Properties of Stock

Option Prices
chapter 10

Notation
c : European call option C : American Call option
price
p : European put option
price
S0 : Stock price today
X : Strike price
T : Life of option
: Volatility of stock
price

price
P : American Put option
price
ST :Stock price at option
maturity
D : Present value of
dividends during options life
r : Risk-free rate for
maturity T with cont comp

Effect of Variables on Option

Pricing
Variable
S0
X
T

r
D

?
+
+

+?
+

+
+
+

+
+
+

Intuition:
Lets look at the American call:
Payoff from exercising = MAX(Spot Strike, 0)
If the spot price :
the call is more valuable.
If strike price : the call is less valuable.
Time to maturity :
the call can produce unlimited gains,
losses are limited by its price. If t-t-m ,
gains can be higher
value of the call Volatility :
the call can produce
unlimited gains,
losses are limited by its price. If volatility ,
gains can be higher value of the call .
Interest rate : can be proven that the value
Dividends :
dividends reduce the stock price on the
ex-dividend
date. Bad for the value of the call
option. The higher the
dividend, the worse.

Intuition:
Time to maturity for European option:
Since European option cannot be exercised prior to expiration
date, the effect of time to maturity depends on the dividend
payment schedule

Bounds for European Call and Put Option

Prices; No Dividends

S0 c S0 - Xe -rT
Xe -rT p Xe -rT - S0

If bounds are violated:

Call: S0 c S0 - Xe -rT
(1) If c > S0: buy the stock, sell the call option
At t=0: positive cash flow (c - S0)
At t=T: positive cash flow (ST - max{0, ST - X})
(2) If S0 - Xe -rT >c:
t=0:
Buy the call, short the stock, invest $Xe -rT
Note: positive cash flow = S0 - Xe -rT - c
t=T:
If ST >X then exercise the option at X, close the short position. Cash flow is zero
If ST <X then buy the stock on the market, close the short position. Cash flow is
positive (X - ST )

If bounds are violated:

Put: Xe -rT p Xe -rT - S0
(1) If p > Xe rT: write the put option, invest Xe rT at the risk-free interest rate
At t=0: positive cash flow (p - Xe rT )
At t=T: non-negative cash flow (X - max{0, X-ST})

(2) If Xe -rT - S0 >p:

t=0:
Borrow Xe -rT and buy both the put and the stock.
Note: positive cash flow = Xe -rT - S0 - p
t=T:
If ST <X then exercise the option at X and repay your debt. Cash flow is zero
If ST >X then sell the stock on the market for ST and repay the debt. Cash flow is
positive (ST - X)

Examples:
(a)What is the lower bound for the price of a one-month put
option on a non-dividend-paying stock when the stock
price is $12, the strike price is $15, and the risk-free
interest rate is 6% per annum?
(b) What if you see that this put sells at $2? How can you
make arbitrage?
(c) What if you see that this put sells at $15? How can you
make arbitrage?

Examples:

(a)What is the lower bound for the price of a one-month put option on a non-dividend-

paying stock when the stock price is $12, the strike price is $15, and the risk-free
interest rate is 6% per annum?
Solution:
The price of this put can not be below
Xe -rT - S0 = 15e -.06(1/12) - 12 =$2.93
(b)What if you see that this put sells at $2? How can you make arbitrage?
t=0:
Borrow 15e -0.06*(1/12)=$14.925 and buy both the put and the
stock. Cash flow = $0.925>0
t=1/12:
Repay $15.
If ST <15 then exercise the put option (sell the stock for $15)
(cash flow = 15 - 15 =0)
If ST >15 then discard the option, sell the stock. (cash flow=ST -15 >0)
(c)What if you see that this put sells at $15? (p>Xe -rT) How can you make arbitrage?
t=0:
Write the put, invest 15e -0.06*(1/12)=$14.925.
Cash flow = $15-$14.925=$0.075>0
t=1/12:
Get $15 from investment.
If ST >$15 then the put will not be exercised. Cash flow = $15>0
If ST <X then pay X for the stock and sell it at ST. Cash flow = ST 0.

Put-Call Parity; No Dividends

Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of the strike
price in risk-free investment
Portfolio C: European put on the stock + the stock
Both are worth MAX(ST , X ) at the maturity of the options
They must therefore be worth the same today
This means that

c + Xe -rT = p + S0

Arbitrage Opportunities
Suppose that
c =3

S0 = 31

T = 0.25
r = 10%
X =30
D=0
What are the arbitrage
possibilities when
p = 2.25 ?
p=1?

Arbitrage Opportunities
Problem: Suppose that c= 3, S0= 31, T = 0.25, r = 10%, X =30, D = 0
What are the arbitrage possibilities when p = 2.25 ? p = 1?
Solution: c + Xe -rT = p + S0
c + Xe rT = 3+30e .1(.25) = 32.26
If p=2.25: p + S0 = 2.25+31=33.25, So, c + Xe -rT < p + S0
The strategy:
1. Buy the call
2. Invest 30e .1(.25) =29.26
3. Short the put
4. Short the stock
Outcome:
Initial cash flow: -3-29.26+2.25+31=$0.99>0
If the stock price at expiration of the option >$30 the call will be
exercised. If it is less than $30, the put will be exercised. In either case,
the investor ends up using his $30 from investment to buy one
share
for $30 and use this share to close out the short position. Hence, the
cash flow at expiration is $0

Arbitrage Opportunities
Problem (cont): Suppose that c= 3, S0= 31, T = 0.25, r = 10%, X =30, D = 0
What are the arbitrage possibilities when p = 2.25 ? p = 1?
Solution: c + Xe -rT = p + S0
c + Xe rT = 3+30e .1(.25) = 32.26
If p=1: p + S0 = 1+31=32, So, c + Xe -rT >p + S0
The strategy:
1. Sell the call
2. Borrow 30e .1(.25) =29.26
3. Buy the put
4. Buy the stock
Outcome:
Initial cash flow: 3+29.26-1-31=$0.26>0.
As in the previous case, either the call or the put will be exercised (when
the stock price at expiration will be above or below $30 respectively.
The short call and long put option position therefore
leads to the
stock being sold for $30.00 just enough to repay the
debt. Hence,
the cash flow at expiration is $0

Arbitrage Opportunities
If

c + Xe -rT < p + S0

The strategy:
1. Buy the call; invest PV of the strike price at risk-free rate
2. Short the put, short the stock

If

c + Xe -rT > p + S0

The strategy:
1. Sell the call; borrow PV of the strike price
2. Buy the put; buy the stock

Practice problem
Problem: Suppose that c= 4, S0= 31, T = 0.25, r = 8%, X =30, D = 0
What are the arbitrage possibilities when p = 3?
Solution: c + Xe -rT = p + S0
c + Xe rT = 4+30e .08(.25) = 33.41
If p=3: p + S0 = 3+31=34, So, c + Xe -rT < p + S0
The strategy:
1. Buy the call, invest PV of the strike price at risk-free rate
2. Short the put, Short the stock
Outcome:
Initial cash flow: -33.41+34=$0.59>0.
If the stock price at expiration of the option >$30 the call will be
exercised. If it is less than $30, the put will be exercised. In either
case, the investor ends up buying one share for $30 using the
proceeds from his investment. This share can be used to close out the
short position. The cash flow is zero.

Early Exercise
An American call on a non-dividend
paying stock should never be exercised
early

Reasons For Not Exercising a Call Early

(No Dividends)
Proof:
c S0 - Xe -rT
Because the owner of an American call option has all the exercise
opportunities open to the owner of the corresponding European call, we
must have:
C c S0 - Xe -rT
Because r>0, we have C > S0 X. If it were optimal to exercise early, C
would equal to S0 X. We deduce that it can never be optimal to
exercise early.

Should Puts Be Exercised

Early ?
Intuition (and proof by example): strike = $40, current price = $1.
Can sell at $40. If wait: will never get more than $40 since
prices must be 0. If well sell now, can invest $39 at r.
If wait: limited gains
If exercise now: can invest $39 at the risk free rate.
It can be optimal to exercise an American put option on a
non-dividend-paying stock early.

The Impact of Dividends on Lower Bounds to

Option Prices

c S 0 D Xe
p D Xe

rT

rT

S0

If bounds are violated:

Call: c S0 D - Xe -rT
If S0 D- Xe -rT >c:
t=0:
Buy the call, short the stock, invest $(D+Xe -rT )
Note: positive cash flow = S0 - D - Xe -rT - c
During the life of the option:
Pay dividends on the short-sold stock. Youll use up the entire $D invested at t=0.
t=T:
If ST >X then exercise the option at X, close the short position. Cash flow is zero
If ST <X then buy the stock on the market, close the short position. Cash flow is
positive (X - ST )

If bounds are violated:

Put: p D + Xe -rT - S0
If D+Xe -rT - S0 >p:
t=0:
Borrow D+Xe -rT and buy both the put and the stock.
Note: positive cash flow = D+Xe -rT - S0 - p
During the life of the option:
Youll receive dividends and use them to repay $D of you original debt.
t=T:
If ST <X then exercise the option at X and repay your debt. Cash flow is zero
If ST >X then sell the stock on the market for ST and repay the debt. Cash flow is
positive (ST - X)

The Impact of Dividends on call-put parity

c + D + Xe -rT = p + S0
Proof:
Consider the following 2 portfolios:
Portfolio A: European call on a stock + (PV of the strike price
+ D) in risk-free investment
Portfolio C: European put on the stock + the stock
Both are worth MAX(ST , X ) + De rT at the maturity of the options
They must therefore be worth the same today
This means that

c + D+Xe -rT = p + S0

Extensions of Put-Call Parity:

American options

American options; D = 0
S0 - X C - P S0 - Xe -rT

American options; D > 0

S0 - D - X C - P S0 - Xe rT

Extensions of Put-Call Parity: American options

American options; D = 0: S0 - X C - P S0 - Xe -rT
Proof of S0 - X C - P:
Consider the following 2 portfolios:
Portfolio A: European call on a stock + $X in risk-free investment
Portfolio C: American put on the stock + the stock
If held to maturity, payoffs from A is higher by X(1- e-rT )
If American put is exercised earlier at time t, then
portfolio C pays Xer(T-t)
Portfolio A pays at least XerT
i.e., portfolio A pays more or the same as C

As a result, c+X P+ S0, hence, c-P S0 X

Since Cc (actually, C=c when D=0), it follows that C-P c-P S0 X

Extensions of Put-Call Parity: American options

American options; D = 0: S0 - X C - P S0 - Xe -rT
Proof of C - P S0 - Xe -rT:
Consider the following 2 portfolios:
Portfolio A: American call on a stock+ $ Xe -rT in risk-free investment
Portfolio C: European put on the stock + the stock
If held to maturity, payoffs are the same
If American call is exercised earlier at time t, then
portfolio C pays max(ST,X)
Portfolio A pays ST-X(1-er(T-t))ST max(ST,X)
i.e., portfolio C pays more or the same as A

As a result, C+ Xe -rT p+ S0, hence, C-p S0 Xe -rT

Since Pp,, it follows that C-P C-p S0 Xe -rT

Extensions of Put-Call Parity: American options

American options; D > 0 : S0 - D - X C - P S0 - Xe -rT
Proof:
Very similar. Try it at home.