agreed price of Rs
110 (or)
– Choosing to exit the contract and buy wheat from the open
market at the prevailing market price?
• In other words, the bread manufacturer is given the option of not
honoring the contract made with the farmer on the date of
settlement.
![Page 9: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/9.jpg)
Such a contract that gives the bread
manufacturer the option of either
executing the contract or exiting it is
known as an ‘Options’ Contract.
But the bread manufacturer
cannot get this privilege just like
that. He obviously has to pay a
premium for exercising this
facility…
![Page 10: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/10.jpg)
• Now, let‟s say that after 3 months the price of wheat falls to
Rs. 90.
• In this case the bread manufacturer quite clearly would want
to exit the contract so that he is free to buy wheat from the
open market for Rs. 90.
• If so, while the bread manufacturer gets away, the farmer is
left high and dry and has no other option but to sell his
produce in the open market at Rs 90.
![Page 11: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/11.jpg)
• But it is that bad a situation for the farmer as it appears as he gets
compensated by the bread manufacturer for having been a party to
the „Options‟ contract.
• This compensation * in the form of price is called the “Option
Premium” that the bread manufacturer has to pay for the Options
contract and is usually a small amount.
• Let‟s assume in our case the amount is Rs 5.
• So the bread manufacturer is obliged to pay the farmer Rs 5 as he has
chosen to opt out of the contract.
* Please note that the bread manufacturer will have to pay an option premium regardless of whether or not the option is actually exercised.
![Page 12: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/12.jpg)
• Thus although the farmer has no other option left but to go
to the open market and sell wheat at Rs. 90, he does get the
benefit of Rs 5 as compensation for being a party to the
„Options‟ contract.
• So even if the price is Rs. 90 in the open market, for him the
effective price turns out to be
Rs. (90+5) = Rs 95
• So by simply participating in the contract he too stands to
gain something.
![Page 13: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/13.jpg)
• For the bread manufacturer, it is a win–win scenario by
participating in the contract.
• Had the prices risen to Rs 120 as he had anticipated, he would
have executed the Options contract at Rs 110 and would have got
protected.
• But since prices fell to Rs 90 he chose to exit the contract. Thus he
is blessed with the „Option‟ of either executing or not executing
the contract based upon the price in the open market at the time of
contract settlement.
![Page 14: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/14.jpg)
• It is important to understand that in an „Options‟ contract,
only one party gets the privilege to exercise the option while
the other party is obliged to honor the option if it is chosen.
• Thus, in our case, the bread manufacturer has the option to
either execute or exit the contract whereas the farmer is
obliged to honour the decision of the bread manufacturer.
• A contract such as this where only the purchaser of the
commodity gets the option to either exercise or exit the
contract is known as „Call‟ option.
![Page 15: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/15.jpg)
You will recall we had studied
the „Put‟ option in our last
lesson.
Hope this explanation has
clarified the difference between
the „Put‟ and „Call‟ option.
![Page 16: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/16.jpg)
Basically in the „Put‟ option
the choice of honoring the
contract was with the farmer
or seller while in the „Call‟
option this option was with
the bread manufacturer or
purchaser.
![Page 17: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/17.jpg)
• Even in an Options contract both parties land up achieving their
goals and their interests are protected.
• The bread manufacturer stands to gain the most by getting to
exercise a choice that benefits him the most.
• The farmer on the other hand too benefits by being a party to
the contract due to the compensation he receives from the bread
manufacturer for not executing the contract.
![Page 18: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/18.jpg)
• The farmer due to the compensation sells the wheat in the open
market at an effective price of Rs. 95
• And hence is better off than the ordinary or spot seller who
would have to sell at Rs 90.
• Thus in a sense both parties landed up getting some gains by
being parties to the „options contract‟.
• However unlike in a „Futures‟ contract, in the „Options‟ contract
one party gains more than the other party.
![Page 19: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/19.jpg)
To Sum Up
• In a ‘Futures Contract’ both parties are
obliged to honor the contract.
• In an ‘Options Contract’ one of the parties is given the privilege to exit the option on settlement date and the party has to oblige.
• In a ‘Put’ option this privilege is given to the seller (in our example - the farmer)
• In a ‘Call’ option this privilege is given to the buyer (in our example - the bread manufacturer)
Copyright © 2009
![Page 20: 3. Simplifying Call Option](https://reader036.fdocuments.in/reader036/viewer/2022062523/577ccefd1a28ab9e788e9656/html5/thumbnails/20.jpg)
Please do let me know if I have managed to clear the concepts of
„Call Option‟ as well as the difference between
„Call‟ & „Put‟ Options.
Your feedback is very important as it helps me plan my future
lessons.
Hence please give your feedback at