Lecture 5:financial Management

Financial Management
Lecture 5: Financial Options II
Professor Andrea Vedolin

ETH Zürich
Today
The GameStop Revolution
Portfolio of Options
Put-Call-Parity
Options on Underlying Assets Paying Dividends
Arbitrage Bounds on Options Prices
American Options: Exercising Early
Financial Management (363-0560) Financial Options II 2 / 24

Call and Put Options: A Summary
Call Put
Contract it gives the right to buy an it gives the right to sell an

underlying asset at a fixed price underlying asset at a fixed price
PayoffT max(ST − K , 0) max(K − ST , 0)
ProfitT max(ST − K , 0) − C0 (1 + r )T max(K − ST , 0) − P0 (1 + r )T
max(ST −K , 0) max(K −ST , 0)

Return C0 −1 P0 −1

Graphically
STOCK RISK FREE ZERO-COUPON BOND
70 70
60 60
50 50
Payoff at T
Payoff at T
40 40
30 30
20 20
10 10
0 0
0 10 20 30 40 50 60 70 0 10 20 30 40 50 60 70
Stock Price ST Stock Price ST
CALL OPTION PUT OPTION
70 70
60 60
50 50
Payoff at T
40 Payoff at T 40
30 30
20 20
10 10
0 0
0 10 20 30 40 50 60 70 0 10 20 30 40 50 60 70
Stock Price ST Stock Price ST

Power Dynamics Shifted on Wall Street
Eye-popping rallies by companies once left for dead–including GameStop, AMC
Entertainment and BlackBerry–upended the established order.... temporarily.
2021 2022
War has broken out between short-selling hedge-fund professionals losing billions
and individual investors jeering at them on social media as they pile into hot
stocks, overloading retail trading platforms.
At some point, a couple of retail brokerage firms stopped taking orders in GME.

A Year After the GameStop Revolution
How have message boards on sites such as Reddit contributed to the recent
rally in selected companies’ share prices?
What is short interest and what is a “short squeeze”?
Why have selected investors bought also call options on selected stocks as
opposed to only the underlying common shares?
What is the “borrow fee” and how has it evolved for shares in Gamestop?
What are likely to be the regulatory repercussions of the recent trading in

Gamestop (if any)?
Interview with Interactive Brokers’ Thomas Peterffy on hearing in Congress

https://www.cnbc.com/video/2021/02/17/interactive-brokers-thomas-peterffy-on-
gamestop-hearing.html

Portfolio of Options
In order to achieve different payoff profiles, investors combine different

positions in call and put options, thus holding a portfolio of options.
Sometimes, a portfolio of options is also combined with positions in the

underlying stocks and in riskless bonds.
Most common combinations:

I Straddle
I Strangle
I Butterfly Spread
I Protective Put

Portfolio of Options: “Straddle”
Portfolio: long one call and long one put on the same stock S with the same
exercise date T and the same strike price K (i.e., Kcall = Kput )
Strategy: used if investors expect the underlying asset to be very volatile
(move up or down by a large amount), but do not necessarily have a view on
which direction the underlying asset will move

Portfolio of Options: “Strangle”
Portfolio: long one call and long one put on the same stock S with the same
exercise date T but the strike prices are such that Kcall > Kput
Strategy: as the Straddle but cheaper

Portfolio of Options: “Butterfly Spread”
Portfolio: long one call with strike price K1 , long one call with strike price
K2 , and short two calls with strike price K3 = (K1 + K2 )/2
Strategy: while a straddle makes money when the stock and strike prices are
far apart, a butterfly spread makes money when they are close

Portfolio of Options: “Protective Put”
Portfolio: long one stock and long one put on the same stock
Strategy: the upside is captured by the stock, the downside is absorbed by
the put. If the protection is on a portfolio of stocks ⇒ Portfolio Insurance
Put Call

Put-Call Parity
Consider the two portfolios:
(1) long one put with strike price K and long the underlying asset
(2) long one call with strike price K and long one bond with face value K
06t<T t=T
Portfolio 1: Buy Put −Pt (K ) max(K − ST , 0)

Buy Stock −St ST
Total Payoff −Pt (K ) − St max(K , ST )
06t<T t=T
Portfolio 2: Buy Call −Ct (K ) max(ST − K , 0)

Buy Bond −PVt (K ) K
Total Payoff −Ct (K ) − PVt (K ) max(ST , K )

Put-Call Parity
Consider the two portfolios:
(1) long one put with strike price K and long the underlying asset
(2) long one call with strike price K and long one bond with face value K
Portfolio 1 Payoff at T = Portfolio 2 Payoff at T

PT (K ) + ST = CT (K ) + K
⇓
Portfolio 1 Price at t = Portfolio 2 Price at t
for any 0 6 t < T : Pt (K ) + St = Ct (K ) + PVt (K ) ⇒ Put-Call Parity
⇓
“Paul + Smith = Calvin + Klein” ⇒ how to remember!

Put-Call Parity
Therefore, the price of a European call is equal to the price of an otherwise
identical put plus the price of the underlying asset minus the price of a bond with
face value and maturity equal to the strike price and the option expiration date,
respectively:
Ct (K ) = Pt (K ) + St − PVt (K )
| {z }
price of replicating portfolio
of a call option
Alternatively, the price of a European put is equal to the price of an otherwise

identical call minus the price of the underlying asset plus the price of a bond with
face value and maturity equal to the strike price and the option expiration date,
respectively:
Pt (K ) = Ct (K ) − St + PVt (K )
| {z }
price of replicating portfolio
of a put option
Note: the put-call parity holds in general only for European options

Example 1
You want to buy a one-year call option and put option on Dell. The strike price
for each is $15. The current price per share of Dell is $14.79. The risk-free rate is
2.5%. The price of each call is $2.23. What should be the no-arbitrage price
of each put?
Using the put-call parity:
P0 = C0 − S0 + PV0 (K )
15
= 2.23 − 14.79 +
(1.025)
= 2.07

Example 2
European call and European put options on IBM’s stock are both currently
trading at $15. They both have two-year maturity and exercise price of $11. The
annual risk-free rate is 10%. IBM’s stock is currently traded at $10 and is not
expected to pay any dividends. Is there an arbitrage opportunity? If so, how
can you make a risk-less profit today?
Using the put-call parity C0 = P0 + S0 − PV0 (K ), the price of the replicating

portfolio of the call is given by:
11
C0 = 15 + 10 − = 15.91
(1.1)2
which is higher than the price of the call. Since the call and its replicating
portfolio will give the same payoff at T , an arbitrage profit can be created by
“buying cheap” and “selling expensive”:
t=0 t=T
Buy Call −15 CT
Sell Replicating Portfolio of Call +15.91 −PT − ST + K
| {z }
SELL PUT, SELL STOCK, BUY BOND
Total Payoff 0.91 0
Put-Call Parity with Dividends
What happens if the underlying asset pays dividends?
A long position in the underlying asset implies an extra cash flow: dividends
Consider again the two portfolios:
(1) long one put P with strike price K and long the underlying asset S
(2) long one call C with strike price K and long one bond with face value K
If Portfolio 1 (which has a long position in the underlying asset) will pay dividends
between t and T , then
Pt + St > Ct + PVt (K )
In order to restore the equality we need to add the present value of the dividends
to Portfolio 2:
Pt + St = Ct + PVt (K ) + PVt (Div )

Intrinsic Value & Time Value
Intrinsic Value of an Option at time t:
Def.: it is the value the option would have if it expired immediately

Call Option: IVtcall = max(St − K , 0)
Put Option: IVtput = max(K − St , 0)
Time Value of an Option at time t:
Def.: difference between the current option price and its intrinsic value
Call Option: TVtcall = Ct − max(St − K , 0)
Put Option: TVtput = Pt − max(K − St , 0)
Therefore, by definition:
Ct = IVtcall + TVtcall
Pt = IVtput + TVtput

Arbitrage Bounds on European Option Prices
European Call Option:
consider the lowest possible strike price, K = 0

then, the payoff at expiration date is equal to:
CT (0) = max(ST − 0, 0) = ST
therefore, for K = 0, the option price is Ct (0) = St and it represents the

upper bound for the price of any call options:
Ct (K ) 6 St

Arbitrage Bounds on European Option Prices
European Put Option:
consider the lowest possible price for the stock at expiration, ST = 0

then, the payoff at expiration date is equal to:
PT (K , ST = 0) = max(K − 0, 0) = K
therefore, since this is the most optimistic payoff, it represents the

upper bound for the price of any put options:
Pt (K ) 6 K

Arbitrage Bounds on American Option Prices
American option can not be worth less than its European counterpart
American options have an “extra option” compared to European options
CtA > CtE , PtA > PtE
American option can not be worth less than its intrinsic value
Otherwise you could buy the option and exercise it immediately
CtA > IVtAcall , PtA > IVtAput
Hence, American options can not have negative time value.
American option can not be worth less than an otherwise identical

American option with an earlier exercise date
You can always turn a longer American option into a shorter one
CtA (T1 ) > CtA (T2 ), PtA (T1 ) > PtA (T2 ) for T2 6 T1

It is never optimal to exercise an American call option on a
non-paying-dividend stock before the expiration date.
Pick any date 0 6 t < T

Suppose that the american call option is in-the-money: St − K > 0
If I exercise at time t, I receive: (St − K )
If I do not exercise at time t, I still own something worth: CtA
Using the bounds for american options and the put-call parity:
CtA > CtE

= St − PVt (K ) + PtE
= St − K + K − PVt (K ) + PtE
= (St − K ) + (K − PVt (K )) + PtE > (St − K )
| {z } |{z}
= dis(K )>0 >0
CA
t > (St − K) ⇒ never exercise early! it’s better to sell the option!!
Therefore, it must have the same price as its European counterpart.

It can be optimal to exercise early an American put option on a
non-paying-dividend stock.
Pick any date 0 6 t < T

Suppose that the american put option is in-the-money: K − St > 0
If I exercise at time t, I receive: (K − St )
If I do not exercise at time t, I still own something worth: PtA
Using the bounds for american options and the put-call parity:
PtA > PtE

= CtE + PVt (K ) − St
= CtE + PVt (K ) − St + K − K
= (K − St ) + (PVt (K ) − K ) + CtE ≶ (K − St )
| {z } |{z} |{z}
= −dis(K )60 >0 ?
PA
t ≶ (K − St ) ⇒ exercise early if (PVt (K ) − K ) + CtE < 0
Therefore, its price can be higher than its European counterpart.

Next Class...
The next class will be on “Option Valuation”

Please, read Chapter 21 of the book if you like (for now skip Section
21.4 and 21.5)

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Financial Management

Lecture 5: Financial Options II

Professor Andrea Vedolin

The GameStop Revolution

Options on Underlying Assets Paying Dividends

Arbitrage Bounds on Options Prices

American Options: Exercising Early

Financial Management (363-0560) Financial Options II 2 / 24

Contract it gives the right to buy an it gives the right to sell an

PayoffT max(ST − K , 0) max(K − ST , 0)

ProfitT max(ST − K , 0) − C0 (1 + r )T max(K − ST , 0) − P0 (1 + r )T

max(ST −K , 0) max(K −ST , 0)

Financial Management (363-0560) Financial Options II 3 / 24

CALL OPTION PUT OPTION

Financial Management (363-0560) Financial Options II 4 / 24

Financial Management (363-0560) Financial Options II 5 / 24

What is short interest and what is a “short squeeze”?

What are likely to be the regulatory repercussions of the recent trading in

Interview with Interactive Brokers’ Thomas Peterffy on hearing in Congress

Financial Management (363-0560) Financial Options II 6 / 24

In order to achieve different payoff profiles, investors combine different

Sometimes, a portfolio of options is also combined with positions in the

Most common combinations:

Financial Management (363-0560) Financial Options II 7 / 24

Financial Management (363-0560) Financial Options II 8 / 24

Financial Management (363-0560) Financial Options II 9 / 24

Financial Management (363-0560) Financial Options II 10 / 24

Financial Management (363-0560) Financial Options II 11 / 24

Portfolio 1: Buy Put −Pt (K ) max(K − ST , 0)

Total Payoff −Pt (K ) − St max(K , ST )

Portfolio 2: Buy Call −Ct (K ) max(ST − K , 0)

Total Payoff −Ct (K ) − PVt (K ) max(ST , K )

Financial Management (363-0560) Financial Options II 12 / 24

Portfolio 1 Payoff at T = Portfolio 2 Payoff at T

Financial Management (363-0560) Financial Options II 13 / 24

Alternatively, the price of a European put is equal to the price of an otherwise

Financial Management (363-0560) Financial Options II 14 / 24

Using the put-call parity:

Financial Management (363-0560) Financial Options II 15 / 24

Using the put-call parity C0 = P0 + S0 − PV0 (K ), the price of the replicating

Consider again the two portfolios:

Pt + St = Ct + PVt (K ) + PVt (Div )

Financial Management (363-0560) Financial Options II 17 / 24

Def.: it is the value the option would have if it expired immediately

Time Value of an Option at time t:

Financial Management (363-0560) Financial Options II 18 / 24

European Call Option:

consider the lowest possible strike price, K = 0

therefore, for K = 0, the option price is Ct (0) = St and it represents the

Financial Management (363-0560) Financial Options II 19 / 24

European Put Option:

consider the lowest possible price for the stock at expiration, ST = 0

therefore, since this is the most optimistic payoff, it represents the

Financial Management (363-0560) Financial Options II 20 / 24

CtA > CtE , PtA > PtE

CtA > IVtAcall , PtA > IVtAput

Hence, American options can not have negative time value.

American option can not be worth less than an otherwise identical

Financial Management (363-0560) Financial Options II 21 / 24

Pick any date 0 6 t < T

CtA > CtE

Therefore, it must have the same price as its European counterpart.

Pick any date 0 6 t < T