Professional Documents
Culture Documents
Banikanta Mishra
Xavier Institute of Management
Bounds on Option Prices
Call price cannot exceed the Stock Price;
if it does, one can make money by writing covered calls.
Similarly, price of a put cannot exceed PV of exercise price X;
if it does, write a put and deposit the premium @ RF rate.
Therefore, the price of a European put can’t exceed PV of X.
European C must at least be S0 - PV(X) [ -D if dividends there];
or else, short the share, buy a call, and lend PV(X) at t=0,
receive X, exercise call to pay X and get the share to deliver
or receive X, buy the share at cheaper S, deliver it, pocket X-S
European P must at least be PV(X) - S0; [+D if dividends there]
or else, buy the share, buy a put, and borrow PV(X)
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Bounds, in Brief
c =< S0 (or else, buy the stock and sell the call)
c >= S0 - X e-rt (or else, short share, buy call, lend X e-rt)
c >= S0 - X e-rt - D
p = < X e-rt (or else, sell the put and lend proceeds @r)
p >= X e-rt - S0 (or else, buy share, buy put, borrow X e-rt)
p >= X e-rt - S0 + D
It does not pay to exercise an American call before maturity.
It may pay to exercise an American put before maturity.
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Put-Call Parity
Inv at t=0 CF at t=T
ST > X ST < X
Buy Stock S0 ST ST
Buy a Put P 0 X - ST
Net S0 + P ST X
Buy a Call C ST - X 0
Net C + X e-rt ST X
Law of One Price => S0 + P = C + X e-rt
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Squared/Hedged Put-Call Position
Buy a Share -S0
Write a Call +C
Borrow PV(X) +PV(X)
Buy a Put -P
=> You will have no CF at maturity
As you either exercise put to get X and repay loan OR
Deliver your share against the call exercise, get X, repay loan
=> -S0 + C + PV(X) - P = 0 => C = P + S0 - PV(X)
American C - P must lie between S0 - X and S0 - PV(X)
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Valuing a Call Option
Given Data
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Computing Call Price C
t=0 (now) t=T
Action Taken Cash Flow Action Taken Cash Flow
STRATEGY-1 If ST=340 If ST=260
Buy ONE Share -300 Sell the Share 340 260
STRATEGY-2
Exercise Price - +
Time to Expiration Q + +
Volatility l or u + +
Riskfree Intrest-Rate r + -
Dividends - +
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The Binomial Model
Portfolio: Portfolio Value
Long D shares
uS0
Short 1 option
Value = DS0 –f fu D uS0 – fu
Equal iff
S0 fu fd
D
f uS 0 dS 0
dS0
D dS0 - fd
fd
Should equal PV of which equals e-RT (D uS0 – fu) = e-RT (D dS0 – fd)
e RT d
=> f = e-RT [p fu + (1-p) fd] where p
ud
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Volatility Matching
uS0
p*
Expected Share Price =
S0 p* uS0 + (1-p*) dS0
e DT d
1-p* => p
dS0 ud
Expected Future Value S0 eDt
s Dt
p* u2 + (1-p*) d2 - [p* u + (1-p*) d]2 = s2 Dt => u e and d e s Dt
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RN Valuation: Another Example
To value a one-year call @X=230.
Now Date 1
S = 200 280 or 180
Write 1 Call (X = 230) -50 0
Buy 1/2* Shares @ 200 140 90
Borrow Rs.75 @RF=20% -90 -90
Total CF: C - 25 0 0
No Arbitrage => C - 25 = 0 => C = 25
* (50 - 0) / (280 - 100) = 1/2
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Binomial Model: Matching bs
Write 1 Call (X = 230) Beta = bc => Wtd Beta = -bc (C/I)
Buy 1/2 Shares @ 200 Beta = bs => Wtd Beta = bs (100/I)
Total Investment = I Overall Beta= -bc (C/I) + bs (100/I)
=> bc = bs (100 / C) = 4 bs if C = 25
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Inferring C in an RN World
Now Date 1
S = 200 280 or 180
p 1-p
Expected Share Price = p x 280 + (1-p) 180
Must = S x (1 + RF) = 240
=> p = 0.6 1-p = 0.4
Expected Loss from writing a call= p x 50 + (1-p) 0
= 30
C = Call Price = PV of 30 = 25
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C in a Risk-Averse World
Now Date 1
S = 200 280 or 180
0.7 0.3
Expected Share Price = 0.7 x 280 + 0.3 x 180
= 250
Must = 200 x (1 + RRRs)
So, RRRs = 25%
=> RPs = bs (RM - RF) = 5% => bc (RM - RF) = 20%
=> RRRc= RF+ 20% = 40% => C= Exp Loss / (1+40%)
Expected Loss from writing a call= 0.7 x 50 + 0.3 x 0 = 35
=> C = 35 / 1.40 = 25
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