NISM Series I · Unit 4 of 10 · about 20% of the paper
Exchange traded currency options: NISM Series I notes and practice questions
Option terminology, payoffs, premium, and factors affecting option value.
What to know in Unit 4
- Calls and puts.
- Payoff and break-even.
- Intrinsic value and time value.
- Greeks in outline.
Key terms, examples and exam traps
Currency option
A currency option gives the buyer the right but not the obligation to buy or sell a currency at a fixed rate on or before a date.
Example. A buyer pays a premium for the right to buy dollars at 83.
Exam trap. This statement is false: An option obliges both parties to trade.
Call option
A call gives the right to buy the underlying at the strike price.
Example. The holder of a USD call gains if the dollar rises above the strike.
Exam trap. This statement is false: A call gives the right to sell.
Put option
A put gives the right to sell the underlying at the strike price.
Example. The holder of a USD put gains if the dollar falls below the strike.
Exam trap. This statement is false: A put gives the right to buy.
Strike price
The strike price is the fixed rate at which the option can be exercised.
Example. A call with a strike of 83.00 allows buying dollars at 83.
Exam trap. This statement is false: The strike is the premium paid.
Premium
The premium is the price paid by the buyer to the seller of the option, and is the buyer's maximum loss.
Example. The buyer pays ₹0.50 per dollar.
Exam trap. This statement is false: The premium is paid at expiry only if exercised.
Option buyer and writer
The buyer pays the premium and has the right; the writer receives the premium and has the obligation if the buyer exercises.
Example. A writer must deliver if the buyer exercises.
Exam trap. This statement is false: The buyer has an obligation to deliver.
European style
Exchange traded currency options in India are European style and can be exercised only on expiry.
Example. The holder cannot exercise before the expiry day.
Exam trap. This statement is false: They can be exercised any time before expiry.
Cash settlement of options
Options are settled in cash in rupees, with the in-the-money amount paid at expiry.
Example. A call with strike 83 and final price 84 pays ₹1 per dollar.
Exam trap. This statement is false: Options are settled by physical delivery.
In, at and out of the money
A call is in the money if spot is above strike; a put is in the money if spot is below strike; at the money if equal.
Example. A put with strike 83 when spot is 82 is in the money.
Exam trap. This statement is false: A call is in the money if spot is below strike.
Intrinsic value
Intrinsic value is the in-the-money amount, and is zero if the option is out of the money.
Example. A call with strike 82 and spot 83 has intrinsic value of 1.
Exam trap. This statement is false: Intrinsic value can be negative.
Time value
Time value is the premium minus intrinsic value and declines to zero at expiry.
Example. An at-the-money option has only time value.
Exam trap. This statement is false: Time value increases near expiry.
Long call payoff
A long call's payoff is the greater of zero and spot minus strike, less premium paid.
Example. Strike 83, premium 0.40, spot 84 gives a net 0.60.
Exam trap. This statement is false: A long call can lose more than the premium.
Long put payoff
A long put's payoff is the greater of zero and strike minus spot, less premium paid.
Example. Strike 83, premium 0.40, spot 82 gives a net 0.60.
Exam trap. This statement is false: A long put has unlimited loss.
Short call risk
A short call has limited profit equal to the premium received and unlimited potential loss.
Example. A writer of a call faces rising losses as the currency climbs.
Exam trap. This statement is false: A short call has limited loss.
Short put risk
A short put has limited profit equal to the premium received and substantial loss if the price falls.
Example. A writer of a put loses if the currency falls sharply.
Exam trap. This statement is false: A short put has unlimited profit.
Factors affecting premium
Option premium depends on spot, strike, time to expiry, volatility and interest rate differentials.
Example. Higher volatility raises both call and put premiums.
Exam trap. This statement is false: Volatility does not affect premium.
Volatility and premium
Greater expected volatility increases the chance of large moves and hence raises option premiums.
Example. A calm market leads to cheaper options.
Exam trap. This statement is false: Falling volatility raises premiums.
Delta
Delta measures the change in option price for a unit change in the underlying; a call has positive delta and a put negative.
Example. A delta of 0.5 means the option moves half as much as the currency.
Exam trap. This statement is false: Delta measures time decay.
Gamma
Gamma measures the rate of change of delta as the underlying moves.
Example. A high gamma means delta changes quickly.
Exam trap. This statement is false: Gamma measures the effect of interest rates.
Theta
Theta measures the loss in option value as time passes, which hurts option buyers and helps sellers.
Example. An option loses value each day, all else being equal.
Exam trap. This statement is false: Theta measures sensitivity to volatility.
Vega
Vega measures the change in option price for a change in volatility.
Example. A rise in volatility lifts the option's price.
Exam trap. This statement is false: Vega measures the change with time.
Rho
Rho measures the sensitivity of option price to changes in interest rates.
Example. A change in rate differential changes option value slightly.
Exam trap. This statement is false: Rho measures sensitivity to volatility.
Put-call parity
Put-call parity links the prices of a call and put with the same strike and expiry to the forward price.
Example. A violation allows arbitrage.
Exam trap. This statement is false: Put and call prices are independent.
Hedging with options
Options let a hedger fix a worst-case rate while keeping the benefit of favourable moves, at the cost of the premium.
Example. An importer buys a call to cap the price of dollars.
Exam trap. This statement is false: Options fix the rate completely like forwards.
Option contract specs
USD-INR options have a lot size of 1,000 dollars, a tick of 0.0025 and expiry on the last working day of the month with cash settlement.
Example. One lot covers $1,000.
Exam trap. This statement is false: The lot size of options is $100,000.
Exercise and assignment
At expiry, in-the-money options are automatically exercised and writers are assigned by the clearing corporation.
Example. A call with a profit is exercised without any instruction.
Exam trap. This statement is false: The holder must give a written exercise notice.
6 practice questions
Read each question and choose your answer before opening the free mock, which shows the correct answer and the reason.
Q1. Which term is described here? Greater expected volatility increases the chance of large moves and hence raises option premiums.
- Confidentiality
- Volatility and premium
- Forward rate formula
- Daily mark-to-market
Q2. Which statement best describes “Option contract specs”?
- USD-INR options have a lot size of 1,000 dollars, a tick of 0.0025 and expiry on the last working day of the month with cash settlement.
- SPAN margin is computed by a risk-based method that estimates the worst loss across scenarios for the portfolio.
- Basis is the difference between spot and futures price, which narrows to zero as expiry nears.
- A fund maintained by the clearing corporation protects the market in the event of member default.
Q3. Which term is described here? A short put has limited profit equal to the premium received and substantial loss if the price falls.
- Final settlement
- Suitability and mis-selling
- Short put risk
- Open interest
Q4. Which term is described here? Option premium depends on spot, strike, time to expiry, volatility and interest rate differentials.
- Bid and ask
- Purchasing power parity
- Factors affecting premium
- Risk disclosure
Q5. Which statement best describes “Option buyer and writer”?
- A currency future is a standardised exchange-traded contract to buy or sell a currency pair at a fixed price on a future date.
- Resident individuals and entities may trade in exchange traded currency derivatives only with underlying exposure limits for certain pairs, and FPIs have separate limits.
- The buyer pays the premium and has the right; the writer receives the premium and has the obligation if the buyer exercises.
- Gamma measures the rate of change of delta as the underlying moves.
Q6. Which statement best describes “Long call payoff”?
- A long call's payoff is the greater of zero and spot minus strike, less premium paid.
- Rates move with interest rate differentials, inflation, trade and capital flows, growth and sentiment.
- Currency futures are settled in cash in rupees; there is no delivery of foreign currency.
- Reserves are foreign currency assets held by the central bank to manage the exchange rate and meet external obligations.
Frequently asked questions
How much of NISM Series I comes from Unit 4?
Unit 4 (Exchange traded currency options) usually carries about 20% of the questions. The whole exam has 100 questions and the pass mark is 60%.
What should I study in NISM Series I Unit 4?
Calls and puts. Payoff and break-even. Intrinsic value and time value. Greeks in outline.
Are these NISM Series I practice questions free?
Yes. Take the full free mocks to see the correct answer and the reason for every question.
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