Options

An option gives its buyer (or holder) the right, but not the obligation, to buy or sell a specified amount of the underlying asset at an agreed rate on or before a specified future date.

The seller, therefore, has the obligation, but not the right, to the mirror terms of the contract. For the right, the buyer of the option pays the seller (or writer) a premium. This is the price of the option.

An option differs from a futures or forward contract in that exercising an option is a matter of choice for the holder, while the holder has an obligation in a futures or forward contract.

An options contract has many different elements:

Amount

The contract will have a national principal amount of the option, as face value.

Strike or Exercise Price

The strike price is set out to indicate the price at which the option may be exercised. For example, the strike price on an option on a futures contract may be 92.50, (equivalent to a yield of 7.5% pa), or an exchange rate of 0.8500 USD per EVR. An option with a strike price that is the same as the cash or spot price of the underlying asset is called an 'at-the-money' spot option. An option with a strike price identical to the underlying asset’s forward price is as an at-the-money-forward option. A holder of an option will exercise the option only if it is profitable to do so -- that is, if the strike price of an option is more favourable than the cash or spot price of the product. Such an option is described as 'in-the-money'. If the option is not profitable for the holder, then it is said to be 'out-of-the-money'.

Exercise Date

The date at which the option may be exercised will be specified. There are three standard types of option contracts, which treat the exercise date differently. An American option allows the buyer to exercise the option at any time up to and including the expiry date. A European option permits the buyer the right to exercise the option only on the expiry date. A hybrid option is a composite of the American and the European options and has specified dates or periods on or during which the option can be exercised, and is called a Bermudian option.

Premium

In return for the benefits of holding an option, the buyer pays a premium to the writer or seller of the option.

Call option

A buyer of a call option has the right to buy the underlying asset.

Put option

A buyer of a put option has the right to sell the underlying asset.

The type of risk generated by options differs from most other financial instruments. The market risk for a holder of an option is limited to the amount of premium paid. Once that cost has been met, the buyer of an option has no further obligations. The exposure that remains for the buyer is the credit risk that the writer of that option will not meet his or her obligations upon exercise of the option. In contrast, the writer of an option gains the amount of premium received but bears an unlimited exposure to market risk, since there is an obligation to fulfil the option contract at the exercise price regardless of market price. The writer is not, however, exposed to credit risk once the premium has been received.

You can enter into a variety of options including interest rate options and currency options.

Interest Rate Options

An interest rate option is an agreement giving the buyer the right, but not the obligation, to fix at a point of time in the future, either the rate of interest on a notional deposit or loan, or the price of an instrument such as a futures contract or security, where the price is normally determined by reference to interest rates. The buyer is protected against an adverse movement in interest rates, while retaining the ability to benefit from a favourable movement.

Bond Options

A bond option gives the buyer the right to buy or sell a given fixed or floating interest rate security at a specified rate, on or before a specified future date.

Caps

An interest rate cap agreement enables a borrower of floating rate debt to place an upper limit on interest rate exposure. The seller of the interest rate cap agrees to compensate the borrower for any excess of interest costs above the cap level, based on a stated notional principal amount. The buyer of a cap is required to pay a premium, which may be expressed as a percentage of the principal value of the cap, or as an absolute amount to be paid.

Floors

An interest rate floor agreement works in the same way as a cap, but in reverse. It is an option product for which the seller receives a premium for losing his right to borrow more cheaply if market rates of interest fall below a certain level.

Collars

A collar is a combination of a purchased cap agreement and a written floor agreement, or vice versa. A borrower, who purchases a cap and simultaneously writes a floor with the same party, obtains protection against interest rates rising above the level specified in the cap, while losing the potential benefit of rates falling below the level specified in the floor. The initial cost of such a collar is normally less than that of a cap in isolation, because the premium payable on the purchase of one is offset by the premium earned on the other.

A currency option is an agreement giving the buyer of the option the right, but not the obligation, to exchange two currencies at a fixed rate at a future date.

Currency options are used to provide:

• Import or export cover when there are uncertain foreign exchange cashflows. These cashflows can be protected against downside risk by using currency options.
• Cover against contingent currency exposures, such as a tender to contract in foreign currency. If a contingent exposure is covered in the forward foreign exchange market and then fails to materialise, the company is left with the negative exposure of the forward contract. However, if a currency option is used and the contract fails to materialise, the company's loss will be limited to the premium paid on the option. The company can also resell option for its residual value.
• Cover against adverse currency movements which affect the value of balance sheet assets and liabilities.

A currency option gives the holder (buyer) the right to buy or sell a currency during an agreed period, while a forward exchange contract also makes it obligatory for the holder to buy or sell at some agreed future date.

The currency option holder's loss is limited to the premium paid.

A currency option allows the holder to benefit from favourable currency movements while protecting against adverse movements. A forward foreign exchange contract protects the holder only from adverse currency movements. A currency option eliminates downside risk and retains unlimited upside potential, whereas a forward exchange contract, while eliminating downside risk, has no upside potential.

Swaptions

A swaption is an option over a swap. It gives the buyer the right to enter into a swap at a future date, but imposes no obligation on the buyer to do so.

Barrier Options

An option with a payoff pattern and survival to expiration dependent on not only the final price of the underlying asset, but also on whether the underlying asset trades at or beyond/ below a barrier price during the life of the option.

Average Price Options

These options have a settlement value based on the difference between the strike price and the average price of the underlying stock / index / interest rate / exchange rate on specified dates or periods during the life of the option.

For more details, write to us at derivatives@hdfcbank.com