OPTION CONTRACTS

by

Evony Silvino Violita

Universitas Indonesia,
2017

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Definition
A call option is a contract that gives the holder the right to buy a particular
asset at a specified price (called the exercise price or strike price) within a
specified period of time.

A put option is a contract that gives the holder the right to sell a particular
asset at a specified price within a specified period of time.

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Some terms
Strike Price
Price set for calling/putting asset
Premium
Purchase price of option
In the Money
Exercise would generate positive cash flow
Out of the Money
Exercise would generate negative cash flow
At the Money
Exercise price equals asset price

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Definition
call option is a contract that gives the holder the right to buy a particular asset at a
specified price (called the exercise price or strike price) within a specified period of
time.
A put option is a contract that gives the holder the right to sell a particular asset at a
specified price within a specified period of time.
payoff payoff

St St
X X
Payoff=Max (0,St-X) Payoff=Max (0,X-St)
Buy call option payoff Buy put option
payoff

Payoff= -Max (0,X-St)

St St
X sell call option X
Payoff= -Max (0,St-X) sell put option

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 Buy a Call Sell a Call
payoff
payoff

St St
X X
Payoff=Max (0,St-X) Payoff= -Max (0,St-X)

Payoff without option premium Payoff without option premium

Payoff with option premium

Payoff with option premium

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 Buy a Put Sell a Put
payoff payoff Buy put option

Payoff= -Max (0,X-St)

St St
X X
Payoff=Max (0,X-St)

Payoff without option premium Payoff without option premium

payoff

St
X

Payoff with option premium

Payoff with option premium

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Put-Call Parity
Suppose you bought a share of stock today for a price of S0 and
simultaneously borrowed an amount of money X(1+r)-T. How much
sould your portfolio be worth at the end of T years? Assume that the
stock does not pay a dividend.

Consider the second condition: you buy a call option and sell a put
option with a maturity date of T and an exercise price of X. How
much will you options be worth at the end of T years?

Position I 0 T Position II 0 T

Buy stock S0 ST Buy call -CE Max(0, ST-X)

Borrow X(1+r)-T -X Sell put PE -Max(0, X-ST)

Net position X(1+r)-T S0 ST - X Net position PE-CE ST - X

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Put-Call Parity
Position I Position II
payoff payoff
ST
Buy stock
ST-X ST-X

net net
0 0 buy call
Stock price Stock price
sell put

Payoff on borrowing
-X -X

Position I = position II

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Put Call Parity
The two position have the same payoff at date T. Hence, they must
have the same price today.
The put-call parity relationship:

Ce Pe = S0 X (1+r)-T

Ce = Pe + S0 X (1+r)-T

If the equation does not work, the investor can take an arbitrage gain
by combining the four actions to have positive result.

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Put-Call parity
T0 Terminal value
ST < X ST > X
Sell call Ce 0 -(ST - X)
Buy put -Pe X - ST 0
Buy stock -S0 ST ST
X (1 + rf )
T
Borrow money X at T -X -X
C E PE S + X (1 + r f )
T
Net payoff 0 0

C E > PE S + X (1 + rf )
T
If

So: Sell call

Buy put
Buy stock
Borrow money X at T

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Put Call Parity example
A stock is currently selling for $100. A call option with an exercise price of $90 and
maturity of 3 months has a price of $12. A put option with an exercise price of $90
and maturity of $2. The one-year government bond rate is 5%. Is there an arbitrage
opportunity available in these prices?

From put-call parity equation:

Ce = Pe + S0 X (1+r)-T
12 = 2 + 100 90 (1.05)-0.25
12 < 13.09
Since the market price of Call is 12, it is underprice by 1.09. hence we would:
Buy a call
Sell a put
Sell a stock
Invest money of 90(1.05)-0.25 for 3 months

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Special Strategies

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Straddle
buying a call and put option with the same exercise price X and the same time to
maturity
ST <X payoff = X-ST and the call is worthless.
ST >X payoff = ST -X and the put is worthless
raddle
ayoff

0 ||
8 9 10 11 12 Stock Pr

You might buy a straddle if you believe the stock is going to move a lot, but are not
sure of the direction

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Straddle - payoff

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Bull Spread
buying a call struck at X1 and selling a call struck at X2 where X2 >X1.
You might use this strategy when you think
the stock price is going to go up but not beyond X2.
The cost of the strategy is the cost of the X1-call less the cost of the X2-call.

Bear Spread
Payoff

0 ||
8 9 10 11 12 Stock Pri
X1 X2

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Bull Spread

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Protective Put
Buy stock, buy put
Protect stock with a right to sell/put

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Protective Put

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Covered Call
Buy stock, sell call
option at the same time

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Covered Call

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Callable bonds

Issued with coupon rate higher than on straight debt

Investors compensation for call option retained by issuer

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American vs. European Option
American options: allow the holder of the option to exercise at any time prior to
maturity
European options: only permit the holder of the option to exercise at maturity
European options can be valued by using Black-Scholes call option formula:

European options:
Ce = SN(d1)-X(1+rf)-TN(d2)
Pe = -SN(-d1)+X(1+rf)-TN(-d2)

N(d1) = cummulative normal probability distribution, of

NORMSDIST(.) in EXCEL
d1 =

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Optionlike Securities
Warrants
Option issued by firm to purchase shares of firms stock
Collateralized Loans
The borrower should pay L (borrow L)
The borrower will pay the loan only if the collateral is higher than L
The borrower turn over collateral to lender, but retaining right to reclaim it by
paying off the loan
The borrower will pay the L with certainty but also retain the option to sell the
collateral to the lender.

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Exotic option
Options with some additional feature to make it more interesting.
It is usually complex

Asian Options
Options with payoffs that depend on average price of underlying asset during
portion of option life
Currency-Translated Options
Have either asset or exercise price denominated in foreign currency
Digital Options
Have fixed payoffs that depend on price of underlying asset

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