Basic Option Pricing

Relationships at Expiry
 At expiry, an American call option is worth the
same as a European option with the same
characteristics.
 If the call is in-the-money, it is worth S – E.
T

 If the call is out-of-the-money, it is worthless.

CaT = CeT = Max[ST - E, 0]

7-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Basic Option Pricing
Relationships at Expiry
 At expiry, an American put option is worth the
same as a European option with the same
characteristics.
 If the put is in-the-money, it is worth E - S .
T

 If the put is out-of-the-money, it is worthless.

PaT = PeT = Max[E - ST, 0]

7-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Basic Option Profit Profiles
Profit

If the call is in-the-

money, it is worth Long 1 call
ST – E.
If the call is out-of-
the-money, it is
worthless and the –c ST
0
buyer of the call E + c0
loses his entire E
investment of c0. Out-of-the-money In-the-money
loss
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 Basic Option Profit Profiles
Profit

If the call is in-the-

money, the writer
loses ST – E.
If the call is out-of- c0
the-money, the
writer keeps the ST
option premium. E + c0
E
short 1
loss Out-of-the-money In-the-money call
7-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Basic Option Profit Profiles
Profit
If the put is in-
the-money, it is E – p
0
worth E – ST.
The maximum
gain is E – p0
If the put is out-
of-the-money, it ST
– p0
is worthless and
the buyer of the E – p0 long 1 put
put loses his
E
entire investment In-the-money Out-of-the-money
of p0. loss
7-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Basic Option Profit Profiles
Profit
If the put is in-
the-money, it is
worth E –ST. The
maximum loss is
– E + p0
p0
If the put is out-
of-the-money, it ST
is worthless and
the seller of the E – p0 short 1 put
put keeps the E
option premium– E + p
0
of p0. loss
7-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Example
Profit
 Consider a call option
on £31,250.
 The option premium Long 1 call
is $0.25 per pound on 1 pound
 The exercise price is
$1.50 per pound.
–$0.25 ST

$1.75
$1.50

loss
7-7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Example
Profit
 Consider a call option
on £31,250.
 The option premium Long 1 call
is $0.25 per pound on £31,250
 The exercise price is
$1.50 per pound.
–$7,812.50 ST

$1.75
$1.50

loss
7-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights res
 Example
Profit What is the maximum gain on this put option?
$42,187.50 $42,187.50 = £31,250×($1.50 – $0.15)/£
 Consider a put option on At what exchange rate do you break even?
£31,250.
 The option premium is
$0.15 per pound

–$4,687.50 ST
 The exercise price is $1.35
$1.50 per pound. Long 1 put
$1.50 on £31,250
loss $4,687.50 = £31,250×($0.15)/£
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