Page 65 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management Mahesh Kumar Sarva, Lovely Professional University

Notes Unit 6: Introduction to Options

CONTENTS
Objectives
Introduction
6.1 Options Terminology

6.2 Types of Options
6.3 Index Derivatives
6.4 European and American Calls and Puts

6.4.1 Call Options
6.4.2 Put Options
6.5 Exotic and Asian Option
6.6 Summary
6.7 Keywords

6.8 Review Questions
6.9 Further Readings

Objectives

After studying this unit, you will be able to:

 Define options
 Describe the terminology and types of options
 State the meaning of index derivatives
 Illustrate European and American calls and puts

 Describe exotic and Asian options

Introduction

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an
underlying asset at a specific price on or before a certain date. An option, just like a stock or
bond, is a security. It is also a binding contract with strictly defined terms and properties. Say,
for example, that you discover a house that you would love to purchase. Unfortunately, you do
not have the cash to buy it for another three months. You talk to the owner and negotiate a deal
that gives you an option to buy the house in three months for a price of ` 200,000. The owner
agrees, but for this option, you pay a price of ` 3,000.
Now, consider two theoretical situations that might arise:
1. It has been discovered that the house is of historical importance and as a result, the market
value of the house skyrockets to ` 10,00,000. Because the owner sold you the option, he is
obligated to sell you the house for ` 200,000. In the end, you stand to make a profit of
` 7,97,000 (` 10,00,000 – ` 2,00,000 – ` 3,000).

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