Question

A)Explain and discuss the parameters that influence the price of European-style options and the nature of their impact.

b) Discuss ways in which a put or a call option may be used in hedging and speculation.

Answer 1

Answer a:

The parameters that influence the price of European options are:

1. Value of Underlying stock: The price of European options (call or put) is directly related the value of underlying shares or stocks..If the share price is expected to increase then the European options (call or put) also rises and vice versa..

2. Strike price: The strike price ie E is another parameter on which the European options depends..If the srike price is lower then the price of options rises and if the strike price is higher than the price of European options reduces..ie they are indirectly related to each other.

3. Time of expiry or termination of options: Tenure or time of options also have an impact on the price of European options..If the time period of options is more then the price of European options rises..Reason behind is that ,more days or time means more up and down movements of price of underlying stocks which means more risk are involved,so higher price and vice versa.

4..Volatality: Volatality means increase or decrease of price of shares around the mean..It not only means only increase or decrease.More volatile options means more risk and more vulnerable so increase in price and vice versa.

5. Carrying cost..: In cost accounting or management accounting carrying cost has a big influence to determine the actual cost..Same is the case with option pricing..Options with more carrying cost involves more cost and vice versa.

Answer b:

Put and Call option in Hedging:

1. Hedging by buying options: Buying options is theoritically the best option..The firm will be protected against the adverse movement while at the same time the firm will enjoy the favourable movement..

2. Hedging by selling options: This is the worst alternative theorically..No protection and no enjoyment.But this strategy may be the best if there is little movement..

Put and Call in Speculation:

Based on the price belief and risk apetitite there are many startegies of speculation:

1. Elementary Strategy : P+ or P- OR C+ or C-

2. Combination Strategy:

a. Straddle : One Put and One Call at same Exercise Price

b Strip : Two Put and One Call at same Exercise price

c Strap : One Put and two Call at same Exercise price

d Strangle : One Put at lower Exercise price and One Call at higher Exercise price

3. Spread Strategy:

a. Bull/ Bear spread

b. Volatile or non volatile spread