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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

Options

Option is an agreement that gives the buyer the right but not the
obligation to buy or sell a given asset (such as a share) to a pre-
determined price at a given time (European type), or within the given
period (American type). An option is equivalent to 100 shares.

The seller on the other hand, is always obliged to deliver or buy the
asset if the buyer so wishes!

NOTATION- definitions
S = ”stock” price, (the actual share price): The underlying asset on
what the contract is signed.

E = ”exercise” price, (or strike price): The pre-determined price that


the seller will buy or sell if the buyer wishes.

t = “expiration date”, (or maturity date): t = 0 means maturity date


(time is counted backwards). European options are exercised at
maturity (and traded of course all time). American options are
exercised any time upp to maturity.

CE = “Call-option premium for price E”: What the buyer pays, the
seller receives.

PE = “Put-option premium for price E”: What the buyer pays, the
seller receives.

r = risk-free interest rate (constant)

The following 4 option possibilities (2 for buyers & 2 for sellers)


exist:

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

Call options

Buy a call (owner)

One buys a call option today at a given E (say $50), and hopes that S
in the future will exceed E + CE in order to profit from that. The
premium to pay is CE. No security is required. Check the figure
below.

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Call Option Payoffs at expiration

60

40 Buy a call
Option payoffs ($)

20

0
0 10 20 30 40 50 60 70 80 90 100

-20 Stock price ($)

-40

-60

Exercise price = $50


McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Sell (Write) a call (issuer)

One receives a CE today and hopes that S in the future will be below E
(say $50), so that the buyer’s call option will be worthless and will not
be exercised. If the price rises > E he looses, because he must sell it at
E.

In order to issue a call option, it is required high security (money or


shares should be deposited). This is because, if S in the future rises to

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

say $100, the owner of the call option has the right to buy the stock at
E = $50! Check the figure below.

22-10
Call Option Payoffs at expiration

60

40
Option payoffs ($)

20

0
0 10 20 30 40 50 60 70 80 90 100

-20 Stock price ($)


Write a call
-40

-60

Exercise price = $50


McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Put options

Buy a put (owner)

Assume that you want to secure your shares (you are afraid of a price
fall, but you do not want to sell the shares now).

You buy a put option today at a given E (say $50). (i) If S falls below
E, you do not care, because you have the right to sell your shares at E
> S. In that case you gain the difference between E - S. (ii) If S does
not fall, you have just lost the premium you have paid, PE. Remember
you are not forced to sell it! No security is required. Check the figure
below.

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

22-14
Put Option Payoffs at expiration

60

40 Buy a put
Option payoffs ($)

20

0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20

-40

-60

Exercise price = $50


McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Sell (Write) a put (issuer)

One receives a PE today and hopes that S does not fall below E (say
$50), since the buyer of the put wouldn’t exercise the option in that
case. If S < E, the seller is forced to sell the share at E, despite the fact
that its price is lower (=S).

In order to issue a put option, it is required high security (money or


shares should be deposited). This is because, if the stock price falls to
zero, the owner of put option has the right to sell it at $50!!! Check
the figure below.

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

22-15
Put Option Payoffs at expiration

60

40
Option payoffs ($)

20

0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20

-40 write a put

-60

Exercise price = $50


McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Example: August 3, 2001, at close, Ericsson (j, v = October).

Call options

Option Buy Sell Latest Highest Lowest Number


ERIC-1J50 7,00 8,50 9,50 9,50 9,50 10
ERIC-1J55 5,50 6,00 5,75 7,00 5,75 11500
ERIC-1J60 2,65 4,00 3,75 4,50 3,75 11750
ERIC-1J65 2,40 2,65 2,40 2,75 2,35 11310

Put options

Option Buy Sell Latest Highest Lowest Number


ERIC-1V45 1,60 2,20 2,00 2,00 1,50 3520
ERIC-1V50 3,20 3,75 3,20 3,30 2,85 240
ERIC-1V55 5,25 5,75 5,50 5,50 4,50 3530
ERIC-1V60 8,00 9,50 8,00 8,00 7,00 80

S = SEK55; C60 = SEK3.75; P50 = SEK3.20; t = 77 days (19 Oct.)

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

Call options

If one bought 1000 Ericsson shares, it would cost SEK 55,000.

If instead, one bought 10 call options and paid 3.75x1000 = SEK


3750, he would have the right to buy 1000 shares at E = 60, on
October 19.

Assume on Oct. 19 the following prices: (i) SEK50, (ii) SEK70

(i) The buyer does not exercise the call option, since 50 < 60. He loses
SEK3750, that seller earns (the premium he received in August).

(ii) The buyer will exercise the call option. He has the right to buy
Ericsson at the price 60, but the option is worth 70 – 60 = 10. He
earns net (70 - 60)x1000 - 3750 = SEK6250. The seller loses that
amount, because he received in August 3750, but he sells the shares
now at 60 despite the fact that their price is 70 (i.e. he buys them at 70
and sells them at 60, so he loses 3750 – 10,000 = SEK6250).

Put options

Assume the X-investor had 1000 Ericsson shares and wanted to hold
them. Assume that he was interested in securing their value at the
lowest, at SEK 50 000.

If she bought 10 put options at E = 50, for 3.20x1000 = SEK3200, she


was entirely insured.

Assume on Oct. 19 the following prices1: (ii) SEK70, (iii) SEK45

(ii) The buyer does not exercise the put option, because 70 > 50 (she
can sell her shares if she likes at 70). She loses SEK3200 (i.e. the put
premium), which the seller of put option received in August.

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The price in October fell to SEK 33!

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

(ii) The buyer will exercise the put option. She has the right to sell
Ericsson at 50, but her option is worth 50 - 45 = SEK5. Thus, she
earns net: 5x1000 - 3200 = SEK1800, which the seller loses.

Limits of call options

(a) Upper limit

One should never pay more for C than for the S itself! If the premium
C was more expensive than the share S, buy the share! At the extreme,
if S increases by SEK1, the premium C should increase by the same
0
(i.e. the upper limit is a line from the origin with a slope of 45 ). That
can be expressed as:

C≤S (1)

(b) Lower limit

(i) If S > E ⇒ C > 0 (i.e. one will exercise the call option)
(ii) If S < E ⇒ C = 0 (i.e. the call option is worthless)

(i) & (ii) can be written as: C = max {0, S - E} (2)

However, this relationship is valid at maturity.

In Ericsson example, on Oct. 19 it is: C60 = max {0, 70 - 60}, i.e.


either SEK0 or SEK10. See the figure below.

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

Limits of call option


Price of C0
Upper Lower
limits limits

E=60 Share Price S0

But, over time until maturity, E must be discounted by (1 + r)t . Why?


If one planed to exercise the call option to buy the shares at maturity,
he would need to save Y < E, so that: Y(1 + r)t = E. The relationship
(2) can then be written as:

E
C ≥ max {0, S − (1 + r ) t } (2)´
• If t = 0 ⇒ (1 + r)t = 1, i.e. (2)´ = (2), i.e., the call option is on the
lower limit at maturity day.
• If t > 0 ⇒ (1 + r)t > 1, i.e. (2)´ > (2), or (2)´ is valid as inequality,
i.e. the call option is above the lower limit prior to maturity.

Normally its time value is positive. In Ericsson example there were 77


days left to maturity and one paid SEK3.75 for a call option whose
share price was 60 - 55 = SEK5 less than E! Time value = 3.75 + 5 =
SEK8.75, despite the fact that in August, it was out of money, since its
real value, (”intrinsic value”) was zero.

A call option’s path starts from the origin (no premium if S = 0), and
starts to increase before the share price S reaches the exercise price E,

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

if there is long time left to maturity. As time passes, it follows


approximately the lower limit until it matures. (call option’s path figure)

Limits of call option

Price of C0
Upper
Lower
limit
limit

Option’s
path

Time value

Real value
E Share price S 0

Two simple option strategies

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

22-26
Protective Put Strategy: Buy a Put and Buy
the Underlying Stock: Payoffs at Expiry
Value at Protective Put strategy
expiry has downside protection
and upside potential; the
money you loose from
your stock you get it from
$50 your put

Buy a put with an exercise


Buy the price of $50, i.e to sell your
stock stock at $50 if its price is below

$0
Value of
$50
stock at
expiry

McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22-28 Covered Call Strategy (buy the stock &


sell a call)
Value at Buy the stock at $40; the money you earn
expiry if stock rises, you loose it to the buyer of
$40 the call who buys your stock at $50

Covered call
$10
$0
Value of stock at expiry
$30 $40 $50
-$30 Sell a call with
-$40 exercise price of
$50 for $10

McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

How to price a call option (a binomial model)

Example: Assume a share’s price today is S0 = SEK50. In a year, its


price is expected to be, either S1 = 60 or S2 = 40. Investors can borrow
& save at an r = 10 %. How much should you pay for a C50 today
(remember 1 call option is equivalent to 100 shares).

Let us consider the following two strategies:

(i) Buy a C50; but at what price?


(ii) Borrow Y to buy a δ share of stocks, (0 < δ < 1).

These strategies must of course give the same results next year, no
matter if the stock price is S1 = 60 or S2 = 40.

We construct now a Synthetic C50

Position Cash-flow now Cash-flow next year


S1 = 60 S2 = 40

Call option -C 10 0

or,

Buy δ share of stock - δ(50) δ(60) δ(40)


Borrow Y +Y -Y(1.1) -Y(1.1)

Since these strategies are equivalent, it must be:

- C = - δ(50) + Y 10 = δ(60) -Y(1.1)


0 = δ(40) -Y(1.1)

The solution of the system gives: δ = 1/2 and Y = 18.18 (per share)

Interpretation: Buy (1/2)*100 = 50 shares (and pay 50*50 = 2500).


You need to borrow (18.18)*100 = 1818 now, and pay your loan +
interest in a year of 1818*(1.1) = 2000. The difference is 682, i.e. that

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

amount you have to pay according to the second strategy. That


implies that the price of the call option according to the first strategy
must be the same. In fact, it is if we put these values in:

- C = - δ(50) + Y, we get C = 6.82.

Check now why both strategies give the same future values.

If S1 = 60, the stock portfolio has the following net value:


(60)(50) - 2000 = 1000, which is the same as the value of C50.

If S1 = 40, the stock portfolio has the following net value:


(40)(50) - 2000 = 0, which is the same as the value of C50.

δ = 1/2 = hedge ratio (i.e. the number of shares per option that ensures
that no arbitrage profit is possible. Why?

Assume that an investor buys 25 % of shares (i.e. δ = 0.25).

The system gives two values on Y; Y1 = 4.545 and Y2 = 9.091 and


therefore two values on C; C1 = 7.955 and C2 = 3.41. All would buy
C2 because it was cheap and sell C1 because it was expensive, until
the prices were equal to 6.82.

Alternatively, an arbitrageur would do the following:

Buy 1/4 of a share and pay: – 12.50


Sell a C1 and get: + 7.955
Borrow: 4.545

If S1 = 60, the stock portfolio has the following net value:


(60)(25) - (454.5)(1.1) = 1000, which is the same as the value of C50.

If S1 = 40, the stock portfolio has the following net value:


(40)(25) - (454.5)(1.1) = 500 > than the value of C50 which is 0!

The hedge ratio can be defined much simpler as:

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

Chigh − Clow 10 − 0
δ= = = 0 .5
S high − S llow 60 − 40

An alternative formula for call options

K = worse case (40)


S0 = actual price (50)
n = number of call options per share = 1 =2 (because δ = 0.5)
δ

K = (1 + r ) ⇒ 40 = 1.1 ⇒ C0 = 6.82
S − nC 50 − 2C
0 0 0

Put-Call Parity

Put-call parity shows that there is an exact relationship between S, C


and P, for the same E, t and r.

Example: Calculate P50 for the same example.

Strategy 1: Buy 100 shares and a put option P50, to insure them.

(i) If S1 = 60, the put option is P50 = 0, but S1 – S0 = 10.


(ii) If S2 = 40, the put option is P50 = 50 – 40 =10.

This strategy ensures that S + P50 is 10, either through option or the
share.

Strategy 2: Buy instead a call option C50. Because you need E kronor
(per share) if you exercise your C50 after 1 year, you must save also
the PV of E, i.e., E
( 1 + r )t

(i) If S1 = 60, the call option is: C50 = 10

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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008

(ii) If S2 = 40, the call option is: C50 = 0

Since at equilibrium both strategies must give the same results, it is


required that:
S+P= E +C
(1 + r ) t (3)

This is the put-call parity.

In our example it is: S = 50, r =0,1, t = 1, E = 50 and C50 = 6.82. From


(3) we obtain: P50 = 2.275.

An alternative formula for put options

K = worse case (60)


S0 = actual price (50)
n = number of call options per share = 1 =2 (because δ = 0.5)
δ

K = (1 + r ) ⇒ 60 = 1.1 ⇒ P0 = 2.273 .
S + nP 50 + 2 P
0 0 0

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