T7_2.

Put Option
So now that we have a basic understanding of what a call option is, let's get into a little more
detail about two kinds of options. The call we've already seen is the right to buy one unit of the
underlying. Now, there also exists something called a put option, which is the right to sell one
unit of the underlying has very similar, except that one is the right to buy, the other is the right
to sell. Now, whether call or put, I want you to remember that there is always two sides of this
transaction, right? The long side of the transaction is the one who is buying or selling who has
the right to exercise this option. And the person who surrenders the right or gives up the right
in exchange for a premium is called the short side of this transaction. Now all this can be very
easily visualized, if we look at all of these in one picture.

So here goes, let us look at this. Now here, what I'm showing you is really a call option, I'm
showing you the long position. In the top panel, I'm showing you the short position on the
bottom panel. Now currently, the exercise price is 90. Suppose I make that 100. can see I can
vary the exercise price here. And if I make that 100, what I ended up doing is that the shape
remains the same. But notice, as exercise price changes, the profits to the call option buyer or
the long position are going to be above that particular exercise price. In this case 100 or more,
remember, at exactly the same moment. Now the short position, that is the person on the
other side is starting to lose money. This is what I meant when I said it's a zero sum game. If you
sum up these two graphs, if you can imagine that, they will sum up to zero, which is your gain is
my loss and vice versa.

Now think about a put option. In a put option, what you will see is that the payoff is on the
downside, what does this mean? Remember, a put option is an option to sell. So when would I
get a payoff from this option? Well, when the underlying price of this underlying asset is going
to go down? Well, when the price of this underlying asset actually moves down rather than in
the case of a call option when it was paying off at a higher price. So you can see it is now the
mirror image around the vertical. Here too. There is a long side, there is a short side. And I urge
you to imagine scenarios where the exercise price is going to change. And at that point, what is
going to happen is identical payoffs, positive and negative to the long and short to the buyer
and the seller of the option are going to happen. So remember, calls profit on the upside to the
buyer put profit on the downside to the buyer, and the converse is true. They lose money on
the upside with the call the short side and they lose money on the downside with a put that is
the basic story of options. Now the question might be why do we need to study options in
corporate finance? I think this is an excellent question. Because the point is most of us may or
may not end up being options traders in the market. There's a very small fraction of finance
professionals who are engaged in what might be called a rather esoteric market. The question
is why do I need to learn this in of all things, a course in corporate finance? That's a good
question. And the point is, I'm going to try and convince you that options and option pricing in
general are going to yield several insights which are enormously valuable for studying our basic
ideas in corporate finance.
Now, before we move on, here is a question to ask. Now these 80 rupees with my call option.
Remember the nifty option, I said is a market price. What is the market price, like the market
price of anything else like say bananas or potatoes or stock or options? It is going to be an
outcome of demand and supply. This is your basic economics 1.1. Very simple. Now, that is a
market price. But suppose I wanted to understand, can I write a formula by any chance to
evaluate or value a call option or a put option with certain parameters? The answer is yes. The
answer is it's a beautiful formula that we will explore soon. But before we get to formulas and
pricing, which we will do in some detail, let us try and understand why options methodology is
important to study.

So for the corporate finance implications of options, let's make a start with risk management.
Think of a personal risk management tool, let's say insurance like I was hinting at before, what
have we done by purchasing insurance, auto life, whatever, what we are doing really is we are
transferring our risk to the insurance company. And naturally, the insurance company is
demanding a premium, because you are indeed giving your risk to them, and they're willingly
accepting it, which is fine. So the question, of course, is, what kind of an option is that. Strictly
speaking, that's like a put option, because what they're doing is, they're selling you an option,
which profits on the downside, because generally, accidents, health incidents, and God forbid
death are all on the negative side, that is, these insurance contracts are really put options. Now
come to a concrete corporate example. Suppose you're an airline company, naturally, a big part
of your expenses is going to be fuel costs. And as we all know, oil prices fluctuate. Now, what
that tells you is, clearly an airline company or a shipping company would like to hedge their
risks from oil, because after all, they're in the business of transportation, they do not want to
be exposed to this big risk called oil price risk. So how might they do that they might want to
purchase options to hedge against or protect themselves against the vagaries of oil prices.

Now, in both cases, personal as well as corporate, let us ask two questions. First of all, why is
the other party the counterparty willing to accept what is really your risk? The answer is very
simple, because they get paid for it. In the insurance company's case, the insurance company
gets a premium. Similarly, an oil price hedging from a certain company is going to cost them
some money in terms of setting up this hedge with investment bank, for example, a large
investment bank. Second question, realize that when you buy an option, you have the upper
hand at expiration, in the sense that you have the right but you can always walk away. Now,
remember, the key fact that the other side of the transaction cannot walk away, even if it is to
his disadvantage? What I mean is, when it is to your advantage is the buyer of the option,
naturally, it is going to be to their disadvantage, and they have to go through with the
transaction. That is you have the right, they have the obligation. Now, this opens up a question,
what prevents that other counterparty from simply running away from disappearing? This is a
very real risk. It's called counterparty risk. Right. Now, when I buy insurance, what gives me the
assurance that the insurance company will actually pay up? Well, there is legal remedies if they
do not pay up. And of course, there is competition in the insurance market. And word gets out
that a certain insurance company does not honour their obligations. Clearly reputation and the
law, make sure that the insurance company is going to be there to make the payout.
Similarly, the same considerations apply for let's say, an investment bank in the corporate
context. Now since we are talking about risks and risk management, let me bring your attention
to one point. Fine, I have traded my risk to a counterparty. The question is what does the
counterparty do to their risk? Well, they're collecting risk from a bunch of people like you and
me. The question now is, what will they do with the risk? Well, obviously, at some point, their
balance sheet, if you will, will contain a lot of risk. What's going to happen to all that risk? Well,
after a while, they're going to sell off pieces of that risk to somebody else, in the case of an
insurance company that somebody else is a reinsurance company. So in essence, risk is being
passed along from one party to the other to another party and so on we go. The big point we
need to note here is risk does not disappear simply because we are transferring amongst
ourselves. So the important point is we are passing the risk around and paying a price for
somebody else accepting my risk. But in aggregate, the risk is still there. It is in so many hands.
Now the key is when the music stops, just like in a game of musical chairs, right? Somebody is
indeed held, holding the risk. And you have to have the financial muscle to hold the risk. This is
why investment banks and insurance companies and every financial institution has very
rigorous risk management practices.

Now, if we are going to all this trouble managing risks and transferring risks and pricing risk, this
seems like an awful lot of bother. Some of us might actually wonder, very fundamental
question, why do we take all this risk in the first place? Why not just not take risk? Well, the
straight answer to that from a finance professor is, without risk, the world would be a very
boring place. This is the point. If, of course, if you can imagine a world without risk at all, what
would all of us do, we would all buy government bonds, and sit at home, there would be
absolutely no economic activity, or entrepreneurial activity around us. But of course, we know
that's not the real world, people have this instinct to pursue risky ventures. And this is just
fundamental human beings. So you can stop that. So the point is, these systems have evolved
to really take care of enabling me to keep the risk I want to, because indeed, I want to keep
some risk, but also parcel out or give away the risk I don't want to. That is the essence of risk
management.

Now, here's another application of options in corporate context, which may be relevant to you
actually, think about ESOPs or Employee Stock Option Plans. What are these employee stock
option plans, often, companies will give you an ESOP plan, which is they will endow you with
options as part of your pay package. And why would they do that? Remember, they're giving
away call options to you? In other words, they're giving you some upside. Should the stock price
of your company do well, just like the call option we talked about earlier? Question is why is the
company giving away free options to you? The answer is incentives. The point is that people
respond to incentives in their compensation, and to enable you to be more aligned with the
shareholders of the company, in your daily activity, they are going to compensate you with
something that will benefit the shareholders as well as you personally because now you
through the options could become a shareholder of the company. And you could have these
unlimited gains coming from call options. So compensation is really one of the big motivators,
why we want to study options in the first place.
Now here the question I was asking earlier, how do I price an option? Remember I said market
values are demand and supply driven? Very nice. But is there a way to write down a formula? It
turns out a couple of people wrote down a formula Black and Scholes, Fischer black and Myron
Scholes, way back in 1973, wrote up the first option pricing model, and later on Robert Merton
join them and hence today we know their formulas by the name Black Scholes Merton
formulas. Of course, many years later, in 1997, Scholes and Merton won the Nobel Prize, Black
could not because he was gone by then he passed away. Now, what is this formula, it looks very
complex, it looks like a maze of Greek and English letters. The point is, nobody in their right
mind expects you to memorize the formula. The only people I know who memorize this formula
or finance professors, let me tell you that, but the key is to understand what goes into this
formula. Please remember, this formula, although it looks formidable, has five key inputs, the
underlying asset price, in my earliest example, the nifty index today, the exercise price, the
17,000 from my earlier example, the time to expiration, that is the time between August 26 and
September 30. From an earlier example, the risk free rate that is the government bond rate on
August 26, which is easily known, and most importantly, the volatility of the underlying asset. It
turns out a lot of the action in option pricing and indeed, the options market revolves very
critically around the volatility of the underlying market. So in Nifty options, obviously, the
action is going to be cantered around the anticipated volatility in the Indian stock market as
symbolized by the nifty. Now I want to make this point very, very clear. So this is what I propose
to do. Let us examine critically the difference between options and volatility of the underlying
next.