Page 135 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes The following table now differentiates between options on actuals and options on futures.

Table 8.1: Options on Actuals and Futures
Options on Actuals Options on Futures
(Options on Spots)
1. Exercising a spot option entails trading of 1. Exercising a futures option entails assuming a
the actual spot asset which may be a stock, position in a futures contract written on a spot
stock index, currency or commodity. asset.
2. To exercise a spot option, the exerciser 2. Futures options have less severe capital
must have sufficient capital to cover the requirements as this entails depositing the
entire exercise price. futures margins.
3. Spot options pose liquidity problems. A 3. Futures options help maintain liquidity by
spot option of a unique asset has limited creating additional supplies of the deliverable
trading due to fixed supply of the unique asset – traders can write and contract in more
asset. futures contracts.

Self Assessment

Fill in the blanks:
14. Options trading represents a …………………… game, i.e., any profits (losses) experienced
by option buyer are offset by losses (profits) experienced by option writers while options
trading (transaction costs included) must be a less than zero sum game.
15. …………………… are options written on assets paying no dividends or interest and having
no substantial storage costs.

8.6 Pricing of Currency Options

The most technically challenging aspect of currency options is setting their prices or premium.
Since even small exchange rate changes can have significant effects on the profitability of options,
it is necessary to develop option pricing models. Thus, while options have been of interest for
many years, it was only in 1973 that Fisher’ Black and Myro Scholes came up with a satisfactory
analysis for the actual pricing of currency. Their model is referred to as the Black-Scholes model.
Various factors influence the value of an option. A summary of the effect of these factors on
value of a call option/put option is given below:

Table 8.2: Factors Influencing the Value of an Option
Determining Factors Effect of Increase in the Factor
On Put Option On Call Option
1. Current stock price (S) - +
2. Striking price (K) + -
3. Time to expiration (t) + +
4. Stock volatility + +
5. Interest rates - +
6. Cash dividends + -
Note: + Increase in put/call value
– Decrease in put/call value

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