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Lecture 7 Options

Lecture 7 Options

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KVShenai-ia-031
Investment Management and Capital Markets
Lecture 7 : Options
Option: A right but not an obligation to buy(call) or sell(put) the underlying asset by a specified date at a price fixed in advance.( Unlike futures/forwards which are agreements to buy/sell the underlyingasset at a set price at a later date. )Call and Put options have an initial `sunk cost’ = option premium.Call Option:A Call option is worth exercising when the Share price S > X, the exercise price.In the region X < S < ( X + C ), exercising the option reduces the sunk cost;in the region S > ( X +C ), exercising the option realises a profit = S - ( X + C ).
Π
Share Price= Profit/LossS-XC X S-X SXMarket Value of CallPut OptionA Put option is worth exercising when the Share price S < X, the exercise price.In the region ( X-P ) < S < X , exercising the option reduces the sunk cost;in the region S < ( X -P ), exercising the option realises a profit = X - ( P + S ).Share priceV
Π
 X - P X P SMarket Value of Put
ote the distinction between Pay-off (
ΠΠΠΠ
) and Value (V) diagrams
 
 
 
KVShenai-ia-032
Compare with the profit/loss profile on a share transaction:
Π
 Sp S
 Common Option diagramsCALL OPTIO
Buyers Writers(sellers) 
PUT OPTIO
A European option can be exercised only at the expiry date whilean American option can be exercised at any time before the expiry date.
 
 
KVShenai-ia-033
Put-Call Parity for European Options
 If we compare the outcome from a portfolio created by combining long positions inthe security with a put option and a short position in the call option, both withExercise price 'X' and expiry period 't,' if at expiration:
Value diagram ( y -axis)
 ShareSharePut OptionX S
a
S
a
XShare priceWritten call option(i) S > = XShare = SPut Option = 0Written Call option = - (S-X)Value of portfolio = X(ii) S <= XShare = SPut Option = x-SWritten Call option = 0Value of portfolio = XSo in all cases, the value of the portfolio at expiry is 'X.' This in turn implies that thevalue of the portfolio so constructed at the beginning of the period must also be
S + P-C = PV(X) = X e
rt
(alternatively =x/(1 + rf. t)
This is the no-arbitrage condition and implies that a Portfolio made up of a long position in the share, with a put option and a short position in the call option, bothwith Exercise price 'X' and expiry period 't,' is a riskless hedge portfolio, with thesame outcome at expiry as an investment in a risk-free bond which matures to a valueX at expiry.

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