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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.

the seller will buy or sell if the buyer wishes.

(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.

exist:

1

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

Call options

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 Buy a call

Option payoffs ($)

20

0

0 10 20 30 40 50 60 70 80 90 100

-40

-60

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

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.

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

0 10 20 30 40 50 60 70 80 90 100

Write a call

-40

-60

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

Put options

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 Buy a put

Option payoffs ($)

20

0

0 10 20 30 40 50 60 70 80 90 100

Stock price ($)

-20

-40

-60

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

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).

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

0 10 20 30 40 50 60 70 80 90 100

Stock price ($)

-20

-60

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

Call options

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

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

5

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

Call options

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

October 19.

(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.

was entirely insured.

(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.

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)

(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)

either SEK0 or SEK10. See the figure below.

7

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

Price of C0

Upper Lower

limits limits

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.

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

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

Price of C0

Upper

Lower

limit

limit

Option’s

path

Time value

Real value

E Share price S 0

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 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 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.

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.

10

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

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).

(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.

S1 = 60 S2 = 40

Call option -C 10 0

or,

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

0 = δ(40) -Y(1.1)

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

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

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:

Check now why both strategies give the same future values.

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

(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?

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.

Sell a C1 and get: + 7.955

Borrow: 4.545

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

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

12

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

Chigh − Clow 10 − 0

δ= = = 0 .5

S high − S llow 60 − 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

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

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

(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

13

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

required that:

S+P= E +C

(1 + r ) t (3)

(3) we obtain: P50 = 2.275.

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

14

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