15.

401 Recitation
5: Options

Learning Objectives

R i of Review f Concepts C t

o Payoff profile o Putcall parity y o Valuation of options o Binomial tree

Examples

o Payoff replication o Arboreal Corporation

2010 / Yichuan Liu

Review: elements of a call/put option

Type:

o Call: holder has the right but not the obligation to buy o Put: holder has the right but not the obligation to sell

Q Quantity tit of f the th underlying d l i asset: t

o Usually one share of stock with current price S

Strike/exercise price (K) Expiration date (T) Style:

o European: can only be exercised at T o American: can be exercised at any time between 0 and T.
2010 / Yichuan Liu 3

Review: payoff profile

Call
Payoff Payoff

Put

Long

45 K Asset Price

45 K Asset Price

45

Asset Price

45

Asset Price

Short

Payoff
2010 / Yichuan Liu

Payoff
4

Review: payoff profile

The payoff of a portfolio of options is the sum of payoffs of the individual components:
1 put 1 call Straddle

+
K1 1 call @ K1 2 call @ K1 K1

=
K1 1 call @ K3 Butterfly spread

+
K1
2010 / Yichuan Liu

+
K2 K3

=
K1 K2 K3
5

Review: putcall parity

Two portfolios with identical payoffs

1 call @ K Bond w/ FV=K

Portfolio 1

+
K 1 put @ K

=
K 1 stock

Portfo olio 2

+
K

=
K

2010 / Yichuan Liu

Review: putcall parity

No arbitrage implies that the two portfolios must have the same cost:
C PV K P S K PS C T 1 r

This is the putcall parity. Note: the call and put must have the same exercise price (K).

2010 / Yichuan Liu 7

Review: value of an option

Value of call price ( (K) ) Strike p
Pric ce of options

Value of put Increase Decrease Increase Increase Decrease

Decrease Increase Increase Increase Increase

Price of underlying asset (S) Volatility of the underlying asset () Maturity (T)
Price of underlying asset

Interest rate (r)

2010 / Yichuan Liu

Review: binomial tree

Idea: if there are only two states of the world next period, we can price options given the underlying asset and a riskfree asset (bond) by replication:
Underlying Asset p S 1p Sd Su B/(1+r) B Bond B C Cd Call Cu

2010 / Yichuan Liu

Review: binomial tree

Replication:
CF at t = 0 CF at t=1 (up state) A x Su B A x Su + B = Cu CF at t=1 (down state) A x Sd B A x Sd + B = Cd

A shares of underlying asset Bond (FV=B) Total Replication

A x S B/(1+r) A x S B/(1+r) =C

o A = ( C u C d ) / ( Su Sd ) o B = C u A x Su o C = A x S + B/(1+r)
2010 / Yichuan Liu 10

Review: binomial tree

Equivalently, we can solve for the riskneutral probability, q:

qSu 1 q S d q S 1 r

Then,

qCu 1 q Cd C 1 r

Note: q is not related to the state probability p. In fact, , p is not used in the pricing g of C.
11

2010 / Yichuan Liu

Example 1: payoff replication

How would you replicate the following payoff profile using only call and put options?
a)

10

15

25

30

b)
8

8
2010 / Yichuan Liu

12

16

20
12

Example 1: payoff replication

Answer:
a) Long 1 call (K=10) Short 1 call (K=15) Sh t 1 call Short ll (K (K=25) ) Long 1 call (K=30) b) Long 1 put (K=8) Short 1 call (K=8) Long 2 calls (K=12) Short 1 call (K=20) (K 20)

2010 / Yichuan Liu

13

Example 2: Arboreal Corporation

Arboreal Corporations stock price is currently $102. At the end of 3 months it will be either $120 or $90. The 3month spot rate is 2%. What is the value of a 3month European call option with a strike price of $110?
Stock $120 $102 $90 C $0 Call $10

2010 / Yichuan Liu

14

Example 2: Arboreal Corporation

The call can be replicated with:

o Long 1/3 stock: costs $34 o Short bond with FV=30: costs$30/(1+2%) =$29.41

Th price The i of f th the call ll must tb be

C 34 29.41 $4.59

Alternatively, we can solve for the riskneutral Alternatively probability: 120q 901 q
1 2% 102 q 0.468

The price of the call is then

100.468 01 0.468 $4.59 C $4 59 1 2%

2010 / Yichuan Liu

15

MIT OpenCourseWare http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

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