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Summary of Part I Discrete Dividends: , = () + (Dividends) Continuous Dividends: , = ()() For strike prices 1 < 2 < 3 and assuming

uming the same time to expiration: Bear Spread (two calls or two puts): Sell 1 , buy 2 . Box Spread: buy a call and sell a put at 1 , and sell a call and buy a put at 2 . Bull Spread (two calls or two puts): Buy 1 , sell 2 Butterfly Spread: Buy 1 , sell two 2 , and buy 3 . o If 3 2 1 = = , 3 1 2 the butterfly spread is said to be symmetric. Otherwise, it is asymmetric. Collar: Buy a put at 1 , and sell a call at 2 . Ratio Spread (calls or puts): buy options and sell of the same kind of option at two different strike prices and . Straddle: Buy a call and a put at 1 . Strangle: Buy a put at 1 and buy a call at 2 .
() , = ,

Actuarial present value = discounted expected value [( )+ ] = { [ | > ] } ( > ) [( )+ ] = { [ | < ]} ( < ) [( )+ ] + [ ] = [ ] [( )+ ] + [ ] = Eur ( , , ) = [( )+ ] () Eur ( , , ) = [( )+ ] ()

Properties of European and American premiums of options: 1. (1 ) (2 ). 2. (1 ) (2 ). 3. 1 SL (1 , 2 ) 0 (slope) 4. 0 SL (1 , 2 ) 1 (slope) 5. SL (2 , 3 ) SL (1 , 2 ), SL (2 , 3 ) SL (1 , 2 ) (convexity) For arbitrage: buy at a lower premium, and sell at a higher premium. For condition 5, where 3 2 , 3 1 buy puts/calls at 1 , sell 1 put/call at 2 , and buy (1 ) puts/calls at 3 . =

() = , Bonds: , coupons dividends Futures: , , Currency: , 1 , , = , = ,

, ( ) Eur ( , , ) , ( ) , ( )+ 0 , ( ) Eur ( , , ) , ( ) , ( ) 0 +

Call exchange options allow one to exchange a strike asset for an underlying asset. Payoff: ( )+
( , , ) ( , , ) = , ( ) , ( ) Non-dividend: ( , , ) = ( , , )

Put exchange options allow one to sell an underlying asset for a strike asset. Payoff: ( )+.

T-bill: = () + (Dividends) (discrete dividends) = () (continuous dividends). Synthetic long position = conversion Synthetic short position = reverse conversion
() Synthetic long forward: = ,

Amer ( , , ) Eur ( , , ) , ( ) , ( )+ 0 Amer ( , , ) Eur ( , , ) , ( ) , ( )+ 0 ( , , ) ( )+ Amer ( , , ) ( )+

For 1 < 2 , Amer ( , , 1 ) Amer ( , , 2 ).

For non-dividend and 1 < 2 : Amer ( , , ) = Eur ( , , ) (never optimal to exercise American call early) Eur ( , , 1 ) Eur ( , , 2 ) Exercise at 1 2 if Amer 1 , , 2 1 1 . If = 0, one should exercise when > . If 1 (2 1 ) 1 (Dividends), then one should exercise an American call at time 1 .

American options: why wait? Calls: o Interest on strike price o Risk of stock price going down Puts: o Interest on strike price (could get more interest) o Risk of stock price going up o Lose value of future dividends Reason to exercise American call: receive dividends. Continuation value: APV of waiting to exercise the option. Exercise if the continuation value at some time is less than the value of exercising the option at the same time .

Early exercise boundary: set of stock prices at which the continuation value at time is equal to the value of immediate exercise at the same time
, Amer Amer , ()

The early-exercise criterion of an option on a stock become more stringent as the volatility of the stock increases, and less stringent as the option has less time to expiration.

Hints: How to remember inequalities:


, ( ) Eur ( , , ) , ( ) , ( )+ 0 , ( ) Eur ( , , ) , ( ) , ( ) 0

Think of this as:

So, for a call, which has payoff ( )+ , a call receives positive payoff if . At time , the stock is valued . The immediate payoff is ( )+ .
Thus, , ( ) Eur ( , , ) , ( ) , ( )+ 0. A similar principle can be used for puts. Every part is valued at time . () Note also that . , ( ) = , ( )

Positive Payoff part back at time , on positive payoff part at time option value [prepaids on immediate payoff]+ 0

End of Part I Summary