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Investment Management and Capital Markets

Lecture 7 : Options

Option: A right but not an obligation to buy(call) or sell(put) the underlying asset
by a specified date at a price fixed in advance.
( Unlike futures/forwards which are agreements to buy/sell the underlying
asset at a set price at a later date. )

Call and Put options have an initial `sunk cost’ = option premium.

Call Option:

A Call option is worth exercising when the Share price S > X, the exercise price.
In the region X < S < ( X + C ), exercising the option reduces the sunk cost;
in the region S > ( X +C ), exercising the option realises a profit = S - ( X + C ).

Π Share Price
= Profit/Loss

S-X
C X S-X S
X
Market Value of Call

Put Option

A Put option is worth exercising when the Share price S < X, the exercise price.
In the region ( X-P ) < S < X , exercising the option reduces the sunk cost;
in the region S < ( X -P ), exercising the option realises a profit = X - ( P + S ).

Share price
V
Π

X-P X P S
Market Value of Put

Π) and Value (V) diagrams

ote the distinction between Pay-off (Π

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Compare with the profit/loss profile on a share transaction:

Sp S

Common Option diagrams

CALL OPTIO
Buyers Writers(sellers)

PUT OPTIO

A European option can be exercised only at the expiry date while

an American option can be exercised at any time before the expiry date.

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Put-Call Parity for European Options

If we compare the outcome from a portfolio created by combining long positions in
the security with a put option and a short position in the call option, both with
Exercise price 'X' and expiry period 't,' if at expiration:

Value diagram ( y -axis)

Share
Share
Put Option

X Sa Sa X
Share price
Written call option

(i) S>=X
Share = S
Put Option = 0
Written Call option = - (S-X)
Value of portfolio = X

(ii) S <= X
Share = S
Put Option = x-S
Written Call option = 0
Value of portfolio = X

So in all cases, the value of the portfolio at expiry is 'X.' This in turn implies that the
value of the portfolio so constructed at the beginning of the period must also be
S + P-C = PV(X) = X ert (alternatively =x/(1 + rf. t)
This is the no-arbitrage condition and implies that a Portfolio made up of a long
position in the share, with a put option and a short position in the call option, both
with Exercise price 'X' and expiry period 't,' is a riskless hedge portfolio, with the
same outcome at expiry as an investment in a risk-free bond which matures to a value
X at expiry.

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Review of Option features;

Premium

Calls Puts

As the Asset Price increases up down

As the Exercise price increases down up

Unexpired time increases up up

Further note:

Interest rates increase up down

Share price Volatility up up

C=S-PV(X)

Call Value C= S-X

C=S

PV(X) X

Options have a time value and an intrinsic value

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Options can be used for Speculation, Hedging or Arbitrage.

Speculation

Holding a call or put option on its own without a previous position in the
corresponding asset is speculative. You gain or lose depending on which way the
market moves.

Call Put

Loss Gain Loss

Gain

Hedging

eg. The insurance feature of put options

Put options can be used to hedge against fall in value of the underlying share over a
specific period.

P S

Share price

If the share falls in price, the payoff on the bought put option compensates for the fall
in the share value, the loss is restricted to the premium on the put option.

If the share rises in price, the holder of the share can take the benefit of the increased
price, less only the premium paid for the put option.

The premium paid for the put option is thus the cost of insurance.

Arbitrage possibilities in Options

The pricing of puts and calls follows a basic relationship called the `Put-Call’ parity
when arbitrage opportunities have been eliminated:

S + P = PV ( K ) + C

Holding a share (long position) plus buying a put on the share involves the same
outlay and gives the same payoff as depositing an amount equal to the present value
of the exercise price in an interest earning account and buying a call option.

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Binomial Model for valuing a European Option

The valuation of a call option at the end of `n’ time periods where the stock price S
of a share may have only two outcomes at the end of a period:
uS =multiplicative upward movement: u > 1+rf > 1
dS = “ downward movement : d < 1 < 1+ rf
rf is the riskless rate of interest over one period.
Probability of increase at the end of any period is q; probability of decrease is 1-q.

For a one period frame:

-the outcomes on the share are uS and dS.
If C represents a call option written on the share at an exercise price X , the payoffs
of the call are Cu and Cd; where
Cu = max (0, uS-X )
Cd = max (0, dS-X )

uS Cu
q q

S C

1-q 1-q
ds Cd

In the above circumstances, a `risk free hedge portfolio’ comprised of one share of
stock and m call options written against the stock can be constructed.

By definition if such a portfolio is riskfree, the initial value of the portfolio must
grow by 1+rf and be equal to the other outcomes:

ie (S- mC) (1+rf) = uS- mCu = dS – mCd

`m’ is called the `hedge ratio’

Put options

The corresponding relationship for put options is

(S+nP)(1+rf)= dS+nPd=uS+nPu
ie a share made up of one share and n put options equals the outcomes in the
downward or upward movement state of the share.

ote: the value of puts and calls can be tested from the no arbitrage price condition:

S + P = PV(X) + C

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Example

Mr. Sharpe is considering an investment in Drum plc.

Drum shares are currently trading at $20.00 each.

Options are available on the shares, they have a strike price of $21 and a one year
maturity.

Mr. Sharpe expects that in one years’ time1 it is an equally probable that the shares
will be either $24 or $13.40.

Drum plc will not pay a dividend in the next year and the risk free rate will be 5 %
throughout the period.

Required

a) Calculate the value of a put option on Drum shares, from first principles.

b) Calculate the value of a call option on Drum shares, from first principles.

c) What is the condition for non arbitrage pricing on options?

Test your answers of (a) and (b).

d) An investor approaches you with £ 1,000 and asks you to explain clearly to him
the outcomes of investing in a bank deposit, shares, puts or calls of Drum plc over a
one year period.

Illustrate your answer with diagrams outlining clearly the risk –return
associated with each alternative.

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The Black Scholes Model

Cox, Ross and Rubenstein showed the equivalence of the above formula to the Black
Scholes model with the following modifications as

`n’ the number of binomial periods per year becomes very large -

for continuous time: (1+rf ) n becomes e Rf. T ( where Rf is the riskfree rate of
interest for one period and T is the number of periods)
σ√ T/n
u= e ; d = e - σ√ T/n where `σ’ is the annualised standard deviation

In continuous time, therefore the binomial expression converts into:

C = S N(d1) - X e -Rf.T N(d2)

d1 = ( ln(S/X) + Rf.T ) / (σ√ T) + ½ σ√ T

d2 = d1 - σ√ T

S is the share price

N (d1) = hedge ratio ( the number of shares bought / number of calls sold)

X e -Rf.T = the present value of the exercise price at expiry

N (d2) = the probability that option will be worthwhile exercising at expiry

The value of a European Put option can be found using the Put-Call parity equation.

S+P= X+C
ie a portfolio consisting of a long share, a long put and a short call which will mature
to a value of `X’ the exercise price; equivalent to a riskless asset which grows from
X e -Rf.T over the same period.

Limitations of Black Scholes Model

- the model in its common form does not allow for payment of dividends
- it applies to European options only
- constant riskfree interest rate through life of option
- the model is very sensitive to the calculated values of sigma

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Applications of option theory

- Insurance as a put option

- Equity as a call option
- Share Warrants
- Convertible debentures
- ESOPs
- A Mining Lease

Points to note about Futures and Options

- futures contracts lock the investor into a commitment; the contract has to be
performed by physical delivery or cash settlement.

- with purchased options there is a right but not an obligation, so that the option
investor can exercise the option only in circumstances favourable to him, or
abandon the contract at a loss equal to the premium on the option if the
circumstances are unfavourable to him.

- There is no cost to hedging through futures but purchasing options to hedge

involves payment of a premium. It can be expected that options are expensive.

- options allow you to avail of upside potential at a cost while limiting

the downside risk to the cost paid for the premium.

Options example

In November 2002, the FTSE-100 Index is at 5491. A Fund Manager with a

diversified portfolio of beta 0.8 and a current value of £2m would like to hedge his
portfolio upto the end of June 2003 before which he fears the FTSE index will fall.
(i) What kind of options should he consider? How many contracts should be
purchased to hedge the fund completely.
(ii) What will be his net position, if, at the end of June the FTSE-100 Index actually
was (a) 6000 (b) 5200.
The premium for the nearest to future put options (exercise price 5600) expiring at the
end of June is 478p per point)

Suggested solution

In view of the worry about the falling FTSE by end June, the strategy is to buy put
options, which can limit losses to the put premium but give it the insurance feature at
a cost, allowing you to take advantage of upside potential by abandoning the option, if
need be.

No of put options to be bought (take nearest exercise price to prevailing ie 5600):

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= 2m x 0.8 (1+(0.065-0.025)7/12)/ 10 x 5600 = 29.23, say 29 contracts

Cost of puts = 29 x 478 x 10 = £138,720

If the FTSE at June is below 5600 you exercise the put option and compensate
for the loss on the portfolio. If the FTSE at June is above 5600 you abandon the
option.

(i) FTSE rises to 6000:

Gain on portfolio = (6000-5491) x 0.8 x Pds 2.0m /5491 = £ 148,315
Cost of puts = (£138,620)
Dividend income = £ 29,200
Net Gain = £ 38,895

(ii) FTSE falls to 5200

Loss on portfolio = (5200-5491) x Pds 2 m x 0.8 / 5491 = (£ 84,793)
Gain on puts = 400 (5600-5200) x 29 x 10 =£116,000
Cost of puts = (£138,620)
Dividend income = £ 29,200
Net cost = (£78,213)

The net cost on the downside slightly varies because of the slight imbalance
in the number of contracts used for cover.

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