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Options, one of the most common derivative instruments, can be full of surprises. That’s the reason pricing of options is one of the most challenging jobs. However, we have different pricing models, which try to bring some order in an otherwise chaotic world of options. But these models use complicated equations which are beyond the reach of our friend Johnny. So let’s try to learn, in the language of a newbie, what goes into the pricing of options.
Jinny: Hi, Johnny! I see you are in a lighter mood. What’s up?
Johnny: I remain in a lighter mood whenever I am thinking about something serious.
Jinny: Really? Can I also join?
Johnny: Of course, you can. In fact, I was just wondering whether we can make a mathematical model for catching a fish. I am sure if we are ever able to make such a model, it would not be as complicated as some of our options pricing models. What do you say?
Jinny: Well, I can’t talk much about models for catching fish, but I can surely explain how options are priced without going into complicated details of models, if that is what you want to understand.
Johnny: That’s right, Jinny. But let’s get into the basics first.
Jinny: Options, as you know, are contracts in which the option buyer acquires the right but no obligation to buy from or sell to the option seller the underlying asset at a predetermined price called “strike price”. Options that give the right to buy are called “call options” and options that give the rights to sell are called “put options”. Further, options can be classified as “European options”, which can be exercised only on the expiry date, and “American options”, which can be exercised on or any day before the expiry date. As if these two were already not enough, we also have “Bermuda options” and “Asian options”, which we will ignore for now to avoid confusion.
In options of any kind, the option buyer is under no obligation to exercise his option. However, once he chooses to do so, the option seller is bound to honour his promise. To avail this kind of one-way ticket, the option buyer has to pay a price called “option premium” to the option seller.
we come to the crucial part. How do we decide the option price that is good enough to induce the option seller to undertake all the risk? Well, we can use any of the option pricing models such as the Black Scholes model or Binomial option pricing model or any one of the other variants for determining the option premium. These models no doubt use complex mathematical equations that look very intimidating to beginners. But once you understand their basics, you can use them like playthings.
Johnny: So far, so good. Tell me, Jinny, how is the price of an option determined?
Jinny: The pricing of an option revolves around two components—one is called the “intrinsic value” and the other is called the “time value”. “Intrinsic value” represents the true worth of your option at present. This value does not remain constant but keeps changing over the life of your option. In fact, its value may fluctuate between zero and infinite positive numbers.
What, you may wonder, if the intrinsic value gets into negative territory? Well, an option having intrinsic value in negatives is only as bad as an option having zero intrinsic value. Why? That I will explain in a while. Just keep in mind that at worst you can lose the bird in hand. You can’t lose more than what you actually had.
Johnny: How can we find out the intrinsic value of an option?
Jinny: For finding out the intrinsic value, there is no need to use complex mathematical equations. You simply need to find out whether the strike price of the underlying asset of your option is higher or lower than its current market price.
For a call option, a strike price lower than the current market price means you can buy the underlying asset at a lower price than the current market price by exercising your option. Such options have a positive intrinsic value which you can find out by subtracting the strike price from the current market price.
Suppose you hold a call option for buying a single share of company X at a strike price of Rs100 per share before the expiry date and the same share is presently trading at a higher price of Rs120. The intrinsic value of the present option is Rs120 minus Rs100, or Rs20. The benefit of such a situation is obvious. You can earn a profit of Rs20 by exercising an option having an intrinsic value of Rs20. In technical terms, we can also say that your option is “in the money” by Rs20.
Johnny: But what if the strike price of the call option is higher than the current market price?
Jinny: Well, that’s something you can think about till we meet next week.
What: The price of an option or option premium consists of “intrinsic value” and “time value”.
How: We can know the intrinsic value by comparing the current market price of the underlying asset with its “strike price”.
When: A call option is “in the money” when the strike price of the underlying asset is lower than its current market price.
Source : Live Mint
Equity markets disappointed investors last year and there is no clear sign of a quick revival in the near term. We have to search for such options which can sustain our wealth with acceptable returns in these bearish times. Debt schemes are one such opportunity where you can park your money in these tough times. With further rate cuts expected, debt investment instruments are likely to offer attractive platform to invest in low risk and high yield avenues. Apart from the traditional fixed deposits and provident fund schemes, mutual funds too actively manage debt products. Debt funds seek to invest in various debt instruments whose maturity could be short-term or long-term.Debt funds can be broadly classified as income funds, liquid funds and fixed maturity plans. The classification is based on the nature of instruments and their maturity.
Starting from Income Funds, these funds invest in Corporate Bonds and Government securities. These Funds provide investors with an opportunity to increase returns and generate capital gains, by taking duration bets in a benign interest rate environment.The credit quality of the instruments and the fund manager’s ability to tactically manage the portfolio maturity based on interest rate cycles would determine the performance of such funds.One should be careful while investing in these funds on the portfolio side because sometimes in urge of delivering high returns, the asset quality of the portfolio could be deteriorated. Here we take a look at the various debt funds:
At a time when investors have turned risk averse and credit concerns abound, gilt funds can fill a critical gap in asset allocation. These funds seek to generate steady and consistent returns from a basket of government securities across various maturities through proactive fund management aimed at controlling interest rate risk. These funds will invest in gilt including T-Bills with medium to long maturity. On the back of a possibility of deterioration in corporate credit quality, gilts funds are safer than income funds as Government debt comes with a sovereign guarantee and there is no risk to capital or interest payments
When some one wants to park their money for a very short term, liquid funds is one of the prudent options. These funds invest in short term debt market and money market instruments having very short maturity period, which ensures high liquidity. Liquid funds invest with minimal risk (like money market funds). Usually these funds do not have a lock-in period and offer redemption proceeds within 24 hours. As these funds have restrictions on the quantum of investment in mark-to-market instruments, the interest rate risk is lower. They do not, therefore, benefit from interest rate cycles, unlike income or gilt funds. Liquid-plus funds, on the other hand, can invest in slightly longer-term maturity instruments, thus enhancing the risk-return potential.
They offer flexibility in portfolio constitution according to the perception regarding interest rate movements. Investing in these kind fund are sensible decisions in volatile interest rate when you don’t have time for research and don’t want to shift your options on an active basis.
Fixed maturity plans are close-end funds whose maturity is linked to the expiry of the underlying instruments in which they invest. While FMPs typically help investors lock into the yields of the underlying instruments, such returns would be feasible only if an investor holds on to the fund, until its maturity. Further FMPs carry credit risk in case there is a default on some of the Corporate Papers which they might be holding. While FMPs are no doubt a superior option from a taxation perspective, they are not strictly comparable, as fixed deposits offer assured returns and are not directly linked to market sensitivities once the investment is made.
Floating Rate Funds is another option which is currently out of favor due to expectation of fall in interest rates. These funds have the potential to provide you returns in line with the prevailing interest rate. These should be preferred in times when the interest rates are likely to go up.
To conclude, we think that interest rates are likely to fall further from current levels which would help income funds and gilt funds to deliver good returns. Though, gilt funds have delivered handsome returns recently but still there is some steam left. A conservative investor who does not want to take any credit risk can park their money in gilt funds. The next rally in this category is most likely to be led by Income Funds as they have not seen a major movement yet. Further, the spread between G-sec yield and AAA papers is also very wide. Moderate and aggressive investors with a short and medium-term investment horizon can invest in income funds and can expect decent returns.
