Chapter 11

Properties of Stock Options

1
Notation
> Can be exercised only at maturity date Can be exercised at any time
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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
Exercise price
maturity
K: Strike price
D: PV of dividends paid
T: Life of option
during life of option
: Volatility of stock
price r Risk-free rate for
maturity T with cont.
comp.

2
Effect of Stock Price on Option
Pricing

The value of call option increase when stock price increase in both European and American options The value of put option decreases when stock price increase in both European and American options

3
Effect of Strike Price on Option
Pricing

The value of call option will decrease when the strike price increase in both European and American options The value of put option will increase when the strike price increase in both European and American options

4
Effect of Expiration Time on
Option Pricing

The value of put option will increase when the time increase only in American options
The value of call option increase when the time increase only in American options
In European options, the impact of the time on the value of the put option is uncertain.
In European options, the impact of the time on the value of the call option is uncertain.
When time increase, the European put option may increase or decrease
When time increase, the European call option may increase or decrease

5
Effect of Volatility on Option
Pricing

The value of call option increase when the volatility increase in both European and American options The value of put option will increase when the volatility increase in both European and American options

6
Effect of Interest Rate on Option
Pricing

The value of call option increase when the r increase in both European and American options
The value of put option will decrease when the r increase in both European and American options

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Effect of Variables on Option
Pricing (Table 11.1)
Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
 + + + +
r + − + −
D − + − +
The value of call option will decrease when the D announced in both European and American options
The value of put option will increase when the D announced in both European and American options

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American vs European Options
An American option is worth at least as much
as the corresponding European option
Cc
Pp

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Calls: An Arbitrage
Opportunity?
Suppose that
Stock price

c=3 S0 = 20
T=1 r = 10%
Strike price

K = 18 D=0

Is there an arbitrage opportunity?

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 Lower Bound = So - Ke^ -rt = 20 - 18e ^ - 10% (1) = 3.71. So, the price of call caption should be not less than this value,
otherwise will be an arbitrage opportunity. c = 3 , so will be an arbitrage opportunity

Arbitrage strategy:

1- Short selling the stock @ 20$ “the stock price So = 20” you will receive 20$ “inflow”

2- Buy 1 year call option @ 3$ “the price of call option c = 3$”. You are the long call position, you have to make payment to the
other party. You will pay 3$ “outflow”
Net cash flow = 20 - 3 = 17$

3- Invest the 17$ for one year “T =1”

(After one year, it will grow to 17e^10%*1 = 18.79)

After one year:

1- If stock price in the market > 18$ (Strike price)

- Arbitrager will exercise the call option @ 18 $
- Use the stock you bought from the call option to close out your position in the short selling
Profit = 18.79 - 18 = 0.79

2- If stock price in the market < 18$ (Strike price), assume it’s 17$
- Arbitrager will not exercise the call option and buy the stock from the market @ 17$
- Use the stock you bought from the market to close out your position in the short selling
Profit = 18.79 - 17 = 1.79
Lower Bound for European Call
Option Prices; No Dividends
(Equation 11.4)
Lower Bound
Upper bound

The price of option should be between the LB and UB,

if it’s not, there is arbitrage opportunity “weather it’s
less than the LB or more than the UB”

It’s equal to the stock price

Formula of LB for European call option

c  max(S0 –Ke –rT, 0)

Should be the maximum out of these values
If it’s So - Ke ^ -rT = more than zero, it’s should be this value. If it’s less than zero, it’s should be zero
Ex: So - Ke^ -rt = 2, the LB = 2 Or So - Ke ^ rt = -2, the LB = 0
So, the LB can’t be negative

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Puts: An Arbitrage Opportunity?

Suppose that
p= 1 S0 = 37
T = 0.5 r =5%
K = 40 D =0

Is there an arbitrage opportunity?

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Lower Bound = Ke^ -rt - So = 40e^-5%(0.5) - 37 = 2.01 . So, the price of put option should be not less than this value, otherwise will
be an arbitrage opportunity. p = 1 , so will be an arbitrage opportunity

Arbitrage strategy:

1- Borrow 38$ for 6 months, why 38? Since the put option price p = 1, and the stock price So = 37. So Cash needed
= 37 + 1 = 38

2- Buy 6-months put option @ 1$ “the price of put option p = 1$”

After 6-months:

1- If stock price in the market < 40$ (Strike price)

- Need to pay 38e^5%*0.5 = 38.96 to the lender
- Exercise the put option @ 40$ (Strike price)
Profit = 40 - 38.96 = 1.04

2- If stock price in the market> 40 (Strike price), assume it’s 42$

- Arbitrager will not exercise the put option and sell the stock in the market @ 42$
- Repay the loan
Profit = 42 - 38.96 = 3.04
Lower Bound for European Put
Prices; No Dividends (Equation 11.5)
Same with call option but with deferent equation

p  max(Ke -rT–S0, 0)
The Upper Bound in European put options is equal to the strike price

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 Balancing the call and put options European

Put-Call Parity: No Dividends

Why there is a zero coupon bond ? since it’s call option “you have the right to buy” you will need to
deliver the cash to get the stock. “That pays K” which is the cash you will need to pay the strike price

Consider the following 2 portfolios: at maturity. “at time T” which is the expiry date of the call option
Zero coupon bond: No coupon payment, only the par value at maturity

Portfolio A: European call on a stock + zero-

coupon bond that pays K at time T Since the coupon have a value at T maturity, we have to discount the coupon value to
its value today. Present value = Ke ^-rT. So, this the cash you need it today

Portfolio C: European put on the stock + the stock

Why there is a stock? since it’s put option “you have
the right to sell” you will need to deliver the stock

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Values of Portfolios (Table 11.2)
ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total ST K
Portfolio C Put Option 0 K− ST
Share ST ST
Total ST K

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The Put-Call Parity Result (Equation
11.6)
Both are worth max(ST , K ) at the maturity of
the options
They must therefore be worth the same
today. This means that

c + Ke -rT = p + S0
First portfolio A Second portfolio B
c = call option p = put option
+ the cash today for zero coupon bond So = stoke price

Put - Call parity means these tow portfolios should be equal

If it’s equal, No arbitrage opportunity

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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 ?
p=1?

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 c + Ke ^ -rt = p + So
3 + 30e^ -10%(3/12) = p + 31
eft side of put - call parity (Portfolio A) = c + Ke^ -rt = 3 + 30e^-10%(3/12) = 32.25 (lower than C) There is a value that’s unknown which is p
ight side of put - call parity (portfolio C) = p + So = 2.25 + 31 = 33.25 (higher than A) Scenario 1: p > 1.25, there is arbitrage opportunity
ortfolio A (left side) is under priced and Portfolio C (right side) is over priced 32.2593 = p + 31
you have any asset that under priced, always try to buy that’s asset
you have any asset that over priced, always try to sell that’s asset p= 1.25
o, we will buy portfolio A ( 1 call option + cash Ke^-rt)
So, if we want put - call parity , the p should equal 1.25
nd sell portfolio C ( 1 put option + the stock)

Your position here is long call (buying the call option) , you will make
payment 3$ (option price) to the other party “the short call”. 3$ is outflow

Your position here is short put (selling the put option), you will receive payment
2.25 (option price) from the other party “the long put”. 2.25 is inflow

You will sell a stock that you borrowed

31 is inflow

Your net cash flow = 31 + 2.25 - 3 = 30.25 inflow. You will invest it to 3 months

30.25e^10%(3/12) = 31.015

Step 1, you have the right to buy the stock at 30, in

the market the price > 30. You will exercise your right Return the stock that you borrowed, step 3

What about step 2? The option will not be exercised from the party with long put since the strike
31.02 - 30 = 1.02
price to sell is 30 and the stock price in the market is > 30. Better for him to sell it in the market

Step 2, The option will be exercised from the party with long
You have to buy the share from the long put position at 30$. You will deliver 30$ (pay from the
put since the strike price to sell is 30 and the stock price in
receiving from the investment) and receive the stock. Return the stock that you borrowed, step 3
the market is < 30. Better for him to exercise the option and
sell to you the stock for 30

31.02 - 30 = 1.02
What about step 1? Since the stock price in the market < strike price, you will not
exercise your right and nothing will happen in this step

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 Left side of put - call parity (Portfolio A) = c + Ke^ -rt = 3 + 30e^-10%(3/12) = 32.25 (higher than C)
Right side of put - call parity (portfolio C) = p + So = 1 + 31 = 32 (lower than A) Scenario 2: p < 1.25, there is arbitrage opportunity
Portfolio A (left side) is over priced and Portfolio C (right side) is under priced
If you have any asset that over priced, always try to sell that’s asset
If you have any asset that under priced, always try to buy that’s asset
So, we will sell portfolio A ( 1 call option + cash Ke^-rt)
and buy portfolio C ( 1 put option + the stock)

Net cash flow from step 2,3,4 = 3 - 1 - 31 = 29. So you need to borrow that’s amount

Your position is short call, you will receive 3$ “option price” from the long call position. 3$ is inflow

Your position is long put, you have to make payment 1$ “option price” to the party with short put. 1$ is outflow

31$ is outflow

Step 2, The option will be exercised from the party with long call since the
You have to sell the share (from step 4) to the long call position at 30$. You will deliver stock and receive the 30
strike price to buy is 30 and the stock price in the market is > 30. Better for
him to exercise the option and buy the stock for 30

29e^10%(3/12) = 29.73

What about step 3? Since the price in the market > 30, you will not exercise your right
30 - 29.73 = 0.27

Step 3, you will exercise your right and sell the stock at 30 since the stock price
in the market < 30. You will deliver the stock “from step 4” and receive 30$

29e^10%(3/12) = 29.73

30 - 29.73 = 0.27
What about step 2? The option will not be exercised from the party with long call since the strike price to
buy is 30 and the stock price in the market is < 30. Better for him to buy it from the market
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Early Exercise
In American call options, should not exercise early except when it’s dividends paying stock
Call option in dividends paying stock should exercise early

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

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An Extreme Situation
For an American call option:
S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
What should you do if
You want to hold the stock for the next 3 months?
You do not feel that the stock is worth holding for the
next 3 months?

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Reasons For Not Exercising a
Call Early (No Dividends)
No income is sacrificed
You delay paying the strike price
Holding the call provides insurance against
stock price falling below strike price

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Bounds for European or American Call
Options (No Dividends) Figure 11.3
If call options are in this
region, there is no arbitrage
opportunity

Upper bound

Lower Bound

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 In American put options, always better to exercise as early as possible when ever gives you a profit “when ever it’s in the money”

Should Puts Be Exercised

Early ?
Are there any advantages to exercising
an American put when
S0 = 60; T = 0.25; r=10%
K = 100; D = 0

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Bounds for European and American
Put Options (No Dividends) Figure 11.4
Upper bound
Upper bound

If American put options are in this region,

If European put options are in this region, there is no arbitrage opportunity
there is no arbitrage opportunity

Lower bound
Lower bound

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The Impact of Dividends on Lower
Bounds to Option Prices On European options

(Equations 11.8 and 11.9)

With Dividends
With no Dividends

− rT
We will subtract the amount of dividends
S
c  S 0 − D − Ke
With Dividends
With no Dividends

− rT
We will add the amount of dividends

E
p  D + Ke − S0

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Extensions of Put-Call Parity With no dividends

American options; D = 0
S0 − K < C − P < S0 − Ke−rT The American call price C - the American put price P should be more than or equal So - K and less than or equal So - Ke^-rt

Equation 11.7

European options; D > 0

c + D + Ke −rT = p + S0
Equation 11.10
With dividends

American options; D > 0

S0 − D − K < C − P < S0 − Ke −rT The American call price C - the American put price P should be more than or equal So - D - K and less than or equal So - Ke^-rt

Equation 11.11

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Put-Call Parity

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 19 - 20 <= C - P <= 19 - 20e^-10%(5/12)

Why? Because the price of call and

put options can’t be negative
Change the sign for the whole equation -1 <= C - P <= - 0.1837
- 1 become 1, less than sigh (<) become
more than sigh (>), C - P become P -C,
and - 0.1837 become 0.1837 1 >= P - C >= 0.184

First equation:
1 >= P - C
1 >= P - 1.5

2.50 >= P

Second equation:
P - C >= 0.184
P - 1.5 >= 0.184

P >= 1.684

So, P must lies between 1.68 (P grater than 1.68) and 2.50 (P
less than 2.50)

In American options if we have one value of C, we will have tow values of P/ a range of P. Vice versa
P must lie between $1.68 and $2.50.
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