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Principles of Option Pricing

The document discusses principles of option pricing, including: 1) The minimum and maximum values of calls and puts, and their values at expiration, which are affected by factors like exercise price, time to maturity, interest rates, and volatility. 2) The difference between American and European style options and conditions for early exercise. 3) Put-call parity, which relates the prices of puts and calls on the same stock with identical terms through a formula involving the stock price, exercise price, and risk-free rate.

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3K views23 pages

Principles of Option Pricing

The document discusses principles of option pricing, including: 1) The minimum and maximum values of calls and puts, and their values at expiration, which are affected by factors like exercise price, time to maturity, interest rates, and volatility. 2) The difference between American and European style options and conditions for early exercise. 3) Put-call parity, which relates the prices of puts and calls on the same stock with identical terms through a formula involving the stock price, exercise price, and risk-free rate.

Uploaded by

charansap
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Principles of Option Pricing

MB 76

Outline
Minimum values of calls and puts
Maximum values of calls and puts Values of calls and puts at expiration Effect of Exercise Price, Time to Maturity,

Interest Rates, Volatility American versus European Style Options Put-Call Parity

Options
A contract between two partiesa buyer and a seller/writerin which the buyer purchases from the seller/writer the right to buy or sell an asset at a fixed price. The buyer pays the seller a fee called the premium, which is the options price.
An option to buy an asset at a predetermined price (also known as exercise price) is known as the call option An option to sell as asset at a predetermined price (also known as exercise price) is known as put option

Types of Options
American-style
European-style Asian Options

Options
In-the-Money Option
One that would lead to positive cash flows to the holder if it were exercised immediately

At-the-Money Option
One that would lead to zero cash flows to the holder if it were exercised immediately

Out-of-Money Option
One that would lead to negative cash flows to the holder if it were exercised immediately

In-Money Calls and Puts


Call is in the money if S > E Put is in the money if E > E

Out of Money Calls and Puts


Call is out of money if S < E Put is out of money if E < S

Minimum Value of a Call Option


A call cannot have a negative value Thus, C(S,T,E) 0 For American Calls, Ca Max [0,(S-E)] Minimum value also called intrinsic value Intrinsic value positive for in-the-money

calls and zero for out-of-money calls Usually, call options trade above their intrinsic valueWhy?

Maximum Value
Call derives its value from the underlying

asset/stock on which it is written. Therefore, it cannot never exceed the value of the underlying asset C S

Lower Bound of a European Call


Ce Max [0,{S E(1+r)-T}] What if
Ce < Max [0,{S E(1+r)-T}] leads to arbitrage Buy call and risk-free bonds and sell short the stock. The portfolio will have positive initial cash flow, because the call price plus the bond price is less than the stock price. At maturity, the payoff is either E ST if E > ST and 0 otherwise.

The Effect of Time to Expiration on a Call Option


Two American call options differ only in

their times to expirations, one with a higher time to expiration will be worth at least as much as a shorter-lived American call with the same terms When will the longer-lived call is worth the same as shorter-lived call?

The Effect of Exercise Price and Call Value


The price of a European call must be at least as high as the price of an

otherwise identical European call with a higher exercise price


Ce(S, Elow,T)

Ce(S, Ehigh, T) Ca(S, Ehigh, T)

The price of an American call must be at least as high as the price of

another otherwise identical American call with a higher exercise price


Ca(S, Elow,T)

The difference in the price of two American calls that differ only by

their exercise price cannot exceed the difference in their exercise prices
Ca(S, Elow,T) -Ca(S,

Ehigh, T) (Ehigh Elow)

The difference in the price of two European calls that differ only by

their exercise price cannot exceed the present value of the difference in their exercise prices
Ce(S, Elow,T) -Ce(S,

Ehigh, T) (Ehigh Elow)(1+r)-T

Interest Rates and Calls


A call option is a deferred substitute for the purchase of the stock of the stock
If the stock price is expected to rise, the investor

can either choose to buy the stock or buy the call. Buying the call will cost far less than purchasing the stock. Invest the difference in risk-free bonds. If rates rise, the combination of calls and risk-free bonds will be more attractive

Volatility and Call Options


Volatility gives rise to risk and need to buy

insurance Greater volatility increases the gains on the call if the stock price rises big time, and Zero downside risk if the stock price declines big time

American Call versus European Call


An American call must be worth at least as

much as a European call with the same terms.


Ca Ce

An American call on a non-dividend

paying stock will never be exercised early, and we can treat it as if it is a European call

Early Exercise of American Call


Early Exercise of a call on a dividend

paying stock Exercise it just before the ex-dividend date if the DPS exceeds Speculative value of the call Do not exercise it if the DPS is less than the speculative value of the call

Minimum Value of a Put


A put cannot have a negative value
P(S,T,E) 0

An American put can be exercise early.

Therefore, Pa Max [0, (E-S)] Minimum value also known as intrinsic value Lower bound of a European Put
Pe Max [0, E(1+r)-T S]

Maximum Value of a Put


At expiration, the payoff from a Put is Max

[0, (E-S)]. What is the best outcome that a put holder can expect at put expiration? Maximum value of American put E Maximum value of European put E(1+r)-T

Time to Expiration and Put Value


Longer lived American put must always be

worth at least as much as a shorter-lived American put with the same terms. Time and Put Pricemore complex

Exercise Price and Put


The price of a European put must be at least as high as the price of otherwise identical European put with a lower exercise price

What if Pe(S,Ehigh,T) < Pe(S,Elow,T) The price of an American put must be at least as high as the price of an otherwise identical American put with a lower exercise price. The difference in the prices of two European puts that differ only by the exercise prices cannot exceed the present value of the difference in their exercise prices The difference in the prices of two American puts that differ only by exercise price cannot exceed the difference in their exercise prices

Interest Rates and Puts


Put options vary inversely with put interest

ratesWhy? A put is like deferring the sale of stock. When you sell the stock, you will receive E dollars. If interest rates rise, the present value of E dollars will be lower.

Early Exercise of American Puts


Does it pay to exercise an American put

before maturity? If the put is deep in-the-money, it should be exercised early even if the stock does not pay dividend

Value of Put at Maturity


No time value left
P = Max (0, E-ST)

Put-Call Parity
The prices of European puts and calls on

the same stock with identical exercise prices and expiration dates have a special relationship. The put price, call price, stock price, exercise price, and risk-free rate are all related by a formula called putcall parity

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