Executive MBA Americas

Lecture 6: Options and Futures

Lecture 6.1: Options

Managerial Finance
NCCB5060/MBQCB821
Professor Mao Ye
 Plans for Derivatives

• Options

• Futures

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 This Class: Option Basics

• Different types of options

• Pay-off and profit for options

• Price for options

• Put-call parity

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 The Option Contract: Calls
• A call option gives its holder the right to buy an asset:
– At a pre-specified price, also called exercise or strike price
– On a future date, also called expiration date
– Example: the right to buy 1 share of Google at $1000 on May 1, 2023

• Exercise the option if market value > strike on expiration date

– Price of Google = $1010
• Buy Google at $1000 and sell it at $1010
• Payoff of $10

– Suppose the price of Google is $990

• You will not exercise the option

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 The Option Contract: Puts
• A put option gives its holder the right to sell an asset:
– At the exercise or strike price
– On the expiration date
– Example: the right to sell 1 share of Google at $1,000 on May 1, 2023

• Exercise the option if market value < strike.

– Price of Google = $1,010
• You will not exercise the option
– If the price of Google is $900
• Buy a share of Google at $900
• Sell at $1,000
• Payoff of 100

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 Premium of the Option: Example

• Suppose Mao sells you an option to get at least B-

• You can choose whether to exercise this option after final

• B- is a low score, but you may still consider this option

– Because you can choose not to exercise the option

• Option gives you a right, and it is sold at a premium

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 The Option Contract

• The purchase price of the option is called the premium.

• Buyers (holders) of the options pay the premium.

• Sellers (writers) of options receive the premium income.

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 This Class: Option Basics

• Different types of options

• Pay-off and profit for options

• Price for options

• Put-call parity

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 Profit and Loss on Buying a Call

• A January 2017 call on IBM with an exercise price of $130 was selling on December
2, 2016, for $2.18.

• If IBM remains below $130, the call will expire worthless.

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 Profit and Loss on Buying a Call

• IBM price = $132 on the expiration date.

• Option value = stock price-exercise price

$132- $130= $2

• Profit = Final value – Premium

$2.00 - $2.18 = -$0.18

• Option will be exercised to offset loss of premium.

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 Profit and Loss on Buying a Put

• Consider a January 2017 put on IBM with an exercise price of $130, selling on
December 2, 2016, for $4.79.

• If IBM goes above $130, the put is worthless.

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 Profit and Loss on Buying a Put
• Suppose IBM’s price at expiration is $123.

• Value at expiration = exercise price – stock price:

– $130 - $123 = $7

• Investor’s profit:
– $7.00 - $4.79 = $2.21
– Some people invest in options because it needs less investment ($7 vs $130)
– Some other people likes the leverage
• Return: $2.21/$4.79 = 46.1%
• Return is – 100% if IBM’s price increases above $130
• Higher risk, higher return

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 Four Situations

Buyer Seller
Call • Call Holder (Buyer) • Call Writer (Seller)

Put • Put Holder (Buyer) • Put Writer (Seller)

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 Two Strategies

• Exercise

• Walk Away

• Suppose Mao sells you an option to get at least B-

I Hope You Choose to Walk Away!

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 Payoffs and Profits for the Call Holder

Notation
Stock Price = ST
Exercise Price = X

Payoff to Call Holder

(ST - X) if ST >X
0 if ST < X

Profit to Call Holder

Payoff – Premium Can you figure out the strike price?
An option is not free
100 ! 15
 Payoffs and Profits for the Call Writer

Payoff to Call Writer

- (ST - X) if ST >X

0 if ST < X

Profit to Call Writer

Payoff + Premium

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 Payoffs and Profits for the Put Holder

Payoffs to Put Holder

0 if ST > X
(X - ST) if ST < X

Profit to Put Holder

Payoff - Premium

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 Payoffs and Profits for the Put Writer

Payoffs to Put Writer

0 if ST > X
-(X - ST)if ST < X

Profits to Put Writer

Payoff + Premium

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 Bearish or Bullish?

• Bullish
– Buy call
– Write put

• Bearish
– Write call
– Buy put

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 This Class: Option Basics

• Different types of options

• Pay-off and profit for options

• Price for options

– What is the value, or the premium for options

• Put-call parity

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 Valuation of Option: Example

115 5

100 C

95 0

Stock Price Call Option Payoff

X = 110

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 Binomial Option Pricing: Example

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Alternative Portfolio
Buy 1 share of stock at $100
Borrow $86.36 (10% Rate) 95/(1+10%) 13.64
Net outlay $13.64
Payoff in the future 0
Value of Stock 95 115
Payoff Structure
Repay loan -95 -95 is exactly 4 times
Net Payoff 0 20 the Call

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 Binomial Option Pricing: No Arbitrage

20 20

13.64 4C

0 0

4C = $13.64
C = $3.41
Otherwise, there will be arbitrage opportunities!

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 Another Way to Examine the Problem

•Alternative Portfolio - one share of stock and 4 calls written (X = 110)

•Portfolio is perfectly hedged:

Stock Value 95 115
Call Obligation 0 -20
Net payoff 95 95

•Risk-free asset
– Hence 100 - 4C = $95/(1+10%) = $86.36
– C = $3.41

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 Hedge Ratio

•In the example, the hedge ratio = 1/4 or 1 share to 4 calls

•If the investor writes one option and holds H shares of stocks, the value of the portfolio
will not be affected by stock price

•Generally, the hedge ratio is:

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 Volatility and the Value of Call Option

The value of call option _____ with volatility.

A. Increases

B. Decreases

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 Higher Volatility Increases Call Value

120 10

100 h𝑖𝑔h − 𝑣𝑜𝑙

𝐶

90 0

Stock Price Call Option Payoff

X = 110

h𝑖𝑔h − 𝑣𝑜𝑙 𝐶 𝑢 −𝐶 𝑑 10 − 0 1
𝐻 = = =
𝑢 𝑆0 − 𝑑 𝑆0 120 − 90 3

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 Higher Volatility Increases Call Value

120-90=30 30

18.18 h𝑖𝑔h − 𝑣𝑜𝑙

3𝐶

90-90=0 0

Stock Price Call Option Payoff

X = 110

•Alternative Portfolio
– Buy 1 share of Stock at 100
– Borrow $81.82 (10% interest Rate)
•Buy 3 contract of Call has the same payoff
– Net outlay $18.18 • = $18.18
• = 6.06
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 Another Way to Examine the Problem

•Alternative Portfolio - one share of stock and 3 calls written (X = 110)

•Portfolio is perfectly hedged:

Stock Value 90 120
Call Obligation 0 -30
Net payoff 90 90

•Risk-free asset
– Hence 100 - 3C = $81.82 or C = $6.06 > $3.41

• An increase in volatility increases option value!

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 Life Story
• Intuition: options protect you from bad performance and are profitable when
performance is good
– The worst thing you can get is 0 when things is really bad
– Option allows you to keep the upside
– The value of options increase with volatility

• My experience at Cornell Board of Trustees

• Searching for new jobs

– Be ambitious

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 Four Levels of Learning

• Pass the exam

• Have great understanding of investment

• Apply the knowledge to your financial life

• Apply the philosophy of finance to your personal life

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 This Class: Option Basics

• Different types of options

• Pay-off and profit for options

• Price for options

• Put-call parity

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 Put-Call Parity
•Another application of no-arbitrage condition
– Financial assets with the same payoff should have the same price

•Same payoff for two strategies

•A protective put portfolio

– Buy stock
– Buy put option with strike price X

•Call-plus-bills portfolio
– Buy call option with strike price X
– Buy treasury bills with face value equal to the strike price of the call

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Different Assets, Same Payoff

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 Put-Call Parity

• The call-plus-bond portfolio (on the left) must cost the same as the stock-plus-put
portfolio (on the right):

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 Put-Call Parity – Disequilibrium Example

•Stock Price = 110 Call Price = 17

•Put Price = 5 Risk-Free Rate = 5%
•Maturity = 1 yr X = 105

𝑿 𝟏𝟎𝟓
𝑪+ 𝑻
=𝟏𝟕+ 𝟏
=𝟏𝟏𝟕
(𝟏+𝒓 𝒇 ) 𝟏.𝟎𝟓
Buy the low-cost alternative (115) and sell the high-cost
alternative (117)

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Arbitrage Strategy

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