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March 2, 2011

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1 Summary of Lecture 11
1. Notation:

(a) S0 , St , Su , or ST = underlying asset price at various times.

(b) X = exercise price, assumed positive.
(c) T = exercise or expiry time, T > 0 = today.
(d) σ > 0, volatility of the asset price
(e) r > 0, the risk-free interest rate
(f) d ≥ 0, a dividend to be paid during the life of the option.
(g) Also,
c0 , p0 , C0 , P0 , ct , Pt , etc.
are the prices of the European call, European put, American call,
and American put prices at various times.

2. Call and Put Payoffs:

(a) The holder of the call option at T gets


ST − X, if ST > X
cT or CT = .
0, if ST ≤ X

(b) The holder of the put option at T gets


X − ST , if ST < X
pT orPT = .
0 if ST ≥ X

1
 3. The Plus Function is

x+ = max [x, 0]

x, if x > 0
=
0, if x ≤ 0

4. In this notation,
+
CT or cT = (ST − X)

and
PT or pT = (X − ST )+

5. The writer: Every option that is held had to be sold, or written by

someone, and that seller is said to be short the option. This writer will
get the payoff at T
+ +
− (ST − X) or − (X − ST ) ,

in the case of a call or a put, respectively.

6. The net payoff to the writer is

c0 erT − cT or p0 erT − pT ,

which takes into account the effects of receiving the premium at time 0.
7. The Plus Identity: For any real number x,
+
x+ − (−x) = x.

The proof consists of checking the two cases x > 0 and x ≤ 0.

8. The Black-Scholes Model assumes that for any two times t and u > t

log Su − log St
= a normal random variable,
with variance σ 2 × (u − t).

The model also assumes that if t < u < v are three times, then the
logarithmic increments over the nonoverlapping periods t to u, and u to
v, are statistically independent.

9. The parameter σ 2 √is the variance per unit of time in the logarithm of S.
The number σ = σ 2 is the volatility of the price, and is the standard
deviation of a one-year change in log S.
10. Typical values for σ lie in the range .10 to .40, and lead to surprisingly
wide confidence intervals for an asset price in one year.

2
11. It is a theorem, not an assumption, that in derivative asset pricing, we
can assume that the mean of the logarithmic change is
E (log Su − log St )
σ2
 
= r− × (u − t).
2

12. For any normal random variable

X ∼ N (m, v) ,
X
the expected value of e is
 v
E (exp(X)) = exp m + .
2
13. It follows that at time 0, the expectation of ST is
E (ST ) = S0 erT ,
as if the asset had a riskless rate of return.
14. Theorem: Any European option, or derivative written on ST , has an
arbitrage-free price equal to the expected discounted value of the deriva-
tive’s payoff at T .
15. The European option prices are therefore
 + 
c0 = E e−rT S0 erT eY − X


 + 
= E S0 eY − Xe−rT
and similarly  + 
p0 = E Xe−rT − S0 eY ,
where
σ2
 
Y ∼ N − T, σ 2 T
2
16. The Black-Scholes Formula is
c0 = S0 N (z1 ) − Xe−rT N (z2 ) ,
in which
 
S0 σ2


log + r+
X 2 T
z1 = √ ,
σ T
√
z2 = z1 − σ T ,
and the function N is the standard normal cumulative distribution func-
tion: Z z  2
−1 x
N (z) = Pr (Z ≤ z) = (2π) 2 exp − dx.
−∞ 2

3
17. The European Put Formula is

p0 = c0 − S0 + Xe−rT

= S0 (N (z1 ) − 1)
+ Xe−rT (1 − N (z2 ))

= Xe−rT N (−z2 ) − S0 N (−z1 ) ,

using the symmetry property of the normal distribution function

N (−z) = 1 − N (z) .

18. The Table of sensitivities of option prices, to changes in the factors de-
termining them, is

EC EP AC AP
S0 + – + –
X – + – +
T +* ? + +
σ + + + +
r + – + –
d – + – +

(The starred + requires the assumption of no dividends).

19. The effects of S, X, and r on European option prices are easiest to find
from the formulas
 +   + 
c0 = E S0 eY − Xe−rT and p0 = E Xe−rT − S0 eY .

The plus function is increasing, and the random variables in the expecta-
tions are either increasing or decreasing in S0 , X, and r. It follows that
c0 is increasing in S0 , decreasing in X, and increasing in r; and p0 has the
opposite sensitivities.
20. Without dividends, C0 has the same sensitivities as c0 , because of the
Better- Alive- than- Dead Principle, which says that a rational investor
will optimally wait as long as possible to exercise an American call. The
American put is not so easy to analyze.

21. The effects of T are easier to analyze in the case of American options.
Increasing T , say to T 0 > T , gives the holder of the option all the same
rights, and more; consequently, American call and put prices both in-
crease, when T increases. Without dividends, the European call and the
American call are equivalent, so the European call price also increases
with T .

4
 22. The European put price can react either way, to an increase in T .
23. Dividends have effects on option prices that are the opposite of the effects
of S. The ex dividend effect is to decrease the asset price, by the amount
of the dividend.
24. Volatility has an increasing effect on all four types of options in the table.
25. Easy Arbitrage Relations include

(a)
ct ≤ Ct and pt ≤ Pt .
(If not, just buy the American option, write the European option,
and wait until expiry.)
(b) Any American option is always worth at least its intrinsic value:

Ct ≥ (St − X)+ and Pt ≥ (X − St )+ .

(If not, just buy the option and exercise it immediately.)

(c)
Ct ≤ St .
(If not, buy the asset, write the call, and wait until exercise time.)
(d)
Pt ≤ X.
(If not, write the put, invest the proceeds, and wait until exercise
time.)

2 Lecture 12
3 Call Minus Put Equals (Long) Forward
The identity
x+ − (−x)+ = x,
is valid for any number x. In applications to call and put options, we always
have x = S − X, or x = X − S; and the time subscript is missing here, because
we may have S = ST or S = St , for some t < T .

Suppose that at time 0 you buy the European call option and write the
European put option. Then effectively you have the right and the obligation to
exchange X for the asset.

Exactly one of the options will be in the money, and whichever one it is will
be exercised; so your payment of X for the asset is going to take place, and the
only question is whether you will gain or lose by doing so.

5
 At time T you will get the payment

cT − pT

= (ST − X)+ − (X − ST )+
= (ST − X)+ − (−[ST − X])+
= x+ − (−x)+ = x = ST − X,
the same as if you had entered a long forward contract on the asset, and agreed
to pay X for it at time T .

For this reason, the combination of buying a call and writing a put is some-
times called a synthetic forward contract.

Since X might not equal the forward price, the synthetic forward may cost
or generate money when it is entered; but if you take accurate account of the
premiums c0 and p0 , by adding

(p0 − c0 ) erT

to your payoff at T , you get a total of

ST − X + (p0 − c0 ) erT

at T , and no other payments.

By entering a long forward, you would get just

ST − F0

at T , and no other payments; so you should suspect immediately that if these

two payments are any different, there is an arbitrage:

Proposition: Without arbitrage,

ST − X + (p0 − c0 ) erT = ST − F0 ,

or equivalently
(p0 − c0 ) erT = X − F0
Proof : Assume temporarily that

(p0 − c0 ) erT > X − F0 ,

so that
ST − X + (p0 − c0 ) erT > ST − F0 .
You can collect the left side and pay the right, by

6
 1. buying the call,
2. writing the put,
3. investing (p0 − c0 ) (or borrowing − (p0 − c0 )), and
4. entering a short forward contract.

There are no net payments at time 0, and at time T your net payment is

cT − pT = ST − X,

plus
(p0 − c0 ) erT (or − (c0 − p0 ) erT )
plus
F0 − ST .
It all adds up to
ST − X + (p0 − c0 ) erT + F0 − ST
= (p0 − c0 ) erT − (X − F0 ) > 0.
Similarly, if
(p0 − c0 ) erT < X − F0 ,
then an arbitrage consists of

1. buying the put,

2. writing the call,

3. investing (c0 − p0 ) (or borrowing − (c0 − p0 )), and

4. entering a long forward contract.

Another way to test your knowledge of the equation is to give you the implied
repo rate  
∗ 1 X − F0
r = log ,
T p0 − c0
the interest rate that solves the equation. (We need to assume that p0 > c0 and
X > F0 , or the reverse inequalities).

1. Show that if you can borrow for less than this rate, then you can construct
an arbitrage.
2. Show that if you can invest at a rate higher than r∗ , then you can construct
an arbitrage.

7
 3. Show that if the quantity inside the logarithm operation is negative, there
is an arbitrage.

An answer to 1 begins by writing out and manipulating the given inequality:

 
1 X − F0
rb < log
T p0 − c0
 
X − F0
T rb < log
p0 − c0
 
rb T X − F0
e <
p 0 − c0
erb T (p0 − c0 ) < (X − F0 ) (∗) .
(This is what you get with p0 − c0 > 0; if not, you have to remember to switch
the inequality.)
If you can get this far, the rest is easy. To make erb T (p0 − c0 ) a relevant
quantity in any calculation, you will have to

1. borrow (p0 − c0 ). With this amount of money, you can

2. buy the put and
3. write the call.
4. Since call minus put equals long forward, and you just bought the put and
wrote the call, the next step is to enter a long forward contract.
5. There are no net cash flows at time 0. Your payoff at T is

pT − cT − erb T (p0 − c0 ) + ST − F0
+ +
= (X − ST ) − (ST − X) − erb T (p0 − c0 ) + ST − F0
= X − ST − erb T (p0 − c0 ) + ST − F0
= X − F0 − erb T (p0 − c0 ) > 0,
since you have received the large side, and paid the small side of equation
(∗).

To solve 2, start with the given inequality and manipulate it until you get
an interest rate factor on one side:
 
1 X − F0
r` > log
T p0 − c0
 
X − F0
T r` > log
p 0 − c0

8
 X − F0
e r` T > .
p0 − c0
This time assume you are given that p0 < c0 , and manipulate the inequality
further:
(p0 − c0 ) er` T < X − F0 ,
(c0 − p0 ) er` T > F0 − X.
The left side is what you get by writing the call and buying the put, generating
c0 − p0 > 0 in cash at time 0, and investing the proceeds. You will also get the
put payoff minus the call payoff, which you should recognize as a synthetic short
forward payoff. To make your money riskless, enter a long forward contract, in
addition to the transactions so far.

At time T , you get the total payments

(c0 − p0 ) er` T + pT − cT + ST − F0
+ +
= (c0 − p0 ) er` T + (X − ST ) − (ST − X) + ST − F0
= (c0 − p0 ) er` T + X − ST + ST − F0
(using the plus identity with x = X − ST )

= (c0 − p0 ) er` T + X − F0 .

We were assuming that (c0 − p0 )er` T > F0 − X, so this riskless costless amount
of money is positive, and so is an arbitrage profit.

What if the logged quantity in

 
∗ 1 X − F0
r = log
T p0 − c0

is negative? You should guess that the arbitrage is easier to construct in this
case. You might even guess that there is an arbitrage that generates money both
today and at time T , regardless of the interest rate.

There are two ways for X−Fp0 −c0 to be negative: X − F0 < 0 and p0 − c0 > 0,
0

and X − F0 > 0 and p0 − c0 < 0. In the first case, X < F0 , so you should guess
that a short forward contract will be part of an arbitrage. (You want to receive
the price that is too high).

To add an option position that will generate riskless payments, you need a
synthetic long forward contract, so buy the call and write the put. (Call minus
put equals long forward.) Since p0 − c0 > 0, you get a positive amount of money
at time 0.
At time T , you get
cT − pT + F0 − ST

9
 + +
= (ST − X) − (X − ST ) + F0 − ST
= ST − X + F0 − ST
= F0 − X > 0.

Another way to read the arbitrage equation

(p0 − c0 ) erT = X − F0

is as
p0 = c0 + e−rT (X − F0 ) .
This equation expresses the put price in terms of the call price, the interest rate,
and the forward price.

It should lead you to suspect that one can create synthetic puts out of call
options, forward markets, and money markets. You should be prepared to
answer a question like this one:

Suppose that an asset costs nothing to store and pays no dividends until
after T , which is both the delivery time of a forward contract, and the exercise
time for a European call option. The exercise price of the call is $25, its price
is $1.50, the continuously compounding interest rate is 5%, and the current
forward price is $24.
Show how to create a synthetic put option, by dealing in the option, forward,
and money markets.

If you have studied the graphs of forward contract payoffs, and put and call
payoffs, you should be able to see that a call option payoff, plus a short forward
payoff, has a slope of −1 up to the point where ST = X, and a slope of zero
thereafter.

It is just like a put option payoff, except that it may not equal zero past
the point where the slope changes. It should now be clear that a synthetic put
option should consist of a call option, plus a short forward contract, plus some
amount of borrowing or lending.
If you buy the call option, and enter a short forward contract, then your
payoff at T will be
cT + F0 − ST

ST − 25 + 24 − ST , if ST > 25
=
24 − ST , if ST ≤ 25

−1, if ST > 25
=
24 − ST , if ST ≤ 25

10
If you include the effects of borrowing the c0 you need at time 0, to buy the
call, the total payoff becomes

−1 − 1.5e.05T ,

if ST > 25
24 − 1.5e.05T − ST , if ST ≤ 25

If only we could add 1 + 1.5e.05T to this payoff, it would be exactly the same
as a put payoff. The way to make this addition is to invest e−.05T + 1.5 today;
and this amount is all it costs, to get the put payoff (there are no other net cash
flows at time 0).

The price of the synthetic put is thus

p0 = 1.5 + e−.05T = c0 + e−rT (X − F0 ) ,

a fact that could have been foretold, by anyone who had memorized the arbitrage
equation. But knowing that equation would probably not help you to answer
the question, would it?

Figure 7.10 illustrates synthetic forwards. The default options are Buy Call
together with Write Put, and you can choose whether to “Borrow or invest all
cash flows at 0”, or show “Payoff at T only”. If you show only the payoff, you
will see
cT − pT = ST − X,
a line with slope +1 just as with a long forward contract. This pair of transac-
tions is not equivalent to a long forward, unless the prices of the call and the
put are the same, and there is no net cash flow at 0.

If in addition you “Borrow or invest...”, graph the resulting payoff, and

then unclick the options and click on Long forward, the payoff that gets drawn
(choose a different colour) will merely redraw the payoff function already shown.
This coincidence of lines shows that without arbitrage,

ST − F0 = cT − pT − (c0 − p0 ) erT ,

or
ST − F0 = ST − X − (c0 − p0 ) erT
or equivalently
(c0 − p0 ) erT = F0 − X.

Similarly, if you buy the put, write the call, and “Borrow or invest...”, you
will get exactly the same payoff as if you had entered a short forward contract.

11
4 Put-Call Parity, or
5 Call Minus Put Equals Stock Minus Bond
Another use of the identity x+ − (−x)+ = x is to write the price of the put in
terms of the call price and the asset price.

If we buy a put and write a call, then at T we get the payment

+
pT − cT = (X − ST ) − (ST − X)+

= X − ST ,
the negative of the calculation from the last section.
If in addition we buy the asset, and there are no dividends until after T ,
then our wealth at T will be just X, a riskless amount. The transactions at
time 0 cost p0 − c0 + S0 , and generate X at T , risklessly. But another simpler
way to generate X at T would be to invest Xe−rT . So without arbitrage, we
must have
Xe−rT = p0 − c0 + S0 ,
or equivalently
c0 − p0 = S0 − Xe−rT ,
which is called the put-call parity equation.

On the left is the call price minus the put price, and on the right is the stock
price minus Xe−rT . This last quantity is the price of a riskless discount bond
with face value X, maturing at T ; hence “Call Minus Put Equals Stock Minus
Bond”.

For half of an arbitrage proof, that

c0 − p0 = S0 − Xe−rT ,

assume temporarily that

c0 + Xe−rT > p0 + S0 .

Borrow Xe−rT , and write the call, so that we collect the left side of the inequality
at 0. Then buy the put and the asset, so that at time 0 we collect the left side
minus the right side of the assumed inequality, a positive amount.

At time T the effect on our wealth is

pT − cT + ST − X

= (X − ST )+ − (ST − X)+ + ST − X

12
 = (−x)+ − x+ + x (x = ST − X)
= 0,
+ +
because x = x − (−x) . Thus we have an arbitrage.

Again, we can turn the arbitrage equation

Xe−rT = p0 − c0 + S0

into an implied repo rate, by solving for r:

 
∗ 1 p0 − c0 + S0
r = − log .
T X

This time, suppose we can lend at the rate r > r∗ . Then

 
p0 − c0 + S0
rT > r∗ T = − log ,
X

 
p0 − c0 + S0
erT > exp − log
X
  −1
p0 − c0 + S0
= exp log
X

X
=
p0 − c0 + S0
and, assuming p0 − c0 + S0 > 0,

Xe−rT < p0 − c0 + S0

all follow. (A much easier arbitrage exists, if p0 − c0 + S0 ≤ 0. ) In this case,

buy the asset
Short sell the asset, write the put, and buy the call, to generate the amount and the put,
p0 − c0 + S0 > Xe−rT . Invest Xe−rT until T , so that there is some leftover and write the
money at time 0. The resulting payments at T add up to 0, so we have an call, to gener-
arbitrage. ate c0 − S0 −
p0 ≥ 0 at time
0. At time T ,
For future times t > 0, we can update and rewrite the put-call parity equa- you get
tion as any of
Xe−r(T −t) = pt − ct + St , pT − cT + ST
or + +
= (X − ST ) −(ST − X) +S
ct = pt + St − Xe−r(T −t) .
= X−ST +ST = X > 0.
The arbitrage proofs are all the same as they are at time 0.

13
 There are extensions of these arbitrage equations that can deal with (known)
dividends, but they are not part of this course.

The put-call parity equation is illustrated in Figure 7.11. The default options
are Buy call, Write put, Borrow or invest all cash at 0, so if you click Draw
Graph, you get the net payoff at T

cT − pT − (c0 − p0 ) erT .

This payoff costs nothing, and is equal to

ST − X − (c0 − p0 ) erT ,

which is just ST minus a riskless amount. If you clear the option positions,
click Buy stock, and continue to Borrow or invest all cash flows, you will see
the payoff
ST − S0 erT ,
another payment of the form ST minus a riskless amount. The difference be-
tween these two payments is riskless and costless, so without arbitrage it should
be zero.

Indeed, if you do not change colours before graphing the stock position,
nothing will appear to happen, because the program will just redraw the same
function. In other words,

ST − S0 erT = ST − X − (c0 − p0 ) erT ,

or equivalently
c0 − p0 = S0 − XerT ,
the parity equation.

Another way to see this relation is to buy the call, write the put, short the
stock, and borrow or invest all cash at 0. The payoff at T is

cT − pT − (c0 − p0 ) erT + S0 erT − ST

= ST − X − (c0 − p0 ) erT + S0 erT − ST

= S0 erT − X − (c0 − p0 ) erT ,
a riskless costless payment. Since the program assumes no arbitrage, it must
draw the function 0.

14
6 More Arbitrage Relations
The put-call parity equation

c0 − p0 = S0 − Xe−rT

can easily be turned into either of two arbitrage relations,

c0 ≥ S0 − Xe−rT

and
p0 ≥ Xe−rT − S0 .
Either lower bound follows from the put-call parity equation, and the simple
observations that c0 ≥ 0 and p0 ≥ 0.

It is worth a reminder here that these arbitrage relations require the assump-
tion of no dividends until after T .

For later times t > 0, we must have

ct = pt + St − Xe−r(T −t)

≥ St − Xe−r(T −t)
and
pt = ct + Xe−r(T −t) − St
≥ Xe−r(T −t) − St .
The first inequality leads directly to the Better-Alive-than-Dead Principle, an
important result on American call options, and the topic of the next section.

We can combine these bounds with our earlier ones,

0 ≤ ct ≤ Ct ≤ St ,

and
0 ≤ p t ≤ Pt ≤ X
to get Figure 7.3, showing how the call and put prices look as functions of S0
or St .

7 The BAD Principle

We have already seen that without dividends, a European call option and an
American call option are equivalent, for the holder of the American call will
rationally wait until T to exercise.

15
 This fact follows from the following arbitrage relation:
Proposition: Without arbitrage or dividends, we must have

ct ≥ St − Xe−r(T −t) .

Proof : As mentioned in the last section, this arbitrage inequality follows

from the put-call parity equation, and the observation that pt ≥ 0. To give
an arbitrage proof, we could always just rewrite the proof of put-call parity,
updated for times t > 0; but it will lead (eventually, not in these notes) to a
much more general result if we give a direct arbitrage proof. (If you are asked
on an exam to prove that something holds, without arbitrage, you have to give
an arbitrage proof).
As always, we assume temporarily that the inequality is violated:

ct < St − Xe−r(T −t) ,

or
ct + Xe−r(T −t) < St .
Now we need a way to profit from the situation. Obviously, we have to short the
security, buy the call option, and invest Xe−r(T −t) (so that at T we have X).
The cash we get at t is just the right side minus the left side of the inequality,
and is positive. Between t and T , there are no dividends to cover (as we must,
if we are short the security). At time T we exercise in the call option if it is in
the money, buy back the security, and collect our money from the bank, to get

(ST − X)+ − ST + X

= (ST − X)+ − (ST − X)

= (x)+ − x,
with x = ST − X. Since
x = x+ − (−x)+ ,
and hence
x+ − x = (−x)+ ≥ 0,
we cannot lose money at T . So we have an arbitrage, if the inequality is violated;
and without arbitrage the inequality must hold.

Another way to prove the Proposition is first to prove the put-call parity
equation
ct − pt = St − Xe−r(T −t) ,
which (without dividends) is valid for all times t ≤ T . Then, using pt ≥ 0, you
get

ct = pt + St − Xe−r(T −t)
≥ St − Xe−r(T −t) .

16
 The point of the Proposition is to show that the price of the American call
is always higher than the option’s intrinsic value at t, or the payment its holder
would get if it expired at t instead of T .

One of the easy arbitrage inequalities is that Ct ≥ ct ; for in general an

American option is always worth at least the price of its European counterpart.

Thus
Ct ≥ ct ≥ St − Xe−r(T −t) .
By exercising the option at t, the holder would get

(St − X)+ = St − X,

provided that this amount is positive (exercising would be stupid if St < X).
Since r > 0, T − t > 0, −r(T − t) < 0 and

0 < e−r(T −t) < 1,

we have
Xe−r(T −t) < X,
for call options always have positive exercise prices. Therefore

St − Xe−r(T −t) > St − X.

Put these results together, and get

Ct ≥ ct ≥ St − Xe−r(T −t) > St − X,

showing that the holder would get more money by selling the option than by
exercising it. Thus we have proven the
Better-Alive than Dead Principle: If an asset pays no dividends until
after T , the expiry time of an American call option, then the holder the option
will rationally exercise it only at T .

Therefore, holders of American calls will get exactly the same payoffs as
holders of European calls with the same parameters. It follows that ct = Ct ;
but as before, an arbitrage proof is really required. Assume that all investors
behave rationally, and assume temporarily that ct < Ct . Write the American
call, buy the European call, and collect the (positive) difference in the prices.
+
The holder will rationally wait until T , when you collect [ST − X] from holding
+
the European call, and have to pay the same [ST − X] from having written
the American call. The resulting payments are an arbitrage.

17
8 Option Strategies
Figure 7.12 can graph several of the more common option strategies, or com-
binations of options, perhaps with some holdings of the underlying asset, that
investors use to collect payoffs reflecting their opinions.

For example, a call bull spread consists of buying a call option, and writing
another call option with a higher exercise price.
The time T payoff is zero until ST reaches the lower exercise price, say X1 ;
then it has a slope of +1 for values of ST between X1 and X2 , the second, higher
strike price; and beyond X2 , every dollar gained from owning the first option is
lost by having written the second, so the slope of the payoff is zero.

When you include the effects of paying and receiving the premiums, the
graph shifts down, by the difference in the two options’ prices. (The call option
that is written, with exercise price X2 , must have a smaller price than the one
with the lower exercise price X1 ).

If X1 > S0 , the current asset price, this position is bullish, but only moder-
ately so. An investor in this position presumably thinks that the asset’s price
will increase, but not enough to push the second call into the money; so the
investor is willing to give up any increases in S beyond X2 , in exchange for the
second option’s premium.

Another common option strategy is the covered call. It consists of buying

or owning a unit of the asset, and writing a call option on the asset, normally
with an exercise price somewhat larger than the current price.

The point is to participate in any normal gains the asset might make, and
give up the abnormal gains in exchange for the option’s premium. Investors and
fund managers take this position hoping to increase income from their portfolios
during what they predict will be sluggish markets, or times of low volatility.

An advantage of covered call writing is that owning the asset is perfectly

adequate security against any increases in its price, whose possibility normally
entails significant margin account deposits from call writers.

Provided that the exercise price is above the current asset price, this position
is moderately bullish.

An example of a moderately bearish position is the put bear spread. It

consists of buying a put option with a higher exercise price X1 , and writing a
put with a lower exercise price X2 .

If ST < X2 , both options are in the money, but the option bought has a
higher exercise price than the one written. The spread has the payoff X1 −X2 >

18
0 at T in all of these cases.

If ST > X1 , the higher exercise price, both options are out of the money, and
the position’s payoff is zero. And if X2 ≤ ST ≤ X1 , the written option is out
of the money, and the bought option loses money, one-for-one, with increases in
ST ; so in this range, the put bear spread payoff has a slope of −1.
If X2 < X1 < S0 , the position is moderately bearish, because it gains from
a moderate decrease in S, but no more from a large one.

What if S0 < X2 < X1 ? In this case the put bear spread gains, as long
as the asset price does not increase too much. (The breakeven point must be
somewhere between X2 and X1 ).

A good adjective for such a position is anti-bullish. It is not really bearish,

for nothing happens to the position’s intrinsic value if S does nothing but fall.
The position is easier to characterize by the bullish events will cause it to lose
money.

Some option positions are neither bullish nor bearish. For example, a long
straddle consists of long positions in both a call and a put. (If the exercise prices
are different, it is called a long combination straddle.)

This strategy’s payoff is the V-shape function

+ +
[X − ST ] + [ST − X] = |ST − X| .

The net payoff is

|ST − X| − (c0 + p0 ) erT ,
which cuts below the axis in an interval centered at X.
If X is close to the current asset price, this position is a bet that the asset
price will change a lot by time T , but is indifferent as to the direction of the
change.

The negative of a long straddle is (of course) a short straddle: Write both a
put and a call, and get the net payoff

(c0 + p0 ) erT − |ST − X| .

If X is close to S0 , this position is a bet that the asset price will not change
much.
It has a positive net payoff only in an interval centered at X. Like the long
straddle, it is neither bullish nor bearish; but its payoff is large and negative if
there are large price swings in either direction.

In an exam question, I once asked the 372 students to invent animal or

other adjectives, comparable to bullish and bearish, to describe this position.

19
The nearly universal response was sluggish, and I have already used this word
as a technical term in this section.

But what about the long straddle? No clear consensus emerged. My two
favourites were batty and froggish (or froggy), which are suggestive of the large
random swoops and jumps that the long straddle holder hopes will befall the
asset price.

Because of put-call parity, or equivalently the existence of synthetic puts

and calls, any payoff that can result from a combination of call options can also
be created with a combination of puts, perhaps with the addition of a short or
long position in the underlying asset.

For example, you should use Figure 7.12 to show that the following two
positions have the same net payoffs:

1. A call bull spread:

(a) buy a call option with exercise price X1 , and

(b) write a call option with exercise price X2 > X1 .

2. A put bull spread :

(a) buy a put option with exercise price X1 , and

(b) write a put option with exercise price X2 > X1 .

The call bull spread payoff at T is zero whenever ST ≤ X1 . Then, from X1

to X2 , it has a slope of +1, so it reaches X2 − X1 at X2 . The payoff is flat for
ST > X2 , so the payoff function is

 0 ST ≤ X1
f (ST ) = ST − X1 X1 ≤ ST ≤ X2 .
X2 − X1 X2 ≤ ST


If you take account of the premiums, the effect is to lower the entire payoff
function by
[c0 (X1 ) − c0 (X2 )] erT .
Now look at the put bull spread. If ST ≤ X1 , both options are in the money.
The one you own is worth X1 − ST , and the one you have written is worth
X2 − ST , so the payoff is X1 − X2 < 0, for every ST ≤ X1 .

Between X1 and X2 , only the second option is in the money. Since the
position has −1 of this option, and the option’s payoff has a slope of −1, the
position’s payoff has a slope of +1 between X1 and X2 .

20
 The payoff is flat for ST > X2 , because both options are out of the money.
Thus the payoff function is


 X1 − X2 ST ≤ X1
X1 − X2

g (ST ) = X1 ≤ ST ≤ X2

 +ST − X1
0 X2 ≤ ST


 X1 − X2 ST ≤ X1
= ST − X2 X1 ≤ ST ≤ X2
0 X2 ≤ ST


The appropriate correction for initial premiums is to add

[p0 (X1 ) − p0 (X2 )] erT

By checking all the cases, it is easy to see that the uncorrected payoffs satisfy

f (ST ) = g (ST ) + X2 − X1 .

In other words, the two payoff functions are parallel, and differ only by a con-
stant. It follows that without arbitrage, correcting for the effects of initial
premiums will make the net payoffs of the two strategies identical :

f (ST ) − [c0 (X1 ) − c0 (X2 )] erT

= g (ST ) + [p0 (X1 ) − p0 (X2 )] erT

If this statement is not obvious, think for a minute before reading further. If two payoff
functions dif-
Suppose that the above claim is false, for example by having fer only by a
constant, then
f (ST ) − [c0 (X1 ) − c0 (X2 )] erT the difference
> g (ST ) + [p0 (X1 ) − p0 (X2 )] erT . is a riskless
amount, be-
If this inequality happens once, it must also happen for every ST , because f cause it does
and g differ only by a constant. not depend
Then here is an arbitrage: Get the left side by buying call (1a) and writing on ST , the
call (1b), and pay the right side by writing put (2a) and buying put (2b). This only unknown
set of transactions will generate the left side minus the right side, of the above in the payoff
inequality. functions.
Since this amount does not depend on ST , or anything else that is not known To get the
at time 0, it is a riskless positive amount of cash. It costs nothing at time 0 difference,
either, because all the cash flows at time 0 were borrowed or invested. Therefore arrange to
the positive amount of cash at T is an arbitrage profit. receive the
larger by buy-
By the way, since ing or writing
f (ST ) − g (ST ) = X2 − X1 , whatever
options it re-
quires. To pay
21 the smaller
amount, write
or buy what-
ever options
are bought
or written to
generate it.
Just “pile up
the above argument shows that without arbitrage,
 
p0 (X1 ) − p0 (X2 )
X2 − X1 = erT .
+c0 (X1 ) − c0 (X2 )

Does this equation follow from any of our previous results?

By using options, investors can generate a limitless number of payoffs, that

are positive, negative, increasing, decreasing, or flat, in almost arbitrary regions
of a graph of a function of ST .
The only restriction is that the payoff must be piecewise linear and contin-
uous.

For a far-fetched example, suppose that some time-traveller from the future
shows you a fragment of the Globe and Mail’s financial section from the Saturday
following the third Friday of some month in the future, when some now-existing
options are going to expire.

Suppose that the newspaper page is so torn up that all you can tell for sure
is that a certian stock will be trading at either $20.00 or $30.00. How can you
profit from this knowledge?

1. Buy a call option with exercise price $19.

2. Write two call options with exercise price $20.
3. Buy a call option with exercise price $21.

4. Buy a call option with exercise price $29.

5. Write two call options with exercise price $30.
6. Buy a call option with exercise price $31.

Use Figure 7.12 to build this option strategy, and then graph it, with and
without including the effects of premiums. Without including premiums, you
will find that the payoff is zero for every ST outside the intervals [19, 21] and
[29, 31], and reaches its maximum of 1 at the points ST = 20 and ST = 30. If
you include the premiums, the resulting net payoff will be small and negative
outside the intervals [19, 21] and [29, 31], and will reach a maximum a bit smaller
than 1 at ST = 20 and ST = 30.
For this option strategy, and others where the effects of the premiums is too
small to show up on your computer screen, you should use the zoom feature
that is built into Figure 7.12.
When the graph is completed, click, drag, and unclick the mouse across the
part of the graph you want to examine more closely (in the above case, a small
square containing the one of the intervals [19, 21] and [29, 31]).

22
 A larger picture will appear, with some extra grid lines that will enable you
to determine to two decimal places what the vertical displacement is, between
two parallel payoff functions.

9 Announcements
1. The final exam will take place on August 12th, at 7:30PM in RCH301.
2. I will hold extra office hours, from 4:30-8:30 on August 10th and 11th, in
HH125.

3. Office hours on Tuesday, up to 6PM, will be your last chance to appeal

any midterm mismarking. (We will check for addition mistakes only, on
unchecked exams.)
4. The exam will look a lot like the previous final exams from the past 3
years:

(a) There will be a swap question.

(b) There will be a chapter 5 question, based on one of
i. synthetic discount bonds
ii. forward rates
iii. EDFs (ignore TBFs)
(c) There will be a chapter 7 question, based on
i. the Black-Scholes model, and the table of sensitivities (+s and
–s)
ii. call minus put equals forward
iii. put-call parity
iv. the BAD principle
v. the option positions you can graph with Chapter7372.exe
(d) Material from every chapter will appear on the test, and there are
more chapters than there are questions. Therefore, some questions
will touch on material from more than one chapter. So, as you pre-
pare for the test, look for ways to combine material from different
chapters, in an exam question.

5. Expect an Excel file with all the marks (including appeals) by one week
after the test. Go to the index file, which is linked to Economics 372
Announcements.
6. Remember, if you have not specified a PID, your PID is the last 5 digits
of your student number.

23
 7. During the exam, do not ask to go to the bathroom. You have been
warned about this several times, so if you even ask, it is reasonable to
assume that you are sick, you are a complete bonehead, or you are trying
to cheat. If you are sick, you can write the makeup. If you are a complete
bonehead, you do not belong in finance. If you are trying to cheat, you
don’t really need to go to the bathroom.
8. During the exam, do not ask questions about the test questions. If there
is a typo, make a sensible assumption on how to fix it, just like you did
during the second midterm.
9. At the end of the exam, stop writing. Make sure that everyone around
you has stopped writing too.
10. Those who cannot attend the final, or fail the course, must get on the
make-up exam mailing list by sending me an e-mail with this request.
11. To qualify as one of the people who get to determine the date of the exam,
you have to send this e-mail request within one week of the time the marks
are posted (i.e., by about August 24th).
12. If you become eligible to write the makeup test, you will get a grade of
INC until you write the test and pass it. If you do not pass the makeup
test, or do not write it, you will fail the course.

24