Properties of Stock Options

Chapter 9
1
2
Notation
c : European call
option price
p : European put
option price
S
0
: Stock price
today
X : Strike price
T : Life of option
: Volatility of stock
price
C : American Call
option price
P : American Put
option price
S
T
:Stock price at option
maturity
D : Present value of
dividends during
options life
r : Risk-free rate for
maturity T with cont
comp
3
Effect of Variables on Option
Pricing

c p C P Variable
S
0

X
T

r
D
+ +

+
? ?
+ +
+ + + +
+

+



+

+

+
4
Upper & Lower Bound for Option
Prices
We derive the Upper & Lower bounds for option prices.
If the option prices is above the upper & lower bound ,
there are profitable arbitraging opportunities
An upper & lower bound for the value of a call-option
The value of an American or European call-option does not
exceed the value of the stock
lower bound for a European call-option on non dividend paying
stock is S - X e
-rT

An upper & lower bound for the value of a put-option
The value of American or European put option can never exceed
X.
The value of a European put-option is less than or equal to X e
-
rT
.
A lower bound for a European put-option is X e
-rT
- S

5
Calls: An Arbitrage Opportunity?
Suppose that
c = 3 S
0
= 20
T = 1 r = 10%
X = 18 D = 0

Is there an arbitrage opportunity?
6
Lower Bound for European Call
Option Prices; No Dividends
c max(S
0
Xe
rT
, 0)

7
Puts: An Arbitrage Opportunity?

Suppose that




Is there an arbitrage
opportunity?
p = 1 S
0
= 37
T = 0.5 r =5%
X = 40 D = 0
8
Lower Bound for European Put Prices;
No Dividends

p max(Xe
-rT
S
0
, 0)

9
Early Exercise
Usually there is some chance that an
American option will be exercised early
An exception is an American call on a
non-dividend paying stock. This should
never be exercised early

10
Early Exercise on a Non dividend
Paying stock
Call Option- not optimal to exercise early
If its hold till expiry it protect from falling
stock price
Time Value is more
Put Option- may be optimal to exercise
early if it is sufficiently deep in the money
Receiving now is always worth more than in future
Thats why American put option value is always
worth more than European
To replicate the gain/loss characteristics of a long stock
position, one would purchase a call and write a put
simultaneously. The call and put would have the same strike
price and the same expiration. By taking these two combined
positions (Long call and short put), we can replicate a third
one (Long stock).
Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 11
Put-Call Parity
PutCall parity defines a relationship between the price of
a European call option and European put option, both with the
identical strike price and expiry, namely that a portfolio of long a
call option and short a put option is equivalent to (and hence has
the same value as) a single future contract at this strike price and
expiry.
This is because if the price at expiry is above the strike price,
the call will be exercised, while if it is below, the put will be
exercised, and thus in either case one unit of the asset will
be purchased for the strike price, exactly as in a future
contract.

A protective put (holding the stock and buying a put) will deliver the
exact payoff as a long call (buying one call and investing the
present value (PV) of the exercise price).

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 12
Put-Call Parity
13
Put-Call Parity; No Dividends

Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of
the strike price in cash
Portfolio C: European put on the stock + the
stock
Both are worth max(S
T
, K ) at the maturity of the
options
They must therefore be worth the same today.
This means that
c + Ke
-rT
= p + S
0

14
Arbitrage Opportunities
Suppose that
c = 3 S
0
= 31
T = 0.25 r = 10%
K = 30 D = 0
What are the arbitrage possibilities
when p = 2.25 ?
p = 1 ?
15
The Impact of Dividends on Lower Bounds
to Option Prices

rT
Ke D S c

0
0
S Ke D p
rT