Chapter 2 (continue)

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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
: Volatility of stock
price r Risk-free rate for
maturity T with cont.
comp.

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Effect of Variables on Option
Pricing (Table 10.1, page 215)
Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
 + + + +
r + − + −
D − + − +

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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
Why is an American option more expensive
than European option?

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Calls: An Arbitrage
Opportunity?
Suppose that

c=3 S0 = 20
T=1 r = 10%
K = 18 D=0

Is there an arbitrage opportunity?

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Lower Bound for European Call
Option Prices; No Dividends
(Equation 10.4, page 220)

c  S0 –Ke -rT

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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 for European Put
Prices; No Dividends
(Equation 10.5, page 221)

p  Ke -rT–S0
Upper Bound for Put/Call
Prices; No Dividends?
(page 219)

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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 C: European put on the stock + the stock

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Values of Portfolios at the maturity
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

Worth of Portfolios at the

current time?
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The Put-Call Parity Result (Equation
10.6, page 222)
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

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Arbitrage Opportunities (the table 10.3)

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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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

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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)

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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)

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The Impact of Dividends on Lower
Bounds to Option Prices
(Equations 10.8 and 10.9, page 229)

− rT
c  S 0 − D − Ke
− rT
p  D + Ke − S0

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Extensions of Put-Call Parity
American options; D = 0
S0 − K < C − P < S0 − Ke−rT
Equation 10.7 p. 224

European options; D > 0

c + D + Ke −rT = p + S0
Equation 10.10 p. 230

American options; D > 0

S0 − D − K < C − P < S0 − Ke −rT
Equation 10.11 p. 230

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Trading Strategies Involving
Options

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Strategies to be Considered
Bond plus option to create principal
protected note
Stock plus option
Two or more options of the same type (a
spread)
Two or more options of different types (a
combination)

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Principal Protected Note
Allows investor to take a risky position without
risking any principal
Example: $1000 instrument consisting of
3-year zero-coupon bond with principal of $1000
3-year at-the-money call option on a stock
portfolio currently worth $1000

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Principal Protected Notes continued
Viability depends on
Level of dividends
Level of interest rates
Volatility of the portfolio
Variations on standard product
Out of the money strike price
Caps on investor return
Knock outs, averaging features, etc

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Positions in an Option & the Underlying
(Figure 11.1, page 237)

Profit Profit

K
K ST ST
(a)
(b)
Profit Profit

K
ST K ST

(c) (d)
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Bull Spread Using Calls
(Figure 11.2, page 238)

Long call, K1
Profit
Buying
call option
with a
strike
price K1 &
ST
selling
other call K1 K2
option
with a Short call, K2
strike
price K2
K1< K2
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Bull Spread Using Puts
Figure 11.3, page 239

Profit Short put, K2

K1 K2 ST

Long put, K1

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Example 11.2 page 239

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Bear Spread Using Puts
Figure 11.4, page 240

Profit
Short put, K1

K1 K2 ST

Long put, K2

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Bear Spread Using Calls
Figure 11.5, page 241
Profit

Long call, K2

K1 K2 ST

Short call, K1

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Example 11.2 page 239

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Box Spread
A combination of a bull call spread and a bear
put spread
If all options are European a box spread is
worth the present value of the difference
between the strike prices
If they are American this is not necessarily so
(see Business Snapshot 11.1)

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Options, Futures, and Other Derivatives, 8th Edition,
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Butterfly Spread Using Calls Long call, K1
Figure 11.6, page 242
Long call, K3
Profit

K1 K2 K3 ST

Short 2 calls, K2

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Butterfly Spread Using Puts
Figure 11.7, page 243
Profit Long put, K3
Long put, K1

K1 K2 K3 ST

Short 2 puts, K2
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Options, Futures, and Other Derivatives, 8th Edition,
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A Straddle Combination
Figure 11.10, page 246

Profit

K ST

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Options, Futures, and Other Derivatives, 8th Edition,
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Strip & Strap
Figure 11.11, page 248

Profit Profit

K ST K ST

Strip (one call + 2 puts) Strap (two calls + one put)

Options, Futures, and Other Derivatives, 8th Edition,
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A Strangle Combination
Figure 11.12, page 249

Profit
Long call, K2

K1 K2
ST
Long put, K1

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