15.

401

15.401 Finance Theory

MIT Sloan MBA Program

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lectures 10–11: Options

© 2007–2008 by Andrew W. Lo
Critical Concepts 15.401

ƒ Motivation
ƒ Payoff Diagrams
ƒ Payoff Tables
ƒ Option Strategies
ƒ Other Option-Like Securities
ƒ Valuation of Options
ƒ A Brief History of Option-Pricing Theory
ƒ Extensions and Qualifications

Readings:
ƒ Brealey, Myers, and Allen Chapters 27

© 2007–2008 by Andrew W. Lo Slide 2

Lecture 10–11: Options
Motivation 15.401

Derivative: Claim Whose Payoff is a Function of Another's

ƒ Warrants, Options
ƒ Calls vs. Puts
ƒ American vs. European
ƒ Terms: Strike Price K, Time to Maturity τ

ƒ At Maturity T, payoff

© 2007–2008 by Andrew W. Lo Slide 3

Lecture 10–11: Options
Motivation 15.401

Put Options As Insurance

ƒ Differences
– Early exercise
– Marketability
– Dividends

© 2007–2008 by Andrew W. Lo Slide 4

Lecture 10–11: Options
Payoff Diagrams 15.401

Call Option:

12

10

8
Payoff / profit, $

2
Stock price
0
10 15 20 25 30
-2

© 2007–2008 by Andrew W. Lo Slide 5

Lecture 10–11: Options
Payoff Diagrams 15.401

Stock Return vs. Call Option Return

133%

100%

67%

33%

0%
30 34 38 42 46 50 54 58 62 66 70
-33%

-67%

-100%

-133%

© 2007–2008 by Andrew W. Lo Slide 6

Lecture 10–11: Options
Payoff Diagrams 15.401

Put Option:

12

10

8
Payoff / profit, $

2
Stock price
0
10 15 20 25 30
-2

-4

© 2007–2008 by Andrew W. Lo Slide 7

Lecture 10–11: Options
Payoff Diagrams 15.401

25 25

20 20

15
Long Call 15 Long Put
10 10

5 5

0 0
30 40 50 60 70 30 40 50 60 70
-5 -5
Stock price Stock price
5 5
Stock price Stock price
0 0
30 40 50 60 70 30 40 50 60 70
-5 -5

-10
Short Call -10
Short Put
-15 -15

-20 -20

-25 -25

© 2007–2008 by Andrew W. Lo Slide 8

Lecture 10–11: Options
Payoff Tables 15.401

Stock Price = S, Strike Price = X

Call option (price = C)

if S < X if S = X if S > X
Payoff 0 0 S–X
Profit –C –C S–X–C

Put option (price = P)

if S < X if S = X if S > X
Payoff X–S 0 0
Profit X–S–P –P –P

© 2007–2008 by Andrew W. Lo Slide 9

Lecture 10–11: Options
Option Strategies 15.401

Trading strategies
Options can be combined in various ways to create an unlimited
number of payoff profiles.

Examples
ƒ Buy a stock and a put
ƒ Buy a call with one strike price and sell a call with another
ƒ Buy a call and a put with the same strike price

© 2007–2008 by Andrew W. Lo Slide 10

Lecture 10–11: Options
Option Strategies 15.401

Stock + Put
70 25
Payoff Payoff
65
20
60
55 Buy stock 15 Buy a put
50
45 10
40
5
35
30 0
30 40 50 60 70 30 40 50 60 70
Stock price Stock price

70
Payoff
65
60
55
50
45
40 Stock + put
35
30
30 40 50 60 70
Stock price

© 2007–2008 by Andrew W. Lo Slide 11

Lecture 10–11: Options
Option Strategies 15.401

Call1  Call2
25 25
Payoff Payoff
20 20
15 15
10 Buy call with 10 Write call with
5 X = 50 5 X = 60
0 0
-5 30 40 50 60 70 -5 30 40 50 60 70

-10 Stock price -10 Stock price

-15 -15
-20 -20

20
Payoff
16

12 Call1 – Call2

0
30 40 50 60 70
Stock price

© 2007–2008 by Andrew W. Lo Slide 12

Lecture 10–11: Options
Option Strategies 15.401

Call + Put
25 25
Payoff Payoff
20 20

15 15
Buy call with Buy put with
10 10
X = 50 X = 50
5 5

0 0
30 40 50 60 70 30 40 50 60 70
-5 -5
Stock price Stock price
-10 -10

25
Payoff
20

15
Call + Put
10

0
30 40 50 60 70
-5
Stock price
-10

© 2007–2008 by Andrew W. Lo Slide 13

Lecture 10–11: Options
Other Option-Like Securities 15.401

Corporate Liabilities:

ƒ Equity: hold call, or protected levered put

ƒ Debt: issue put and (riskless) lending
ƒ Quantifies Compensation Incentive Problems:
– Biased towards higher risk
– Can overwhelm NPV considerations
– Example: leveraged equity

© 2007–2008 by Andrew W. Lo Slide 14

Lecture 10–11: Options
Other Option-Like Securities 15.401

Other Examples of Derivative Securities:

ƒ Asian or “Look Back” Options
ƒ Callables, Convertibles
ƒ Futures, Forwards
ƒ Swaps, Caps, Floors
ƒ Real Investment Opportunities
ƒ Patents
ƒ Tenure
ƒ etc.

© 2007–2008 by Andrew W. Lo Slide 15

Lecture 10–11: Options
Valuation of Options 15.401

Binomial Option-Pricing Model of Cox, Ross, and Rubinstein (1979):

ƒ Consider One-Period Call Option On Stock XYZ
ƒ Current Stock Price S0
ƒ Strike Price K
ƒ Option Expires Tomorrow, C1= Max [S1−K , 0]
ƒ What Is Today’s Option Price C0?

0 1

S0 , C0 = ??? S1 , C1= Max [S1−K , 0]

© 2007–2008 by Andrew W. Lo Slide 16

Lecture 10–11: Options
Valuation of Options 15.401

Suppose S0 → S1 Is A Bernoulli Trial:

p uS0
S1 u>d
1− p dS0

p Max [ uS0 − K , 0 ] == Cu
C1
1− p Max [ dS0 − K , 0 ] == Cd

© 2007–2008 by Andrew W. Lo Slide 17

Lecture 10–11: Options
Valuation of Options 15.401

Now What Should C0 = f (⋅) Depend On?

ƒ Parameters: S0 , K , u , d , p , r
Consider Portfolio of Stocks and Bonds Today:
ƒ ∆ Shares of Stock, $B of Bonds
ƒ Total Cost Today: V0 == S0∆ + B
ƒ Payoff V1 Tomorrow:

p uS0∆ + rB
V1
1− p dS0 ∆ + rB

© 2007–2008 by Andrew W. Lo Slide 18

Lecture 10–11: Options
Valuation of Options 15.401

Now Choose ∆ and B So That:

p uS0∆ + rB = Cu
∆* = (Cu− Cd)/(u − d)S0
V1 ⇒
B* = (uCd− dCu)/(u − d)r
1− p dS0 ∆ + rB = Cd

Then It Must Follow That:

1 r −d u −r
C0 = V0 = S0 ∆* + B* = Cu + C
r u−d u−d d

© 2007–2008 by Andrew W. Lo Slide 19

Lecture 10–11: Options
Valuation of Options 15.401

Suppose C0 > V0
ƒ Today: Sell C0 , Buy V0 , Receive C0 − V0 > 0
ƒ Tomorrow: Owe C1, But V1 Is Equal To C1!
Suppose C0 < V0
ƒ Today: Buy C0 , Sell V0 , Receive V0 − C0 > 0
ƒ Tomorrow: Owe V1, But C1 Is Equal To V1!
C0 = V0 , Otherwise Arbitrage Exists

1 r −d u −r
C0 = V0 = S0 ∆* + B* = r u−d
Cu +
u−d d
C

© 2007–2008 by Andrew W. Lo Slide 20

Lecture 10–11: Options
Valuation of Options 15.401

Note That p Does Not Appear Anywhere!

ƒ Can disagree on p, but must agree on option price
ƒ If price violates this relation, arbitrage!
ƒ A multi-period generalization exists:

ƒ Continuous-time/continuous-state version (Black-Scholes/Merton):

© 2007–2008 by Andrew W. Lo Slide 21

Lecture 10–11: Options
A Brief History of Option-Pricing Theory 15.401

Earliest Model of Asset Prices:

ƒ Notion of “fair” game
ƒ The martingale
ƒ Cardano’s (c.1565) Liber De Ludo Aleae:
The most fundamental principle of all in gambling is simply equal
conditions, e.g. of opponents, of bystanders, of money, of situation, of
the dice box, and of the die itself. To the extent to which you depart
from that equality, if it is in your opponent's favor, you are a fool, and if
in your own, you are unjust.

ƒ Precursor of the Random Walk Hypothesis

© 2007–2008 by Andrew W. Lo Slide 22

Lecture 10–11: Options
A Brief History of Option-Pricing Theory 15.401

Louis Bachelier (1870–1946):

ƒ Théorie de la Spéculation (1900)
ƒ First mathematical model of Brownian motion
ƒ Modelled warrant prices on Paris Bourse

ƒ Poincaré’s evaluation of Bachelier:

The manner in which the candidate obtains the law of Gauss is most original, and all the
more interesting as the same reasoning might, with a few changes,be extended to the
theory of errors. He develops this in a chapter which might at first seem strange, for he
titles it ``Radiation of Probability''. In effect, the author resorts to a comparison with the
analytical theory of the propagation of heat. A little reflection shows that the analogy is
real and the comparison legitimate. Fourier's reasoning is applicable almost without
change to this problem, which is so different from that for which it had been created. It
is regrettable that [the author] did not develop this part of his thesis further.

© 2007–2008 by Andrew W. Lo Slide 23

Lecture 10–11: Options
A Brief History of Option-Pricing Theory 15.401

Kruizenga (1956):
ƒ MIT Ph.D. Student (Samuelson)
ƒ “Put and Call Options: A Theoretical and Market Analysis”

Sprenkle (1961):
ƒ Yale Ph.D. student (Okun, Tobin)
ƒ “Warrant Prices As Indicators of Expectations and Preferences”

What Is The “Value” of Max [ ST − K , 0 ]?

ƒ Assume probability law for ST
ƒ Calculate Et [ Max [ ST − K , 0 ] ]
ƒ But what is its price?
ƒ Do risk preferences matter?

© 2007–2008 by Andrew W. Lo Slide 24

Lecture 10–11: Options
A Brief History of Option-Pricing Theory 15.401

Samuelson (1965):
ƒ “Rational Theory of Warrant Pricing”
ƒ “Appendix: A Free Boundary Problem for the Heat Equation Arising
from a Problem in Mathematical Economics”, H.P. McKean

Samuelson and Merton (1969):

ƒ “A Complete Model of Warrant Pricing that Maximizes Utility”
ƒ Uses preferences to value expected payoff

Black and Scholes (1973):

ƒ Construct portfolio of options and stock
ƒ Eliminate market risk (appeal to CAPM)
ƒ Remaining risk is inconsequential (idiosyncratic)
ƒ Expected return given by CAPM (PDE)

© 2007–2008 by Andrew W. Lo Slide 25

Lecture 10–11: Options
A Brief History of Option-Pricing Theory 15.401

Merton (1973):
ƒ Use continuous-time framework
– Construct portfolio of options and stock
– Eliminate market risk (dynamically)
– Eliminate idiosyncratic risk (dynamically)
– Zero payoff at maturity
– No risk, zero payoff ⇒ zero cost (otherwise arbitrage)
– Same PDE
ƒ More importantly, a “production process” for derivatives!
ƒ Formed the basis of financial engineering and three distinct industries:
– Listed options
– OTC structured products
– Credit derivatives

© 2007–2008 by Andrew W. Lo Slide 26

Lecture 10–11: Options
A Brief History of Option-Pricing Theory 15.401

The Rest Is Financial History:

Photographs removed due to copyright restrictions.

© 2007–2008 by Andrew W. Lo Slide 27

Lecture 10–11: Options
Extensions and Qualifications 15.401

ƒ The derivatives pricing literature is HUGE

ƒ The mathematical tools involved can be quite challenging
ƒ Recent areas of innovation include:
– Empirical methods in estimating option pricings
– Non-parametric option-pricing models
– Models of credit derivatives
– Structured products with hedge funds as the underlying
– New methods for managing the risks of derivatives
– Quasi-Monte-Carlo methods for simulation estimators
ƒ Computational demands can be quite significant
ƒ This is considered “rocket science”

© 2007–2008 by Andrew W. Lo Slide 28

Lecture 10–11: Options
Key Points 15.401

ƒ Options have nonlinear payoffs, as diagrams show

ƒ Some options can be viewed as insurance contracts
ƒ Option strategies allow investors to take more sophisticated bets
ƒ Valuation is typically derived via arbitrage arguments (e.g., binomial)
ƒ Option-pricing models have a long and illustrious history

© 2007–2008 by Andrew W. Lo Slide 29

Lecture 10–11: Options
Additional References 15.401

ƒ Bachelier, L, 1900, “Théorie de la Spéculation”, Annales de l'Ecole Normale Supérieure 3 (Paris,

Gauthier-Villars).
ƒ Black, F., 1989, “How We Came Up with the Option Formula”, Journal of Portfolio Management 15, 4–8.
ƒ Bernstein, P., 1993, Capital Ideas. New York: Free Press.
ƒ Black, F. and M. Scholes, 1973, “The Pricing of Options and Corporate Liabilities”, Journal of Political
Economy 81, 637–659.
ƒ Kruizenga, R., 1956, Put and Call Options: A Theoretical and Market Analysis, unpublished Ph.D.
dissertation, MIT.
ƒ Merton, R., 1973, “Rational Theory of Option Pricing”, Bell Journal of Economics and Management
Science 4, 141–183.
ƒ Samuelson, P., 1965, “Rational Theory of Warrant Pricing”, Industrial Management Review 6, 13–31.
ƒ Samuelson, P. and R. Merton, 1969, “A Complete Model of Warrant Pricing That Maximizes Utility”,
Industrial Management Review 10, 17–46.
ƒ Sprenkle, C., 1961, “Warrant Prices As Indicators of Expectations and Preferences”, Yale Economic
Essays 1, 178–231.

© 2007–2008 by Andrew W. Lo Slide 30

Lecture 10–11: Options
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

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