Page 111 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes opposite direction for puts. As more dividends are paid out, the stock price will jump
down on the ex-date which is exactly what you are looking for with a put.
6. Time to Expiration: Generally, both calls and puts will benefit from increased time to
expiration. The reason is that there is more time for a big move in the stock price. Consider
the case of two options that differ only as far as their expiration date is concerned. The
owner of the long-life option has all the exercise opportunities open to the owner of the
short-life option and more. The long-life option must therefore always be worth at least as
much as the short life option As the time to expiration increases, the present value of the
exercise price decreases. This will increase the value of the call and decrease the value of
the put. Also, as the time to expiration increases, there is a greater amount of time for the
stock price to be reduced by a cash dividend. This reduces the call value but increases the
put value.
Let's summarize these effects in Table 8.1 as given below. The table shows all effects on the
buyer side of the contract.
Table 8.1: Determinants of Option Value

Sl.No. Factors Effect of Increase on
Value of Call Option Value of Put Option
1 Current Stock/Spot Price Increase Decrease
2 Exercise Price Decrease Increase
3 Volatility Increase Increase

4 Risk-free Interest Rate Increase Decrease
5 Dividends Decrease Increase
6 Time to Expiration Increase Increase

Notes Basic Principles of Option Valuation
The two basic principles/rules of option valuation are as follows:
1. If one portfolio of securities gives a higher future payoff than another portfolio in
every possible circumstance, then the first portfolio must have a higher current
value than the second portfolio.

2. If two portfolios of securities give the same future payoff in every possible
circumstance, then they must have the same current value.

Self Assessment

Fill in the blanks:
1. The ………….. of an option contract is that amount which is paid by the option buyer to the
option seller.
2. The option price is also known as ……………...
3. The option price changes as per changing ………… price.

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