Question

Derivatives are contracts enabling both buyers and sellers to execute a future transaction at a price determined at the outset of the derivatives contract. Please answer the following questions.

1. What is the difference between a call and put option?
2. What does the exercise - -or strike price denote?
3. Of the five inputs used on the Black-Scholes model, please list three of the most important inputs used in the model.  
4. What happens to the call-option premium when the strike price begins to rise (Assuming that there are no changes to the other variables in the Black-Scholes model)?

Answer 1

A. Difference between a Call and a Put option:

1. A call option provides a right to buy to the buyer whereas a put option provides a right to sell to the buyer of it.
2. Call option premium increases when the underlying price increases whereas put option premium increases when underlying price decreases.
3. Buying call gives an expectation of bull (positive) market whereas buying put gives an expectation of bear(negative) market.
4. Similarly, selling call is signal of bearish (negative) market whereas selling put is signal of bullish (positive) market.
5. A call option is In the money if spot price is greater than strike price whereas a put option is in the money if the spot price is lesser than the strike price.
6. Similarly, A call option is Out of the money if spot price is lesser than the strike price whereas a put option is out of the money if spot price is higher than the strike price.

Answer b: Exercise price or strike price is the price beyond which the option will have the positive intrinsic value. For call option, if value of underlying goes above strike price then it will have a positive intrinsic value and for put, if value of underlying goes below the strike price then it will have a positive intrinsic value.

For Example, If strike price of a call $ 100 and if value of underlying is $110 then intrinsic value of call option will be $10 because it is 10 points above than the strike price.

C. The five inputs to the Black Scholes Model are:

1. Spot Price
2. Strike Price
3. Volatility
4. Risk Free Interest rate
5. Time to Expiry

Though, all the variables are very important for pricing of options, but most important inputs should be:

1. Spot Price: Since, change in spot price will be directly have an impact on the price of call or put premium.

2. Volatility: High volatility stock's call or put option will be more expensive because high time value.

3. Strike Price: Strike Price is also very important for pricing a call and put. If an option is far out of the money, its premium may be very less whereas the option premium and trade volumes will be very high for in the money options.

d. As Strike price begins to rise (considering other factors constant) the premium of call option should tend to go down since the probability of the stock price to break its strike price will keep on decreasing (because of increasing gap between spot price and strike price).