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Exotic Options: I

Derivatives Markets (2nd Edition)

Online Excerpt of Section 14.5 with Three Questions and Solutions

Introduction

This document provides a sample excerpt of the ActuarialBrew.com MFE/3F Chapter 14

Review Note. Our goal is to help you pass the actuarial exams on your first attempt by

brewing better actuarial exam preparation products.

Our Review Notes for the MFE/3F Exam are a detailed supplement to the McDonald

Derivatives Markets text that helps you quickly understand the concepts as you prepare for

the exam. Focusing on the more difficult areas, our Review Notes cover all of the MFE/3F

learning objectives.

Free email support is provided to students who purchase our MFE/3F Review Notes.

A gap option has a strike price, K1 , and a trigger price, K 2 . The trigger price

determines whether or not the gap option will have a nonzero payoff. The strike price

determines the amount of the nonzero payoff. The strike price may be greater than or

less than the trigger price.

If the strike price is equal to the trigger price, then the gap option is an ordinary option.

A gap call option has a nonzero payoff (which may be positive or negative) if the final

stock price exceeds the trigger price.

A gap call option has a payoff of:

ÏST - K1 if ST > K 2

Gap call option payoff = Ì

Ó0 if ST £ K 2

where:

K1 = Strike price

K 2 = Trigger price

Exam MFE/3F Chapter 14 – Exotic Options: I

If we graph the payoff of a gap call option as a function of its final stock price, then we can

see that there is a gap where ST = K 2 . In the graph below, there are no negative payoffs

because the trigger price is greater than the strike price:

K2 – K1

Gap

0 K2

K1 ST

If the trigger price is less than the strike price for a gap call option, then negative payoffs

are possible as shown below:

0 ST

Gap K2 K1

K2 – K1

A gap put option has a nonzero payoff if the final stock price is less than the trigger price.

A gap put option has a payoff of:

Ï K1 - ST if ST < K 2

Gap put option payoff = Ì

Ó0 if ST ≥ K 2

where:

K1 = Strike price

K 2 = Trigger price

Exam MFE/3F Chapter 14 – Exotic Options: I

If we graph the payoff of a gap put option as a function of its final stock price, once again

we see that there is a gap where ST = K 2 . There are no negative payoffs in the graph

below because the trigger price is less than the strike price:

K1 – K2

Gap

K2 K1 ST

If the trigger price is greater than the strike price for a gap put option, then negative

payoffs are possible:

K1

0

K1 K2 Gap ST

K1 – K2

Because negative payoffs are possible, gap options can have negative premiums.

A gap option must be exercised even if it results in a negative payoff, so perhaps it

shouldn’t really be called an “option.”

Don’t confuse gap options with knock-in barrier options! There are two differences:

1. For barrier options, the barrier can be reached prior to expiration, but for gap

options, only the final stock price is compared to the trigger.

2. Barrier options never have negative payoffs.

Exam MFE/3F Chapter 14 – Exotic Options: I

The pricing formulas for gap calls and gap puts are similar to the Black-Scholes formulas

for ordinary calls and puts, but there are two differences:

1. K1 is substituted for K in the primary formula.

The prices of gap options are:

GapPut( S , K1 , K 2 ,T ) = K1e - rT N ( -d2 ) - Se -d T N ( -d1 )

where:

Ê Se -d T ˆ s 2

ln Á ˜+ T

Ë K 2 e - rT ¯ 2

d1 = d2 = d1 - s T

s T

and:

K1 = Strike price K 2 = Trigger price

The textbook doesn’t provide the formula for the gap put price shown above, but it does

state that the “modification to the put formula is similar” to the modification to the call

formula needed to produce the gap call price formula. Furthermore, Problem 14.13 (a) in

the problems at the end of Chapter 14 asks us to calculate gap put prices. Therefore, it is

reasonable to expect that students should know the gap put price formula.

As mentioned in the Chapter 12 Review Note, the value of s used to calculate d1 and d2

is always positive.

From the formula above, we can see that the price of a gap option is linearly related to its

strike price. This means that if we know the prices of two gap options that are identical

other than their strike prices, then we can use linear interpolation (or extrapolation) to

find the price of yet another gap option with a different strike price.

Example:

The following gap call options have the same underlying asset:

Gap Call Option 1 46 50 1 year 5.75

Gap Call Option 2 51 50 1 year ?

Gap Call Option 3 53 50 1 year 3.05

Exam MFE/3F Chapter 14 – Exotic Options: I

Solution:

The price of Gap Call Option 2 can be found using linear interpolation:

Ê 51 - 46 ˆ

5.75 + Á (3.05 - 5.75) = 3.82

Ë 53 - 46 ˜¯

For a given strike price, the trigger price that produces the maximum gap option price is

the strike price. When the strike price and the trigger price are equal, the gap option is

the same as an ordinary option. Increasing the trigger price above the strike price causes

the value of the gap option to fall, and decreasing the trigger price below the strike price

also causes the value of the gap option to fall.

Example: Which of the three gap call options has the highest value?

A 50 40

B 50 50

C 50 60

Solution: Option B has the same value as an ordinary European call. Option B pays only if

ST > 50 .

Option A has the same payoffs as Option B if ST > 50 . Option A also has payoffs if

40 < ST < 50 , and these payoffs are negative. Therefore, Option A is worth less than

Option B.

Option C has the same payoffs as Option B if ST > 60 . If 50 < ST £ 60 , then Option B

makes a positive payoff while Option C has a payoff of zero. Therefore, Option C is worth

less than Option B.

Since Option A and Option C are both worth less than Option B, the option with the

highest value is Option B.

The example above deals with gap call options, but similar reasoning applies for gap put

options. Increasing the trigger price of a gap put option above its strike price introduces

negative payoffs. Decreasing the trigger price of a gap put option below its strike price

cuts off some of the positive payoffs.

If a gap call option and a gap put option both have a trigger price of K 2 and a strike price

of K1 , then the purchase of a gap call option and the sale of a gap put option is certain to

result in a payoff of:

ST - K1

Exam MFE/3F Chapter 14 – Exotic Options: I

To see that this is the case, observe that if ST > K 2 , then the gap put option has a payoff

of zero. But if ST < K 2 , then the gap call option has a payoff of zero and the payoff of the

gap put option is:

-( K1 - ST ) = ST - K1

The current value of this payoff is the prepaid forward price of the stock minus the

present value of the strike price, and this can also be expressed as the value of the gap

call minus the value of the gap put:

In the Key Concept below, this equation is rearranged into the familiar form for put-call

parity.

If a gap call option and a gap put option have the same strike price of K1 and also have

the same trigger price, then the gap call price plus the present value of the strike price is

equal to the prepaid forward price of the stock plus the gap put price:

The delta of a gap call is the partial derivative of its price with respect to the stock price:

∂(GapCall ) ∂d ∂d

DGapCall = = e -d T N (d1 ) + Se -d T N '(d1 ) 1 - K1 e -rT N '(d2 ) 2

∂S ∂S ∂S

2 2

-d T -d T e-0.5d1 1 - rT e -0.5d2 1

=e N (d1 ) + Se ¥ - K1 e ¥

2p Ss T 2p Ss T

2 2

Se -d T e-0.5d1 - K1 e -rT e-0.5d2

= e -d T N (d1 ) +

Ss 2p T

Using put-call parity for gap options, we can find the delta of a gap put in terms of the

delta of the corresponding gap call:

GapCall + K1 e - rT = Se -d T + GapPut

DGapCall + 0 = e -d T + DGapPut

DGapPut = DGapCall - e -d T

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