CH 06

Chapter 6 Financial Options
 Financial Options Terminology

 Option Price Relationships
 Black-Scholes Option Pricing Model
 Put-Call Parity
1
What is a financial option?
 An option is a contract which gives its
holder the right, but not the obligation,
to buy (or sell) an asset at some
predetermined price within a specified
period of time.
 It does not obligate its owner to take
any action. It merely gives the owner
the right to buy or sell an asset.
2
Option Terminology
 Call option: An option to buy a specified number of
shares of a security within some future period.
 Put option: An option to sell a specified number of
shares of a security within some future period.
 Exercise (or strike) price: The price stated in the

option contract at which the security can be bought or
sold.
 Option price: The market price of the option contract.
3
Option Terminology
(Continued)
 Expiration date: The date the option matures.
 Exercise value: The value of a call option if it were
exercised today = Current stock price - Strike price.
 Covered option: A call option written against stock held

in an investor’s portfolio.
 Naked (uncovered) option: An option sold without the
stock to back it up.
4
Option Terminology
(Continued)
 In-the-money call: A call whose
exercise price is less than the current
price of the underlying stock.
 Out-of-the-money call: A call option
whose exercise price exceeds the
current stock price.
5
Option Terminology
(Continued)
 LEAPS: Long-term Equity AnticiPation
Securities that are similar to
conventional options except that they
are long-term options with maturities of
up to 2 1/2 years.
6
Consider the following data:
Exercise price = $25.

Stock Price Call Option Price
$25 $3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
7
Exercise Value vs. Stock Price
Price of Strike Exercise Value
stock (a) price (b) of option (a)–(b)
$25.00 $25.00 $0.00
30.00 25.00 5.00
35.00 25.00 10.00
40.00 25.00 15.00
45.00 25.00 20.00
50.00 25.00 25.00
8
Option Value vs. Exercise
Value
Exercise Value Mkt Price Time Value
Of option (c) Of option (d) (c) – (d)
$0.00 $3.00 $3.00

5.00 7.50 2.50
10.00 12.00 2.00
15.00 16.50 1.50
20.00 21.00 1.00
25.00 25.50 0.50
9
Call Time Value Diagram
Option value
30
25
20
Market price
15
Exercise value
10
5 10 15 20 25 30 35 40 Stock Price
10
An Example
t t* T
$47 $55
At t, stock price is $47, exercise price = $50,
cost of the call option = $3.75.
At t*, stock price is $55.
What actions will you take at time t*?
11
Three Alternatives
 Alternative one: exercise the call option
and realize a gross profit of $5.00 and
net profit of $1.25.
 Alternative two is to sell the call option
in the market.
 Alternative three is to keep holding the
call option and do nothing.
12
Black-Scholes Option Pricing Model
V = P[N(d1)] - Xe -r t[N(d2)]
RF
ln(P/X) + [rRF + (2/2)]t

d1 =
 t 0.5
d2 = d1 -  t 0.5
Five key variables:
V: call value; P: stock price; X: exercise price;
t: time to expire; rRF: risk-free interest rate 13
What is the value of the
following call option according to
the OPM?
 Assume: P=$27; X=$25; rRF=6%; t=0.5 years; σ2= 0.11
First, find d1 and d2.
d1 = {ln($27/$25) + [(0.06 + 0.11/2)](0.5)}
÷ {(0.3317)(0.7071)}=0.5736
d2 = d1 - (0.3317)(0.7071) =0.3391
Second, find N(d1) and N(d2). (Excel NORMSDIST)
N(d1)=N(0.5736)=0.7168. N(d2)=N(0.3391)=0.6327.
Third, find value of option.
V = $27(0.7168) - $25e-(0.06)(0.5)(0.6327)
= $19.3536 - $25(0.97045)(0.6327) = $4.0036. 14
What impact do the following parameters
have on a call option’s value?
 Current stock price: Call option value

increases as the current stock price
increases.
 Exercise price: As the exercise price
increases, a call option’s value
decreases.
15
Impact on Call Value
(Continued)
 Option period: As the expiration date is
lengthened, a call option’s value increases
(more chance of becoming in the money.)
 Risk-free rate: Call option’s value tends to
increase as rRF increases (reduces the PV of
the exercise price).
 Stock return variance: Option value increases
with variance of the underlying stock (more
chance of becoming in the money).
16
Put Options
 A put option gives its holder the right to
sell a share of stock at a specified stock
on or before a particular date.
17
Put-Call Parity
 Portfolio 1:
 Put option, P
 Share of stock, S
 Portfolio 2:
 Call option, C
 PV of exercise price, X
18
Portfolio Payoffs for
S<X and S≥X
S<X S≥X
Port. 1 Port. 2 Port. 1 Port. 2
Stock S S
Put X-S 0
Call 0 S-X
Cash X X
Total X X S S
19
Put-Call Parity Relationship
 Portfolio payoffs are equal, so portfolio values
also must be equal.
 Put + Stock = Call + PV of Exercise Price
-rRFt
P + S = C + Xe
-rRFt
P = C – S + Xe
20

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Chapter 6 Financial Options

 Financial Options Terminology

 Exercise (or strike) price: The price stated in the

 Covered option: A call option written against stock held

Exercise price = $25.

$0.00 $3.00 $3.00

ln(P/X) + [rRF + (2/2)]t

 Current stock price: Call option value

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