Day 02 Financial Options

Preliminaries Factors affecting option prices Upper and lower bounds for option prices Early exercise
Financial Options
António Barbosa
(antonio.barbosa@iscte-iul.pt)
Day 02: 12/Sep/23
António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 1 / 48

Outline
1 Preliminaries
2 Factors affecting option prices
3 Upper and lower bounds for option prices
4 Early exercise

Outline
1 Preliminaries
4 Early exercise

Discrete compounding
The future value of $1 invested at the interest R for n years and
annual interest compounding is
(1 + R)n
If interest is compounded m times a year, the future value
becomes
R m×n

1+
m
For example, the future value of $100 compounded annually at
the rate R = 4% for n = 2.5 years is
100 × (1 + 0.04)2.5 = $110.30
If it’s compounded quarterly (m = 4) it is
0.04 4×2.5

100 × 1 + = $110.46
4
Continuous compounding
In the limit, when m → ∞, interest is compounded continuously
(think of compounding interest every fraction of a second)
Assuming continuous compounding, the future value of $1
becomes
R m×n

lim 1 + = eR×n
m→∞ m
If, instead of the future value, we are interested in the present
value, then we discount $1 instead of compounding it
Since discounting is inverse operation of compounding, the
present value of $1 n years from now is
1
R×n
= e−R×n
e
Resuming the example, if the $100 are compounded continuously,
it’s future value is
100e0.04×2.5 = $110.52
Converting discrete to continuously compounded rates

To convert the discrete compounding interest rate Rm (interest
compounded m times a year) into a continuously compounded
interest rate Rc we equate
Rm m×n

Rc n Rm
1+ =e ⇔ Rc = m × ln 1 +
m m
Rc
⇔ Rm = m × e m − 1
In the previous example, the continuous compounding interest
rate that is equivalent to a 4% annually compounded interest rate
is
0.04
Rc = 1 × ln 1 + = 3.9221%
1
To confirm
100 × e0.039221×2.5 = $110.30 = 100 × (1 + 0.04)2.5
Outline
1 Preliminaries
4 Early exercise

Notation
ct : price of European call option on date t (years from today)

Ct : price of American call option on date t
pt : price of European put option on date t
Pt : price of American put option on date t
K: strike price
T : time to expiration date (in years from today)
St : price of the underlying asset on date t
σ: volatility of the underlying asset’s continuously compounded
rate of return
D: dividends payed
r: continuously compounded risk-free interest rate

Option price at expiration
The price of the option at the expiration date is trivial: it’s equal
to the payoff
cT = CT = max (ST − K,0) ≡ IVT ⇒ T VT = 0

pT = PT = max (K − ST ,0) ≡ IVT ⇒ T VT = 0
Putting it in another way:

at the expiration, there is only intrinsic value (which corresponds
to the option payoff)
there is no time value because we reached the expiration date (and
so there is no more time left for the price of the underlying asset
to change before the exercise decision has to be taken)

Factors affecting the option price: St
∂ct ∂Ct ∂pt ∂Pt

∂St >0 ∂St >0 ∂St <0 ∂St <0
The higher St is, the more likely it is that ST will be high as well
And the higher ST is:
the more valuable is the option to buy the asset at a fixed price K
(call option)
the less valuable is the option to sell the asset at a fixed price K
(put option)

Factors affecting the option price: K

∂K <0 ∂K <0 ∂K >0 ∂K >0
The higher the strike price:

the higher the price at which we can buy the asset in a call option
(which is bad)
the higher the price at which we can sell the asset in a put option
(which is good)

Factors affecting the option price: T (1/2)

∂T =? ∂T >0 ∂T =? ∂T >0
The value of American options increases with the time to

expiration:
an American option with expiration in 2 months has all the
exercise opportunities of an option expiring in 1 month, and more
the extra exercise opportunities cannot hurt the option value

Factors affecting the option price: T (2/2)
But the effect of the time to expiration on the price of European

options is uncertain:
on the one hand, a longer time to expiration makes big changes in
the price of the underlying asset more likely
because losses are limited but gains are unlimited, the expected
result from those big changes is positive for both types of options
but, on the other hand, a longer time to expiration:
may be the difference between a dividend being paid during the
life of the option (which hurts call options) or not
decreases the present value of the strike (which hurts put options)
in general the time value of European options is positive, but if
this second set of factors is strong enough, the time value can end
up being negative

Factors affecting the option price: r

∂r >0 ∂r >0 ∂r <0 ∂r <0
The higher the interest rate, the smaller the present value of the
strike price
this is good for a call holder, which may have to pay the strike
price in the future (if the option is exercised)
but it is bad for a put holder, which may receive the strike price in
the future

Factors affecting the option price: σ

∂σ >0 ∂σ >0 ∂σ >0 ∂σ >0
A higher volatility makes big changes in the price of the

underlying asset more likely
Because losses are limited but gains are unlimited, this has a
positive impact on the price of all types of options

Factors affecting the option price: D

∂D <0 ∂D <0 ∂D >0 ∂D >0
The distribution of dividends decreases the value of the

underlying asset
This is unfavorable for a call option and favorable for put options

Factors affecting the option price: summary
ct Ct pt Pt
St + + – –
K – – + +
T ? + ? +
r + + – –
σ + + + +
D – – + +

Outline
1 Preliminaries
4 Early exercise

Arbitrage opportunity
Definition: arbitrage opportunity

An arbitrage opportunity is the possibility of obtaining a risk-free
profit with a zero investment.
An arbitrage opportunity can be seen as a free lunch, since you

can get something (at least in probability) for nothing
An arbitrage opportunity is a consequence of mispricing which
cannot subsist for long in the market
since the strategy to take advantage of the arbitrage opportunity
does not require any money to set up, it can be infinitely scaled
this means that you could become a billionaire in a second
unfortunately that doesn’t happen because when you try to
exploit it, you correct the mispricing that originated it

Upper and lower bounds on option prices
Before we introduce option pricing models (which are always

approximations to the real option price), we will start by defining
the upper and lower boundaries for the option prices
Any reasonable option pricing model has to generate prices that
remain within these bounds
For now, we will assume that the underlying asset does not pay
dividends
Later on, we will analyze the effect of dividends
Also, it is assumed that the risk-free rate is positive (r > 0)1
1
Which was not the case for the EUR until recently.
Upper bound on American call price
C0 ≤ S0
Intuition: the right to buy the asset (call option) cannot be
worth more than the asset itself
Arbitrage opportunity exists if:2 C0 > S0
Arbitrage strategy:3 short call + long asset
t=τ ≤T
t=0 Sτ < K Sτ ≥ K
Short Call C0 0 − (Sτ − K)
Long Asset −S0 Sτ Sτ
Portfolio C0 − S 0 > 0 Sτ ≥ 0 K≥0
Note: τ is the exercise date of the American option
2
In other words, whenever the bound is violated
3
The arbitrage strategy is based on the principle “buy the cheap, sell the
expensive”
Upper bound on European call price
c0 ≤ C0
Intuition:
the additional exercise opportunities of an American option
cannot have a negative value
Corollary:
c0 ≤ C0 ≤ S0

Lower bound on European call price
c0 ≥ max S0 − Ke−rT ,0

Intuition:
the call cannot have a negative value, since its payoff is
nonnegative
and the call cannot be worth less than a forward with forward
price K (S0 − Ke−rT ) because of its added flexibility (it gives the
right to buy and not the obligation to buy)
Arbitrage opportunity if c0 < S0 − Ke−rT :
t=T
t=0 ST < K ST ≥ K
Long call −c0 0 ST − K
Short asset S0 −ST −ST
Risk-free deposit −Ke−rT K K
Portfolio S0 − Ke−rT − c0 > 0 K − ST > 0 0
Lower bound on American call price
C0 ≥ c0 ≥ max S0 − Ke−rT ,0

This is a corollary from the previous two results

Lower bound on American put price
P0 ≥ max (K − S0 ,0)
Intuition:
the put cannot have a negative value, since its payoff is
nonnegative
and the American put cannot be worth less than its intrinsic
value, otherwise you can buy the put option for P0 and exercise it
immediately, obtaining its intrinsic value K − S0

Upper bound on American put price
P0 ≤ K
Intuition: the American put option cannot be worth more than

its maximum payoff K, which is obtained when S0 = 0
Arbitrage opportunity when P0 > K:
t=τ ≤T
t=0 Sτ < K Sτ ≥ K
Short put P0 − (K − Sτ ) 0
Risk-free deposit −K Kerτ Kerτ
Portfolio P0 − K > 0 Sτ + K (erτ − 1) ≥ 0 Kerτ > 0

Upper bound on European put price
p0 ≤ Ke−rT ≤ K
Intuition: the European put option cannot be worth more than

the present value of its maximum payoff K, which is obtained
when S0 = 0
Arbitrage opportunity when p0 > Ke−rT :
t=T
t=0 ST < K ST ≥ K
Short put p0 − (K − ST ) 0
Portfolio p0 − Ke−rT > 0 ST ≥ 0 K>0

Upper bound on European put price
P0 ≥ p0
Intuition: the additional exercise opportunities of an American

option cannot have a negative value

Lower bound on European put price
p0 ≥ max Ke−rT − S0 ,0

Intuition:
the put cannot have a negative value, since its payoff is
nonnegative
and the put cannot be worth less than a short position in a
forward with forward price K (Ke−rT − S0 ) because of its added
flexibility (it gives the right to sell and not the obligation to sell)
Arbitrage opportunity if p0 < Ke−rT − S0 :
t=T
t=0 ST < K ST ≥ K
Long put −p0 K − ST 0
Long asset −S0 ST ST
Risk-free borrowing Ke−rT −K −K
−rT
Portfolio Ke − S0 − p0 > 0 0 ST − K ≥ 0
Upper and lower bounds on option prices
Lower bound Upper bound

European call (c0 ) max S0 − Ke−rT ,0 C0 or S0
American call (C0 ) c0 or max S0 − Ke−rT,0 S0
European put (p0 ) max Ke−rT − S0 ,0 P0 or Ke−rT
American put (P0 ) p0 or max (K − S0 ,0) K
The expressions in blue are the bounds when information about

the option prices that constitute the tighter bounds are not
available

Upper and lower bounds on call option prices (1/2)

O
Call Price

UB = S0 LB = max S0 − Ke−rT ,0
IV = max (S0 − K,0)
/
Ke−rT K S0

Upper and lower bounds on call option prices (2/2)

O
Call Price
UB
LB
IV
•





 TV >0




•






IV

/



Ke−rT K S0

Upper and lower bounds on put option prices (1/2)

O
Put Price
UBa = K
K
UBe = Ke−rT
Ke−rT
LBa = max (K − S0 ,0) = IV

LBe = max Ke−rT − S0 ,0

|
/
Ke−rT K S0

Upper and lower bounds on put option prices (2/2)

O
Put Price
UBa
K
UBe
Ke−rT •
 
TV < 0




•























IV 























/


 LBe LBa = IV
Ke−rT K S0

Put-call parity (1/2)
The price of European calls and puts with the same

characteristics (same underlying asset, strike price and expiration
date) obeys the following relationship
c0 + Ke−rT = p0 + S0
This is known as the put-call parity

To demonstrate the put-call parity, let’s consider the following 2
portfolios:
long call and risk-free deposit of Ke−rT (portfolio value is
c0 + Ke−rT )
long put and long asset (portfolio value is p0 + S0 )
And now, let’s show that these portfolios generate the same
payoff in all possible scenarios

Put-call parity(2/2)
t=T
t=0 ST < K S T ≥ K
Long call −c0 0 ST − K
Portfolio A −c0 − Ke−rT K ST
Long asset −S0 ST ST
Portfolio B −p0 − S0 K ST
Since the payoff of the two portfolio is the same in every scenario,
they have to be worth the same
c0 + Ke−rT = p0 + S0
otherwise there is an arbitrage opportunity

Call, put and asset replication
From the put-call parity it’s easy to see how we can replicate the
following positions:
Long call = long put + long asset + risk-free borrowing of Ke−rT
c0 + Ke−rT = p0 + S0 ⇔ c0 = p0 + S0 − Ke−rT
Long put = long call + short asset + risk-free deposit of Ke−rT
c0 + Ke−rT = p0 + S0 ⇔ p0 = c0 − S0 + Ke−rT
Long asset = long call + short put + risk-free deposit of Ke−rT
c0 + Ke−rT = p0 + S0 ⇔ S0 = c0 − p0 + Ke−rT

Effect of (discrete) dividends
Suppose that we know that the underlying asset will pay

dividends with a present value of P V (D) during the life of the
option
If we remove those dividends from today’s price, the
dividend-adjusted price is
S00 = S0 − P V (D)
Everything that we saw until now stands with S00 = S0 − P V (D)

instead of S0
Notice that now a long position in the asset also involves a
risk-free borrowing of an amount P V (D), to be repaid with the
dividends received:
this is the way to “kill” the effect of the dividends

Put-call parity with (discrete) dividends

Assuming that the dividend is paid at only one date τ , in which
case P V (D) = De−rτ , the put-call parity becomes
c0 + Ke−rT = p0 + S0 − De −rτ
| {z }
P V (D)
t=T
t=0 t=τ ST < K ST ≥ K
Long call −c0 0 0 ST − K
Risk-free deposit −Ke−rT 0 K K
Portfolio A −c0 − Ke−rT 0 K ST
Long asset −S0 D ST ST
Risk-free borrowing De−rτ −D 0 0
Portfolio B −p0 − S0 + De−rτ 0 K ST

Outline
1 Preliminaries
4 Early exercise

Regretting the exercise of American options (1/4)
Before we move on to the analysis of the early exercise of American

options, we need to understand one thing that seems counterintuitive
“If an American option is OTM at expiration, anyone who ex-
ercised it before expiration would regret having done so.”
To illustrate why this is so, consider:
an American call with a strike of K = $25 and expiration in T = 1
year
that the spot price of the underlying asset is currently S0 = $40,
meaning the call is deep ITM
that you want to buy the underlying asset during the next year
and hold it for the long run
two scenarios for the underlying asset’s price in 1 year: (i) $60
(the option expires ITM); (ii) $20 (the option expires OTM)

Asset position Asset purchase

Payoff
at t = 1 price
Early exercise 40 − 25 = $15 Long 1 unit $25
No early exercise (i) 60 − 25 = $35 Long 1 unit $25
No early exercise (ii) $0 Long 1 unit $20
If the option expires ITM, exercising early or at expiration is always

equivalent: you end up owning the asset, and paying $25 for it (the strike)
The payoff may be different, but it only represents how much you saved by
buying the asset through option exercise instead of at the market price of the
moment; it does not represent a cash amount you receive4
However, if the option expires OTM, you can buy the asset for less than $25
by buying it on the open market. If you exercised the option early, you
already bought the asset and overpaid it. That’s something to regret
4
For that you would have to sell the asset immediately after exercise, but that’s not
your goal in this case.
As long as the option is alive (not expired or exercised) you have

the guarantee that you can buy the asset for the $25 strike price.
What’s the point in using the option before expiration? It’s better
to wait to see if you can buy it cheaper on the market.
If that’s not possible, you can always use the option to buy it for
$25
The American call option is like an insurance policy which
guarantees that you can buy the asset for $25 until the expiration
date of the option

Payoff strategy (a) Payoff strategy (b)
Early exercise 40 − 25 = $15 40 − 25 = $15

No early exercise (i) 60 − 25 = $35 40 − 25 = $15
No early exercise (ii) $0 40 − 20 = $20
But what if you are a speculator and don’t want to hold the asset?
If you sell the asset immediately after exercise (strategy (a)) you can
materialize the payoff. So, when you see the current market price at $40, it
might make sense to pocket a payoff of $15 right away, rather than risking
the option expiring OTM and getting $0
But there’s a better alternative (strategy (b)). Short sell the asset whenever
you feel the price is high enough (for example right now at $40). You will
then have to buy the asset back in the future. As long as you still have the
option (not exercised nor expired), you know you will not pay more than $25
for the asset. But there’s a possibility the option expires OTM and you can
buy the asset on the market for less, in which case you would have regretted
exercising the option early
Early exercise of American calls (1/2)

If the underlying asset does not pay dividends until expiration,
the early exercise of an American call is never optimal
C0 = c0
Intuition:
delaying the exercise decreases the present value of the (strike)
price paid by the asset (delaying is good)
there is always the possibility of the call being OTM at expiration,
in which case the call holder would regret his decision to exercise
early (delaying is good)
Proof:
C0 ≥ max S0 − Ke−rT ,0 ≥ max (S0 − K,0) = IV ⇒ T V ≥ 0

Therefore, in this case the American call always has a

nonnegative time value, and so it should not be exercised early
Early exercise of American calls (2/2)
If the underlying asset pays dividends until expiration, then it

may be optimal to exercise the American call immediately before
an ex-dividend date
Intuition:
delaying the exercise past an ex-dividend date will make the call
holder miss the opportunity to collect the dividend, which may
not compensate the other factors
delaying up to the ex-dividend date is still optimal, since there is
no income lost

Early exercise of American puts (1/2)
If an American put is deep ITM, early exercise is optimal

Intuition:
delaying the exercise decreases the present value of the price
received by the asset (delaying is bad)
but there is always the possibility of the put being OTM at
expiration, in which case the put holder would regret his decision
to exercise early (delaying is good)
when the option is deeply ITM, there is little chance that it will
end OTM and so the first effect dominates (and the option should
be exercised early)

Early exercise of American puts (2/2)
It is never optimal to exercise an American put right before an

ex-dividend date
Intuition:
if the put holder waits a little longer, he will collect the dividend

Day 02 Financial Options

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Preliminaries Factors affecting option prices Upper and lower bounds for option prices Early exercise

Day 02: 12/Sep/23

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 1 / 48

2 Factors affecting option prices

3 Upper and lower bounds for option prices

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 2 / 48

2 Factors affecting option prices

3 Upper and lower bounds for option prices

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 3 / 48

Converting discrete to continuously compounded rates

2 Factors affecting option prices

3 Upper and lower bounds for option prices

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 7 / 48

ct : price of European call option on date t (years from today)

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 8 / 48

Option price at expiration

cT = CT = max (ST − K,0) ≡ IVT ⇒ T VT = 0

Putting it in another way:

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 9 / 48

Factors affecting the option price: St

∂ct ∂Ct ∂pt ∂Pt

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 10 / 48

Factors affecting the option price: K

∂ct ∂Ct ∂pt ∂Pt

The higher the strike price:

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 11 / 48

Factors affecting the option price: T (1/2)

∂ct ∂Ct ∂pt ∂Pt

The value of American options increases with the time to

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 12 / 48

Factors affecting the option price: T (2/2)

But the effect of the time to expiration on the price of European

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 13 / 48

Factors affecting the option price: r

∂ct ∂Ct ∂pt ∂Pt

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 14 / 48

Factors affecting the option price: σ

∂ct ∂Ct ∂pt ∂Pt

A higher volatility makes big changes in the price of the

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 15 / 48

Factors affecting the option price: D

∂ct ∂Ct ∂pt ∂Pt

The distribution of dividends decreases the value of the

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 16 / 48

Factors affecting the option price: summary

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 17 / 48

2 Factors affecting option prices

3 Upper and lower bounds for option prices

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 18 / 48

Definition: arbitrage opportunity

An arbitrage opportunity can be seen as a free lunch, since you

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 19 / 48

Upper and lower bounds on option prices

Before we introduce option pricing models (which are always

Upper bound on American call price

Upper bound on European call price

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 22 / 48

Lower bound on European call price

Lower bound on American call price

This is a corollary from the previous two results

António Barbosa (ISCTE IBS) Financial Options Day 02: 12/Sep/23 24 / 48

Lower bound on American put price