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Option
A contract that gives the holder the right - not the obligation to buy (call), or to sell (put) a specified amount of the underlying asset, at a set exchange rate and expiration date.
Glossary of terms
The investor buying the option is called the buyer or holder.
Options are traded on options exchanges. The number of outstanding option contracts at any time is called open interest.
American options can be exercised at any time during their life span
Like with any other financial asset, the option premium or market value or option price is a function of future expected cash flows.
Notation
C: price of an American call c: price of an European call P: price of an American put p: price of an European put E: exercise or strike price S: stock price before maturity ST: stock price at maturity T: time to maturity r: risk-free rate
At expiration:
C = max[0, (ST -E)]
Before expiration
Upper bound: A call cannot sell for more than the stock: C < S and c < S
Lower bound: C > = max[0, (S -E)] c > = max[0, (S - E/(1+r)T)]
Assume the Exxon December 26 call struck at $80 sells for $1. It is now December 17. The stock of Exxon is at $83/share. The risk-free rate is 6%.
If the option is American, buy the call for $1, exercise it and make $3
Arbitrage profit = $2
When
Action
Short one share of Exxon Today, December 17 Buy one call Lend $79.8835 at 6% for 9 days
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days
net CF = $2.116
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days Collect $79.8835(1.06)
0.025
Cash flow $83 -$1 -$79.8835 net CF = $2.116 $80 -$80 0 net CF = 0
December 26
Exercise your call and buy one Exxon share at $80 Return the Exxon share you borrowed
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days Collect $79.8835(1.06)
0.025
Cash flow $83 -$1 -$79.8835 net CF = $2.116 $80 -$80 0 net CF = 0
December 26
Exercise your call and buy one Exxon share at $80 Return the Exxon share you borrowed
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days Collect $79.8835(1.06)
0.025
Cash flow $83 -$1 -$79.8835 net CF = $2.116 $80 -$80 0 net CF = 0
December 26
Exercise your call and buy one Exxon share at $80 Return the Exxon share you borrowed
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days Collect $79.8835(1.06)
0.025
Cash flow $83 -$1 -$79.8835 net CF = $2.116 $80 -$80 0 net CF = 0
December 26
Exercise your call and buy one Exxon share at $80 Return the Exxon share you borrowed
Action Short one share of Exxon Buy one call Lend $79.8835 at 6% for 9 days Collect $79.8835(1.06)
0.025
December 26
Exercise your call and buy one Exxon share at $80 Return the Exxon share you borrowed
net CF = 0
Analysis
We have created a riskless portfolio: the terminal cash flow is zero, regardless of the stock price, while the up-front cash flow is positive.
At expiration:
P = max[0, (E -ST)]
Before expiration
Upper bound: A put cannot sell for more than the stock: P < S and p < S Lower bound: P > = max[0, (E - S)]
Boundary violations
By now, we know that if price boundaries are violated, we might be able to construct an arbitrage portfolio.
Assume the Exxon December 26 put struck at $80 sells for $2. It is now December 17. The stock of Exxon is at $75/share. The risk-free rate is 6%.
If the option is American, we can buy it for $2 and exercise it.
net CF = 0
Analysis
We have created a riskless portfolio: the terminal cash flow is zero, regardless of the stock price, while the up-front cash flow is positive.
Intrinsic value - how much the call is worth if exercised. Market value, price, or premium - the price at which the call can be sold/purchased in the market. Time value - the difference between premium and intrinsic value
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Remark
As expiration approaches, the market value of the option converges to its intrinsic value At the same time, time value converges to zero
Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends
European call + ? + + -
European put + ? + +
American call + + + + -
American put + + + +
Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends
European call + ? + + -
European put + ? + +
American call + + + + -
American put + + + +
Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends
European call + ? + + -
European put + ? + +
American call + + + + -
American put + + + +
Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends
European call + ? + + -
European put + ? + +
American call + + + + -
American put + + + +
Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends
European call + ? + + -
European put + ? + +
American call + + + + -
American put + + + +
Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends
European call + ? + + -
European put + ? + +
American call + + + + -
American put + + + +