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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 predetermined 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:

1

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.

22-9

**Call Option Payoffs at expiration
**

60 40 Option payoffs ($) 20 0 -20 -40 -60 0 10 20 30 40 50 60 70 80 90 100 Buy a call

Stock price ($)

**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

2

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

Stock price ($) Write a call

**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.

3

Christos Papahristodoulou, Mälardalen University/HST/Economics

23/06/2008

22-14

**Put Option Payoffs at expiration
**

60 40 Option payoffs ($) 20 0 -20 -40 -60 0 10 20 30 40 50 60 70 80 90 100 Stock price ($) Buy a put

**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.

4

Christos Papahristodoulou, Mälardalen University/HST/Economics

23/06/2008

22-15

**Put Option Payoffs at expiration
**

60 40 Option payoffs ($) 20 0 -20 -40 -60 write a put 0 10 20 30 40 50 60 70 80 90 100 Stock price ($)

**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 ERIC-1J50 ERIC-1J55 Buy 7,00 5,50 Sell 8,50 6,00 Latest 9,50 5,75 Highest 9,50 7,00 Lowest 9,50 5,75 Number 10 11500

ERIC-1J60

ERIC-1J65

2,65

2,40

4,00

2,65

3,75

2,40

4,50

2,75

3,75

2,35

11750

11310

Put options

Option ERIC-1V45 Buy 1,60 Sell 2,20 Latest 2,00 Highest 2,00 Lowest 1,50 Number 3520

ERIC-1V50

ERIC-1V55 ERIC-1V60

3,20

5,25 8,00

3,75

5,75 9,50

3,20

5,50 8,00

3,30

5,50 8,00

2,85

4,50 7,00

240

3530 80

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

5

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.

1

The price in October fell to SEK 33!

6

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 (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} 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. (2) (1)

7

Christos Papahristodoulou, Mälardalen University/HST/Economics

23/06/2008

**Limits of call option
**

Price of C0 Upper limits Lower 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,

8

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 C 0 Upper limit Lower limit

**Option’s path Time value Real value E Share price S
**

0

**Two simple option strategies
**

9

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 expiry Protective Put strategy has downside protection and upside potential; the money you loose from your stock you get it from your put Buy a put with an exercise price of $50, i.e to sell your stock at $50 if its price is below

$50 Buy the stock $0

$50

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

$10 $0 $30 $40 $50 -$30 -$40

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

McGraw-Hill/Irwin

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

10

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 10 or, Buy δ share of stock - δ(50) Borrow Y +Y δ(60) -Y(1.1) δ(40) -Y(1.1) 0

Call option

-C

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

11

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:

12

Christos Papahristodoulou, Mälardalen University/HST/Economics

23/06/2008

δ=

Chigh − Clow S high − S llow

=

10 − 0 = 0 .5 60 − 40

An alternative formula for call options K = worse case (40) S0 = actual price (50) n = number of call options per share =

δ

1 =2

(because δ = 0.5)

40 K = (1 + r ) ⇒ = 1.1 ⇒ C0 = 6.82 50 − 2C S − nC 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 E the PV of E, i.e., ( 1 + r )t (i) If S1 = 60, the call option is: C50 = 10

13

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 =

δ

1 =2

(because δ = 0.5)

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

14

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