Page 69 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes price. An in-the-money option conversely does have intrinsic value. 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 cashflow 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
t t
greater value of 0 or (K – S ). S is the spot price at time t; K is the strike price.
t t
17. Time value of an option: The time value of an option is the difference between its option
premium and its intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when the
option is ATM. The longer the time to expiration, the greater is an option's time value, all
else being equal. At expiration, an option should have no time value.

Self Assessment

Fill in the blanks:
1. ……………is also referred to as the option premium.
2. …………… options are options that can be exercised at any time upto the expiration date.

3. ………….options are options that can be exercised only on the expiration date itself.
4. The option premium can be broken down into two components - intrinsic value and
……………. .

5. A call option on the index is out-of-the-money when the current index stands at a level
which is less than the …………..

6.2 Types of Options

There are two basic types of options-call options and put options.

1. Call option: A call option gives the holder the right but not the obligation to buy an asset
by a certain date for a certain price.
2. Put option: A put option gives the holder the right but not the obligation to sell an asset
by a certain date for a certain price.
The price of options is decided between the buyers and sellers on the trading screens of the
exchanges in a transparent manner. The investor can see the best five orders by price and

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