Chapter 11
Properties of
Stock Options
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Notation
c: European call option C: American call option price
price
p: European put option P: American put option price
price
S0: Stock price today ST: Stock price at option
maturity
K: Strike price
D: PV of dividends paid
T: Life of option during life of option
s: Volatility of stock
price r Risk-free rate for maturity
T with continuous
compounding
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Effect of Variables on Option Prices
Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
s + + + +
r + − + −
D − + − +
(Table 11.1, page 257)
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American vs. European Options
An American option is worth at least as much
as the corresponding European option
C³c
P³p
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Call: An Arbitrage Opportunity?
Consider a European call with:
c=3 S0 = 20
T=1 r = 10%
K = 18 D=0
Is there an arbitrage opportunity?
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Calls: An Arbitrage Opportunity?
At t = 0: Short 1 stock, go long 1 call
Invest the proceeds ($17) in riskless asset.
At t =1 : Receive
max(ST - K,0) - ST + $17 x e0.1x1
If the option is in the money, the payoff is
$17 x e0.1x1 - $18 = $0.79.
If the option is out of the money, the payoff is
$17 x e0.1x1 – ST = $0.79 + ($18 - ST ) > 0.
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Lower Bound for Call Price
European call & No dividends on stock
c ³ max(S0 –Ke –rT, 0)
(Equation 11.4, page 262)
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Lower Bound for Call Price
In the previous example, does the no-arbitrage
condition c ³ max(S0 –Ke –rT, 0) hold?
S0 – Ke –rT = 20 – 18 x e-0.1 x 1
= $ 3.71
> c = $3.00.
The call price is too low relative to the stock price.
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Put: An Arbitrage Opportunity?
Consider a European put with:
p=1 S0 = 37
T = 0.5 r =5%
K = 40 D =0
Is there an arbitrage opportunity?
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Put: An Arbitrage Opportunity?
At t = 0: Go long 1 call and 1 put
Borrow $38(=$37+$1) at the riskless rate.
At t = 1: Receive
max(40-ST ,0) + ST - 38 x e0.05x0.5
If the option is in the money, the payoff is
$40 - 38 x e0.05x0.5 = $1.04.
If the option is out of the money, the payoff is
ST - 38 x e0.05x0.5 = $1.04 + (ST -$40) > 0.
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Lower Bound for Put Price
European put & No dividends on stock
p ³ max(Ke -rT–S0, 0)
(Equation 11.5, page 263)
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Put: An Arbitrage Opportunity?
In the previous example, does the no-arbitrage
condition p ³ max(Ke –rT - S0 ; 0) hold?
max(Ke –rT - S0;0) = max(40 e-0.05 x0.5 - 37;0)
= $2.01
> p = $1
The put price is too low relative to the stock price.
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Put-Call Parity: No Dividends
Consider the following 2 portfolios:
Portfolio A: European call on a stock +
zero-coupon bond that pays K at time T
Portfolio B: Stock + European put on the stock
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Payoffs of Portfolios at T
ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total payoff ST K
Portfolio B Put Option 0 K− ST
Share ST ST
Total payoff ST K
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The Put-Call Parity
Both portfolios are worth max(ST , K ) at T.
The portfolios must therefore have the same
cost today:
c + Ke -rT = p + S0
(Equation 11.6, page 264)
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Arbitrage Opportunities
Suppose that
c = $3 S0= $31
T = 0.25 r = 10%
K = $30 D = $0
What are the arbitrage possibilities
when p = $2.25 ? When p = $1 ?
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Arbitrage Opportunities
The no-arbitrage price is
p = c + Ke-rT – S0
= 3+ 30 e-0.1 x 0.25 – 31
= $1.26.
The put is underpriced if p = $1 and
overpriced if p = $2.25.
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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.
Such an American call should never be exercised
early.
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Explanation
Consider the American call option:
S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
No!
C0 ³ c0 ³ max(S0 –Ke –rT, 0)
Note that max(S0 –Ke –rT, 0) > S0 –K if r > 0.
Hence C0 > S0 – K.
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Reasons For Not Exercising Early
No income is sacrificed
You delay paying the strike price.
You are better off selling the American call
rather than selling it.
The European call and the American call have
the same price C0 = c0 .
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Bounds on Call Price (No Dividend)
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Should Puts Be Exercised Early ?
Are there any advantages to exercising an
American put?
Consider the example
S0 = 0; T = 0.25; r=10%; K = 100; D = 0
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European & American Put Bounds
Consider a stock that does not pay dividends.
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Impact of Dividends
- rT
c ³ S 0 - D - Ke
- rT
p ³ D + Ke - S0
(Equations 11.8 and 11.9, page 271)
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Extensions of Put-Call Parity
European options; D > 0
c + D + Ke −rT = p + S0 (Eq. 11.10 p. 250)
American options; D = 0
S0 − K < C − P < S0 − Ke−rT (Eq. 11.7 p. 244)
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