NISM Series V-D · Chapter 21: Exchange Traded Interest Rate Options

L1 · Foundation

Foundation — Option basics, styles, moneyness and the two components of value

What an option is through the land and car-insurance examples, the full terminology set, how options differ from futures, European versus American versus Bermuda styles, the moneyness grid, and the split of premium into intrinsic value and time value.

15 min read · Worth 4% of the paper · Written from pages 537–562 of the official NISM workbook · Updated 18 September 2026

21.1 What an option is

"forward/futures contract is a COMMITMENT to buy/sell the underlying and has a LINEAR PAY OFF, which indicates UNLIMITED LOSSES AND PROFITS. Some market participants desired to RIDE UPSIDE AND RESTRICT THE LOSSES. Accordingly, OPTIONS EMERGED as a financial instrument, which RESTRICTED THE LOSSES with a provision of UNLIMITED PROFITS."

"An Option is a contract that gives the option buyer RIGHT, BUT NOT AN OBLIGATION, to buy or sell the underlying asset ON OR BEFORE A SPECIFIED DATE/DAY, at a PRE-DETERMINED PRICE. For acquiring right option buyer pay certain PRICE/PREMIUM to option seller."

The land example

Mr X wants to buy 1 acre from Mr Y, valued at Rs 10,00,000. An infrastructure project is expected nearby within 3 months — "However, if the news turns out to be a RUMOUR, then Mr X would be STUCK WITH A USELESS PIECE OF LAND."

"Mr X pays an UPFRONT FEE OF RS 50,000 today i.e., August 01, 2021, to Mr Y. Consider this as a NON-REFUNDABLE"
"Against this fees, Mr Y AGREES TO SELL the land after 3 months to Mr X"
"The price of the land... is FIXED TODAY at Rs 10,00,000"
"Mr X has paid an upfront fee and hence ONLY HE CAN CALL OFF THE DEAL at the end of 3 months, Mr Y CANNOT"
"In the event Mr X calls off the deal... Mr Y GETS TO KEEP THE UPFRONT FEES"

"An option is a contract between two parties giving the buyer of an option the RIGHT, BUT NOT THE OBLIGATION, to buy or sell an underlying asset at a specific price on or before a certain date."

The terminology, taken from that example

Term	Definition	In the example
Call option	"The RIGHT TO BUY the asset"	Mr X received the right to buy the land, "hence it is a CALL OPTION transaction"
Put option	"The RIGHT TO SELL the asset"	—
Strike price	"The PRE-SPECIFIED PRICE at which the underlying asset MAY BE PURCHASED OR SOLD by the option holder"	Rs 10,00,000
Expiration date	"The date at which the option contract WILL EXPIRE / OR CEASES TO EXIST"	October 31, 2021
Time to maturity	"The DIFFERENCE between the date of entering into the contract and the expiration date"	3 months
Option buyer	"The party which BUYS THE RIGHTS BUT NOT OBLIGATION and PAYS PREMIUM"	Mr X
Option seller / writer	"The party which SELLS THE RIGHT AND RECEIVES PREMIUM for ASSUMING SUCH OBLIGATION"	Mr Y
Option price / premium	"The price which option buyer PAYS TO OPTION SELLER TO ACQUIRE THE RIGHT"	Rs 50,000
Underlying	"The asset which is bought or sold"	Land
To exercise	"To PUT INTO EFFECT THE RIGHT to buy or sell the underlying security specified in the contract"	If the land is worth Rs 15 lacs on 31 October, "Mr X will exercise its option as he will pay only Rs 10 lacs"

The car insurance example — a real-life put

"When you get your car insured, you PAY AN INSURANCE PREMIUM to the insurance company and the insurance company GUARANTEES TO COMPENSATE YOU for the damages... In this example, you are BUYING A PUT OPTION from the insurance company and paying it an option premium in the form of insurance premium. If your car gets damaged... you can use your policy to CLAIM, and if all goes well and you do not need to claim, THE INSURANCE COMPANY KEEPS THE PREMIUM IN RETURN FOR TAKING ON THE RISK."

21.2 Futures versus options

The similarities — "Both the contracts have a BUYER AND A SELLER; both have a SET PRICE for the underlying asset; both have a SET SETTLEMENT DATE." And "just like futures, options can be used for HEDGING, or to generate returns by TAKING A VIEW on the future direction of the market, or for ARBITRAGE."

The difference — "in FUTURES both the parties are under RIGHT AS WELL AS OBLIGATION to buy or sell and therefore face SIMILAR RISK. Whereas in OPTIONS, the BUYER has ONLY RIGHTS AND NO OBLIGATION and therefore he faces ONLY THE RISK OF PREMIUM PAID. On the other hand, option seller is UNDER OBLIGATION to buy or sell... and therefore faces UNLIMITED RISK. At the same time, the option buyer has chances to get UNLIMITED UPSIDE and the option seller has LIMITED UPSIDE EQUAL TO THE PREMIUM RECEIVED."

"The CALL option buyer would exercise the option, ONLY IF the price of underlying asset is HIGHER than the strike price. Similarly, the PUT option buyer would exercise the option, ONLY IF the price of the underlying asset is LESS than the strike price."

	Option buyer	Option seller / writer
Rights	Right, no obligation	Obligation, no right
Maximum loss	LIMITED — the premium paid	UNLIMITED
Maximum gain	UNLIMITED	LIMITED — the premium received
Pays or receives	Pays premium	Receives premium

21.3 Styles of options

Style	When exercisable
European	"can be exercised by the buyer of the option ONLY ON THE EXPIRATION DATE. Hence, option buyer enjoys LESS FLEXIBILITY. However... in case of exchange traded options, participants CAN SELL THEIR OPTION IN THE SECONDARY MARKET PRIOR TO EXPIRATION to square-off their position"
American	"can be exercised by the buyer ANY TIME ON OR BEFORE the expiration date... MORE FLEXIBILITY to option buyer"
Bermuda	"the contract... DENOTES SPECIFIC DAYS BEFORE EXPIRATION on which the trader can exercise his option. The specified exercise dates are USUALLY NEAR THE TIME OF THE OPTION'S EXPIRATION DATE. Thus, Bermudan options FALL IN BETWEEN American and European options"

Exchange traded interest rate options in India are premium style EUROPEAN call and put options — but note carefully that European style limits exercise, not exit: you can always sell the option in the market.

21.4 Moneyness

"Moneyness of an option indicates whether the contract would result in a POSITIVE CASH FLOW, NEGATIVE CASH FLOW or ZERO CASH FLOW for the option buyer AT THE TIME OF EXERCISING IT."

In the money (ITM) — "if on exercising it, the option buyer gets a POSITIVE CASH FLOW. Thus, a call option would be in the money if underlying price is HIGHER than the strike price, and similarly a put option would be in the money if underlying price is LOWER than the strike price"
Out of the money (OTM) — "if on exercising it, the option buyer gets a NEGATIVE CASH FLOW... call OTM if underlying price is LOWER than strike; put OTM if underlying price is HIGHER than strike"
At the money (ATM) — "if spot price is EQUAL to the strike price. On exercise... buyer gets ZERO cash flows. Any movement in spot price... would either make the option ITM or OTM"

Strike	Call Option	Put Option
In-the-money	Strike price < Spot price	Strike price > Spot price
At-the-money	Strike price = Spot price	Strike price = Spot price
Out-of-the-money	Strike price > Spot price	Strike price < Spot price

The chapter adds a practical caveat: "In certain cases, TRANSACTION/REGULATORY CHARGES ARE APPLICABLE AT THE TIME OF EXERCISE. If these costs are included, the decision of the option buyer would TAKE INTO ACCOUNT THESE COSTS ALSO."

21.5.1 Option value — the two components

Intrinsic value

"for an option, intrinsic value refers to THE AMOUNT BY WHICH OPTION IS IN THE MONEY i.e., the amount an option buyer will realize, BEFORE ADJUSTING FOR PREMIUM PAID, IF HE EXERCISES THE OPTION INSTANTLY. Therefore, ONLY IN-THE-MONEY OPTIONS HAVE INTRINSIC VALUE whereas AT-THE-MONEY AND OUT-OF-THE-MONEY OPTIONS HAVE ZERO INTRINSIC VALUE. THE INTRINSIC VALUE OF AN OPTION CAN NEVER BE NEGATIVE."

"with minimum value possible as zero because NO ONE WOULD LIKE TO EXERCISE HIS RIGHT UNDER NO ADVANTAGE CONDITION."

Time value

"The DIFFERENCE BETWEEN OPTION PREMIUM AND INTRINSIC VALUE is the TIME VALUE of that option. ATM AND OTM OPTION WILL HAVE ONLY TIME VALUE because the intrinsic value of such option is zero."

"The time value is DIRECTLY PROPORTIONAL to the length of time to expiration date... LONGER THE TIME TO EXPIRATION, HIGHER IS TIME VALUE. Therefore, everything else remaining the same, call option for TWO MONTHS maturity would be PRICED HIGHER than the call option at the same strike price for ONE MONTH maturity."

"The time value REFLECTS THE PROBABILITY that the option will GAIN IN INTRINSIC VALUE or PROFITABLE TO EXERCISE before its maturity... AT EXPIRY THE OPTION VALUE IS ITS INTRINSIC VALUE AND TIME VALUE WILL BE ZERO."

Think of it like this

The non-refundable token on a plot of land

The chapter's own opening example is the best one in the book for an Indian reader, because it is a transaction many families have actually done. Mr X pays Rs 50,000 non-refundable to lock a price of Rs 10,00,000 on land. Note the asymmetry the chapter is careful to spell out: "ONLY HE CAN CALL OFF THE DEAL at the end of 3 months, Mr Y CANNOT", and "Mr Y GETS TO KEEP THE UPFRONT FEES." That is the whole of option theory in one property deal — one side bought a choice, the other sold an obligation and was paid for it.

Your car insurance policy is a put option

The chapter says it outright: "you are BUYING A PUT OPTION from the insurance company", and the insurance premium is the option premium. If your car is damaged you claim — you exercise. If nothing happens, "the insurance company KEEPS THE PREMIUM IN RETURN FOR TAKING ON THE RISK" — the option expires worthless, as most do. This also explains Chapter 19's claim that insurance as a risk approach "requires a particular derivative called OPTION": only an option removes the bad outcome while leaving the good one untouched, and only an option charges an explicit premium for doing so.

Options exist because futures are too even-handed

The chapter opens Chapter 21 by explaining the gap options were invented to fill: futures have "a LINEAR PAY OFF, which indicates UNLIMITED LOSSES AND PROFITS. Some market participants desired to RIDE UPSIDE AND RESTRICT THE LOSSES." A future treats both parties identically — same rights, same obligations, same risk. An option deliberately breaks that symmetry and charges the buyer a fee for the privilege. Symmetric versus asymmetric is the single distinction that generates everything else in this chapter.

European limits exercise, not exit

A misunderstanding worth killing early. European options "can be exercised ONLY ON THE EXPIRATION DATE", which sounds like you are trapped until expiry. You are not: "in case of exchange traded options, participants CAN SELL THEIR OPTION IN THE SECONDARY MARKET PRIOR TO OPTION EXPIRATION to square-off their position." Think of a confirmed train ticket on a non-cancellable fare — you cannot use it early, but you can transfer it. The chapter's own square-off illustration does exactly this: a dealer buys puts on 1 October and cancels them on 15 October at the prevailing market price.

Bermuda sits between America and Europe — even on the map

A mnemonic the chapter practically hands you. American = exercise any time; European = only at expiry; Bermudan "denotes SPECIFIC DAYS before expiration" and therefore "FALL IN BETWEEN American and European options in terms of how much freedom a trader has." The island of Bermuda sits in the Atlantic between the two continents, and so does the option. Note too that its exercise dates are "usually NEAR THE TIME OF THE OPTION'S EXPIRATION DATE" — it leans European.

Intrinsic value can never be negative

This is the rule that makes the whole moneyness grid work. A call's intrinsic value is S − X with a floor of zero, a put's is X − S with a floor of zero, because "no one would like to exercise his right under NO ADVANTAGE CONDITION." You will never exercise a right that costs you money — you simply walk away and lose only the premium. So while an option position can lose (the premium), the option itself is never worth less than nothing. That floor is exactly what makes the payoff diagram bend at the strike.

Options are wasting assets, like a block of ice

"At expiry the option value IS ITS INTRINSIC VALUE and TIME VALUE WILL BE ZERO." Every day that passes, part of what you paid evaporates whether the market moves or not. The chapter calls options "wasting assets" for exactly this reason. A two-month call is worth more than a one-month call at the same strike — you are buying more time for the market to come good. Buy an option and you are buying ice in a Mumbai summer: you must use it before it melts.

ATM and OTM options are pure hope

"ATM AND OTM OPTION WILL HAVE ONLY TIME VALUE because the intrinsic value of such option is zero." If you pay Rs 0.20 for an out-of-the-money call, you have bought nothing but probability — every paisa is the market's estimate of the chance it comes good before expiry. That is why cheap far-OTM options are seductive and dangerous: a large percentage of the premium can vanish on a quiet day, since there is no intrinsic floor underneath it to slow the decline.

Key terms in this chapter

American option: Exercisable any time on or before the expiration date, offering the buyer more flexibility.
Assignment: Being called upon to deliver when the option buyer exercises. Every option writer must treat assignment as a distinct possibility.
Asymmetric risk exposure: The gain when the underlying moves one way differs significantly from the loss when it moves the other. Options are asymmetric; futures are symmetric.
At the money (ATM): Spot equals strike, so exercise gives zero cash flow. Any movement makes it ITM or OTM.
Bermuda option: Exercisable only on specific days before expiration, usually near the expiry date. It falls between American and European in flexibility.
Binomial pricing model: Developed by William Sharpe in 1978. It builds a binomial tree of possible prices at equally spaced steps. Very accurate but lengthy and time consuming because it is iterative.
Black (1976) model: Substitutes the discounted future price for the spot price, addressing negative cost of carry. Used in India for computing theoretical prices of exchange traded interest rate options.
Black and Scholes model: Published in 1973 by Fisher Black and Myron Scholes. It uses spot prices and five determinants, does not iterate, and assumes exercise only at maturity with no dividends.
Break-even point (BEP): Strike plus premium for a call, strike minus premium for a put. BEP is independent of position and specific to the instrument.
Call option: The right to buy the underlying asset at the strike price.
Caps, floors and collars: OTC interest rate option products. Exchange traded IRO are mainly plain European options; caps, floors, collars, reverse collars, swaptions and structured products belong to the OTC market.
Contrarian indicator: An indicator signalling potential reversals at extreme levels. A very high PCR may signal an oversold market inviting call buying; a very low PCR an overbought market inviting put buying.
Delta: Change in option premium per unit change in the underlying price. The most important Greek. Long call and short put are 0 to +1; long put and short call are 0 to -1.
European option: Exercisable only on the expiration date. Exchange traded options can still be sold in the secondary market before expiry to square off.
Exercise: Putting into effect the right to buy or sell the underlying security specified in the contract.
Gamma: Change in delta per unit change in the underlying price, the second derivative. It acts as the acceleration of delta, and is positive for both long calls and long puts.
Historical volatility: Volatility computed from past closing prices. Easy to calculate and useful for day-to-day requirements.
Implied volatility (IV): The market consensus expectation of future price fluctuation, denoted sigma, reflected in the premium. It is the only factor in the model not directly observable, and it does not predict direction.
In the money (ITM): Exercise gives a positive cash flow. A call is ITM when spot exceeds strike; a put when spot is below strike. Only ITM options have intrinsic value.
Intrinsic value: The amount by which the option is in the money: S minus X for a call, X minus S for a put, with a minimum of zero. It can never be negative.
Long build up: Rising underlying with rising open interest, read as a bullish signal. Falling underlying with rising open interest is a short build up and bearish.
Moneyness: Whether exercising would give the buyer a positive, negative or zero cash flow, classifying the option as ITM, OTM or ATM.
Open interest: The total number of option or futures contracts not closed in a trading cycle. A key indicator of market participation and liquidity.
Option: A contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date, in exchange for a premium.
Option premium: The price the option buyer pays the option seller to acquire the right. It equals intrinsic value plus time value.
Option writer: The seller who receives the premium and assumes the obligation. The writer has obligation but no right, and must be aware that assignment is a distinct possibility.
Out of the money (OTM): Exercise would give a negative cash flow. A call is OTM when spot is below strike; a put when spot exceeds strike.
Premium style option: An option where the premium is paid upfront by the buyer. Exchange traded interest rate options in India are premium style European calls and puts.
Put-call parity: C + PV(x) = P + S, the relationship that must hold between European puts and calls on the same underlying, expiry and strike. It holds only for European options.
Put Call Ratio (PCR): Put open interest divided by call open interest, or put volume divided by call volume. High PCR indicates bearishness, low PCR bullishness. For equity options an average of 0.7, not 1, is the working benchmark.
Put option: The right to sell the underlying asset at the strike price. Car insurance is the chapter's real-life example of buying a put.
Rho: Change in option premium per one percentage point change in the risk-free interest rate. Positive for calls, negative for puts.
Square-off of options: Closing an option position before expiry by taking the opposite trade in the secondary market, available even for European style exchange traded options.
Strike price: The pre-specified price at which the underlying asset may be purchased or sold by the option holder.
Strike price interval: The gap between consecutive available strikes. For exchange traded IRO it is Rs 0.25, with a minimum of eight ITM, eight OTM and one near-the-money strike.
Theta: Change in option premium for a one-day decrease in time to expiration. Negative for buyers, positive for sellers. Theta is a friendly Greek to the option seller.
Time decay: The gradual fall of time value towards zero with the passage of time. It is why options are called wasting assets and why option sellers have a fundamental advantage.
Time value: The difference between option premium and intrinsic value. It reflects the probability the option will gain intrinsic value before maturity, and is zero at expiry.
Vega: Change in option premium per change in volatility. Positive for a long call and a long put. Its effect is highest when more days are left to expiry.
Wasting asset: An asset whose value erodes with time. Options are wasting assets because their time value gradually falls to zero.

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Original explanatory writing based on the official NISM workbook for Series V-D, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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