LECTURE 4 PART 1 INTRODUCTION TO OPTIONS

An option is the right, but not the obligation, to do something

Usually the something is the act of either buying or selling some
asset or financial instrument.
Options are derivative securities. This term means that the value
of the contract is derived from (i.e. depends on) the value of
some other underlying asset.
Financial Options are options over financial instruments such as
shares, bonds, share price indexes, bank bills etc. These are
options to either buy or to sell an asset / financial instrument.
There are 2 basic types:
CALL OPTIONS AND PUT OPTIONS
CALL OPTIONS
A Call Option is a contract which gives the owner of the contract
(the holder ) the right to buy the asset.
Example: Suppose you have a call option over 100 ounces of
gold. The contract gives you as the investor the right, but not the
obligation, to buy 100 ounces of gold, in exactly 1 years time, for
a price of $US 300.00 per ounce.
Then
The underlying asset is 100 oz of gold.
term of the contract is 1 year
the exercise price or strike price of the option is $300 per
ounce, which for 100 ounces is $30,000.00
You as the investor have the right to buy gold from the writer of
the option. The writer of the option is the person or organisation
1

which originally sold the option and which takes on the obligation
to sell 100 ounces of gold in 1 years time in return for receiving
$30,000.00.
At the time when you buy the option, you do not know what the
price of gold will be in 12 months time.
If, in 1 years time the gold price is $250.00 per ounce then you
could buy the 100 oz of gold in the open market for $25,000
instead of buying the gold under the option contract for
$30,000.00. The word option means that you do not have to buy
the gold for $30,000 in 12 months unless you choose to. In this
case you would be paying too much if you did exercise your rights
under the contract and could do better by buying gold in the open
market for $5,000 less. If you do not exercise your right to buy
then the option is said to lapse.
If on the other hand, the price of gold were to go up to $500 per
ounce in 12 months time then you would (and should) exercise
your right to buy gold at a price of $300 per ounce under the terms
of the option contract. You could then sell the gold in the open
market for $500 per ounce and make a profit of $200 per ounce on
100 ounces which is a profit of $20,000.
The date by which you have to choose whether to exercise the
option is called the exercise date or the expiry date or the
maturity date these terms all mean the same thing.
PUT OPTION
Another kind of option is an option to sell an asset / instrument on
some future date for an agreed price. This is called a put option.
For instance you may have bought the right (but not the
obligation) to sell 100 ounces of gold for a price of $350 per
ounce in 12 months time.
2

You would exercise the right to do this if and only if there is a

profit (and not a loss) to be had from doing so. This would be true
if and only if the price of gold on the maturity date is less than the
exercise price of $350 per ounce.
European and American Options
Another way to classify options is according to the exercise
rights of the contract. Some contracts will only allow you to
exercise the right to buy or sell on the maturity date itself. These
are called European options.
Other types of contract will allow you to exercise the right to buy
or sell the asset on any date up to and including the maturity date.
These sorts of options are called American Options.
Note that the terms European and American refer only to the type
of exercise rights the option contracts have and not the geographic
location where the options are traded. For instance we have
European Options traded in American Financial Markets and
American options traded on European Financial Markets.
Bermudan Option
can be exercised early on a specific date or set of dates

USES OF OPTIONS
Option contracts are used by banks, investors, governments and
corporations for a range of different purposes.
The main reasons for using them are:
for hedging (the motivation being to reduce financial risk) This
is like buying insurance against financial risk
for speculation (the motivation being to make trading profits
from taking a bet on which way market prices may move) this
is like gambling. There are many different strategies that can be
implemented with options more on this later.
for arbitrage by exploiting differences in prices between
different markets or different instruments we may be able to
make a risk free profit.
Fee income: to make money from selling options for banks
and other option writers, it is like selling an insurance policy
and they want to sell it for more than it is going to cost them (at
least on the average)
INTRINSIC VALUE
The intrinsic value of an option is defined as the payoff from
exercise of the option assuming it could be exercised immediately.

Market Value = Time Value + Intrinsic Value

Option contracts have a market value. We can think of the market
value as being made up of 2 components:
1. the intrinsic value and
2. the time value.
The time value is defined to be the difference between the
market value of the option contract and the intrinsic value of the
option, provided this difference is positive, and zero otherwise.

For American options, the time value represents the value of the
opportunity presented by the possibility that the asset will increase
above its current level.
American options can be exercised immediately but European
options cannot be exercised until their maturity date.
Notation
S = market price of the underlying asset
ST = market price of the underlying asset at time T
X = exercise price of the option contract
T = Term to maturity of the option
c = market value of a European call option contract over
S with exercise price X and term to maturity T
p = market value of a European put option contract over
S with exercise price X and term to maturity T
C = market value of American call option contract over
S with exercise price X and term to maturity T
P = market value of American put option contract over S
with exercise price X and term to maturity T
The intrinsic value of a call option is max( S X ,0) because:
If S X then we could
buy the asset for price X by exercising our rights under the
contract
then sell the asset in the market for S
make a profit of S X as a result
If S X then we would
not exercise our rights under the contract and the profit would
be 0.00
This is written more compactly as payoff
Note: Y
max(Y ,0)

max( S

X ,0)

The intrinsic value of a put option is max( X S ,0) X S

because:
If S X then we could
buy the asset for price S in the open market
sell the asset for a price of X by exercising our rights under
the put option contract
The resulting profit is X S
If S

X then we would

not exercise our rights under the contract and the profit would
be 0.00
This is written more compactly by writing payoff

max( X

S ,0)

Example:
Consider an American Put Option with
a term to maturity of 1 year,
the underlying asset is 1000 shares in company XYZ.
exercise price of the option is $1000
Suppose the interest rate is 10% p.a. and the company XYZ has
just gone into liquidation with its liabilities exceeding its assets.
Answer the following questions:
(a) what is the intrinsic value of the put option?
(b) when should you exercise the option should you do it
immediately or should you wait until some later time? Why?
(c) If the option were a European Option then what would the
value of the option be and why?
(d) Why is an American option always worth at least as much as
and possibly more than the equivalent European Option?
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Answers
(a) the shares of XYZ will have a value of $0.00 they will have
no value. Thus the intrinsic value of the put option is
payoff max( X S ,0) max(1000 0,0) 1000 .
(b) this put option is an american option you can exercise it
immediately and you should exercise immediately. Doing so
gives you an immediate payoff of $1000 now. Delaying the
decision means you receive $1000 at some later time. It is
better to have money now rather than later so exercise
immediately.
(c) If the option were European then you could (and should)
exercise your right to sell the shares in 1 years time for a
price of $1000 and the profit to be had from doing this is
$1000 received at the end of a year. The option is european
and cannot be exercised before then. In this situation the
value of the option is the present value (@ 10%) of $1000
received in 1 years time. This is

$1000.00
1.10

$909.91

(d) An American option is equivalent to a European one plus the

additional feature of being able to exercise the option early.
This additional feature can only add to its value and not
reduce its value.

Payoff and Profit Diagrams

A payoff diagram for an option shows the payoff from exercising
the option as a function of the price of the underlying asset.
This is distinguished from the profit diagram which shows the
profit to the investor from exercising the option profit is the
payoff received minus the price paid for the option(s).
example: call option with:
spot price S= $3.00, strike price X=$2.50
term T = 1
Cost = $0.72
We shall show the calculation of the payoff at maturity from
exercising this option, and the profit at maturity as well.
The price we agree to pay in return for the stock is called the
"strike price" or "exercise price" and for this option it is X=$2.50.
We use X to denote it.
The term to maturity is denoted by T and for this option it is T= 1
year
The variability of the return on the stock is called the "volatility"
and it is an annualised measure.
This option gives us the right, but not the obligation to buy the
stock for a price of $2.50 in 1 year's time. We will do this if it is
financially worthwhile at the time, but not if we will make a loss
from doing so.
The price of the option is called the "premium" and for this option
it is $0.72.
8

We have to pay $0.72 to buy the option contract (which gives us

the right to buy the stock in 1 year for a price of $2.50).
The current price of the stock is called the "spot price" (S) and it is
$3.00 for this option.
The following table shows the payoff at maturity and the profit at
maturity for a range of values for the underlying asset.
If S = 3.00 then
the payoff is max(3.00-2.50,0)=0.50 but
the profit is payoff - cost = 0.50-0.72 = -0.22.
We would exercise the option because not doing so makes
the profit lower at -0.72
If S = 2.00 then
the payoff is max(2.00-2.50,0)=0.00
the profit is payoff - cost = 0.00-0.72 = -0.72.
We would not exercise the option because doing so makes
the profit even lower - the act of buying at 2.50 a stock
worth 2.00 is a loss making transaction.

Table Showing Payoff from exercise and Profit from Exercise

S
Payoff Profit
$2.00 $0.00 -$0.72
$2.10 $0.00 -$0.72
$2.20 $0.00 -$0.72
$2.30 $0.00 -$0.72
$2.40 $0.00 -$0.72
$2.50 $0.00 -$0.72
$2.60 $0.10 -$0.62
$2.70 $0.20 -$0.52
$2.80 $0.30 -$0.42
$2.90 $0.40 -$0.32
$3.00 $0.50 -$0.22
$3.10 $0.60 -$0.12
$3.20 $0.70 -$0.02
$3.30 $0.80 $0.08
$3.40 $0.90 $0.18
$3.50 $1.00 $0.28
$3.60 $1.10 $0.38
$3.70 $1.20 $0.48
$3.80 $1.30 $0.58
$3.90 $1.40 $0.68
$4.00 $1.50 $0.78
If S = 3.40 then Payoff = max(3.40-2.50,0)=0.90
but profit = 0.90-0.72 = 0.18 = revenue cost
If S = 2.90 then Payoff = max(2.90-2.50,0)=0.40
but profit = 0.40-0.72 = -0.32 = revenue cost
If S = 2.00 then Payoff = max(2.00-2.50,0)=0.00
but profit = 0.00-0.72 = -0.72 = revenue cost

10

call option payoff and profit at maturity

$3.00
$2.50
$2.00

$value

$1.50
$1.00
$0.50

-$0.50

$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
$2.60
$2.80
$3.00
$3.20
$3.40
$3.60
$3.80
$4.00
$4.20
$4.40
$4.60
$4.80
$5.00

$-

-$1.00
spot price

Option Terminology:
In the money
The option is said to be "in the money" if it has a positive intrinsic
value, i.e. if it would be worth exercising (if you could exercise it).
a call is in the money if S > X, while
a put is in the money if S<X
At the money
The option is said to be "at the money" if S=X.
a call is in the money if S = X
a put is also in the money if S=X

11

Out of the money

The option is said to be "out of the money" if it is not worth
exercising
a call is out of the money if S < X
a put is out of the money if S >X
ETO's
Options can be bought and sold like any other financial
instrument.
Some options are traded on exchanges.
These are known as "exchange traded options", or ETO's.
OTC's
Some options are not traded on exchanges but are individually
negotiated between buyer and seller. The seller in these
circumstances is the party who accepts the obligations to provide
the payoff to the buyer of the option should the buyer choose to
exercise the option.
These sorts of options are called "over the counter options" or
OTC options.

12

Buying / selling / writing options

If you have bought an option then you are (while you own it) the
"holder" of the option and you can sell it to some other investor.
The party that has the obligation to provide the payoff on the
option is called the option writer. If you sell an option that you
bought, you dont have the obligation to make the option payoff
on the maturity date, the option writer does.
If you do not own the option you can "short sell" the option or
"write" the option. This (writing or short selling) means you
accept the liability involved for the other side of the deal. The
payoff to the option writer is the reverse of the payoff to the
option holder.
For a call option
the payoff to the option holder at maturity is max( ST X ,0)
the payoff to the option writer at maturity is max( ST X ,0)
Writing an option is equivalent financially to short selling an
option. In some books they don't distinguish between selling an
option and writing (short selling) an option. Usually by selling
they mean writing. This can lead to confusion.

13

Variables that impact on option values

The variables which affect the option prices and the effect of
changes (increases) in them are as follows:
variable
spot price S
Strike price X
dividends paid
Term to maturity
risk free interest
rate
Volatility

effect on call
increases
decreases
decreases
increases
increases

effect on put
decreases
increases
increases
increases
decreases

increases

increases

The effect of increases in either term to maturity or volatility is to

increase the values of both call and put options.
The basic reason is that an increase in either volatility or term will
increase the likelihood that the option will be worth exercising at
maturity.
What is the volatility?
The term "volatility" is a measure of the variability of the stock
price. It is actually defined as the annualised standard deviation of
the continuously compounded return on the stock.
We measure / define it as
2

1
S
var log e T
T
S0

, where

or equivalently,

1
T

var log e

ST
S0

14

Note that
ST
is called the price relative. If you invest $1.00 at
S0
S
time 0, it will grow in value to an amount of T at time T
S0

the ratio

log e

ST
S0

is the continuously compounded return on the

stock over the period from time 0 to time T

r

log e

ST
S0

1
is the continuously compounded rate of return
T

(per year) on the stock

This return is random, since we do not know in advance what
the future value ST of the stock will be
The volatility is the square root of the variance of the
annualised rate of return on the stock
European vs American Options
American option is always worth at least as much as the
equivalent European option. (equivalent meaning same strike
price, underlying asset, term to maturity etc)
The reasons are
1. American option is equal to a European option plus the right to
exercise early
2. the right to exercise early must have a value 0

15

CALL OPTIONS
It can be shown that for
an american call option
over a non dividend paying stock,
it is never optimal to exercise the option early.
Therefore it follows that American call value = European call
value in this case.
This does not necessarily apply in the case of dividend paying
stocks. American calls on dividend paying stocks may be worth
exercising early.
By dividend paying we mean the stock pays a dividend during the
term of the option.
PUT OPTIONS
For put options over non dividend paying stocks it is sometimes
optimal to exercise the option early. Therefore american put
options have a value that is european put options.

16

Part 2: the Black Scholes Formula

There is an analytic formula for European call and put options
over an asset that does not pay a dividend during the life of the
option. It is called the Black Scholes formula.
This analytic formula does not apply to American options in
general. This is one of the deficiencies of the BS formula.
Black Scholes Formula for a European Call Option over a non
dividend paying stock
c

S N (d1 ) Xe

rT

N (d 2 )

where
S = "spot price" (i.e. the current price) of the stock
X = the exercise price of the option
r = the risk free interest rate per annum
T = term to maturity of the option
= volatility of the stock
c = value a european call option
d1

d2

1
T
1
T
x

N x

log e

S
X

1
2

log e

S
X

1
2

1
e
2

1 2
z
2

d1

dz

17

N(x) is the cumulative density function of the standard normal

distribution. You do not have to calculate it. We use tables of the
normal distribution to obtain the value of N(x).
Excel has a built in function that computes it, called the
"normsdist" function.
What is N(x)
The following graph shows both
the probability density function n(x) (the bell shaped curve) and
the cumulative density function N(x) (the S shaped curve) for
the standard normal distribution.
N(x) is the area under the curve n(x) to the left of the value x.
N(x) varies between 0 and 1.
It is the probability that Z<x when Z has the standard normal
distribution.
standard normal distribution
1.2

0.8
0.6
0.4
0.2

3.74

3.31

2.88

2.45

2.02

1.59

1.16

0.73

0.3

-0.1

-0.6

-1

-1.4

-1.8

-2.3

-2.7

-3.1

-3.6

0
-4

n(x)and N(x)

x value

18

Black Scholes Formula for a European Put Option over a non

dividend paying stock
p

Xe

rT

N ( d 2 ) S N ( d1 )

where the definitions of the various variables are as above for a

call option.
Under the Black Scholes Model, the logarithm of the price relative
has a normal distribution.
ST
is the price relative, the ratio of the value of the stock at the
S0

maturity date to its initial value

log e

ST
S0

is the natural logarithm of the price relative

the BS model is based on the assumption that log e

ST
S0

has a

normal distribution with

1. mean

1
2

2
2. variance
T
3. standard deviation

T
T

Note we usually write just S instead of S0 for the initial value

of the stock.
This distribution of the log of the price relative implies that the
stock price has what is called a "log normal distribution".
The expected rate of return on the stock is the risk free interest
rate under this distribution. The distribution is called the "risk
neutral distribution" of the stock price.
19

This is because a "risk neutral investor" would be indifferent

between a risk free bond returning rate r and a risky stock with the
same expected return of r.
Worked example of call option valuation
We shall calculate the value of a 3 month European call option
with a strike price of $9.50 over a non dividend paying stock
worth $10.00. The details are
S = $10.00 = spot price of asset
X = $9.50 = exercise price (strike price) of option
r = 10% = risk free rate of interest
= 20% = volatility of asset
T = 0.25 years = 3 months
We shall also calculate the value of a put option and the intrinsic
value and time value of the call and of the put
For the call option, the calculation procedure is as follows:
Step 1: compute d1 and d2
S
X

10.00
1.052632
9.50
S
log e
log e 1.052632 0.051293
X
1 2
1
0.10
0.202 0.25 0.03
r
T
2
2
T 0.20 0.25 0.10

20

d1

S
X

1
2

T
T
0.081293
0.81293
0.10
d 2 d1
T 0.81293 0.10 0.71293
log e

Step 2:
Calculate (or lookup in tables) the values of N (d1 ) & N (d 2 )
To 4 decimal places these values are:
N (d1 ) 0.7919
N (d 2 ) 0.7621

These can be computed in excel or looked up in tables of the

standard normal distribution.
Step 3:
Now we have the values of N (d1 ) and N (d 2 ) we plug these values
into the BS formula
c

S N (d1 )

Xe

10.00 0.7919

0.8579

rT

N (d 2 )

9.50 0.975310 0.7621

The value of the call option is 85.79 cents.

Note: e x is exp(x) in excel, the function log e x is ln x in excel.
The intrinsic value of the call option here is $0.50.
The value of the option using BS model was $0.8579
The difference between the option value and the intrinsic value is
called the "time value" of the option ($0.3579 for this example).
21

Put Option valuation

We shall now calculate the value of a 3 month European put
option with a strike price of $9.50 over a non dividend paying
stock worth $10.00. The details are as above.
We have already done the hard work of computing the d's and
N(d)'s when we valued the call option.
The formula for the put option is
p

Xe

rT

N ( d 2 ) S N ( d1 )

Now that we have the value of N (d1 ) & N (d 2 ) we can compute the
values of N ( d1 ) & N ( d 2 ) using the relationship
N ( x)

N ( x) 1.0

from which it follows that

N ( x) 1.0 N ( x)

This allows us to compute the values N ( d1 ) & N ( d 2 ) without

having to redo the calculations above.
p

Xe
Xe

rT

rT

N ( d2 )
1 N (d 2 )

9.50 0.975310
p

S N ( d1 )
S

1 N (d1 )

1 0.7621

10.00

1 0.7919

0.1234

The intrinsic value of this option is 0.00 as it would not be worth

exercising the right to sell the stock for $9.50 when its market
value is $10.00. The time value of the option is thus $0.1234,
which is 100% of the option's value.

22

ADJUSTING BLACK SCHOLES FORMULA FOR STOCKS

THAT PAY DIVIDENDS
We can adapt the BS formula to cope with options over shares that
pay a dividend during the life of the option. We consider 2
different adjustments:
Case 1: known dollar dividend amount
Let D be the amount of dividends paid at time
where 0< <T and T is the maturity date of the option.
We compute the "adjusted share price" S ' S D e

This is the share price less the present value (at the risk free rate)
of the dividends paid during the life of the option.
We then compute the option price using the Black Scholes
formula but we use the adjusted share price instead of the actual
share price as the spot price input for the calculations.
Example: 4 month call option over IBM
Assume that the valuation assumptions are
0.244949
S = $50.00, X = $45.00, r = 3%,
D = $0.56 paid in 2 months (
Then the adjusted share price is
S'

D e

50.00 0.56 e

2
)
12

0.03 2 /12

$49.44

23

We use this share price instead of $50.00 as the spot price input to
the BS formula. The calculations are as follows:
spot price S
strike price X
term T
volatility v
int rate r
S/X
ln(S/X)
(r+0.5vol^2)T
vol*root(T)
d1
d2
Nd1
Nd2
C

$49.44
$45.00
0.3333
24.49%
3.00%
1.098729
0.094154
0.0200
0.1414
0.8072
0.6658
0.7902
0.7472
$5.7804

The option price is found to be $5.78. Exercise: check this

numerically using a spreadsheet or otherwise.
Case 2: known dividend yield
Let the dividend yield on the underlying asset (stock) be q.
We take this to mean a continuous dividend yield.

24

BS formulae for options over an asset with a continuous dividend

yield at rate q:
The formulae for European Calls and Puts are
c

Se

Xe

qT

rT

N (d1 )

N ( d2 )

Xe

rT

Se

N (d 2 )
qT

N ( d1 )

Where
d1

log e

T
1
log e
T

d2

S
X
S
X

1
2
1
r q
2

r q

d1

Note that the dividend yield q appears as part of a discount factor

applying to the stock price and also in the definitions of the d's
here.
Exercise:
Show algebraically that we get exactly the same value for both
calls and puts if we use the standard black scholes model with an
adjusted stock price of S ' Se qT and use this adjusted stock price
as the spot price input to the BS model
c

c S , X , r , q, , T

d1

d1 S , X , r , q, , T

d2

d1

SN (d1 )

1
T

Xe

log e

rT

N (d 2 ) where

S
X

r q

1
2

Write an expression for c S ' , X , r , q, , T

25

Numerical Worked example:

Consider the above option on IBM but now value it assuming a
2% p.a. dividend yield.
spot price S
strike price X
term T
volatility v
int rate r
div yield q
S/X
ln(S/X)
(r-q+0.5vol^2)T
vol*root(T)
d1
d2
Nd1
Nd2
C

$50.00
$45.00
0.3333
24.49%
3.00%
2.00%
1.1111
0.1054
0.0133
0.1414
0.8393
0.6979
0.7993
0.7574
$5.9592

26

PART 3: Put Call Parity and Bounds on option values

Bounds means upper and lower limits for option values
Option values are influenced by a range of factors as reflected in
the parameters of the Black-Scholes option valuation formula.
With European options the payment of a dividend can make a
longer maturity European call option less valuable than a shorter
maturity contract since the dividend results in a fall in the share
price ex-dividend usually around 60-70% of the amount of the
dividend because of tax and other factors.
The bounds we cover here are general in that they only rely on
simple arbitrage arguments. If they do not hold then there exists a
strategy that can be used to guarantee a profit without taking any
risk. It is important to realise that minimal assumptions are made
in order to derive these results.
notation:
Notation
Call
Put

European
C
P

American
C
P

note that
0 max X S ,0
0 max S X ,0

X
S

27

For upper bounds when there are no dividends on the asset:

C

S, c

Both American and European call option

values are less than the stock price.
S is an upper bound for these option values.
The right to buy the stock cant be worth more
than the stock itself. The reason is that
If c S then we can
sell the call for c, buy the stock for S,
time t = 0 cashflow = c-S>0
wait till time T, if the call is exercised,
give the stock to the option holder and
receive X for it, otherwise sell stock for S.
time 0 payoff = c-S>0
time T payoff = min(X,S)>0
we make a risk free profit

28

X, p

Both American and European put option values

are less than the exercise price.
X is an upper bound for these option values
Because:
If p X then we can
sell the put at time 0 for amount p,
immediately invest amount X in a risk free
bond for term T at rate r,
keep the difference p-X
hold this position until either the put is
exercised or till time T (maturity)
if the put is exercised the value of our
position is Xert max X S ,0 0
X

if the put isnt exercised then our position

at maturity is zero
overall we make a profit at time 0 and may
make a profit at some future time too but not
a loss

29

For a European put option the bound can be improved:

p

Xe

rT

European put option values are less than

the present value of the exercise price Xe
Xe

rT

rT

is an upper bound for these option values

Otherwise we would have p Xe rT

If so we could write (sell) the put option and
invest the proceeds at the risk free interest rate
to make a guaranteed profit.
If you did this you get a payoff of p at time 0.
By investing it to time T at the risk free rate
you have pe rT at time T and this is more than
X, pe rT Xe rT e rT X
If the option holder who you sold the option to
did exercise the option, then the payoff to them
would be max X S ,0 and your payoff as the
option writer would be max X S ,0 . Our put
option liability is max X S ,0 X .
So the worst case for you at maturity is a
payoff of pe rT max X S ,0 0
X

This happens only if the put option is

exercised.
If the put is not exercise then you get a payoff
of p at time 0 which has an equivalent value of
pe rT X at time T

30

For lower bounds when there are no dividends on the underlying:

European call option: c max( S Xe rT ,0)
max( S Xe rT ,0) is a lower bound for the option value
Proof: we compare the pay-offs at maturity of 2 portfolios:
1. a European call option (c) with
2. a portfolio of one share and borrowing equal to the present
value of the exercise price Xe rT , borrowed at rate r for term T.
The value of this is S Xe rT at time 0.
At maturity the borrowing has a value of X, because Xe
invested at rate r for term T accumulates to Xe rT e rT X

rT

At the maturity date we must have either ST X or ST X .

We look at what happens to the 2 payoffs under these 2 scenarios.
This is done in tabular form below.
scenario for call option portfolio payoff which
stock price
payoff
payoff is higher?
at maturity
ST X
ST X
ST X
same
ST X
ST X
option is higher
0
It can be seen that the call option pay-off is always greater or
equal to that on the portfolio which means that the value of the
option must be greater than the value of the portfolio. Hence
c S Xe rT . But we also have c 0 ( the value of the option cant
be negative). Hence it follows that c max( S Xe rT ,0)

31

For the European put option p max Xe

max Xe

rT

rT

S ,0

S ,0 is a lower bound for the put

Proof:
This result can be derived by comparing 2 portfolios:
1. a European put option with
2. a portfolio made up of of cash equal to the present value of
the exercise price Xe rT and a short (sold) position in one
share.
At maturity
our risk free investment accumulates to Xe

rT

rT

our liability under the short sale agreement is ST

scenario for put option portfolio payoff which
stock price
payoff
payoff is higher?
at maturity
ST X
X ST 0
put is higher
0
ST X
X ST
X ST
same
The method of taking a short position in a share in practice is to
borrow the share from an existing holder, under a share borrowing
arrangement or a buy-back agreement, and to sell this share.
Alternatively an equivalent short position can be established using
a forward contract or a futures contract.
For the American put option
A lower bound is p max X S ,0
This is true because of the possibility of early exercise
This lower bound is stronger than the one for European puts which
was p max Xe rT S ,0
32

Put Call Parity (when the underlying has no dividends)

This is a very important relationship between the values of a
European call option, the value of a European put option, and
the value of a long forward contract.
All 3 contracts:
are over the same underlying asset,
have the same delivery / exercise price, and
have the same maturity date.
This relationship does not depend on the validity of the Black
Scholes formula.
The relationship says that a combination of a long call option and
a short put option is equivalent to a long forward contract.
c

Xe

rT

p S or equivalently c

long
call

short
put

Proof:
Let S and X be 2 numbers. Then
max S X ,0 max X S ,0 S
Because:
if S X then max S

X ,0

if S X then
max S X ,0
0

Xe

rT

long forward
contract

max X

S X

S ,0

max X

S ,0

X S

33

Alternatively, Consider 2 portfolios:

Portfolio 1 =

a European call option plus

a cash holding equal to the present
value of the exercise price
a European put option plus
a holding of 1 unit of the stock

Portfolio 2 =

Now consider the value at maturity of these portfolios. This is the

same for each of them, because
at maturity the first portfolio has value
max( ST

X ,0)

Xe

call
payoff

rT

cash

rT

max( ST

X ,0)

max( ST , X )

accumulation
factor

and the second has value of ST max( X ST ,0) max( X , ST )

note the results
max( S

X ,0)

max( S , X ) and max( X

S ,0) S

max( S , X )

this is easily proven (try it for yourself)

If the pay-offs are the same at maturity then the values must be
equal, (this is the law of one price) otherwise there is the
opportunity to make arbitrage profits.
Otherwise we could buy the cheaper portfolio and sell the more
expensive one to make a risk free profit.
Hence it follows that c Xe

rT

p S

This is called put call parity.

It is a relationship that holds regardless of whether the BS model

holds. It is enforced by arbitrage.
34

This relationship is sometimes written instead as c p S Xe

rT

can rewrite this as c p S Xe rT

interpretation: long call = long put plus long forward
can rewrite as p c S Xe rT
interpretation: short put = short call plus long forward
can use put call parity to see how to synthetically create some
securities from combinations of others. More on this later
American Calls and European Calls on no dividend stock:
Assume that there are no dividends payable during the term
of the option. In this case it is never optimal to exercise an
American call early and therefore C=c.
Proof:
Assume that it is optimal to exercise the call early at some time
when the option has a remaining term of T years to maturity.
Then:
1. we already showed that c max( S Xe rT ,0)
2. it follows that c S Xe rT because max( S Xe rT ,0) S Xe rT
3. we observed earlier that an American option is equivalent to a
European one plus the right to exercise early. From this it
follows that C c
4. hence we have C S Xe rT
5. the interest rate r is always >0. Hence we have Xe rT X and so
C S X as well
6. if it were optimal to exercise early then it would be true that
C S X at some time before the maturity date.

35

Thus we reach a contradiction because C S X and C S X

cannot both be true.
So it cant be possible for it to be optimal to exercise early.
Accordingly it must be true that C=c (American call option value
is the same as European call option value)
If there are no dividends paid during the term of the option then it
is never optimal to exercise an American call early and
therefore C=c.
Implication: We can value an American call using the Black
Scholes formula for a European call when there are no dividends
paid on the stock during the term of the option.
American Puts and European Puts on no dividend stock:

This result above does not hold for put options.

Early exercise for a put might be optimal since
P p as American option = European option plus right to
exercise early
p Xe rT S was proved earlier
Xe rT S
but P X S on early exercise.
P

if the stock price gets sufficiently low (e.g. close to zero) the
payoff from exercising early is higher than the possible
payoff from waiting until later to exercise. In the extreme
case where the stock price falls to zero we get X now by
exercising early and with interest this accumulates to Xe rt at
time t. If we wait till later the stock price may recover and the
payoff would be less.
it follows that there are some circumstances where P>p
36

Put Call Parity for American Options on a no dividend asset

The Put Call Parity relationship is S X

Xe

rT

This is an inequality that gives a range of values for C P ,

both an upper and a lower bound for it
The put call parity relationship for European Options is an
equality instead, which says that C P S Xe rT
Proof:
1. from put call parity for European options we have
c

Xe

rT

p c Xe

rT

2. we know that P>p (American put worth more than European

put)
3. from 1 and 2 we have P c Xe rT S
4. with no dividends we have C = c
5. from 3 and 4 we have P C Xe rT S and from this it
follows that P C S Xe rT and hence that
C P S Xe rT . This proves part of the inequality
To prove the other part, namely S X C P we have to consider
2 portfolios:
Portfolio 1 = 1 unit of a European Call + cash of amount X
Portfolio 2 = 1 unit of an American Put + 1 unit of the share
Where both options have the same term to maturity and the same
exercise price X.
Assume the cash in portfolio 1 is invested at the risk free rate r for
term T. The value of this cash at time is Xer , where 0
T.

37

The put option is an American put. It can be exercised early. We

look at 2 separate cases.
Case 1: the put is not exercised early and
Case 2: the put is exercised early at time , where 0
T
Consider the value of portfolio 1 at time T under case 1.
V1

max S

X ,0

Xe rT

max S

X ,0

Xe rT
0

max S , X

V1

max S , X

max S , X

Consider the value of portfolio 2 under case 1.

V2
V1

max X

S ,0

max S , X

max X , S

max S , X

max S , X

V2

We see that the value of portfolio 1 is more than the value of

portfolio 2.
Consider the value of portfolio 2 at time under case 2.
The put is only worth exercising at that time if S < X.
V2

put payoff

Consider the value of portfolio 1 at time under case 2.

V1

max S

X ,0

Xe r

max S

X ,0

max S , X

max S , X

Xe r

X
0

max S , X

V1

V2

38

We see that the value of portfolio 1 is more than the value of

portfolio 2. So this holds for both case 1 and case 2, so it is true
under all possible cases.
It follows that
c

C
C

P S
X P S
P S X

Put-Call parity (where underlying asset has dividends)

If D denotes the present value of dividends between the current date and
the option expiration date then the put-call parity result needs to be
modified to allow for the fact that options are not dividend protected
(this means that if a dividend is paid no adjustment is made to the terms of
the option resulting from the change in the share price after the dividend
payment).
The relationship for put-call parity then needs to allow for dividends and
becomes
For European options:
c D

Xe

rT

p S

long a call &

short a put

Xe

rT

value of a long
forward contract f

For American options:

S

Xe

rT

39

Proof of put call parity : European options on dividend paying stock

c D

Xe

Portfolio A

rT

p S

long a European Call +

investment of cash equal to D X invested at rate r
for term T in a risk free asset
Initial value of Portfolio A = VA 0

Portfolio B

c D

long a European Put +

holding of 1 unit of the asset
Initial value of Portfolio B = VB 0

p S

The underlying asset pays dividends with present value D during

the term of the options. Thus a holding of the stock will produce a
flow of dividends to the holder during the term of the option. If
these dividends are reinvested at the risk free interest rate and
accumulated to time T, the accumulated value at time T of the
dividends will be De rT
The value at time T of the two portfolios will be:
VA T

max ST

max ST

VB T

X ,0

max X

X ,0
X
ST ,0

D
De rT
ST

Xe

rT

e rT

max ST , X

De rT

De rT

max X , ST

De rT

We see that the payoff at time T from the 2 portfolios is the same. By the
law of one price the values of the 2 portfolios must be the same at time
t=0 as well. From this it follows that c D Xe rT p S
40

Put call parity : American options on dividend paying stock

The put call parity result in this case is S X D C P S Xe

rT

This is an inequality which defines an upper and a lower bound for the
difference C P
Proof: exercise for students to do.
Lower bound for European Call on a dividend paying asset

We can show that c S0 D Xe

rT

Proof
consider 2 portfolios:
portfolio A = 1 unit of a European Call plus cash of amount D Xe
invested at rate r for term T in a risk free asset.

rT

Portfolio B = 1 unit of the asset

At time T the value of portfolio B is
VB T

ST
value
of 1 unit
of Asset S

De

rT

accumulated
value of dividends
reinvested at rate r

The value at time T of portfolio A is

VA T

max ST

X ,0

Xe

payoff on 1unit
of the call option

VA T

max ST

X ,0

rT

D e

rT

accumulated value
at time T
of cash invested

since it is true that max ST , X

De

rT

max ST , X

De

ST it follows that VA T

rT

VB T

If this is true at time t=T it must also be true at time t = 0

41

If not you could buy portfolio A and short sell B and hold till maturity for
a guaranteed risk free profit.
It follows that VA 0 VB 0 and hence c D Xe
so that c S0 D Xe rT

rT

S0

Lower bound for European Put on a dividend paying asset

Can show that p D Xe

rT

S0 : Consider 2 portfolios:

portfolio A = 1 unit of a European put plus 1 unit of the asset

Portfolio B = cash of amount D Xe rT invested at rate r for term T in
a risk free asset.
At time T
the value of portfolio B is VB T

Xe

rT

D e

rT

De

rT

accumulated value
at time T
of cash invested

The value of portfolio A is VA T

max X

ST ,0

De

value
of asset

payoff on 1unit
of the put option

VA T

ST

max X , ST

De

rT

accumulated
reinvested
dividends
rT

accumulated
reinvested
dividends

since max ST , X

X it follows that VA T

VB T

If this is true at time t=T it must also be true at time t = 0

If not you could buy portfolio A and short sell B and hold till maturity for
a guaranteed risk free profit.
It follows that VA 0 VB 0 and hence p S0
so that p D Xe rT S0

Xe

rT

42

PART 4:
BS Model and the replicating and self financing portfolio

The B.S. model was based on the idea that you can create a
dynamically adjusted portfolio comprised of a position in the
stock and a position in a risk free bond that will
provide the same payoff as the option at maturity
cost a certain amount of money to establish
not cost any extra money as the portfolio is adjusted over time.
If we need to "rebalance" the portfolio by changing the mix of
bonds and shares then the cost of the new portfolio is provided
by liquidating the old portfolio. The strategy is "self financing"
The model is based on the assumption of perfect markets, along
with some other assumptions:
no taxes
no transaction costs
can borrow or lend any amount of money at the risk free rate
not restrictions on short selling shares or bonds
all assets are perfectly divisible (you can hold fractional or
negative amounts)
stock price follows a continuous process called geometric
brownian motion (no jumps in share price)
The number of units of the underlying share you should hold in
the replicating portfolio is called the "option delta" or the "hedge
ratio"
For a long (i.e. bought) call option the hedge ratio is the
coefficient of S in the BS formula
43

S N (d1 )

Xe

hedge
ratio

rT

N (d 2 )
bond
value

The terms in the BS formula can be interpreted as follows:

N (d1 ) is the hedge ratio, which is the number of units of the
share to hold in the hedge portfolio that dynamically replicates
the option
N (d 2 ) can be thought of as the probability that the call option is
worth exercising at maturity
Xe rT N (d 2 ) is the value of the bonds held in the hedge
portfolio and a minus sign indicates borrowing (a short position
in the bond)
For a long position in a put option the formula is
p

Xe

rT

.N ( d 2 )

S .N ( d1 )

here the hedge ratio (the coefficient of S) is N ( d1 ) which means

we short sold N ( d1 ) units of the stock, and invested Xe rT .N ( d 2 )
dollars in risk free bonds.

44

PART 5: WORKED EXAMPLES

EX 1:

Explain how you could construct a sold put synthetically using the
following prices / market information:
$5 call option at a premium of $0.20, (X = $5.00)
$5 put option at a premium of $0.25, (X = $5.00)
and a forward price of $5.00 for the asset
Is there an arbitrage opportunity in these prices?
If so, describe the transactions that would achieve an arbitrage
SOLUTION
c - p = S Xe-rT = f = value of forward contract.
Thus p = c - f, so -p = f c.
Hence we can synthesize a sold put by selling calls and buying the
forward contract (the minus sign means short selling and a plus
sign means a long position).
If the forward price is F = $5 then we can enter into a forward
contract with delivery price X = $5 for no outlay of cash, as either
the holder of a long or the holder of a short position. This means
that f = 0 when X = $5.
Therefore we can do the following and make a risk free profit
(arbitrage profit):
create a synthetic long put position by
selling the forward and buying the call, for a net cost of $0.20
sell the put for $0.25
This creates an up front profit of $0.05 per put option.
At maturity the cashflows on all of the contracts cancel out.

45

This analysis ignores transaction costs and bid offer spreads.

When these are taken into account, it may eliminate or at least
reduce the arbitrage profit.
EX2:
A CAPITAL GUARANTEED INVESTMENT PRODUCT
An Investment Company has guaranteed (in return for an
extra fee) to pay an earnings rate of 5%pa, over the next 2
years, on money invested into a unit trust / mutual fund.
The guarantee only applies at the end of the second year.
This means that the investor is entitled to cash in the
investment for his / her share of the value of the funds
assets in 2 years time and is guaranteed to make at least a
5 % return on the investment.
If the assets backing the fund make a return above 5% p.a.
then the investor gets this higher return, but if the asset
value should not grow at that rate, the investor still gets at
least a 5% return on the money invested over the 2 year
period.
The financial institution will charge a price to the investor for
this investment guarantee we will look at how they could
quantify the price to be charged, using the black scholes
formula for a put option.
Question 1
Assuming a volatility of 10%pa and a risk free rate of 9%pa
continuously compounded, determine the premium to be
charged for this investment guarantee using the appropriate
Black Scholes Formula. Ignore expenses and tax.
46

Question 2
Redo the above calculations using
(a) a revised volatility of 20%pa (& risk free rate =9%)
(b) a revised interest rate of 19%pa (& volatility of 10%).
Comment on the results
Solution

(1) If the amount paid in by the customer was S0 and the

value of the unit fund at time 2 is ST then the guaranteed
maturity payment in 2 years time is
max(ST, S0 1.052)
= ST + max(ST - ST, S0 1.052 - ST)
= ST + max(0, S0 1.052 - ST)
= ST + max(0, X - ST)
where X = S0 1.052
This is a payoff comprised of
the value of the unit fund with no guarantee ( the ST
part of the payoff) plus
the payoff from a put option on the unit fund with a
strike price of X = S0 1.052 (the payoff max(0, S0
1.052 - ST))
We can use the Black Scholes put option formula to derive
a formula for the cost of the guarantee G
The formula is
G

S0 1.052 e

0.09 2

d2

S0 N

d1

or
G

S0 1.052 e

0.09 2

d2

1.00 N

d1
47

Where
ln
d1

S0
S0 1.052

ln 1.05

0.1 2
1
0.09
0.1
2
0.1

1
0.1
2

0.09

which is independent of S, and

d2

d1 0.1

2 which is also independent of S

Calculations:
We shall do the calculation assuming the unit fund has a
(spot) value of $1.00 at the start of the 2 year period i.e.
the investor started off with a $1.00 investment.
The value of the put option with a strike price of $1.1025
is $0.0235, as shown below.
Thus we find that G = P 0.0235 i.e. the guarantee is
going to cost the customer an additional 2.35% on top of
the amount invested
(2) The calculations for 3 sets of valuation assumptions are set
out below.
Looking at the results we see that increasing the volatility
increases the guarantee charge substantially and increasing
the interest rate lowers it. The result is more sensitive to a
change in volatility than to a change in the interest rate.

48

INPUTS

INPUTS

INPUTS

risk free int rate

volatility
term to maturity
spot price
strike price

9.00%
10.00%
2.0000
$1.00000
$1.10250

9.00%
20.00%
2.0000
$1.00000
$1.10250

19.00%
10.00%
2.0000
$1.00000
$1.10250

d1
d2
N(d1)
N(d2)
N(-d1)
N(-d2)
C
P

Results
0.65351
0.51208
0.74328
0.69570
0.25672
0.30430
0.10262
0.02351

Results
0.43282
0.14998
0.66743
0.55961
0.33257
0.44039
0.15209
0.07298

Results
2.06772
1.92630
0.98067
0.97297
0.01933
0.02703
0.24709
0.00105

49

Reverse Engineering Case Study:

GOLD REPURCHASE AGREEMENT
A large bank is also a gold bullion dealer and it is
considering introducing a five year 100 ounce gold
repurchase contract to support its bullion sales.
Under this contract the buyer buys gold at the current
market price and the bank / dealer guarantees to:
repurchase the gold at the original purchase price at the
end of 5 years if the market price of gold at that time is
less than the original purchase price, but
If the market price of gold is above the original purchase
price then the dealer has the right under the contract to
buy 40% of the gold at the original purchase price and
the remaining 60% of the gold at the current market price.
Each repurchase agreement will be for 100 ounces of gold
and all prices and payments are made in US dollars.
For example
an investor buys 100 ounces of gold at US$340 per ounce
(i.e. $US34,000 for a 100 ounce contract)
if the price rose to US$500 / oz then the dealer would buy
40 oz @ $US$340 and 60 oz @ US$500.
If the price fell below US$340 /oz then the dealer would
buy the full 100 oz at US$340 per oz.

50

Scenario:
You are an investor and you have been approached by a
representative (a Mr Devious) of the bank about investing in
this derivative security. Mr Devious is extremely keen on
selling this security to you so much so that you become
suspicious that this is not really such a great deal after all.
Assume that
current gold price is US$340 / oz
5 year AAA rated zero coupon bonds are trading at a yield
of 13.5%pa
5 year at the money 100 oz gold call options are available
in the market at a price of $US24,500
the dealer meets any holding and insurance costs
associated with physical holding of the gold
QUESTION:
Based on the above information determine whether or not
you consider the terms of the repurchase agreement to be
fair to you as the purchaser. (are you being ripped off if you
accept this deal on these terms?)

51

APPROACH TO SOLVING THE PROBLEM:

we write down an expression for the payoff to a purchaser
of the contract at the end of 5 years,
then we try to re express it as something involving a call
option payoff and / or other payoffs we know how to
value.
then see whether the purchaser could reproduce the
payoff more cheaply by synthetically creating the
repurchase agreement with other available market
instruments
the issue to consider is whether the purchaser being
charged a fair price for the payoff they receive
Solution:

From the perspective of a purchaser the contract represents

(a) an initial investment of S = X = $34000
(S is the current cost of 100 oz of gold)
AND

(b) a payoff in 5 years of

X if ST < X
0.4 X + 0.6 ST if ST >X
Where ST = value of 100 oz of gold at the end of 5 years

52

We can rewrite this payoff as X + 0.6

max(0, ST -X)

Because the payoff is

0.4
0.4

X + 0.6
X + 0.6

= 0.4
= 0.4

X + 0.6
X + 0.6

X if ST < X
ST if ST > X
max(X, ST)
(X + max(X-X, ST -X))

= 0.4 X + 0.6 X + 0.6 max(0, ST - X)

= X + 0.6 max(0, ST -X)
This payoff is equivalent to the payoff on
a zero coupon bond with a face value of X = $34000 and
0.6 units of an at the money call option on 100 oz of gold with a
strike price of X = $34000
As such we can value the payoff of the contract and then compare
it with the price to be charged to enter the contract. The value of
the payoff is
X
1.1355

0.60 C

34000
1.1355

0.6 24500 32750.9

This is less than the price being charged by the bullion dealer,
which was $34000.
This means the purchaser could achieve the same payoff more
cheaply by investing in a 5 year zero coupon bond and investing
in an at the money call option on gold.
The repurchase agreement upfront price means the purchaser is
paying too much for the option contract and could do better by
accessing markets directly. Thus the terms of the repo are not
fair to the purchaser.
53