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Option Prices
chapter 10
Notation
c : European call option C : American Call option
price
p : European put option
price
S0 : Stock price today
X : Strike price
T : Life of option
: Volatility of stock
price
price
P : American Put option
price
ST :Stock price at option
maturity
D : Present value of
dividends during options life
r : Risk-free rate for
maturity T with cont comp
r
D
?
+
+
+?
+
+
+
+
+
+
+
Intuition:
Lets look at the American call:
Payoff from exercising = MAX(Spot Strike, 0)
If the spot price :
the call is more valuable.
If strike price : the call is less valuable.
Time to maturity :
the call can produce unlimited gains,
losses are limited by its price. If t-t-m ,
gains can be higher
value of the call Volatility :
the call can produce
unlimited gains,
losses are limited by its price. If volatility ,
gains can be higher value of the call .
Interest rate : can be proven that the value
Dividends :
dividends reduce the stock price on the
ex-dividend
date. Bad for the value of the call
option. The higher the
dividend, the worse.
Intuition:
Time to maturity for European option:
Since European option cannot be exercised prior to expiration
date, the effect of time to maturity depends on the dividend
payment schedule
S0 c S0 - Xe -rT
Xe -rT p Xe -rT - S0
Examples:
(a)What is the lower bound for the price of a one-month put
option on a non-dividend-paying stock when the stock
price is $12, the strike price is $15, and the risk-free
interest rate is 6% per annum?
(b) What if you see that this put sells at $2? How can you
make arbitrage?
(c) What if you see that this put sells at $15? How can you
make arbitrage?
Examples:
(a)What is the lower bound for the price of a one-month put option on a non-dividend-
paying stock when the stock price is $12, the strike price is $15, and the risk-free
interest rate is 6% per annum?
Solution:
The price of this put can not be below
Xe -rT - S0 = 15e -.06(1/12) - 12 =$2.93
(b)What if you see that this put sells at $2? How can you make arbitrage?
t=0:
Borrow 15e -0.06*(1/12)=$14.925 and buy both the put and the
stock. Cash flow = $0.925>0
t=1/12:
Repay $15.
If ST <15 then exercise the put option (sell the stock for $15)
(cash flow = 15 - 15 =0)
If ST >15 then discard the option, sell the stock. (cash flow=ST -15 >0)
(c)What if you see that this put sells at $15? (p>Xe -rT) How can you make arbitrage?
t=0:
Write the put, invest 15e -0.06*(1/12)=$14.925.
Cash flow = $15-$14.925=$0.075>0
t=1/12:
Get $15 from investment.
If ST >$15 then the put will not be exercised. Cash flow = $15>0
If ST <X then pay X for the stock and sell it at ST. Cash flow = ST 0.
c + Xe -rT = p + S0
Arbitrage Opportunities
Suppose that
c =3
S0 = 31
T = 0.25
r = 10%
X =30
D=0
What are the arbitrage
possibilities when
p = 2.25 ?
p=1?
Arbitrage Opportunities
Problem: Suppose that c= 3, S0= 31, T = 0.25, r = 10%, X =30, D = 0
What are the arbitrage possibilities when p = 2.25 ? p = 1?
Solution: c + Xe -rT = p + S0
c + Xe rT = 3+30e .1(.25) = 32.26
If p=2.25: p + S0 = 2.25+31=33.25, So, c + Xe -rT < p + S0
The strategy:
1. Buy the call
2. Invest 30e .1(.25) =29.26
3. Short the put
4. Short the stock
Outcome:
Initial cash flow: -3-29.26+2.25+31=$0.99>0
If the stock price at expiration of the option >$30 the call will be
exercised. If it is less than $30, the put will be exercised. In either case,
the investor ends up using his $30 from investment to buy one
share
for $30 and use this share to close out the short position. Hence, the
cash flow at expiration is $0
Arbitrage Opportunities
Problem (cont): Suppose that c= 3, S0= 31, T = 0.25, r = 10%, X =30, D = 0
What are the arbitrage possibilities when p = 2.25 ? p = 1?
Solution: c + Xe -rT = p + S0
c + Xe rT = 3+30e .1(.25) = 32.26
If p=1: p + S0 = 1+31=32, So, c + Xe -rT >p + S0
The strategy:
1. Sell the call
2. Borrow 30e .1(.25) =29.26
3. Buy the put
4. Buy the stock
Outcome:
Initial cash flow: 3+29.26-1-31=$0.26>0.
As in the previous case, either the call or the put will be exercised (when
the stock price at expiration will be above or below $30 respectively.
The short call and long put option position therefore
leads to the
stock being sold for $30.00 just enough to repay the
debt. Hence,
the cash flow at expiration is $0
Arbitrage Opportunities
If
c + Xe -rT < p + S0
The strategy:
1. Buy the call; invest PV of the strike price at risk-free rate
2. Short the put, short the stock
If
c + Xe -rT > p + S0
The strategy:
1. Sell the call; borrow PV of the strike price
2. Buy the put; buy the stock
Practice problem
Problem: Suppose that c= 4, S0= 31, T = 0.25, r = 8%, X =30, D = 0
What are the arbitrage possibilities when p = 3?
Solution: c + Xe -rT = p + S0
c + Xe rT = 4+30e .08(.25) = 33.41
If p=3: p + S0 = 3+31=34, So, c + Xe -rT < p + S0
The strategy:
1. Buy the call, invest PV of the strike price at risk-free rate
2. Short the put, Short the stock
Outcome:
Initial cash flow: -33.41+34=$0.59>0.
If the stock price at expiration of the option >$30 the call will be
exercised. If it is less than $30, the put will be exercised. In either
case, the investor ends up buying one share for $30 using the
proceeds from his investment. This share can be used to close out the
short position. The cash flow is zero.
Early Exercise
An American call on a non-dividend
paying stock should never be exercised
early
c S 0 D Xe
p D Xe
rT
rT
S0
c + D+Xe -rT = p + S0
American options; D = 0
S0 - X C - P S0 - Xe -rT