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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 buying the option is called the buyer or holder.

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

European options can be exercised only at maturity

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)]

What happens if this relationship is not satisfied?

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

What if the option is European?

Construct an arbitrage portfolio

Arbitrage portfolio to exploit boundary violations for European call options

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

Arbitrage portfolio to exploit boundary violations for European call options

When Today, December 17

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

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

Arbitrage portfolio to exploit boundary violations for European call options

When Today, December 17

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

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

Arbitrage portfolio to exploit boundary violations for European call options

When Today, December 17

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

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

Arbitrage portfolio to exploit boundary violations for European call options

When Today, December 17

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

Cash flow $83 -$1 -$79.8835

net CF = $2.116

Arbitrage portfolio to exploit boundary violations for European call options

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

Arbitrage portfolio to exploit boundary violations for European call options

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

Arbitrage portfolio to exploit boundary violations for European call options

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

Arbitrage portfolio to exploit boundary violations for European call options

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

Arbitrage portfolio to exploit boundary violations for European call options

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.

We made $2.116 in pure arbitrage profits.

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 profit = $3.

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.

We made $2.8835 in pure arbitrage profits.

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

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Call: S - E


S-E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

A Snapshot of the intrinsic value of the American Put: E - S


E-S E

S E

The market value of the American Call as expiration approaches


S-E

S E

The market value of the American Call as expiration approaches


S-E

S E

The market value of the American Call as expiration approaches


S-E

S E

The market value of the American Call as expiration approaches


S-E

S E

The market value of the American Call as expiration approaches


S-E

S E

The market value of the American Call as expiration approaches


S-E

S E

The market value of the American Call as expiration approaches


S-E

S E

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 + + + +