ADVANCED CORPORATE

FINANCE
Instructor:
Dr. Kumail Rizvi

Kumail Rizvi, PhD,CFA, FRM

OPTIONS

OPTIONS

Call option writer is obligated to sell the asset if the

option is exercised
Put option writer is obligated to buy the asset if the option
is exercised

Kumail Rizvi, PhD,CFA, FRM

A call option is an option to buy a certain asset by a

certain date for a certain price (the strike price)
A put option is an option to sell a certain asset by a
certain date for a certain price (the strike price)
Buyer has the right to exercise the option; the seller
is obligated

TYPES OF OPTION

Kumail Rizvi, PhD,CFA, FRM

OPTIONS VS. FUTURES/FORWARDS

A futures/forward contract gives the holder the
obligation to buy or sell at a certain price
An option gives the holder the right to buy or sell at
a certain price
Unlike forwards and futures, options allow a firm to
hedge downside risk, but still participate in upside
potential
Pay a premium for this benefit

Kumail Rizvi, PhD,CFA, FRM

NOTATION
European call
option price

C:

American call option

price

p:

European put
option price

P:

American put option

price

S0:

Stock price today

ST:

K/X:

Strike price

Stock price at option

maturity

T:

Life of option

D:

s:

Volatility of stock
price

PV of dividends paid
during life of option

Risk-free rate for

maturity T with cont.
comp.

Kumail Rizvi, PhD,CFA, FRM

c:

OPTION PAYOFF OR PROFIT????

Kumail Rizvi, PhD,CFA, FRM

CALL OPTION PAYOFF TO LONG

Kumail Rizvi, PhD,CFA, FRM

PROFIT TO LONG CALL BUYER

Kumail Rizvi, PhD,CFA, FRM

OPTION POSITIONS

Kumail Rizvi, PhD,CFA, FRM

Long call
Long put
Short call
Short put

LONG CALL
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months

20

10
0
-5

70

80

90

100

Terminal
stock price ($)
110 120 130

Kumail Rizvi, PhD,CFA, FRM

30 Profit ($)

SHORT CALL
Profit from writing one European call option: option
price = $5, strike price = $100

5
0
-10
-20

-30

110 120 130

70

80

90 100

Terminal
stock price ($)

Kumail Rizvi, PhD,CFA, FRM

Profit ($)

LONG PUT
Profit from buying a European put option: option price
= $7, strike price = $70

20
10
0
-7

Terminal
stock price ($)
40

50

60

70

80

90 100

Kumail Rizvi, PhD,CFA, FRM

30 Profit ($)

SHORT PUT
Profit from writing a European put option: option price
= $7, strike price = $70

7
0
-10
-20
-30

40

50

Terminal
stock price ($)

60

70

80

90 100

Kumail Rizvi, PhD,CFA, FRM

Profit ($)

PAYOFFS FROM OPTIONS

WHAT IS THE OPTION POSITION IN
EACH CASE?
K = Strike price, ST = Price of asset at maturity
Payoff

K
K

ST

Payof
f

ST
Payoff

K
K

ST

ST

Kumail Rizvi, PhD,CFA, FRM

Payoff

ASSETS UNDERLYING
EXCHANGE-TRADED OPTIONS
Kumail Rizvi, PhD,CFA, FRM

Stocks
Foreign Currency
Stock Indices
Futures

SPECIFICATION OF
EXCHANGE-TRADED OPTIONS
Kumail Rizvi, PhD,CFA, FRM

Expiration date
Strike price
European or American
Call or Put (option class)

TERMINOLOGY

At-the-money option
In-the-money option
Out-of-the-money option

Kumail Rizvi, PhD,CFA, FRM

Moneyness :

Upper Bound, Minimum and Lower Bound

Kumail Rizvi, PhD,CFA, FRM

OPTION VALUE

FACTORS INFLUENCING OPTION VALUE

Kumail Rizvi, PhD,CFA, FRM

FACTORS INFLUENCING OPTION VALUE

Kumail Rizvi, PhD,CFA, FRM

Higher the interest rate, it means the present value of strike price is less,
so the prob. of positive payoff is larger (S X), you need less increase in
price to make your payoff positive.
Higher the interest rate, the present of strike price will be less, so the prob.
of positive payoff is less (X S), you need much fall in price to make your
payoff positive.

AMERICAN VS. EUROPEAN OPTIONS

Kumail Rizvi, PhD,CFA, FRM

An American option is worth at least as much as the

corresponding European option
Cc
Pp

OPTION VALUE AT EXPIRATION

Intrinsic Value / Payoff

Kumail Rizvi, PhD,CFA, FRM

OPTION VALUE PRIOR TO EXPIRATION

Option price is usually greater than intrinsic

value prior to expiry

The time value reflects the potential for the

options intrinsic value at expiration to be greater
than its current intrinsic value
At expiration, of course, the time value is zero.

Kumail Rizvi, PhD,CFA, FRM

Option Price = Intrinsic Value + Time Value

MINIMUM AND MAXIMUM VALUES OF

OPTIONS

Kumail Rizvi, PhD,CFA, FRM

MAXIMUM VALUE / UPPER BOUNDS

Kumail Rizvi, PhD,CFA, FRM

SUMMARY

Kumail Rizvi, PhD,CFA, FRM

EXAMPLE:

Kumail Rizvi, PhD,CFA, FRM

SOLUTION:

Kumail Rizvi, PhD,CFA, FRM

PUT-CALL PARITY

Kumail Rizvi, PhD,CFA, FRM

In financial mathematics, putcall parity defines

a relationship between the price of a European
call option and European put option in
a frictionless market both with the
identical strike price and expiry, and the
underlying being a liquid asset.

PUT CALL PARITY

Kumail Rizvi, PhD,CFA, FRM

CONTINUOUS TIME FORMAT

Kumail Rizvi, PhD,CFA, FRM

PUT-CALL PARITY
If the two positions are worth the same at the
end, they must cost the same at the beginning
This leads to the put-call parity condition
S + P = C + PV(E)
If this condition does not hold, there is an
arbitrage opportunity
Buy the low side and sell the high side
You can also use this condition to find the value
of any of the variables, given the other three

Kumail Rizvi, PhD,CFA, FRM

CALL AND SYNTHETIC CALL

Kumail Rizvi, PhD,CFA, FRM

PUT AND SYNTHETIC PUT

Kumail Rizvi, PhD,CFA, FRM

ARBITRAGE OPPORTUNITY
Call Price = $7.50
Put Price = $4.25
Exercise Price on Underlying = $100
Current Price of Underlying = $99
Risk Free Rate = 10 percent
Time to Expiration = Half a Year or 6 months
Requirements

Kumail Rizvi, PhD,CFA, FRM

Construct Fiduciary Call and Protective Put

Check Whether the Put Call Parity Exists or not
Suggest the Appropriate Arbitrage Strategy
Calculate and Prove the amount of Arbitrage Profit

OPTION PRICE SENSITIVITIES

Kumail Rizvi, PhD,CFA, FRM

BSM

STOCK PRICE MOVEMENT ACCORDING TO

GBM AND WEINER PROCESS

S
1 2
ln( ) (r s )T
X
2
d1 =
s T

d2 = d1 - ss T

FINAL BSM EQUATIONS FOR CALL AND

PUT

Kumail Rizvi, PhD,CFA, FRM