Basics of Options

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike) on or before a specified date.

In the context of currency derivatives, the underlying asset is a foreign exchange rate, for example USD/INR. The holder pays a premium to the writer for this right. Because the holder can choose not to exercise, the maximum loss is limited to the premium paid.

For the NISM exam, you must be able to state the definition verbatim, recognise that the right is unilateral, and know that the premium is the cost of acquiring the option.

• Option = Right, not obligation.
• Premium = Price paid for the right.

Strike Price (K) – the exchange‑specified rate at which the option can be exercised. In currency options it is quoted as a number of rupees per unit of foreign currency.

Premium – the amount paid by the buyer to the seller for acquiring the option. It is expressed in rupees per unit of the underlying foreign currency.

Expiry Date – the last trading day on which the option can be exercised. For exchange‑traded currency options SEBI mandates a single expiry date per contract month.

Underlying Spot Rate (S) – the prevailing market exchange rate on the expiry date. It determines the intrinsic value of the option.

Moneyness – describes the relationship between the spot rate and the strike: In‑the‑Money (ITM), At‑the‑Money (ATM), Out‑of‑the‑Money (OTM). The exam frequently asks you to classify an option based on given spot and strike values.

A call option gives the holder the right to BUY the foreign currency at the strike rate. It becomes valuable when the spot rate rises above the strike.

A put option gives the holder the right to SELL the foreign currency at the strike rate. It gains value when the spot rate falls below the strike.

Both call and put options are listed on Indian exchanges (e.g., NSE, BSE) and are settled in cash as per SEBI regulations. The exam expects you to identify which side (buyer or seller) benefits from a rise or fall in the spot rate.

Payoff diagrams plot the option's profit or loss against different spot rates at expiry. The X‑axis shows the spot rate, while the Y‑axis shows profit per unit.

For a call, the line is flat (loss = –premium) until the spot exceeds the strike, after which it rises with a slope of 1. For a put, the line slopes downwards after the spot falls below the strike.

Understanding these graphs helps you answer "what is the profit if the spot is X?" type questions and also clarifies the concepts of intrinsic value (S‑K for calls, K‑S for puts) and time value (premium minus intrinsic).

The break‑even point is the spot rate at which the option holder recovers the premium paid. It is a crucial figure for risk‑return analysis and appears in many NISM multiple‑choice questions.

For a call, break‑even = Strike + Premium. For a put, break‑even = Strike – Premium. If the spot ends exactly at the break‑even, the net profit is zero.

Remember to keep the premium in the same units as the strike (rupees per unit of foreign currency) before adding or subtracting.

European‑style options can be exercised only on the expiry date, whereas American‑style options allow exercise at any time before expiry. All exchange‑traded currency options in India are European style as per SEBI guidelines.

This distinction matters for valuation and for answering questions that ask whether early exercise is permissible. The exam often presents a scenario and expects you to state that early exercise is NOT allowed for Indian currency options.

Even though the payoff formulas are the same, the timing of cash flows differs, influencing the option's time value.

Indian exchange‑traded currency options are settled in cash on the expiry date. The cash settlement amount equals the option payoff (as calculated earlier) multiplied by the contract size (e.g., 1,000 USD). No physical delivery of foreign currency occurs.

SEBI’s "Regulation on Currency Derivatives" mandates that the settlement price be the weighted‑average of the spot rates quoted by the two leading banks during the settlement window.

For the exam, you may be asked to compute the total cash settlement: Cash Settlement = Payoff × Contract Size. Remember to use the contract size given in the question.

Delta measures the change in option price for a one‑rupee move in the spot rate. For a call, delta is positive; for a put, it is negative.

Gamma shows the rate of change of delta itself, indicating how delta accelerates as the option moves deeper ITM or OTM.

Theta represents time decay – the amount by which the option’s value erodes each day as expiry approaches.

Vega captures sensitivity to volatility changes. Higher implied volatility raises both call and put premiums.

While the NISM exam rarely asks you to compute Greeks, it frequently tests conceptual understanding, especially the direction (positive/negative) of delta and the effect of time decay on option value.