Options & Derivative Notes

Lecture 16
Options and option pricing
Lecture 16 1 / 22
Introduction
One of the most, perhaps the most, important family of derivatives are the
options.
Lecture 16 2 / 22
Introduction
One of the most, perhaps the most, important family of derivatives are the
options.
In order to value them we need a stochastic model of the future behavior

of the underlying.
Lecture 16 2 / 22
Options (1)
An option is a derivative in which there is some sort of choice for the

owner of the derivative.
Lecture 16 3 / 22
Options (1)

The two most comman types of options are the call option and the put
option.
Lecture 16 3 / 22
Options (1)

The two most comman types of options are the call option and the put
option.
Like futures, these type of derivatives are traded on many exchanges

around the world.
Lecture 16 3 / 22
Options (2)
Definition
A call option is the right, but not the obligation, of the owner of the
option to buy an asset at a future time T for an amount K .
Lecture 16 4 / 22
Options (2)
Definition
A put option is the right, but not the obligation, of the owner of the
option to sell an asset at a future time T for an amount K .
Lecture 16 4 / 22
Options (2)
Definition
A put option is the right, but not the obligation, of the owner of the
option to sell an asset at a future time T for an amount K .
Here K is known as the strike price and T as the exercise time or maturity
time.
Lecture 16 4 / 22
Options (3)
The payoff at time T of a call option is given by
max(ST − K , 0).
Lecture 16 5 / 22
Options (3)
The payoff at time T of a call option is given by
max(ST − K , 0).
The payoff at time T of a put option is given by
max(K − ST , 0).
Lecture 16 5 / 22
Options (4)
There are different types of options with respect to the exercise time.
European options
Lecture 16 6 / 22
Options (4)
European options
American options
Lecture 16 6 / 22
Options (4)
European options
American options
Bermudan options
Lecture 16 6 / 22
Options (4)
European options
American options
Bermudan options
Other: Parisian, Canadian, Russian,...
Lecture 16 6 / 22
Options (5)
Call and put options are examples of simple derivatives
Lecture 16 7 / 22
Options (5)
In this case the derivative’s payoff X is a function F of the underlying ST
Lecture 16 7 / 22
Options (5)
In this case the derivative’s payoff X is a function F of the underlying ST :
X = F (ST ).
Lecture 16 7 / 22
Options (5)
In this case the derivative’s payoff X is a function F of the underlying ST :
X = F (ST ).
There are also path-dependent derivatives:
X = G ((St , 0 ≤ t ≤ T )).
In this case the whole (or part) of path of the underlying is needed to
know on order to calculate the payoff X .
Lecture 16 7 / 22
Options (6)
Example
An up-and-in contract is a derivative in which the value of the underlying
must reach a given level L in order to be active.
Lecture 16 8 / 22
Options (6)
Example
An up-and-in call option has payoff

X = max(ST − K , 0)1 St ≥ L for some t ∈ [0, T ] .
Lecture 16 8 / 22
Options (6)
Example
An up-and-in call option has payoff

X = max(ST − K , 0)1 St ≥ L for some t ∈ [0, T ] .
There are also up-and-out, down-and-in and down-and-out contracts.
Lecture 16 8 / 22
Option strategies (1)
By combining basic options we can create new payoffs.
Lecture 16 9 / 22
This can be used in order to help an investor to get the payoff he wants.
Lecture 16 9 / 22
Assume that you belive that a stock is going to move from its current
price, but you do not know in which direction.
Lecture 16 9 / 22
If this is the case, you can buy a strangle.
Lecture 16 9 / 22
If this is the case, you can buy a strangle. A strangle is a a sum of a put
option with strike price K1 and a call option with strike price K2 > K1 .
Lecture 16 9 / 22
Other examples of option combinations include

A straddle: this is a strangle with K1 = K2
Lecture 16 10 / 22

A bull spread: buy a call option with strike price K1 and sell a call
option with strike price K2 > K1 .
Lecture 16 10 / 22

A bear spread: sell a put option with strike price K1 and buy a put
with strike price K2 > K1 .
Lecture 16 10 / 22

A bear spread: sell a put option with strike price K1 and buy a put
with strike price K2 > K1 .
A butterfly: buy 1 call with strike price K − a, sell 2 calls with strike
price K and buy 1 call with strike price K + a.
Lecture 16 10 / 22
The put-call parity
If we buy 1 call option and sell 1 put option both having the same strike
price K and maturity time T , then the resulting payoff at T will be
ST − K .
Lecture 16 11 / 22
The put-call parity
ST − K .
This is true since
max(ST − K , 0) − max(K − ST , 0) = ST − K .
Lecture 16 11 / 22
The put-call parity
ST − K .
This is true since
It follows from linear pricing that
Price of call at 0 − Price of put at 0 = S0 − K · d(0, T ).
Lecture 16 11 / 22
The put-call parity
ST − K .
This is true since
It follows from linear pricing that
Price of call at 0 − Price of put at 0 = S0 − K · d(0, T ).
This relation is called the put-call parity.
Lecture 16 11 / 22
Pricing options
In order the find the price (or value) of an option we need to construct a
stochastic model.
Lecture 16 12 / 22
Pricing options
stochastic model.
Two popular models are

The binomial model
Lecture 16 12 / 22
Pricing options
stochastic model.
Two popular models are

The binomial model
The Black-Scholes(-Samuelson) model
Lecture 16 12 / 22
Single-period option pricing (1)
This is the binomial model with only one time period.
Lecture 16 13 / 22
The setup is as follows.

Two times: today (t = 0) and tomorrow (t = 1).
Lecture 16 13 / 22

Two outcomes: ‘up’ and ‘down’.
Lecture 16 13 / 22

Two outcomes: ‘up’ and ‘down’. The probability of up and down is p
and 1 − p respectively.
Lecture 16 13 / 22

Two outcomes: ‘up’ and ‘down’. The probability of up and down is p
and 1 − p respectively.
Two assets: one riskless and one risky.
Lecture 16 13 / 22
The riskless asset has price 1 today and price 1 + rf tomorrow.
Lecture 16 14 / 22
The riskless asset has price 1 today and price 1 + rf tomorrow.
1 + rf
%
1
&
1 + rf
t=0 t=1
Lecture 16 14 / 22
The risky asset has price S today and either uS or dS tomorrow.
Lecture 16 15 / 22
uS
%
S
&
dS
t=0 t=1
Lecture 16 15 / 22
uS
%
S
&
dS
t=0 t=1
We assume that d < u.
Lecture 16 15 / 22
In order to rule out arbitrage opportunities we must have
d < 1 + rf < u
Lecture 16 16 / 22
d < 1 + rf < u
Note the strict inequalities here.
Lecture 16 16 / 22
d < 1 + rf < u
The reason for this is that if 1 + rf ≥ u, then we can create an arbitrage

opprortunity by selling a stock and putting the money in the bank.
Lecture 16 16 / 22
d < 1 + rf < u
The reason for this is that if 1 + rf ≥ u, then we can create an arbitrage

opprortunity by selling a stock and putting the money in the bank.
If 1 + rf ≤ d, then borrowing money in the bank and buying stocks for it

will create an arbitrage opprtunity
Lecture 16 16 / 22
Now let us try to find the price today of a derivative that has payoff
Cu in the up state and Cd in the down state.
Lecture 16 17 / 22
To solve this problem we create a replicating portfolio.
Lecture 16 17 / 22
Assume that we can construct a portfolio of x number of stocks and y

units of money in the bank.
Lecture 16 17 / 22
Assume that we can construct a portfolio of x number of stocks and y

units of money in the bank.
This portfolio will have the following payoff:
In the up state: x · uS + y · (1 + rf )
In the down state: x · dS + y · (1 + rf ).
Lecture 16 17 / 22
To find the replicating portfolio, we solve the following linear system of

equations:
xuS + y (1 + rf ) = Cu
xdS + y (1 + rf ) = Cd .
The solution is given by
Cu −Cd
(
x = (u−d)S
uCd −dCu
y = (1+rf )(u−d)
Lecture 16 18 / 22

equations:
xuS + y (1 + rf ) = Cu
xdS + y (1 + rf ) = Cd .
Cu −Cd
(
x = (u−d)S
uCd −dCu
y = (1+rf )(u−d)
Hence, the value, or price, of the derivative with payoff (Cu , Cd ) is given by
V =x ·S +y
Lecture 16 18 / 22

equations:
xuS + y (1 + rf ) = Cu
xdS + y (1 + rf ) = Cd .
Cu −Cd
(
x = (u−d)S
uCd −dCu
y = (1+rf )(u−d)
Hence, the value, or price, of the derivative with payoff (Cu , Cd ) is given by
Cu − Cd uCd − dCu
V =x ·S +y = +
u−d (1 + rf )(u − d)
Lecture 16 18 / 22
Note that
There exists a unique value of every derivative
Lecture 16 19 / 22
Note that

The probabilities of up and down moves does not enter the valuation
formula.
Lecture 16 19 / 22
Note that

The probabilities of up and down moves does not enter the valuation
formula.
Let
1 + rf − d
q= .
u−d
It follows from the condition d < 1 + rf < u that q ∈ (0, 1).
Lecture 16 19 / 22
Using this q we can write

V = +
u−d (1 + rf )(u − d)
Lecture 16 20 / 22

V = +
u−d (1 + rf )(u − d)
1 (1 + rf )Cu − (1 + rf )Cd + uCd − dCu
= ·
1 + rf u−d
Lecture 16 20 / 22

V = +
u−d (1 + rf )(u − d)
1 (1 + rf )Cu − (1 + rf )Cd + uCd − dCu
= ·
1 + rf u−d

1 1 + rf − d u − (1 + rf )
= Cu + Cd
1 + rf u−d u−d
Lecture 16 20 / 22

V = +
u−d (1 + rf )(u − d)
1 (1 + rf )Cu − (1 + rf )Cd + uCd − dCu
= ·
1 + rf u−d

1 1 + rf − d u − (1 + rf )
= Cu + Cd
1 + rf u−d u−d
1
= (qCu + (1 − q)Cd )
1 + rf
Lecture 16 20 / 22

V = +
u−d (1 + rf )(u − d)
1 (1 + rf )Cu − (1 + rf )Cd + uCd − dCu
= ·
1 + rf u−d

1 1 + rf − d u − (1 + rf )
= Cu + Cd
1 + rf u−d u−d
1
= (qCu + (1 − q)Cd )
1 + rf
1
= Ê (C ).
1 + rf
Lecture 16 20 / 22

V = +
u−d (1 + rf )(u − d)
1 (1 + rf )Cu − (1 + rf )Cd + uCd − dCu
= ·
1 + rf u−d

1 1 + rf − d u − (1 + rf )
= Cu + Cd
1 + rf u−d u−d
1
= (qCu + (1 − q)Cd )
1 + rf
1
= Ê (C ).
1 + rf
Again, Ê means expected value with respect to the risk-neutral

(q, 1 − q)-probabilities.
Lecture 16 20 / 22
Multiperiod models (1)
Now add more time steps, and assume the standard lattice (=recombining
tree) model with independent ups and downs.
Lecture 16 21 / 22
Now add more time steps, and assume the standard lattice (=recombining
tree) model with independent ups and downs.
In this case we can think of the model as a lot af one-period models

‘glued’ together.
Lecture 16 21 / 22
Using risk-neutral probabilities the random variable ST can be written
ST = S0 u X d T −X
Lecture 16 22 / 22
ST = S0 u X d T −X ,
where
X ∼ Bin(T , q).
Lecture 16 22 / 22
where
X ∼ Bin(T , q).
Hence, the value at time 0 of a European derivative with payoff function F
and exercise time T is
1
V = E Q [F (ST )]
(1 + rf )T
Lecture 16 22 / 22
where
X ∼ Bin(T , q).
Hence, the value at time 0 of a European derivative with payoff function F
and exercise time T is
1
V = E Q [F (ST )]
(1 + rf )T
T T
1 X
k T −k
= F S0 u d q k (1 − q)T −k .
(1 + rf )T k
k=0
Lecture 16 22 / 22

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Lecture 16

Options and option pricing

In order to value them we need a stochastic model of the future behavior

An option is a derivative in which there is some sort of choice for the

An option is a derivative in which there is some sort of choice for the

An option is a derivative in which there is some sort of choice for the

Like futures, these type of derivatives are traded on many exchanges

The payoff at time T of a call option is given by

The payoff at time T of a call option is given by

The payoff at time T of a put option is given by

Call and put options are examples of simple derivatives

Call and put options are examples of simple derivatives

In this case the derivative’s payoff X is a function F of the underlying ST

Call and put options are examples of simple derivatives

In this case the derivative’s payoff X is a function F of the underlying ST :

Call and put options are examples of simple derivatives

In this case the derivative’s payoff X is a function F of the underlying ST :

There are also path-dependent derivatives:

An up-and-in call option has payoff

An up-and-in call option has payoff

There are also up-and-out, down-and-in and down-and-out contracts.

By combining basic options we can create new payoffs.

By combining basic options we can create new payoffs.

By combining basic options we can create new payoffs.

By combining basic options we can create new payoffs.

If this is the case, you can buy a strangle.

By combining basic options we can create new payoffs.

Other examples of option combinations include

Other examples of option combinations include

Other examples of option combinations include

Other examples of option combinations include

This is true since

This is true since

It follows from linear pricing that

Price of call at 0 − Price of put at 0 = S0 − K · d(0, T ).

This is true since

It follows from linear pricing that

Price of call at 0 − Price of put at 0 = S0 − K · d(0, T ).

This relation is called the put-call parity.

Two popular models are

Two popular models are

This is the binomial model with only one time period.

This is the binomial model with only one time period.

The setup is as follows.

This is the binomial model with only one time period.

The setup is as follows.

This is the binomial model with only one time period.

The setup is as follows.

This is the binomial model with only one time period.

The setup is as follows.

The riskless asset has price 1 today and price 1 + rf tomorrow.

The riskless asset has price 1 today and price 1 + rf tomorrow.

The risky asset has price S today and either uS or dS tomorrow.

The risky asset has price S today and either uS or dS tomorrow.

The risky asset has price S today and either uS or dS tomorrow.

We assume that d < u.

In order to rule out arbitrage opportunities we must have

In order to rule out arbitrage opportunities we must have

Note the strict inequalities here.

In order to rule out arbitrage opportunities we must have

Note the strict inequalities here.

The reason for this is that if 1 + rf ≥ u, then we can create an arbitrage

In order to rule out arbitrage opportunities we must have

Options & Derivative Notes

Options & Derivative Notes