Page 97 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes Cash Flow
Buy two calls - 14
Short one share + 50
Lend - 32
Total + 4
It can similarly be shown that if the call is valued at a price greater than ` 9, then profit can be
earned by creating a portfolio consisting of writing two calls, buying a share and borrowing
` 32.

To conclude, then, the call cannot sell for higher or lower than the value derived earlier. Call
Option Value= ` 9.



Caselet Use of Long Put Option

Situation: A farmer wants protection in case soybean prices fall by harvest
Strategy: Farmer buys an exchange-traded put option

If falling commodity prices are a risk to your profitability, buying put options will help
you to establish a minimum selling price without giving up the opportunity to profit
from higher prices. Assuming that you are a soybean producer and you have just finished
planting your crop. You are worried that prices may fall before harvest and would like to
establish a floor price for a portion of your expected soybean crop. You go ahead and
purchase an October soybean put with a strike price of ` 1650— this gives you a minimum
selling price of ` 1650 a quintal (excluding basis, commissions, and the cost of the option).
If, just before harvest, the October futures price declines to ` 1575 (your put option is in the
money), you can exercise your option and receive a short futures contract at the ` 1650
strike price. Buying back the futures contract at the lower market price of ` 1575 gives you
an ` 75 per quintal profit (the difference between the strike price and the futures price),
which should roughly offset the decline in the price of soybeans. Or, rather than exercising
the option, you might be able to earn more by selling back the option to someone else.
This would allow you to profit from any remaining time value as well as the ` 75 intrinsic
value, both of which would be reflected in the option premium.

When October soybean futures are trading at ` 1575, the ` 650 soybean put would be worth
at least ` 75 plus any remaining time value. Generally, when an option is in the money and
has time value its common for someone sell back the option rather than exercising it.
That’s because exercising the option will yield only its intrinsic value. Anytime, value that
remains will be forgone. If the price of soybeans increases just before option expiration
and is above the option strike price (your put option is out of the money), you can simply
let the option expire or sell it back prior to expiration to capture any remaining time
value. In either case, your loss on the option position can be no larger than the premium
paid, and you still will be able to sell your crop at the higher market price.
Source: http://agmarketing.extension.psu.edu/Commodity/PDFs/Future_options_
eginners.pdf

6.4 Black-Scholes Model for Call Options

In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made a major breakthrough
in the pricing of stock options by developing what has become known as the Black-Scholes

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