Month: September 2022

Forward Contract Example

Old MacDonald had a farm, and on that farm, he grew corn a lot of corn. This year, he expects to produce 500 bushels of corn that he can sell at the price-per-bushel that’s available at harvest time or he can lock in a price now.

The Crunchy Breakfast Cereal Company needs plenty of corn to manufacture their cornflakes. They send a representative around to Old MacDonald’s farm and offer him a fixed price to be paid upon delivery of 500 bushels of corn at harvest.

With the forward contract, Old MacDonald will receive the delivery price if he can deliver 500 bushels of corn by a specific date. Based upon the expected delivery price, if he’s able to produce the 500 bushels of corn, he can plan this year’s farm revenues and next year’s expenses.

Because Crunchy Breakfast Cereal Company has a forward contract, they can control variable costs (such as the cost of corn) to make their breakfast cereal. Knowing the cost of corn in advance enables them to keep prices steady for the consumer. They risk overpaying Old MacDonald for his corn, but it’s a risk they’re willing to take to hold costs steady and retain market share for their cornflakes.

Example2

Forward contracts were first used by farmers. Let’s understand how a forward contract works with the help of an example of a rice farmer Mr Iyer who is based out of Madurai. Now, cultivation of crops is not an easy job. A farmer needs to plough the fields, sow the seeds, use fertilisers, ensure adequate irrigation etc. Also, he ends up investing a substantial amount of time, energy and resources. But the farmer earns money or returns on his produce only after selling the rice. His entire income is dependent on the produce.

So, let’s assume that currently rice is being sold at 20 per kg. If the price of the rice goes down, he will make losses. And if the price goes up, he stands to gain.

Hence, Mr Iyer would like to eradicate this uncertainty. So, he enters into an agreement with Mr. Raj, who is a wholesaler in Kolkata. The agreement states that Mr Raj will buy 500 kgs of rice at the price of 20 per kg, two months from now from Mr Iyer. This quantity of rice will be delivered to Mr Raj’s warehouse through trucks and the cost of transportation will be borne by Mr. Raj.

It means, in this scenario, Mr Iyer is the seller and Mr Raj is the buyer of this forward contract. The predetermined quantity of rice to be sold is 500 kgs and the price at which the rice will be sold is 20 per kg. Hence, the price of forward contract is 10,000 (500 * 20), which derives its value from the underlying rice.

The contract will be fulfilled on a future date two months from now. This is when the rice will be delivered to Mr Raj’s warehouse and Mr Iyer will receive  10,000. As this a customisable derivative contract terms such as delivering of rice to the warehouse and footing the transport costs can be incorporated into the contract. Also, both the parties in this transaction must agree on these terms.

For example, Crude Oil is currently selling at $60 a barrel, and a futures contract for $65 per barrel is available for three months’ time. As you believe the price of WTI will rise beyond $65 by the time of expiry, you buy the contract.

The market actually rises to $75. That means your prediction is correct and you could buy Crude at $65 per barrel and sell it on for $10 profit.

However, if your prediction was incorrect, and the market ended up short of $65, your contract could result in you paying above the market price in order to settle your contract.

Components

1. Instrument Type:

If the underlying asset is the stock, of the futures contract in which we are entering then we check the details of Stock Futures.

Thus the instrument type is the ‘stock futures’

2. Symbol:

This is the symbol of the stock that is Reliance, TCS Industries in this case.

3. Expiry Date:

This is the date on which the contract ends.

The RELIANCE, TCS futures contract will expire on 27th Aug 2022 that is the last Thursday of the current month.

4. Underlying Value:

This is the price at which the underlying asset is trading in the spot market.

We can see that the current spot price is Rs.2147.80 per share.

5. Market lot (lot size):

As futures contracts are standardized contracts, lot size is also fixed.

The lot size refers to the minimum number of shares that can be bought or sold if we want to enter into an agreement.

An option contract is an agreement that gives the option holder the right to buy or sell the underlying asset at a certain date (known as expiration date or maturity date) at a prespecified price (known as strike price or exercise price) whereas the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.

There are 2 Parties to the Contract

• Option Holder or Buyer of the Option: It pays the initial cost to enter into the agreement. The call option buyer benefits from price increase but has limited downside risk in the event price decreases because at most he can lose is the option premium. Similarly, the put option buyer benefits from price decrease but has limited downside risk in the event when price increases. In short, they limit the investor’s downside exposure while keeping the upside potential unlimited.
• Option Seller or Writer of the Option: It receives the premium at the initiation of the option contract to bear the risk. The call writer benefits from Price decrease but has unlimited upside risk in case price increases. Similarly put writer benefits if price increases as he will keep the premium but may lose a considerable amount of price decrease.

It gives the owner the right to buy an underlying asset at a strike price at the expiration date. The call owner is bullish (expects the stock price to rise) on the movement of the underlying assets. Let’s take an example Consider an investor who buys the call option with a strike of $7820. The current price is $7600, the expiration date is in 4 months and the price of the option to purchase one share is $50.

Long Call Payoff Per-Share = [MAX (Stock Price – Strike Price,0) – Upfront Premium Per Share

• Case 1: if the stock price at expiration is $7920 the option will be exercised and the holder will buy it @ $7820 and sell it immediately in the market for $7920 realizing a gain of $100 considering upfront premium paid of $50, the net profit is $50.
• Case 2: if the stock price at expiration is $7700 the option holder will choose not to exercise as there is no point in buying it at $7820 when the market price of the stock is $7700. Considering the upfront premium of $50, the net loss is $50.

Put option

It gives the owner the right to sell an underlying asset ta strike price at the expiration date. The put owner is bearish (expects the stock price to fall) on the movement of the stock price. Let’s take an example Consider an investor who buys the put option with a strike of $7550. The current price is $7600, the expiration date is in 3 months and the price of the option to purchase one share is $50.

Long Put Payoff Per-Share = [MAX (Strike Price – Stock Price, 0) – Upfront premium Per Share

• Case 1: if the stock price at expiration is $7300 the investor will buy the asset in the market at $7300 and sell it under the terms of put option @7550 to realize a gain of $250. Considering the upfront premium paid $50 the net profit is $200.
• Case 2: if the stock price at expiration is $7700 the put option expires worthless and the investor loses $50 which is the upfront premium.

Types of Swaps in Finance

There are several types of Swaps transacted in the financial world. They are a commodity, currency, volatility, debt, credit default, puttable, swaptions, Interest rate swap, equity swap, etc.

For example, imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise.

The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR​  plus 1.3% on a notional principal of $1 million for five years. In other words, XYZ will fund ABC’s interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat, or rise only gradually.

EDU Inc. enters into a financial contract with CBA Inc. in which they have agreed to exchange cash flows making LIBOR as its benchmark wherein EDU Inc. will pay a fixed rate of 5% and receive a floating rate of LIBOR+2% from CBA Inc.

Now, if we see, in this financial contract, there are two legs of the transaction for both parties.

• EDU Inc. is paying the fixed rate of 5% and receiving a floating rate (Annual LIBOR+2%), whereas CBA Inc. is producing a floating rate (Annual LIBOR+2%) and receiving a fixed percentage (5%).

In the above example, let’s assume that both the parties have entered into a swaps contract for one year with a notional principal of Rs.1,00,000/-(since this is an Interest rate swap, hence the principal will not be exchanged). And after one year, the one year LIBOR in the prevailing market is 2.75%.

To understand the comparative rate advantage, let’s assume that the EDU Inc. and CBA Inc. have their own borrowing capacities in both fixed as well as a floating market (as mentioned in the table below).

In the above table, we can see that EDU Inc. has an absolute advantage in both the market, whereas CBA Inc. has a comparative advantage in the floating rate market (as CBA Inc. is paying 0.5% more than EDU Inc.). Assuming both the parties have entered into a Swap agreement with the condition that EDU Inc. will pay one year LIBOR and receive 4.35% p.a.

The cash flows for this agreement are described in the table below for both the parties.

Looking at the above cash flows, we can say that EDU Inc. has a net cash flow of LIBOR – 0.35% per annum, giving it an advantage of 0.25%, which EDU Inc. had to pay if it went directly in the floating market, i.e., LIBOR – 0.1%.

In the second scenario for CBA Inc., the net cash flow is 4.95% per annum, giving it an advantage of 0.25% in the fixed borrowing market if it had gone directly, i.e., 5.20%.

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

The following are the four components:

• Asset: This is the underlying asset that is specified in the contract.
• Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered and the deliverer is paid.
• Quantity: This is the size of the contract, and will give the specific amount in units of the asset being bought and sold.
• Price: The price that will be paid on the maturation/expiration date must also be specified. This will also include the currency that payment will be rendered in.

Features

No premium: Since these contracts are not traded in markets, so a premium is involved.

Not traded: Forward contracts are designed to meet specific requirements of company. These contracts are not traded in the market.

No margin: Small fees are required to enter into a forward contract.

Physical delivery: These are inflexible and bind in nature. Therefore, at the time of delivery, physical delivery is required.

Expensive: More expensive than other hedge options because, these contracts are tailored made.

Terminologies

• Quantity: This mainly refers to the size of the contract, in units of the asset that is being bought and sold.
• Underlying Asset: This is the underlying asset that is mentioned in the contract. This underlying asset can be commodity, currency, stock, and so on.
• Price: This is the price that will be paid on the expiration date must also be specified.
• Expiration Date: This is the date when the agreement is settled and the asset is delivered and paid.

Working:

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Alice currently owns a $100,000 house that she wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year’s time of $104,000 (more below on why the sale price should be this amount). Alice and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Alice will have the short forward contract.

At the end of one year, suppose that the current market valuation of Alice’s house is $110,000. Then, because Alice is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Alice for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Alice has made a potential loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, in which one party opens a forward contract to buy or sell a currency (e.g. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say US$75.2 million at the current rate these two amounts are called the notional amount(s). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.

Equity derivatives market in India has registered an “explosive growth” and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction.

The two major economic functions of a commodity futures market are price risk management and price discovery. Forward contracting in commodities is an important activity for any economy to meet food and raw material requirements, to facilitate storage as a profitable economic activity and also to manage supply and demand risk. Forward contracts, however, give rise to price risk; so there arises the need of price risk management. Price risk in forward contracts can be managed through futures contracts.

In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories

Among all the products traded on NSE in F& O segment, single stock futures also known as equity futures, are most popular in terms of volumes and number of contract traded, followed by index futures with turnover shares of 52 percent and 31 percent, respectively. In case of BSE, index futures outperform stock futures. An important feature of the derivative segment of NSE which may be observed the huge gap between average daily transactions of its derivatives segment and cash segment. In sharp contrast to NSE, the situation at BSE is just the opposite: its cash segment outperforms the derivatives segment as can be seen.

Despite of encouraging growth and developments, industry analyst feels that the derivatives market has not yet, realized its full potential in terms of growth & trading. Analysts points out that the equity derivative markets on the BSE and NSE has been limited to only four products- index futures, index options and individual stock futures and options, which in turn, are limited to certain select stocks only. Although recently NSE and BSE has added more products in their derivatives segment (Weekly Options, Currency futures, Mini Index etc.) but still it is far less than the depth and variety of products prevailing across many developed capital markets.

LIBOR

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.

LIBOR, which stands for London Interbank Offered Rate, serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks. The rate is calculated and will continue to be published each day by the Intercontinental Exchange (ICE), but due to recent scandals and questions around its validity as a benchmark rate, it is being phased out.

According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates are no longer published as of Dec. 31, 2021.

LIBOR is the average interest rate at which major global banks borrow from one another. It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities overnight/spot next, one week, and one, two, three, six, and 12 months.

The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day.1 The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.

Each day, ICE asks major global banks how much they would charge other banks for short-term loans. The association takes out the highest and lowest figures, then calculates the average from the remaining numbers. This is known as the trimmed average. This rate is posted each morning as the daily rate, so it’s not a static figure. Once the rates for each maturity and currency are calculated and finalized, they are announced and published once a day at around 11:55 a.m. London time by the ICE Benchmark Administration (IBA).

LIBOR is also the basis for consumer loans in countries around the world, so it impacts consumers just as much as it does financial institutions. The interest rates on various credit products such as credit cards, car loans, and adjustable-rate mortgages fluctuate based on the interbank rate. This change in rate helps determine the ease of borrowing between banks and consumers.

But there is a downside to using the LIBOR rate. Even though lower borrowing costs may be attractive to consumers, it does also affect the returns on certain securities. Some mutual funds may be attached to LIBOR, so their yields may drop as LIBOR fluctuates.

MIBOR

The Mumbai Interbank Offer Rate (MIBOR) is one iteration of India’s interbank rate, which is the rate of interest charged by a bank on a short-term loan to another bank. As India’s financial markets have continued to develop, India felt it needed a reference rate for its debt market, which led to the development and introduction of the MIBOR. MIBOR is used in conjunction with the Mumbai interbank bid and forward rates (MIBID and MIFOR) by the central bank of India to set short-term monetary policy.

Banks borrow and lend money to one another on the interbank market in order to maintain appropriate, legal liquidity levels, and to meet reserve requirements placed on them by regulators. Interbank rates are made available only to the largest and most creditworthy financial institutions.

MIBOR is calculated every day by the National Stock Exchange of India (NSEIL) as a weighted average of lending rates of a group of major banks throughout India, on funds lent to first-class borrowers. This is the interest rate at which banks can borrow funds from other banks in the Indian interbank market.

The Mumbai Interbank Offer Rate (MIBOR) is modeled closely on London InterBank Overnight Rate (LIBOR). The rate is used currently for forward contracts and floating-rate debentures. Over time and with more use, MIBOR may become more significant.

An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time, as long as the contract is in effect. By contrast, a futures contract requires a buyer to purchase shares and a seller to sell them on a specific future date, unless the holder’s position is closed before the expiration date.

Options and futures are both financial products investors can use to make money or to hedge current investments. Both an option and a future allow an investor to buy an investment at a specific price by a specific date. But the markets for these two products are very different in how they work and how risky they are to the investor.

Difference between Futures and Forwards

A forward is similar to a futures contract in that it specifies the future delivery of an underlying asset at an agreed price. However, forwards differ from futures in several ways:

• Purpose: Forward contracts are almost always held until expiration and physically settled because the counterparties are interested in exchanging the underlying asset for cash. Physically settled future contracts might be held until expiration for traders who want to buy or sell the underlying. But most futures traders are speculating on the price of the underlying, hoping to make a profit from favorable price movements without taking or making delivery.
• Source of contract: A forward contract is a customized contract, privately traded directly between two identified counterparties. This is called over-the-counter trading and doesn’t involve a futures exchange. In contrast, futures contracts are only available on futures exchanges. You must set up a futures brokerage account to buy and sell these contracts. A futures trader does not directly transact with a counterparty; instead, a futures clearing house mediates all transactions it acts as the buyer to sellers and the seller to buyers.
• Contract terms: A forward contract is completely customized according to the wishes of the buyer and seller. In addition, forward contracts have no built-in default protection, though a custom default-protection scheme can be negotiated and included. Futures contracts are highly standardized and guaranteed against default. Their expiration date, delivery date, delivery point, amount of underlying asset and settlement terms cannot be negotiated the only decisions open to a trader are how much to bid or ask, when to close out the position and to select financial or physical settlement, the contract expiration month and the number of contracts.
• Settlement procedures: Forwards are settled at expiration and perhaps more frequently if both participants agree there is no automatic daily cash settlement. Futures are cash-settled every trading day.
• Margin requirements: Forward contracts typically have few margin requirements, if any. Futures exchanges require traders to deposit into their brokerage accounts a minimum amount of cash per contract, as margin. The deposit is used to guarantee the daily mark to market payment. If the account balance falls below the minimum requirement, then the trader’s broker will issue a margin call a directive to the trader to replenish the account. Failure to do so promptly will lead to a forced offset – the broker closes out the trader’s contracts and adds the cash proceeds to the brokerage account.

Difference between Options and Futures

• Upfront cost: Buyers must pay a premium to purchase an option, and option sellers collect his premium. There are no upfront costs for futures trades, just margin requirements.
• Margin requirements: Option buyers do not have to post margin, but option sellers do, unless their options are “covered” by other assets. For example, if an option trader sells a call stock option while owning 100 shares of the underlying stock, the call is covered, and margin isn’t required. All futures trades require margin.
• Flexibility: The owner of an options contract does not have to execute it – that is, force the trade of the underlying asset for the strike price even if such a trade would be profitable. For physical delivery futures, buyers must take delivery of the underlying asset, and sellers must deliver the asset.
• Risk: Option buyers can lose no more than the premium they pay. Option sellers and futures traders have unlimited risk on their contracts.
• Mark to market: Most options, with a few exceptions, are not marked to market every day. An options trader can collect a gain by exercising a profitable option, closing out a profitable option position via offset or collecting profit at expiration. Futures contracts are always marked to market daily, which is the only way to experience gains and losses.
• Size: Options are generally less expensive than futures, and control a smaller amount of the underlying asset. This means that futures are riskier than options. Of course, option traders can increase their risks by trading multiple options.

Forward price is the predetermined delivery price for an underlying commodity, currency, or financial asset as decided by the buyer and the seller of the forward contract, to be paid at a predetermined date in the future. At the inception of a forward contract, the forward price makes the value of the contract zero, but changes in the price of the underlying will cause the forward to take on a positive or negative value.

Forward Price Formula

The forward price formula (which assumes zero dividends) is seen below:

F = S0 x e^ (rT)

Where:

• F = The contract’s forward price
• S0 = The underlying asset’s current spot price
• e = The mathematical irrational constant approximated by 2.7183
• r = The risk-free rate that applies to the life of the forward contract
• T = The delivery date in years

Underlying Assets with Dividends

For a forward contract with which the underlying asset may incur dividends, the forward price is determined with the following formula:

F = (S0 – D) x e^ (rT)

Where:

D = The sum of each dividend’s present value

An economic variation of the formula will be written as:

Cost of Capital = (Fair Price + Future Value of Asset’s Dividends) – Spot Price of Asset

Forward Price = Spot Price – Cost of Carry

Fundamentals of Forward Price

A forward price is arrived at by considering the current spot price of the asset, which is underlying in the contract. Furthermore, carrying charges, such as interest, forgone interest, storage costs, and other costs are also accounted for when arriving at the forward price.

Despite the forward contracts not having an intrinsic value at the time of the agreement, they may gain or lose value depending on a lot of factors with time. Offsetting of positions in forward contracts is comparable with someone’s loss or someone’s gain theory.

For instance, if an investor holds a long position in one of the pork belly agreements and another investor holds a short position, then gains resulting from the long position will be equal to the losses arising to the investor holding the short position.

By setting the initial value of the contract to zero, both the parties of the contract are on the same level at the time of the agreement.

Limitations:

• As it is a private contract, there is no liquidity.
• Counterparty risk of defaulting on the contract is excessively high.
• The market of forward contracts is extremely unorganized as it is traded over the counter.
• It may be challenging to find a counterparty to enter into a contract.

In finance, a price (premium) is paid or received for purchasing or selling options. This article discusses the calculation of this premium in general. For further detail, see: Mathematical finance Derivatives pricing: the Q world for discussion of the mathematics; Financial engineering for the implementation; as well as Financial modeling Quantitative finance generally.

Intrinsic value

The intrinsic value is the difference between the underlying spot price and the strike price, to the extent that this is in favor of the option holder. For a call option, the option is in-the-money if the underlying spot price is higher than the strike price; then the intrinsic value is the underlying price minus the strike price. For a put option, the option is in-the-money if the strike price is higher than the underlying spot price; then the intrinsic value is the strike price minus the underlying spot price. Otherwise the intrinsic value is zero.

For example, when a DJI call (bullish/long) option is 18,000 and the underlying DJI Index is priced at $18,050 then there is a $50 advantage even if the option were to expire today. This $50 is the intrinsic value of the option.

In summary, intrinsic value:

 = Current stock price − strike price (call option)

 = Strike price − current stock price (put option)

Time value

The option premium is always greater than the intrinsic value. This extra money is for the risk which the option writer/seller is undertaking. This is called the time value.

Time value is the amount the option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying asset. The longer the length of time until the expiry of the contract, the greater the time value. So,

Time value = option premium − intrinsic value

Other factors affecting premium

There are many factors which affect option premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here:

• Price of the underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest effect on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases.
• Strike price: How far is the strike price from spot also affects option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000 strike and of 5100 strike will change a lot compared to a contract with strike of 5500 or 4700.
• Volatility of underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than e.g. stable blue chip shares whose fluctuation is more benign at 2–3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller.
• Payment of Dividend: Payment of Dividend does not have direct impact on value of derivatives but it does have indirect impact through stock price. We know that if dividend is paid, stock goes ex-dividend therefore price of stock will go down which will result into increase in Put premium and decrease in Call premium.

Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is because the money invested by the seller can earn this risk free income in any case and hence while selling option; he has to earn more than this because of higher risk he is taking.