Derivative markets and instruments

Contents

• Upper and lower bound for option prices

• Put-call parity
• Trading strategies involving Options
• Swaps
Upper and lower bound for option prices

 If an option price is above the upper bound or below the lower bound, then there are profitable
opportunities for arbitrageurs.

 Upper bounds

 An option gives the holder the right to buy one share of a stock for a certain price. No matter what
happens, the option can never be worth more than the stock price.

 The stock price is an upper bound to the option price:

and

 If these relationships were not true, an arbitrageur could easily make a riskless profit by buying the stock
and selling the call option.
Lower bound European call options

• Consider two portfolios:

• Portfolio A: one European call option plus an amount of cash equal to (c + )

• Portfolio B: One share ()

• In portfolio A, the cash, if it is invested at the risk-free interest rate, will grow to K in time of T.

• If , the call option is exercised at maturity and portfolio A is worth . If , the call option exercise
worthless and the portfolio is worth K.

• Hence at time T, portfolio is worth of:

Max( K)
Lower bound European call options
Portfolio B: One share

 Portfolio B is worth at time T. Hence, portfolio A is always worth as much as,

and can be worth more than, portfolio B at the option’s maturity. It follows that in
the absence of arbitrage opportunities this much be true today. Portfolio must be
equal to portfolio B or more. Hence:
c+
or
c-
 Because the worst that can happen to a call option is that it expires worthless, its
true value cannot be negative. This mean that c > 0 and therefore,
c
Example of European call option

• Stock price is $51

• Strike price is $50

• Time to maturity is 6 months

• Risk free rate of return 12% per annum

• A lower bound call option price is =

• Option price = 51 - 50 $3.91

Lower bound for European puts on non-dividend paying
stocks

• For a formal arguments:

• Portfolio C: One European put option plus one share (p + )

• Portfolio D: An amount of cash equal to K

• If , then the option in portfolio C is exercised at option maturity, and portfolio become worth K.

• If , then the put option expires worthless, and the portfolio is worth at this time.

• Hence, portfolio C is worth:

Max(, K)
Lower bound for European puts on non-dividend paying
stocks
• Portfolio D: An amount of cash equal to K
• Assuming that the cash is invested at the risk-free interest rate, portfolio D is worth K in
time T.
• Hence portfolio C is always worth as much as, and can sometimes be worth more than,
portfolio D in time T.
• It follows that in the absence of arbitrage opportunities portfolio C must be worth at least
as much as portfolio D today.
• Hence:
p+ =p
• Because worst can happen to a put option is that it expires worthless, its values cannot be
negative: this means that
p)
Example

 Consider a European put option on a non-dividend-paying stock

when the stock price is $38, the strike price is $40, the time to
maturity is 3 months, risk free interest rate is 10% per annum.
 The lower bound for the option price is:

=?

40
Put-call parity

• Put-call parity, which is a relationship between the price of a European call option
and the price of the European put option, and the underlying stock price.
Put call parity
• We will understand an important relationship between p and c.
• Portfolio A: one European call option plus an amount of cash equal to (c + )
• Portfolio C: one European put option plus one share (p + )
• Both are worth:
Max(
• At the expiration of the portfolio must have identical values today:
c+K

It shows that the value of the European call with a certain strike price and exercise
date can be deduced from the value of a European put with the same strike price
and exercise date, and vice and versa.
Put call parity
• What if the previous equation does not hold?

• Suppose that the stock price is $31, the strike price is $30, risk free return is 10% per annum, 3
months European call option is $3, and the price of a three-month European put option is
$2.25.

• Price of the portfolio call option is:

• c + K = 3 + 30 = $32.26

• Price of the portfolio by put option:

• = $2.25 + $31 = $33.25

• Portfolio C is overprices to portfolio A

Arbitrage opportunities
• An arbitrage can buy the securities in portfolio A and short the securities in portfolio C.

• The strategy involves:

• Buying the call and shorting the put and the stock. This will generate the cash flow of:

• -3 + 2.25 + 31 = $30.25

• You are investing this amount for 3 months, this amount grows to

• $30.25

• If the stock price at the expiration of the option is greater than $30, the call option will be exercised; and if
it is less than $30, the put option will be exercised. In either case, the arbitrageur end of buying one share
for $30.

• The net profit therefore: $31.02 - $30.00 = $1.02

For alternative situation

• Call option price is $3

• Put option price is $1

• The value of the portfolio A

• c + K = 3 + 30 = $32.26

• The value of the portfolio A:

• = $1 + $31 = $32.00

• Calculate the strategy and profit form this position?

Trading strategies involving Options

 Spreads: A spreads trading strategy involves a taking a position in two or more

options for the same types.
Trading Strategy: Bull spreads

 Bull Spreads: One of the most popular types of spreads is a bull spread. This can
be created by buying a call option on a stock with a certain strike price and selling
a call option on the same stock with a higher strike price.

 Both option have the same expiration date.

 is the strike price of the call option bought.

 is the strike price of the call option sold

 is the stock price at the expiration date

Trading Strategy: Bull spreads

 A bull spread strategy limits the investor’s upside as well as downside risk.

 The strategy can be described by saying that the investor has a call option with a
strike price equal to .

 Investor has chosen to give up some upside potential by selling a call option with
strike price ( > ).

 In return for giving up the upside potential, the investor gets the price of the
option with strike price
Payoff from a bull spread created using calls

 Three types of spread can be distinguished

1) Both calls are initially out of the money.

2) One call is initially in the money; the other call is initially out of the money.
3) Both calls are initially in the money.
Payoff from a bull spread created using calls
Example: bull spreads

An investor buys for $3 a call with a strike price of $30.

The investor sell for $1 sell a call with a strike price of $35
The payoff from this bull spread strategy is $5 if the stock price is above $35, and
zero if it is below $30.
Profit form bull spread created using call options
Bear Spreads
 An investor who enter into a bear spread is hoping that the stock price will decline.

 Bear spreads can be created by buying a put with one strike price and selling a put
with another strike price.

 The strike price option purchased is greater than the strike price of the option
sold.(contrast to bull where option purchased is always less than the strike price of
the option sold).

 The investor has bought a put with a certain strike price and chosen to give up
some of the profit potential by selling a put with a lower strike price.
Profit form a bear spread created with put options
Profit form bull spread created using put options
Swaps

 A swap is an agreement between two companies to exchange cash flows in the

future.

 The agreement defines the dates when the cash flows are to be paid and the way
in which they are calculated.

 Usually the calculation of the cash flows involves the future value of an interest
rate, an exchange rate, or other market variable.
Plain Vanila interest rate swap
 In this swap a company agrees to pay cash flows equal to interest at a
predetermined fixed rate on a notional principal for a number of years. In return, it
receives interest at a floating rate on the same notional principal for the same
period of time.
Currency Swaps
 Currency swap involves exchanging principal and interest payments in one
currency for principal and interest payment in another currency.
 A currency swap agreement requires the principal to be specified in each of the
two currencies. The principal amounts in each currency are usually exchanged at
the beginning and at the end of the life of the swap.
 Currency can be motivated by comparative advantage.
 Currency Swaps
 We assume that General Electric wants to borrow 20 million AUD and Quants Airways wants
to borrow $15 million and exchange rate 0.75.
 We expect total gain to all parties to be 2.0 - 0.4 = 1.6%
 Both comes to an agreements of swaps and get better off by 0.7%.
 The financial institution gains 1.3% in USD and looses 1.1% in AUD.
 Each year financial institution makes a gain of USD 195,000 (1.3% 15M) and incurs a loss of
AUD 220,000 (1.1 of 20M). They can avoid exchange rate risk by coming for forward market
contract.
Resources

• Chapter 7. Swaps

• Chapter 8 Mechanism of option markets

• Chapter 9. Properties of stock options

• Chapter 10. Trading strategies involvement involving options

• Book John C Hull: Options, Futures and Other derivatives