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# Principles of option pricing

Option

A contract that gives the holder the right - not the obligation to buy (call), or to sell (put) a specified amount of the underlying asset, at a set exchange rate and expiration date.

Glossary of terms

## The investor selling the option is called the writer or seller.

When the holder of the option decides to buy (sell) the asset at maturity, it is said that he/she is exercising the option. The asset to be bought or sold is called the underlying asset. Since the holder enjoys a privilege - the option to buy or sell - he/she must pay a premium to acquire the option. The price agreed upon for buying or selling the underlying asset is called exercise price or strike price.

## Glossary of terms (cont)

Options are traded on options exchanges. The number of outstanding option contracts at any time is called open interest.

## American vs. European options

American options can be exercised at any time during their life span

## Option valuation basics

Like with any other financial asset, the option premium or market value or option price is a function of future expected cash flows.

Notation
C: price of an American call c: price of an European call P: price of an American put p: price of an European put E: exercise or strike price S: stock price before maturity ST: stock price at maturity T: time to maturity r: risk-free rate

## Boundaries to option prices: Call options.

At expiration:
C = max[0, (ST -E)]

Before expiration
Upper bound: A call cannot sell for more than the stock: C < S and c < S
Lower bound: C > = max[0, (S -E)] c > = max[0, (S - E/(1+r)T)]

## Boundaries to option prices: Arbitrage

Assume the Exxon December 26 call struck at \$80 sells for \$1. It is now December 17. The stock of Exxon is at \$83/share. The risk-free rate is 6%.

If the option is American, buy the call for \$1, exercise it and make \$3

Arbitrage profit = \$2

When

Action

## Cash flow \$83 -\$1 -\$79.8835 net CF = \$2.116

Short one share of Exxon Today, December 17 Buy one call Lend \$79.8835 at 6% for 9 days

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days

net CF = \$2.116

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days Collect \$79.8835(1.06)
0.025

Cash flow \$83 -\$1 -\$79.8835 net CF = \$2.116 \$80 -\$80 0 net CF = 0

December 26

Exercise your call and buy one Exxon share at \$80 Return the Exxon share you borrowed

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days Collect \$79.8835(1.06)
0.025

Cash flow \$83 -\$1 -\$79.8835 net CF = \$2.116 \$80 -\$80 0 net CF = 0

December 26

Exercise your call and buy one Exxon share at \$80 Return the Exxon share you borrowed

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days Collect \$79.8835(1.06)
0.025

Cash flow \$83 -\$1 -\$79.8835 net CF = \$2.116 \$80 -\$80 0 net CF = 0

December 26

Exercise your call and buy one Exxon share at \$80 Return the Exxon share you borrowed

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days Collect \$79.8835(1.06)
0.025

Cash flow \$83 -\$1 -\$79.8835 net CF = \$2.116 \$80 -\$80 0 net CF = 0

December 26

Exercise your call and buy one Exxon share at \$80 Return the Exxon share you borrowed

## When Today, December 17

Action Short one share of Exxon Buy one call Lend \$79.8835 at 6% for 9 days Collect \$79.8835(1.06)
0.025

## Cash flow \$83 -\$1 -\$79.8835 net CF = \$2.116 \$80 -\$80 0

December 26

Exercise your call and buy one Exxon share at \$80 Return the Exxon share you borrowed

net CF = 0

Analysis

We have created a riskless portfolio: the terminal cash flow is zero, regardless of the stock price, while the up-front cash flow is positive.

## Boundaries to option prices: Put options.

At expiration:
P = max[0, (E -ST)]

Before expiration
Upper bound: A put cannot sell for more than the stock: P < S and p < S Lower bound: P > = max[0, (E - S)]

## p > = max[0, (E/(1+r)T -S)]

Boundary violations

By now, we know that if price boundaries are violated, we might be able to construct an arbitrage portfolio.

## Boundary violations: American put options

Assume the Exxon December 26 put struck at \$80 sells for \$2. It is now December 17. The stock of Exxon is at \$75/share. The risk-free rate is 6%.
If the option is American, we can buy it for \$2 and exercise it.

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835 December 26 Exercise your put and sell one Exxon share at \$80 Pay back your loan 0.025 \$79.8835(1.06) net CF = 0 \$80 -\$80

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835 December 26 Exercise your put and sell one Exxon share at \$80 Pay back your loan 0.025 \$79.8835(1.06) net CF = 0 \$80 -\$80

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835 December 26 Exercise your put and sell one Exxon share at \$80 Pay back your loan 0.025 \$79.8835(1.06) \$80 -\$80 net CF = 0

## Arbitrage portfolio to exploit boundary violations for European put options

When Today, December 17 Action Buy one share of Exxon Buy one put Borrow \$79.8835 at 6% for 9 days Cash flow -\$75 -\$2 \$79.8835 net CF = \$2.8835 December 26 Exercise your put and sell one Exxon share at \$80 Pay back your loan 0.025 \$79.8835(1.06) \$80 -\$80

net CF = 0

Analysis

We have created a riskless portfolio: the terminal cash flow is zero, regardless of the stock price, while the up-front cash flow is positive.

## Three important concepts

Intrinsic value - how much the call is worth if exercised. Market value, price, or premium - the price at which the call can be sold/purchased in the market. Time value - the difference between premium and intrinsic value

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## The market value of the American Call as expiration approaches

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Remark

As expiration approaches, the market value of the option converges to its intrinsic value At the same time, time value converges to zero

## Relationship between several variables and the market value of options

Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends

European call + ? + + -

European put + ? + +

American call + + + + -

American put + + + +

## Relationship between several variables and the market value of options

Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends

European call + ? + + -

European put + ? + +

American call + + + + -

American put + + + +

## Relationship between several variables and the market value of options

Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends

European call + ? + + -

European put + ? + +

American call + + + + -

American put + + + +

## Relationship between several variables and the market value of options

Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends

European call + ? + + -

European put + ? + +

American call + + + + -

American put + + + +

## Relationship between several variables and the market value of options

Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends

European call + ? + + -

European put + ? + +

American call + + + + -

American put + + + +

## Relationship between several variables and the market value of options

Variable Stock price Strike price Time to expiration Stock volatility Risk-free rate Dividends

European call + ? + + -

European put + ? + +

American call + + + + -

American put + + + +