Week 12 Investment

Management
Options Contracts
 1 Introduction
• Examples of option contracts include
– call and put options written on more than 50 of
the largest companies listed on the Australian
Stock Exchange
– share price indices, together with more exotic
derivatives including LEPOs, warrants and share
ratios.
– Options may be written on a wide range of
underlying assets including shares, foreign
exchange, various futures contracts, commodities
and bonds.
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 1 Introduction
• An option is a contract that gives one party
the right but not the obligation to buy or sell
a particular asset or contract at an agreed
price with delivery at an agreed time or over
an agreed period of time.
• The key characteristic of an option is the
ability of the option purchaser to choose
whether to exercise the option.

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 1 Introduction
• For example:
– The purchaser (taker) of a call option has the
right to buy the underlying asset at the stated
price
– the seller (writer) receives the premium and
must deliver the underlying asset to the option
taker if the buyer decides to exercise the
option.

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 2 Option payoffs
• Call - right to buy asset
– at maturity
– if P > X then exercise and receive P-X,
– if P < X then walk away from contract
• Put - right to sell asset
– at maturity
– if P < X then exercise and receive X-P,
– if P > X then walk away from contract

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2 Option payoffs

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2 Option payoffs

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 2 Option payoffs
• Payoff diagrams show the payoff should the
option be exercised immediately
• Option value = intrinsic value + time value
– Intrinsic value of zero
• "at the money" (where P = X)
• "out of the money"
– Intrinsic value is positive
• "in the money"
– Note: Bought and sold options can be combined in
many ways (eg. synthetic forward)
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 Options

Figure 25.1 Profits and Losses on Options versus Futures Contracts

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 Factors Affecting Premium
1. Higher strike price, lower premium
on call options and higher premium on
put options.
2. Greater term to expiration, higher premiums
for both call and put options.
3. Greater price volatility of underlying
instrument, higher premiums for both call
and put options.

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 Hedging with Options
• Example: Rock Solid has a stock portfolio
worth $100 million, which tracks closely with
the S&P 500. The portfolio manager fears that
a decline is coming and what to completely
hedge the value of the portfolio against any
downside risk. If the S&P is currently at 1,000,
how is this accomplished?

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 Hedging with Options
• Value of the S&P 500 Option Contract = 100 
index
– currently 100 x 1,000 = $100,000
• To hedge $100 million of stocks that move 1
for 1 (perfect correlation) with S&P currently
selling at 1000, you would:
– buy $100 million of S&P put options =
1,000 contracts

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 Hedging with Options
• The premium would depend on the strike price. For
example, a strike price of 950 might have a premium
of $200 / contract, while a strike price of 900 might
have a strike price of only $100.
• Let’s assume Rock Solid chooses a strike price of 950.
Then Rock Solid must pay $200,000 for the position.
This is non-refundable and comes out of the portfolio
value (now only $99.8 million).

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 Hedging with Options
• Suppose after the year, the S&P 500 is at 900 and the
portfolio is worth $89.8 million.
– options position is up $5 million (since 950 strike price)
– in net, portfolio is worth $94.8 million

• If instead, the S&P 500 is at 1100 and the portfolio is

worth $109.8 million.
– options position expires worthless, and portfolio is worth
$109.8 million

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 Hedging with Options
• Note that the portfolio is protected from any
downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager has
to pay a premium upfront of $200,000.

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3 Determinants of option prices

• Option prices are affected by six factors;

– underlying asset price (P),
– exercise price (X),
– time to expiry (t),
– the standard deviation of asset returns (s)
– the risk-free rate of return (r)
– and dividends or cash flows expected during the
life of the option (D)

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3 Determinants of option prices
• Option boundaries
– American option at least as valuable as a European
option
C(P, 0, X) = maximum of 0 or (P – X)
c(P, 0, X) = maximum of 0 or (P – X)
P(P, 0, X) = maximum of 0 or (X – P)
p(P, 0, X) = maximum of 0 or (X – P)

– due to possibility of early exercise

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3 Determinants of option prices
• Option boundaries
– as American-type options can be exercised
before expiry, their value is at least the intrinsic
value.
C(P, t, X) ≥ maximum of 0 or (P – X)
P(P, t, X) ≥ maximum of 0 or (X - P)

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3 Determinants of option prices
• Option boundaries - Put-call parity
– consider two portfolios.
– The first portfolio consists of a bought call option
– the second portfolio consists of a bought put option
and underlying asset combined with borrowing the
present value of the exercise price of the option.
– As the pay-off at expiry is the same for both
portfolios then, by stochastic dominance, the cost
of the two portfolios must be equal.

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3 Determinants of option prices

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3 Determinants of option prices
• Option boundaries - Put-call parity
– Comparison of the cost of the two portfolios gives
rise to the put–call parity relationship:
c – g = P – PV(X)

– where
• c = European-type call option premium,
• g = European-type put option premium,
• P = asset price
• PV(X) = present value of the exercise price
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3 Determinants of option prices
• Option boundaries
– Consider two American-type options are identical
except for time to expiry
– the option with the greater time to expiry has a
premium that is greater than or equal to the premium
of the option with the shorter time to expiry.
C(P,t1, X) ≥ C(P,t2, X)
P(P,t1, X) ≥ P(P,t2, X)
where t1 > t2

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 4 The underlying asset
• The distribution of underlying asset prices
must be modelled before an option can be
valued explicitly.
• Generally the underlying asset price is
assumed to be lognormally distributed
• Where a lognormal process is chosen for
asset prices the price change process is
often described as a Wiener process.

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 4 The underlying asset
• Weiner process can be represented as;
dP = aP dt + sP dw
– where
• dP = instantaneous change in the asset price
• a = the constant rate of change in the price over
the interval dt
• s = the instantaneous standard deviation of asset
price returns
• dw = a normally distributed error term with mean
of zero and standard deviation of √dt
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 5 Valuing European-type options
• The Binomial model
– described in Cox, Ross and Rubistein (1976)
– Take a portfolio of the underlying asset and the
option and create a risk free hedge.
– The risk free hedged portfolio can be valued by
discounting at the risk free rate and so the call
option can also be valued.

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 5 Valuing European-type options
• The Binomial model
– The first step is to create a risk-free hedge, which
requires an appropriate hedge ratio.
– The hedge ratio indicates the number of option
contracts required to hedge the underlying asset
price changes
– the hedge ratio, a, required to ensure the portfolio is
risk free.
Call option: a = (cu – cd) / [(u – d) P]
Put option: a = (gd – gu) / [(u – d) P]
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 5 Valuing European-type options
• The Binomial model
– Example: Assume a two-period world with current
share price of $10.00, interest rate of 8% over the
period and a price increase factor of 1.25 and a
price decrease factor of 0.80 (1/1.25).
– This generates end of period prices of $12.50
(10.00 x 1.25) and $8.00 (10.00 x 0.80). Thus the
price tree consists of two branches.

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 5 Valuing European-type options
• The Binomial model
– Example (cont.):
– The price distribution is drawn as:
Period 0 Period 1
12.50
10.00
8.00
– Assume that you are required to value a put and a
call option, both with an exercise price of $9.00
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 5 Valuing European-type options
• The Binomial model
– Example (cont.):
– The terms u and d are 1.25 and 0.80 (1/1.25)
respectively while the risk-free rate, r = (1+R), is
equal to 1.08:
u = 1.25 and d = 0.80
(1+R) = 1.08
Given these values, a and (1 – a) are:
a = 0.6222, and (1 - a) = 0.3778
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 5 Valuing European-type options
• The Binomial model
– Example (cont.): The option expiration value is
either $3.50 or 0.00;
Period 0 Period 1
3.50
Max (12.50 – 9.00 or zero)
2.02
0.00
Max (8.00 – 9.00 or zero)
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 5 Valuing European-type options
• The Binomial model
– Example (cont.):
– The call premium is calculated as:
c = { 3.50 x 0.6222 + 0 x 0.3778} / 1.08
= $2.02

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 5 Valuing European-type options
• The Binomial model
– Example (cont.): The expiration pay-off and the
premium for the put option are:
Period 0 Period 1
0.00
Max (9.00 - 12.50 or zero)
0.35
1.00
Max (9.00 - 8.00 or zero)
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 5 Valuing European-type options
• The Binomial model
– Example (cont.):
Where the put premium is calculated as:
g = { 0 x 0.6222 + 1.00 x 0.3778} / 1.08
= $0.35

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 6 Valuing American-type options

• In this case the option holder either exercises

the option or sells it on the market.
• For European option exercise can only occur at
expiry
• Now we may need to test for exercise at all
periods as well as at expiry
• Black-Scholes is no longer an exact solution,
rather it is approximate
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 7 Hedging with options
• This is the basic approach underlying
portfolio insurance
• ensures the value of the underlying asset
portfolio cannot fall below a set value
• However, still allows the portfolio value to
increase once the underlying asset price
increases past the minimum acceptable value
• Unlike using a short futures contract

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7 Hedging with options

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7 Hedging with options

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 8 Trading in options
• Option contracts also used for speculation
– If analysis suggests the underlying asset price will
fall in the future the investor can boost returns by
either buying a put option or selling a call option
– If it is believed the asset price will rise the investor
could either buy a call option or sell a put option
– Combinations of options
• straddle
• butterfly spread

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8 Trading in options

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8 Trading in options

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8 Trading in options

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 9 Options on shares
• Australian Stock Exchange (ASX) trading of
options written on equity on Derivatives
Trading Facility or CLICK.
• Both put and call options are written on the
shares of over seventy of the largest
companies listed on the ASX.
• The options are generally American-type
options
– exercisable at any time from transaction date
through to expiration date
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