UNDERSTANDING OPTIONS Robert Kolb ® John Wiley & Sons, Inc. New York ¢ Chichester # Brisbane ¢ Toronto * Singapore‘This text is printed on acidtree paper. Copyright © 1995 by Robert Kolb Fortons ofthis book have been previously published under the titles Understanding ‘Swaps, South-Western, 1989, and The Swaps Market, Second Edition, Kell Publishing, 1993, All rights reserved, Published simultaneously in Canada, Reproduction or translation of any part ofthis work beyond that permited by Section 107 or 108 ofthe 1976 United States Copyright Act without the permission of the copyright owner is unlawful, Requests for permission or further information should be addressed to the Permissions Department, Fohn Wiley & Sons, Inc This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding thatthe publisher isnot ‘engaged in rendering legal, accounting, of other professional services. If legal advice or ‘other expert assistance is required, the services of a competent professional person should be sought, FROM A DECLARATION OF PRINCIPLES JOINTLY ADOPTED BY A COMMITTEE OF THE AMERICAN BAR ASSOCIATION AND A COMMITTEE OF PUBLISHERS. Library of Congress Casaoging-in-Publication Data: Kolb, Robert W. Understanding options / Robert Kolb, P. om. ~ (Wiley marketplace book series) Includes bibliographical references and index. ISBN 0-471-08554-5 1, Options (Finance) 1, Tile. I. Series, HG6O24.A3K653. 1995 38263228-de00 9434050To Lori upon whom I exercised the call option I held on her before she exercised the put option she held on mePreface In Understanding Options, we build our knowledge from the simple to the more complex. Chapter 1 introduces the essential institutional features of the U.S. options market. Chapter 2 begins the analytical por- tion of the book by exploring popular trading strategies and their payoffs at expiration. When an option is at expiration, there is no difference between an American and European option. (An American option can bbe exercised at any time; a European option can be exercised only at expiration.) Also, it is easy to specify what the price of an option must be when it is about to expire. Chapter 3 uses no-arbitrage arguments to place rational bounds on options prices. We assume that traders in options markets are moneyhungry and not foolish. Such traders will exploit any trading opportunity that offers a sure profit with no risk and no invest- ‘ment. By assuming that no such profit opportunities exist, we learn much about what options prices can rationally prevail. The bounds developed in Chapter 3 follow solely on our assumptions of greed and the absence of stupidity. These boundaries do not provide exact options prices, but they specify the range in which the exact price must lie. ‘To specify the exact price that an option should have requires a model ‘of how stock prices can move. Chapter 4 develops formal pricing models for European options. The price of an option depends on the character- istics of the underlying instrument, notably upon the way in which the price of the underlying instrument can vary. We consider the Binomial Model and eventually elaborate this model into the Black-Scholes Model. ‘Chapter 4 also explores the Merton Model. Thus, in Chapter 4 we begin bby assuming that the stock price can change only once before the option expires and that the stock price can rise or fall only by a certain percentage. Next, we allow slightly more realism by allowing the stock price to change more frequently before the option expires. Finally, we allow the stock price to change continuously. Under each circumstance, we can say pre viPreface cisely what the option price should be. By following this building block approach, we come to understand the factors that affect options prices. In addition, we can understand the principles of options pricing without suffering mathematical fatigue. At the end of Chapter 4, we are able to specify prices for options that conform very closely to the prices we observe in the marketplace. Chapter 5 is a companion to Chapter 4 in that it explores the options sensitivities of the Black-Scholes and Merton. models. These sensitivities (DELTA, THETA, VEGA, GAMMA, and RHO) are extremely important in using options to hedge or in controlling the risk of speculative strategies. Chapter 6 develops an extensive treatment of American options. It includes coverage of American puts, the exact American call option pric- ing formula, the analytic approximation approach to pricing American options, and the binomial model as it applies to options with and without dividends. The coverage of the binomial model for American options with dividends includes continuous dividend yields, episodic dividend yields, and cash dividends, Chapter 7 explores stock index options, foreign currency options, and ‘options on futures. In doing so, it covers both European and American options. The chapter begins by focusing on European options and the application of the Black-Scholes and Merton models to these options. ‘Soon the discussion shifts to American options, and the chapter applies the analytic approximation technique, the exact American call option pricing model, and the binomial model to pricing American options with and without dividends. ‘Chapter 8 shows that the principles of options pricing can be extended ‘to analyze corporate securities. The chapter considers the options features of common stock, straight bonds, convertible bonds, callable bonds, and warrants. One of the most useful features of this chapter is that it illus- trates the power of the options approach to the world of finance.Acknowledgments The preparation of this book has benefitted from the assistance of a ‘number of people. Andrea Coens provided timely editing and many use- ful suggestions about the book. Phil Rizika and Adam Carlin reviewed the manuscript and software, and Evelyn Gosnell prepared the graphical illustrations. ‘The students in my futures and options classes in Fall 1993 studied from the pageproofs of this book, giving me a chance to test it in the classroom before publication. A large number of scholars around the country contributed their time and effort to help improve the book. The following individuals commented on the book and made numerous sug- gestions for improvement. My profound thanks to them all: Peter Alonzi ‘Anthony Byrd Chicago Board of Trade Tulane University Fernando Alvarez Alyce Rita Campbell Babson College University of Oregon Michael Auster ‘Chao Chen University of Nevada California State University pees Rupes Universit University of South Alabama tuigers sity Ray Chiang Laurence E. Blose i ; University of Mi University of North Carolina eee Jin Wook Choi Gerald Buetow Chicago Institute of James Madison University Futures and Options Joe Brocato Kewn Victor Chow Tarleton State University West Virginia UniversityAndreas Christof ‘Azusa Pacific University Dennis Debrecht Carroll College Karen Craft Denning West Virginia University David Ding Nanyang Technological University-Singapore Richard J. Dowen Northern Ilinois University Don Fehrs University of Notre Dame James H. Filkins University of St. Thomas Hung Gay Fung University of Baltimore Dean Furbush Economists Incorporated Gerry Gay Georgia State University Nicolas Gressis Wright State University G. D’Anne Hancock University of Missouri T. Harikumar University of Alaska Delvin Hawley University of Mississippi Shantaram Hegde University of Connecticut Anthony Herbst University of Texas Acknowledgments Joanne Hill Goldman Sachs Marcus Ingram Clark Atlanta University Amecta Jaiswal University of St. Thomas Kurt R. Jesswein Laredo State University Joan Junkus DePaul University Kandice Kahl ‘Clemson University Dongcheol Kim Ruigers University Dorothy Koehl University of Puget Sound Gary Koppenhaver Towa State University William Kracaw Pennsylvania State University Paul Laux University of Texas—Austin ©. Jevons Lee Tulane University Chun Lee Southern Illinois University Jae Ha Lee University of Oklahoma Jay Marchand Westminster College Michael B. Madaris University of Southern Mississippi AG. Malliaris Loyola University of Chicago