Page 127 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes The figure 8.2 shows the profits/losses from a short position on the index. The investor sold the
index at 2220. If the index falls, there are profits, else losses.

Payoff Profile for Buyer of Call Options: Long Call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price of the underlying is less than the strike price, he
lets his option expire unexercised. His loss in this case is the premium he paid for buying option.
Figure 8.3 gives the payoff for the buyer of a three month call option (often referred to as long
call) with a strike of 2250 bought at a premium of 86.60.

Figure 8.3: Payoff for buyer of call option

The figure 8.3 above shows the profits/losses for the buyer of a three-month Nifty 2250 call
option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration,
Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent
of the difference between the Nifty-close and the strike price. The profits possible on this option
are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option
expire.

Notes The losses are limited to the extent of the premium paid for buying the option.
Payoff Profile for Writer of Call Options: Short Call

For selling the option, the writer of the option charges a premium. The profits/loss that the
buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the
buyer will exercise the option on the writer. Hence as the spot price increases the writer of the
option starts making losses. Higher the sport price more is the loss he makes. If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets his option expire
unexercised and the writer gets to keep the premium. Figure 8.4 gives the payoff for the writer
of a three month call option (often referred to as short call) with a strike of 2250 sold at
premium of 86.60.

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