Page 70 - DCOM510_FINANCIAL_DERIVATIVES

Unit 5: Introduction to Options

Notes
Did u know? Option premium is the price at which an option trades, and is paid by the
buyer to the writer (seller) of the contract. The premium paid by the buyer is non-refundable
payment for the rights inherent in the long contract. The writer (seller) of an option
contract keeps the premium received, whether assigned or not, and is in turn obligated to
fulfil the short contract’s obligations if assignment is received. The two components of an
option’s total premium are intrinsic value and time value.
15. Moneyness: In finance, moneyness is a measure of the degree to which a derivative is
likely to have positive monetary value at its expiration, in the risk-neutral measure. There
are three positions in options: In-the-money; At-the-money; and Out-of-the-money.
(a) In-the-money option: An in-the-money (ITM) option is an option that would lead to
a positive cash flow to the holder if it were exercised immediately. A call option on
the index is said to be in-the-money when the current index stands at a level higher
than the strike price (i.e. spot price >strike price). If the index is much higher than the
strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the
index is below the strike price.
(b) Out-of-the-money option: An out-of-the-money (OTM) option is an option that
‘leads to a negative cash flow if it were exercised immediately. A call option on the
index is out-of-the-money when the current index stands at a level which is less than
the strike price (i.e. spot price < strike price). If the index is much lower than the
strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the
index is above the strike price.
An out-of-the-money option currently has no intrinsic value e.g. a call option is out-
the-money if the strike price (“the strike”) is higher than the current underlying
price. An in-the-money option conversely does have intrinsic value.

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Caution The strike price of an in-the-money call option is lower than the
current underlying price.
(c) At-the-money option: An at-the-money (ATM) option is an option that would lead
to zero cash flow if it were exercised immediately. An option on the index is at-the-
money when the current index equals the strike price (i.e. spot price = strike price).
In other words, an option is at-the-money if the strike price, i.e., the price the option
holder must pay to exercise the option, is the same as the current price of the
underlying security on which the option is written.

Example: Suppose the current stock price of SBI is ` 1,000. A call or put option with
a strike of ` 1,000 is at-the-money. A call option with a strike of ` 800 is in-the-money (1000
- 800 = 200 > 0). A put option with a strike at ` 800 is out-of-the-money (800 - 1000 = -200 <
0). Conversely, a call option with a ` 1200 strike is out-of-the-money and a put option with
a ` 1,200 strike is in-the-money.

16. Intrinsic value of an option: The option premium can be broken down into two components
— intrinsic value and time value. The intrinsic value of a call is the amount the option is
ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the
intrinsic value of a call is Max [0, (S - K)] which means the intrinsic value of a call is the
t
greater of 0 or (S - K). Similarly, the intrinsic value of a put is, Max [0, (K- S)} i.e. the greater
t
value of 0 or (K- S ). St is the spot price at time t; K is the strike price.
t

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