Options

Chapter 12
Sections: 12.1 to 12.3
2
Options, Options Everywhere
All risky investments have embedded
options
Managers have the option to:
Cut back or abandon investments that go sour
Expand investments that turn out well
3
Options and Volatility (i.e. Risk)
The more volatile the investment, the
more valuable the option
Take advantage of favorable outcomes
Walk away from unfavorable ones
To understand the value of options in
capital investment decisions, we must first
examine standard financial options
4
Financial Options
Contracts between two parties:
Writer or seller and
Holder or buyer
Seller transfers a set of rights to buyer
Value of the contract determined by:
Characteristics of underlying asset
Nature of transferred rights
5
Types of Financial Options
Call option: gives holder the right to buy
underlying asset
For a prespecified price (striking price)
By a prespecified date (expiration date)
Put option: gives holder the right to sell
underlying asset
For a prespecified price (striking price)
By a prespecified date (expiration date)
No obligation for the holder
6
Option Exercise
Exercising the option = buying or selling the
underlying asset at the exercise (striking) price
Expiration date: last day option can be exercised
(it is worthless afterwards)
American option: can be exercised any time prior
to expiration
European option: can be exercised on expiration
date only
7
Payoff from Buying Call Option
Buy call option today (at t = 0, stock price S
0
= $50)
Expiration: in one year
Exercise (striking) price : K = $60
Holder can BUT doesnt have to buy stock for $60 in a year
Stock Price Striking Price Payoff at expiration
S
1
(t = 1) K S
1
K or 0
$35 $60 $35 $60 < 0 $0
$50 $60 $50 $60 < 0 $0
$60 $60 $60 $60 = $0
$65 $60 $65 $60 = $5
$80 $60 $80 $60 = $20
8
Payoff from Buying Call Option
S
1
(Stock price in
1 year)
S
1
$60
$60 $80
$20

<
>
=
60 $ 0
60 $ 60 $
1
1 1
S
S S
if
if
Payoff
{ } 0 , 60 $ max
1
= S Payoff
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9
Payoff from Buying Call Option
S
T
(Stock price at
time T)
S
T
K
K
{ } 0 , max K S
T
= Payoff

<
>
=
K S
K S K S
T
T T
if
if
Payoff
0
Price increased
S
T
> K
Holder gains
No loss when
S
T
< K !!!
P
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10
Payoff from Writing Call Option
Write (sell) call option (at t = 0, stock price S
0
= $50)
Expiration: in one year
Exercise (striking) price : K = $60
Option holders gain = option writers loss (must sell at K!)
($60 $60) = $0 $60 $60 = $0 $60 $60
$80 $60 = $20
$65 $60 = $5
$50 $60 < 0 $0
$35 $60 < 0 $0
Holders
payoff at expiration
Writers
payoff at expiration
Striking
Price
Stock
Price
*
($80 $60) = $20 $60 $80
($65 $60) = $5 $60 $65
$0 $60 $50
$0 $60 $35
*
at time t = 1!
11
Payoff from Writing Call Option
S
1
(Stock price in
1 year)
(S
1
$60)
$60 $80
$20
( )

<
>
=
60 $ 0
60 $ 60 $
1
1 1
S
S S
if
if
Payoff
{ } 0 , 60 $ max
1
= S Payoff
P
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12
Payoff from Writing Call Option
S
T
(Stock price at
time T)
(S
T
K)
K
{ } 0 , max K S
T
= Payoff
Price increased
S
T
> K
Writer loses
P
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13
Payoff from Buying Put Option
Buy put option today (at t = 0, stock price S
0
= $50)
Expiration: in one year
Exercise (striking) price : K = $60
Holder can BUT doesnt have to sell stock for $60 in a year
Stock Price Striking Price Payoff at expiration
S
1
(t = 1) K K S
1
or 0
$35 $60 $60 $35 = $25
$50 $60 $60 $50 = $10
$60 $60 $60 $60 = $0
$65 $60 $60 $65 < 0 $0
$80 $60 $60 $80 < 0 $0
14
Payoff from Buying Put Option
Payoff at
expiration
S
1
(Stock price in
1 year)
$60 S
1
$60 $20
$40

>
s
=
60 $ 0
60 $ 60 $
1
1 1
S
S S
if
if
Payoff
{ } 0 , 60 $ max
1
S = Payoff
$60
15
Payoff from Buying Put Option
S
T
(Stock price at
time T)
K S
T
K
{ } 0 , max
T
S K = Payoff
K
S
T
< K
Holder gains
Payoff at
expiration
16
Payoff from Writing Put Option
S
1
(Stock price in
1 year)
($60 S
1
)
$60 $20
$60
( )

>
s
=
60 $ 0
60 $ 60 $
1
1 1
S
S S
if
if
Payoff
{ } 0 , 60 $ max
1
S = Payoff
$40
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17
Payoff from Writing Put Option
S
T
(Stock price at
time T)
(K S
T
)
K
K
{ } 0 , max
T
S K = Payoff
S
T
< K writer
loses
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18
Call Option Profits
P
r
o
f
i
t
K
Buy call (Long call)
Price
of call
K
Write call (Short call)
P
r
o
f
i
t
Price
of call
19
Put Option Profits
Buy put (Long put)
P
r
o
f
i
t
K
Price
of put
Write Put (Short put)
K
P
r
o
f
i
t
Price
of put
20
Factors Affecting Option Value
Higher stock price makes call more valuable
(holder gets more valuable asset for same K)
Higher strike price makes call less valuable (must
pay more to obtain underlying asset)
Higher risk-free rate makes call more valuable
(call options allow deferred purchase for K at T)
Longer time to expiration makes options more
valuable (can wait for more favorable outcomes)
Higher volatility makes options more valuable
(options allow holder to gain from stock price
changes, while limiting losses to zero)
21
The Put/Call Parity
We now know how the call prices, put prices,
the stock price, and the riskless interest rate
are related:
The interpretation of this is as follows:
Buying a call and shorting a put is the same as:
Buying the stock and borrowing X (the exercise
price) at the risk free rate
(1 )
t
X
C P S
r
=
+
Why does Put-Call Parity work?
Consider Two Portfolios A and B and assume European
options:
Portfolio A:
Buy a put (P) with X = $50
Simultaneously purchase the underlying asset (S)
Portfolio B:
Buy a call (C) with X = $50
Invest the Present value of the exercise price PV(X) in a risk-free
asset paying interest at RF; the investor has $50 available to
exercise the call option.
22
Why does Put-Call Parity work?
Assuming underlying asset price is either $45 or $55.
Underlying Price
$55 $45
Portfolio A
Long put payoff
0 +$5
Long asset payoff
+$55 +$45
Total payoff for A
+$55 +$50
Portfolio B
Long call payoff
+$5 0
Invest present vvalue of $50 at RF
+$50 +$50
Total payoff for B
+$55 +$50
Table 12-2 Payoff from Combining Calls, Puts and Underyling Asset Positions
Pay off is
the same,
regardless
of the
ending
share price.
23
Arbitrage
Arbitrage:
No possibility of a loss
A potential for a gain
No cash outlay
In finance, arbitrage is not allowed to persist.
Absence of Arbitrage = No Free Lunch
The Absence of Arbitrage rule is often used in finance to
figure out prices of securities.
Think about what would happen if arbitrage were
allowed to persist. (Easy money for everybody)
24
25
The Put/Call Parity (contd)
Equilibrium Stock Price Example
You have the following information:
Call price = $3.5, Put price = $1
Striking price = $75
Riskless interest rate = 5%
Time until option expiration = 32 days
If there are no arbitrage opportunities, what is the equilibrium stock price?
Using the put/call parity relationship to solve for the stock price:
18 . 77 $
) 05 . 1 (
00 . 75 $
00 . 1 $ 50 . 3 $
) 1 (
365
32
0
=
+ =
+
+ =
t
r
X
P C S
26
The Put/Call Parity
A stock trades at $50 with a six month put option
(strike price=$50) trading at $4.25. If the interest rate
is 3%, what is a six month call option trading at?
0
0.5
(1 )
$50
$50 $4.25
(1.03)
$4.98
t
K
C S P
r
C
C
=
+
=
=
27
The Put/Call Parity
A stock trades at $60 with a put option (strike
price=$60) trading at $2.75. If the call option trades
at $5.35, what is the interest rate?
0
1
(1 )
$60
$60 $2.75 5.35
(1 )
1 1.045 therefore 4.5%
t
K
S P C
r
r
r r
+ =
+
+ =
+
+ = =
28
Making Arbitrage Profits
A stock trades at $25 with a put option (strike price=$25) trading at
$3.00. If the call option trades at $3.50 and the interest rate is 5%, how
do I make a riskless profit? How much of a profit do I make for each
share traded?
0
1
(1 )
$25
$25 $3.00 3.25 24.75 23.81
(1 .05)
Buy stock, buy put, short call, borrow money
Profit per share 24.75 23.81 0.94
t
K
S P C
r
+ =
+
+ = > =
+
= =
Put-Call Parity & Synthetic
Positions
S = C-P+PV(K) Sell stock short = write call, buy put, &
borrow
-S = -C+P-PV(K) Buy stock = buy call, write put & lend
-P = S-C-PV(K) Buy put = sell stock short, buy call, &
lend
P = -S+C+PV(K) Write put = buy stock, write call, &
borrow
C = S+P-PV(K) Write call = sell stock short, write put, &
lend
-C = -S-P+PV(K) Buy call = buy stock, buy put, & borrow
PV(K) = S-C+P Riskless borrowing = sell stock short,
buy call, & write put
-PV(K) = -S+C-P Riskless lending = buy stock, write call,
& buy put
29
30
Option Trading Strategies:
Covered Call
Buy share at $50 Write a call option:
Expires in one year
Option price: $4
Strike price: $56
S
T
Profit
$50
S
T
$50
S
T
Profit
$56
$4
31
Covered Call
Strike
price
Stock
price
*
Profit from
Stock
Profit from
Option
Profit from
Covered Call
$56 $30 $30 $50 $0 + $4 $20+$4 = $16
$56 $40 $40 $50 $0 + $4 $10+$4 = $6
$56 $50 $50 $50 $0 + $4 $0+$4 = $4
$56 $56 $56 $50 $0 + $4 $6 + $4 = $10
$56 $60 $60 $50 ($60$56)+$4 $10 + $0 = $10
$56 $70 $70 $50 ($70$56)+$4 $20 $10 = $10
*
at time t = 1!
Stock price at t = 0: S
0
= $50
32
Covered Call
$56
$4
S
T
Profit
$50
S
T
$50
$10
Short put
Stock price at T Profit from stock Profit from call Total
S
T
s $50 S
T
$50 0 + $4 S
T
$46
$50 < S
T
s $56 S
T
$50 0 + $4 S
T
$46
$56 < S
T
S
T
$50 (S
T
$56) + $4 $10
33
Option Trading Strategies:
Protective Put
Buy share at $50 Buy put option:
Expires in one year
Option price: $8
Strike price: $55
S
T
Profit
$50
S
T
$50
S
T
Profit
$55
$8
34
Protective Put
Strike
price
Stock
price
*
Profit from
Stock
Profit from
Option
Profit from
Protective Put
$55 $30 $30$50 $55$30$8 $20+$17=$3
$55 $40 $40$50 $55$40$8 $10+ $7=$3
$55 $50 $50$50 $55$50$8 $0 $3 = $3
$55 $55 $55$50 $0 $8 $5 $8 = $3
$55 $60 $60$50 $0 $8 $10 $8 = $2
$55 $70 $70$50 $0 $8 $20 $8 = $12
*
at time t = 1!
Stock price at t = 0: S
0
= $50
35
Protective Put
Stock price at T Profit from stock Profit from put Total
S
T
s $50 S
T
$50 ($55 S
T
) $8 $3
$50 < S
T
s $55 S
T
$50 ($55 S
T
) $8 $3
$55 < S
T
S
T
$50 $0 $8 S
T
$58
$55
$8
Long call
$58
$3
S
T
Profit
$50
S
T
$50