The document provides an example to explain a call option contract between a farmer and bread manufacturer. In a call option: 1) The farmer agrees to sell wheat to the manufacturer at a fixed price of Rs. 110 in 3 months. 2) The manufacturer pays the farmer a premium for the option to either execute the contract or exit without obligation. 3) If wheat prices fall to Rs. 90, the manufacturer can exit while the farmer receives the premium as compensation for participating. The call option gives the manufacturer flexibility while still protecting both parties' interests through the option premium paid.

1. Simplifying Call Option
– By Prof. Simply Simple TM

2. Let‟s look at the same example
for the farmer & bread
manufacturer as we did in our
earlier lessons on „Futures‟ &
on „Options‟.

3. So going back to our farmer
who cultivates wheat…

4. And a bread manufacturer
who needs wheat as an
input for making bread…

5. • The farmer thinks that the price of wheat which is
currently trading at Rs. 100 could fall to Rs. 90 in 3
months.
• The bread manufacturer on the other hand feels that the
price of wheat on the other hand might become Rs. 120 in
3 months.

6. • In such a case, both of them get together & sign a contract
which says that at the end of 3 months the bread manufacturer
would buy wheat from the farmer at Rs. 110.
• Thus the bread manufacturer is protected against a possible
rise in prices.
• And the farmer is protected against any drop in the price of
wheat in the near future.

7. Such a contract is called a
Futures contract as we saw in
our lesson on „Futures‟.

8. • In a Futures contract both parties are obliged to honor the contract
and there is no escape route for either party.
• But what if the contract gives the bread manufacturer the “option”
of (either)
– Buying the wheat from the farmer at the pre-agreed price of Rs
110 (or)
– Choosing to exit the contract and buy wheat from the open
market at the prevailing market price?
• In other words, the bread manufacturer is given the option of not
honoring the contract made with the farmer on the date of
settlement.

9. Such a contract that gives the bread
manufacturer the option of either
executing the contract or exiting it is
known as an ‘Options’ Contract.
But the bread manufacturer
cannot get this privilege just like
that. He obviously has to pay a
premium for exercising this
facility…

10. • Now, let‟s say that after 3 months the price of wheat falls to
Rs. 90.
• In this case the bread manufacturer quite clearly would want
to exit the contract so that he is free to buy wheat from the
open market for Rs. 90.
• If so, while the bread manufacturer gets away, the farmer is
left high and dry and has no other option but to sell his
produce in the open market at Rs 90.

11. • But it is that bad a situation for the farmer as it appears as he gets
compensated by the bread manufacturer for having been a party to
the „Options‟ contract.
• This compensation * in the form of price is called the “Option
Premium” that the bread manufacturer has to pay for the Options
contract and is usually a small amount.
• Let‟s assume in our case the amount is Rs 5.
• So the bread manufacturer is obliged to pay the farmer Rs 5 as he has
chosen to opt out of the contract.
* Please note that the bread manufacturer will have to pay an option premium regardless of whether or not the option is actually exercised.

12. • Thus although the farmer has no other option left but to go
to the open market and sell wheat at Rs. 90, he does get the
benefit of Rs 5 as compensation for being a party to the
„Options‟ contract.
• So even if the price is Rs. 90 in the open market, for him the
effective price turns out to be
Rs. (90+5) = Rs 95
• So by simply participating in the contract he too stands to
gain something.

13. • For the bread manufacturer, it is a win–win scenario by
participating in the contract.
• Had the prices risen to Rs 120 as he had anticipated, he would
have executed the Options contract at Rs 110 and would have got
protected.
• But since prices fell to Rs 90 he chose to exit the contract. Thus he
is blessed with the „Option‟ of either executing or not executing
the contract based upon the price in the open market at the time of
contract settlement.

14. • It is important to understand that in an „Options‟ contract,
only one party gets the privilege to exercise the option while
the other party is obliged to honor the option if it is chosen.
• Thus, in our case, the bread manufacturer has the option to
either execute or exit the contract whereas the farmer is
obliged to honour the decision of the bread manufacturer.
• A contract such as this where only the purchaser of the
commodity gets the option to either exercise or exit the
contract is known as „Call‟ option.

15. You will recall we had studied
the „Put‟ option in our last
lesson.
Hope this explanation has
clarified the difference between
the „Put‟ and „Call‟ option.

16. Basically in the „Put‟ option
the choice of honoring the
contract was with the farmer
or seller while in the „Call‟
option this option was with
the bread manufacturer or
purchaser.

17. • Even in an Options contract both parties land up achieving their
goals and their interests are protected.
• The bread manufacturer stands to gain the most by getting to
exercise a choice that benefits him the most.
• The farmer on the other hand too benefits by being a party to
the contract due to the compensation he receives from the bread
manufacturer for not executing the contract.

18. • The farmer due to the compensation sells the wheat in the open
market at an effective price of Rs. 95
• And hence is better off than the ordinary or spot seller who
would have to sell at Rs 90.
• Thus in a sense both parties landed up getting some gains by
being parties to the „options contract‟.
• However unlike in a „Futures‟ contract, in the „Options‟ contract
one party gains more than the other party.

19. To Sum Up
• In a ‘Futures Contract’ both parties are
obliged to honor the contract.
• In an ‘Options Contract’ one of the
parties is given the privilege to exit the
option on settlement date and the party
has to oblige.
• In a ‘Put’ option this privilege is given
to the seller (in our example - the
farmer)
• In a ‘Call’ option this privilege is given
to the buyer (in our example - the bread
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manufacturer)

20. Please do let me know if I have managed to clear the concepts of
„Call Option‟ as well as the difference between
„Call‟ & „Put‟ Options.
Your feedback is very important as it helps me plan my future
lessons.
Hence please give your feedback at
professor@tataamc.com

21. Disclaimer
The views expressed in these lessons are for information
purposes only and do not construe to be of any investment,
legal or taxation advice. They are not indicative of future
market trends, nor is Tata Asset Management Ltd. attempting
to predict the same. Reprinting any part of this presentation
will be at your own risk and Tata Asset Management Ltd. will
not be liable for the consequences of any such action.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.