Chapter 11

Basic Principles of Options

This chapter covers some basic principles of options’ market that are indispensable for understanding Islamic capital markets and Islamic structured products. It presents notions of call and put options as well as their payoffs. It describes options trading strategies that include covered calls, protective puts, straddles, and spreads. The chapter addresses option pricing, emphasizing the replication of an option by a replicating portfolio and no-arbitrage pricing. It illustrates the notion of a replicating portfolio using the binomial tree. Many basic results of option pricing theory are analyzed. They relate to call–put parity, the delta of an option, and risk-neutral pricing. The chapter covers the Black–Scholes option pricing models, its application to dividends, foreign currencies, and interest rates options called caps and floors.

Options are important instruments of capital markets; they are hedging and speculative instruments. However, they are fundamentally different from forward, futures, and swap contracts. An option gives the holder of the option the right to buy or sell an asset at a predetermined price. The holder of the option does not have to exercise this right. By contrast, in forward, futures, and swap contracts, the two parties have committed themselves to implement the contract. It costs a trader nothing, except for the margin requirement, to enter into a forward or futures contract, whereas the purchase of an option requires ...

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