Page 67 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 2. While touring the house, you discover that the house is not in proper living conditions.
Though you originally thought you had found the house of your dreams, you now consider
it worthless. On the upside, because you bought an option, you are under no obligation to
go through with the sale. Of course, you still lose the ` 3,000 price of the option that is non-
refundable.
This example demonstrates two very important points.
First, when you buy an option, you have a right but not an obligation to do something. You can
always let the expiration date go by, at which point the option becomes worthless.

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Caution If this happens, you lose 100% of your investment (option premium), which is the
money you used to pay for the option.
Second, an option is merely a contract that deals with an underlying asset. For this reason,
options are called derivatives, which mean an option derives its value from something else. In
our example, the house is the underlying asset.

5.1.1 Features of the Options Contracts

Following are the features of the options contracts:

Option contract gives the holder the right to do something.
The holder may exercise his option or may not.
The holder can make a reassessment of the situation and seek either the execution of the
contracts or its non-execution as be profitable to him.

He is not under obligation to exercise the option.
So, this fact distinguishes options from forward contracts and futures con-tracts, where the
holder is under obligation to buy or sell the underlying asset. Recently in India, the banks
are allowed to write cross-currency options after obtaining the permission from the
Reserve Bank of India.

5.1.2 Options that are Currently Traded in the Market

The options that are currently traded in the market are index options and stock options on the 30
stocks. The index options are European options. They are settled on the last day. The stock
options are American options. There are 3 options: 1, 2, 3 month options. There can be a series of
option within the above time span at different strike prices. Another lingo in option is Near and
Far options. A near option means the option is closer to expiration date. A Far option means the
option is farther from expiration date.

Notes

(a) A 1 month option is a near option while a 3 month option is a far option.
(b) In option trading, what gets quoted in the exchange is the premium and all that
people buy and sell is the premium.

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