Chapter 11

Properties of Stock Options

Options, Futures, and Other Derivatives, 9th Edition, Copyright © John C. Hull 2014 1
Introduction
The chapter looks at the factors that affect
stock options prices;
Using a number of no arbitrage arguments,
the relationships between European,
American option and their underlying stock
prices
The most important of these relationships is
the put-call parity

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Notation: for the factors that
affect stock options prices
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 (expiration)
K: Strike price
D: PV of dividends paid
T: Life of option (Time during life of option
to expiration) is
decimals r Risk-free rate for
: Volatility of stock maturity T with cont.
price comp.

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Effect of Variables on Option
Pricing
The change in option pricing if any of these
variables change, ceteris paribus.
The current price of the stock, S0
Call: as S0 increases (decreases)  the value of
the call, c or C increases (decreases)
Put: as S0 increases (decreases)  the value of
the put, p or P decreases (increases)
 the rationale behind that is as the option becomes
closer to or more in-the-money, its values naturally
increases as it is more profitable
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Effect of Variables on Option
Pricing
The Strike price of the option, K
Call: as K increases (decreases)  the value of
the call, c or C decreases (increases)
Put: as K increases (decreases)  the value of
the put, p or P increases (decreases)

the rationale is the same as the prior case.

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Effect of Variables on Option
Pricing
Time to expiration (Life of option), T
American options: the longer the time to expiration
T , the higher the value of the option (call or put).
• Because the likelihood of the option expiring in-
the-money is higher.
European options: this does not apply to European
options as the can only be exercised at maturity

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Effect of Variables on Option
Pricing
Volatility of stock price, 
As volatility increases the value of the option (call
or put) increases
Due to the asymmetric payoffs of the option
unlike the underling stock whose payoffs are
symmetric which results in upward volatility
offsetting the effect of downward volatility
Therefore, the increase in volatility increase the
chance that an option expires in the money.
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Effect of Variables on Option
Pricing
Risk-free rate, r over the life of the option
Call: as r increases (decreases)  the value of
the call, c or C increases (decreases)
Put: as r increases (decreases)  the value of
the put, p or P decreases (increases)

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Effect of Variables on Option
Pricing
Dividends, D
Call: as D is paid  the value of the call, c or C
decreases
Put: as D is paid  the value of the put, p
or P increases
the rationale is that the option holder is not entitled
to any cash flows from the underlying stock. So,
as the price of the stock declines when a dividend
payment is announced this affect the price of the
option by decreasing the price of the call and
increasing the price of the put 9
Effect of Variables on Option
Pricing (Table 11.1, page 235)
Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
 + + + +
r + − + −
D − + − +

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© John C. Hull 2014 10
Assumptions for the bounds of
option prices
These bounds are enforced by arbitragers
If the option price is above these bounds or
below it  an arbitrage opportunity will arise
The usual assumptions (similar to those
required for the cost of carry relation) must
hold to facilitate arbitrage transactions
No transaction costs
All profits are taxed @ the same rate
Lending and borrowing is possible @ risk-free rate
11
Upper and lower bounds for
option prices: upper bound
Call option
Since a call option is the right to buy the
underlying asset @ certain price (the strike or
exercise price), it cannot sell for a price greater
than the underlying asset spot prices.
What if it happens? Every one will sell the option
and buy the stock and realize arbitrage profits.
Therefore, we can write:
c≤S0C ≤ S0

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Upper and lower bounds for
option prices: upper bound
Put option
Since a put option is the right to sell the underlying
asset @ certain price (the strike or exercise price),
it cannot sell for a price greater than the strike or
exercise price.
What if it happens? Everyone will sell the option
and invest the proceeds @ the risk-free rate until
the option expires. Therefore, we can write:
P ≤ K while the European put upper bound can be
reduced to the present value of the strike price:
p≤ Ke –rT because it cannot be exercised early
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Upper and lower bounds for option
prices: lower bound (no Div)
A lower bound of an European call option is:
c  max(S0 –Ke –rT, 0)

The value of the call option cannot be

negative, why?
The option contract gives its owner a right but
not an obligation to exercise it—if 0 S0 –Ke –rT
The option can be left to expire worthless
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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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Calls: An Arbitrage
Opportunity?
c  max(S0 –Ke–rT, 0)
The theoretical minimum value of the call is
given by
c*=S0 –Ke–rT
=20 –18e–0.1(1)
=20 – 16.28=3.71
Since c = 3 & c*=3.71, there is an arbitrage
opportunity
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Calls: An Arbitrage Opportunity?
The call expires in the money
T=0 T=1
Sell short the stock @$20 The call expires in the money so the
option is exercised @-$18
Buy the call @-$3 Close the short position by
delivering the stock to the broker
(no cash flows involved)

Invest @10% the proceeds -$17 The investment matures 18.79

(17e 0.1(1))
Net 0 Net 0.79

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Calls: An Arbitrage Opportunity?
The call expires out of the money
Say the stock price @expiry is $17
T=0 T=1
Sell the stock @$20 buy the stock back @-$17
Buy the call @-$3 The call expires out of the money so
the option is left to expire worthless
(no cash flows involved)

Invest @10% the proceeds -$17 The investment matures $18.79

(17e 0.1(1))
Net 0 Net $1.79

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A more formal argument
Consider the following 2 portfolios:
Portfolio A: European call on a stock + zero-
coupon bond that pays K at time T
Portfolio B: the stock
So, there are two scenarios @Time T
the call expires out of the money portfolio A
will be worth K
the call expires in the money portfolio A will
be worth ST
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A more formal argument
So, we can write that portfolio A is worth
max(ST, K) depending on the whether the call ends
up out of the money or in the money.
the stock will be always worth ST portfolio B
is always worth ST
hence, we can see that portfolio A at least
worth as much as portfolio B @maturity

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A more formal argument
in the absence of arbitrage opportunities:
Portfolio A  Portfolio B
this should hold today or @time T=0. Thus,
c +Ke –rT S0
c S0 - Ke –rT
And as we know the worst that can happen for the
call option is to expire worthless, we obtain
c  max(S0 –Ke –rT, 0)
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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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Puts: An Arbitrage Opportunity?
p  max(Ke –rT – S0, 0)
The theoretical minimum value of the put is
given by
p*= Ke –rT – S0
= 40e –0.05(0.5) –37
=39.01 – 37=2.01
Since p = 1 & p*=2.01, there is an arbitrage
opportunity
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Puts: An Arbitrage Opportunity?
The put expires in the money
T=0 T=1
Borrow to buy the stock and the The put expires in the money so the
put @$38 option is exercised @$40
Buy the stock and the put @-$38 Repay the loan @-$38.96
(37 (s)+1(P) (38e 0.05(0.5))
Net 0 Net 1.04

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Puts: An Arbitrage Opportunity?
The put expires out of the money
Say the stock price @expiry is $42
T=0 T=1
Borrow to buy the stock and the The put expires worthless and the
put @$38 stock is sold for @$42
Buy the stock and the put @-$38 Repay the loan @-$38.96
(38e 0.05(0.5))
Net 0 Net $3.04

25
A more formal argument
Consider the following 2 portfolios:
Portfolio C: European put on a stock + the stock
Portfolio D: zero-coupon bond that pays K at time T
So, there are two scenarios @Time T
the put expires in the money portfolio C will
be worth K
the put expires out of the money portfolio C
will be worth ST
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A more formal argument
So, we can write that portfolio C is worth
max(ST , K) depending on the whether the put ends
up out of the money or in the money.

portfolio D is always worth K

hence we can see that portfolio C at least

worth as much as portfolio D @maturity
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A more formal argument
in the absence of arbitrage opportunities:
Portfolio C  Portfolio D
this should hold today or @time T=0. Thus,
p +S0 Ke –rT
p Ke –rT – S0
And as we know the worst that can happen for the
put option is to expire worthless, we obtain
p  max(Ke –rT – S0 , 0)
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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 aka fiduciary
call. The payoff (again):
• In the money ST (ST – K)+K
• Out of the money K
Portfolio C: European put on the stock + the stock
aka protective put. The payoff (again):
• In the money K (K – ST)+ST
• Out of the money ST
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Values of Portfolios
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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© John C. Hull 2014 30
The Put-Call Parity Result (Equation
11.6, page 242)
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
c = p + S0 – Ke -rT
p = c + Ke -rT – S0
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The Put-Call Parity Result
S0= c – p +Ke –rT
Ke -rT=S0 – c + p
The single securities on the left-hand side of the
equations all have the same payoffs as the
portfolios on the right-hand side. The portfolios
on the right-hand side are the “synthetic”
equivalents of the securities on the left. Note
that the options must be European, and the
puts and calls must have the same strike price
for these relations to hold. 32
Arbitrage Opportunities
Suppose that
c= 3 S0= 31
T = 0.25 (three months) r = 10%
K =30 D=0

What are the arbitrage possibilities when

p = 2.25 ? (We will do together)

p = 1 ? (In the book!!)

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Arbitrage Opportunities: if p=2.25
c + Ke -rT = p + S0
Let us see if the Put-Call Parity (Portfolio A=Portfolio C) holds
given the case we have.
c + Ke -rT =3+ 30e -0.1(0.25) = $32.26
p + S0 = 2.25+31= $33.25
Portfolio A<Portfolio C  Portfolio C is overpriced relative to
A. What will an arbitrageur do in this case? What is the trading
strategy?

34
Arbitrage Opportunities: if p=2.25
if the Call expires in the money
T=0 T=1
Buy the call @-$3 The call expires in the money so the
option is exercised @-$30
Short the put @$2.25 As the call expires in the money i.e.,
ST>30, the put by definition will be
out of the money so the holder of
put will let it expire worthless (no
cash flows involved)
Short the stock @$31 Close the short position by
delivering the stock to the broker
(no cash flows involved)
Invest @10% the proceeds -$30.25 The investment matures 31.02
(30.25e 0.1(0.25))

Net 0 $1.02
35
Arbitrage Opportunities: if p=2.25
if the Call expires out of the money
T=0 T=1
Buy the call @-$3 The call expires out of the money so
the option is left to expire worthless
(no cash flows involved)
Short the put @$2.25 As the call expires out of the money
i.e., ST<30, the put by definition
will be in the money so the holder
of put will exercise it and we will
buy it @K -$30
Short the stock @$31 Close the short position by
delivering the stock to the broker
(no cash flows involved)
Invest @10% the proceeds -$30.25 The investment matures 31.02
(30.25e 0.1(0.25))

Net 0 $1.02
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Early Exercise
The only difference between European and
American option is that American can be
exercised 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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John C. Hull 2014 38
American vs European Options
An American option is worth at least as much
as the corresponding European option
C  c max(S0 –Ke –rT, 0)
When an American option is exercised, it is only
worth S0 –K and this is never larger than
S0 –Ke –rT for r and T >0 it is never optimal to exercise
early. In other words, the investor can keep the cash
equal K which be used to exercise the option early.
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American vs European Options
American put options are optimally exercised early if
the are deep in the money. If the option is
sufficiently in the money, it can be exercised, and the
payoff (K- S0) can be invested to earn interest.

P  pmax(Ke –rT – S0 , 0)

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Copyright © John C. Hull 2014 40
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 11.8 and 11.9, page 249)

 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 11.7 p. 244

European options; D > 0

c + D + Ke −rT = p + S0
Equation 11.10 p. 250

American options; D > 0

S0 − D − K < C − P < S0 − Ke −rT
Equation 11.11 p. 250

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