Option Pricing

Prof Mahesh Kumar Amity Business School profmaheshkumar@rediffmail.com

Options: A Zero Sum Game
Write & Purchase Call Option:

Profit and Loss

Long Call Zero-Sum-Game

Premium Earned x
Stock Price at Expiration

Premium Paid Short Call

Options: A Zero Sum Game
Write & Pull Call Option:

Profit and Loss

Long Put Premium Earned
Stock Price at Expiration

Short Put

Premium Paid

Factors Affecting Option Prices
There are six factors which affect the price of stock option The current stock price S0 The strike price X The time of expiration T The volatility of stock market W The risk free interest rate r The dividends expected during the life of the option.

1. 2. 3. 4. 5. 6.

Notation
c : European call option price p : European put option price S0 : Stock price today K : Strike price T : Life of option W: Volatility of stock price
C : American Call option price P : American Put option price ST :Stock price at option maturity D : Present value of dividends during option¶s life r : Risk-free rate for maturity T with cont. comp.

Effect of Variables on Option Pricing Variable S0 K T W r D c p C P

+ ± ? + + ±

± + ? + ± +

+ ± + + + ±

± + + + ± +

Stock Price and Strike Price
If a call option is exercised at some future time, the payoff will be the amount by which stock price exceeds the strike price. Call options therefore become more valuable as stock prices increases and less valuable as the strike prices decreases. Put options behave in opposite way from call options. They become less valuable as the stock price increase and more valuable as the strike price decrease.

Time to Expiration
Both call and put American options become more valuable as the time of expiration increases. Although European put and call options usually become more valuable as the time to expiration increases; this is not always the case. Consider to European call options on a stock: one with expiration in one month and other with expiration in two months. Suppose that a very large dividend is expected in six weeks. The dividend will cause the stock price to decline, so that the short life option could be worth more than the long life option.

Volatility
Volatility of a stock price is a measure of how uncertain we are about the future stock price movements. Increase in volatility increases the price risk for both call and put options. The values of both calls and puts increases as the volatility increases.

Risk Free Interest Rate
As the risk free interest rates in the economy increase, the expected growth rate of the stock tends to increase. However, the present value of a future cash flow received by the holder of the option decreases. These two effects tend to decrease the value of put option. Hence, put option prices decline as the risk free interest rate increases. In the case of calls, the first effect tends to increase the price whereas the second effect tends to decrease it. It can be shown that the first effect always dominate the second effect; that is, the price of calls always increase as the risk free interest rate increases.

Risk Free Interest Rate
In practice, when interest rate rise (fall), stock prices tend to fall (rise). The net effect of an interest rate increase and the accompanying stock price decrease can be to decrease the value of a call option and increase the value of a put option. Similarly the net effect of an interest rate decrease and the accompanying stock price increase can be to increase the value of call option and decrease the value of put option.

Dividends
Dividends have the effect of reducing the stock price on the ex dividend date. The value of a call option is negatively related and the value of a put option is positively related to the size of anticipated dividends.

American vs. European Options
An American option is worth at least as much as the corresponding European option

Cuc Pu p

Upper and Lower Bounds for Option Prices
If an option price is above the upper bound or below the lower bound, there are profitable opportunities for arbitrageurs. Upper Bound: An American or European option gives the holder the right to buy one share of a stock for a certain price. No matter what happens, the option price can never be worth more than the stock. Hence the stock price is an upper bound to the option price. c=<S0 C=<S0 An American or European put option gives the holder the right to sell one share of stock for X. No matter how low the stock prices becomes, the option can never be worth more than X. p=<X P=<X OR p=<Xe-rT

Lower Bound for calls on Non Dividend Paying Stocks

A lower bound for the price of a European option on a non dividend paying stock is S0-Xe-r T Let S0= Rs.20,X= Rs.18,r=10%p.a. and T=1year In this case lower bound is S0-Xe-r T=20-18-0.1=Rs.3.71

Lower Bound for calls on Non Dividend Paying Stocks

Consider the situation where the European call price is Rs.3 (less than the lower bound limit of Rs.3.71). Then there is an opportunity for an arbitrageur. Strategy: a) Buy the call option b) Short the stock c) Invest the surplus cash at 10% p.a.

Lower Bound for calls on Non Dividend Paying Stocks
How it works  Buying the call option and shorting the stock provides immediate cash flow of Rs.20-3=Rs.17. This Rs.17 is invested at 10% and grows to 17e0.1=Rs.18.79 at the end of 1 year. At this time the option expires.  If the price of the stock is greater than Rs.18, the investor exercises the option and closes out the short position for a profit of Rs.18.79-18=0.79.  If the price of the stock is less than Rs.18 at the end of one year, the option is not exercised and stock is bought in the market and short position closed out. The investor then makes a profit equal to 18.79-ST where ST is the stock price. Because ST<18, the profit is at least as great as 0.79.

Lower Bound for Puts on Non Dividend Paying Stocks

For a European put option on a non dividend paying stock, a lower bound for the price is Xe-r T -S0 Whenever the price of the option is lower than the lower bound price arbitrageurs have opportunity. Let S0= Rs.37,X= Rs.40,r=5%p.a. and T=0.5year In this case lower bound is Xe-r T -S0 =40e-0.05*0.5-37=Rs.2.01

Lower Bound for Puts on Non Dividend Paying Stocks

Suppose option price is Rs.1 (which is less than lower bound limit). The strategy followed by arbitrageur is: Strategy: a) Borrow Rs.38 for six months (Rs.37(S0)+Rs.1) b) Buy one put option c) Buy one share of the stock

Lower Bound for Puts on Non Dividend Paying Stocks

How it works  At the end of six months, 38e0.5*6/12= Rs.38.96 is required to pay off the loan.  If the stock price when option expires is less than Rs.40, the investor exercises the option to sell the stock for Rs.40 and makes profit of Rs.40-Rs.38.96=Rs.1.04  If the price of the stock is greater than Rs.40, the investor does not exercises the option and sells the stock and repays the loan for a profit ST-38.96 where ST is the stock price. The profit is at least as great as Rs.1.04.

Put Call Parity
Let us consider two portfolios  Portfolio A: One European call option plus an amount of cash equal to Xe-r T  Portfolio B: One European put option plus one share. At the expiration both are worth max (ST,X) This implies c+ Xe-r T=p+S0 This relationship is known as put-call parity. It implies that the value of a European call with a certain exercise price and exercise date can be deduced from the value of a European put with the same exercise price and exercise date and vice versa. If the above relationship does not hold good then arbitrage opportunities exist.

Put Call Parity
The put call parity can also be re written as c-p=S0-Xe-r T If the option is at the money then S0=X, then c-p= S0(1-e-r T) c/S0-p/S0=(1-e-r T) e-r T represents the present value of Re1. Accordingly (1e-r T) represents the difference between present and discounted value of Re1, which is nearly equal to the rate of interest. Hence we can deduce that when options are at the money and the underlying stock prices pay no dividends, relative call price c/S0 would exceed relative put prices p/S0 by about the risk free rate of interest.

Put Call Parity-Example 1
Arbitrage opportunity when put call parity does not hold: call price too low relative to put price. An investor has just obtained the following quotes for options on a stock worth Rs.31 when the three month risk free interest rate is 10%p.a. Both options have a strike price of Rs.30 and expiration date in 3 months. The price of 3 month European call option is Rs.3 and the price of 3 month put option is Rs.2.25. Discuss the strategy of investor.

Put Call Parity-Example 1
In this case, Portfolio A=c+ Xe-r T=3+30e-0.1*3/12=Rs.32.26 Portfolio B=p+S0= 2.25+31=Rs.33.25 We see that portfolio B is overpriced than portfolio A. The strategy of investor should be: a) Buy the call b) Short the put c) Short the stock 

This strategy will lead to the cash flow of -3+2.25+31=Rs.30.25 

When invested for 3 months at the risk free rate, this amount grows to 30.25e0.1*3/12=Rs.31.02 at the end of three months.

Put Call Parity-Example 1
How it works  If the stock price is greater than Rs.30. The investor exercises the call. This involves buying one share for Rs.30. The short position is closed off and the net profit is Rs.31.0230=Rs.1.02  If the stock price is less than Rs.30. The counterparty exercises the put option. This involves the investor in buying one share for Rs.30. The short position is closed out and the net profit again is Rs.31.02-Rs.30=Rs.1.02

Put Call Parity-Example 2
Arbitrage opportunity when put call parity does not hold: put price too low relative to call price. An investor has just obtained the following quotes for options on a stock worth Rs.31 when the three month risk free interest rate is 10%p.a. Both options have a strike price of Rs.30 and expiration date in 3 months. The price of 3 month European call option is Rs.3 and the price of 3 month put option is Rs.1 Discuss the strategy of investor.

Put Call Parity-Example 2
In this case, Portfolio A=c+ Xe-r T=3+30e-0.1*3/12=Rs.32.26 Portfolio B=p+S0= 1+31=Rs.32.00
We see that portfolio A is overpriced than portfolio B.

The strategy of investor should be: a) Sell the call b) Buy the put c) Buy the stock 

This strategy involves an investment of Rs.31+1-3=Rs.29 When the investment is financed at risk free rate a repayment of 29e0.1*3/12=Rs.29.73 is required at the end of three months.

Put Call Parity-Example 2
How it works  If the stock price is greater than 30. The counterparty exercises the call. This means investor has to sell shares owned for Rs.30. The net profit is Rs.30-29.73=Re.0.27  If the stock price is less than Rs.30. The investor exercises the put option. This means that the share is sold for Rs.30. The net profit is Rs.30-Rs.29.73=Re.0.27

Early Exercise of an American Call
In contrast to a European call which can be exercised only on due date, an American option can be exercised at any time before the expiration date. It can be shown that it is never optimal to exercise an American call early, if the stock is non dividend paying.

Early Exercise of an American Call-Example
To illustrate this we consider an American call option on a non dividend paying stock with an exercise date two months away when the stock price is Rs.60 and the exercise price is Rs.50 The option is deep in-the-money and the investor who owns the option might well be tempted to exercise it immediately. However, if the investor plans to hold the share beyond two months, it may not be the best strategy. It would be better to keep the call and exercise it when it is due and earn interest on Rs.50 for two months. Since the stock does not pay any dividend, no income is sacrificed.

Early Exercise of an American Call-Example
A further advantage of waiting rather than exercising is that there is some chance that the stock will fall below Rs.50 in two months. In this case, the investor will be glad that the decision to exercise early was not taken. The above two arguments hold true when the investor wants to hold the stock. What if the investor thinks the stock is overpriced and is wondering to exercise his option and sell the stock? In this case, the investor is better off selling the option rather than exercising it (alternatively the investor can hold the option and short the stock). The option will be bought by another investor who does not want to hold the stock. Such investors would certainly exist, because, otherwise the price of the stock would not have been Rs.60.This activity would enable the investor to get a higher profit since the price at which the option will be sold will be greater than its intrinsic value of Rs.10

Early Exercise of an American Call
To summarize there are two reasons options should not be exercised early in the case of American call 1. One relates to insurance that it provides. A call option, when held instead of the stock itself, in effect insures the holder against the stock price falling below the exercise price. Once the option is exercised the insurance vanishes. 2. Time value of money. From the perspective of the option holder, the later the strike price is paid out the better.

Early Exercise of an American Put
It can be optimal to exercise an American put option on a non dividend paying stock early. Indeed at any given time during its life, a put option should always be exercised early if it is sufficiently deep in the money.

Early Exercise of an American Put-Example
To illustrate this we may consider an extreme situation in which the exercise price is Rs.20 and the underlying stock is selling at a price which is nearly zero. An immediate exercise of the put option causes an immediate gain of Rs.20. If, however, the investor waits, the gain from exercising the put might be lowered (if the stock price recovers) and, in any case, it cannot exceed the present gain of Rs.20 since the stock prices cannot assume negative values. Further a receipt of Rs.20 now is preferable to an equal amount receivable at some time in future date due to time value of money.

Early Exercise of an American Put-Example
A put option, held along with the stock, provides an insurance cover to the holder against any fall in the stock price below a certain level. However, unlike the situation for a call option, it may be better for an investor to forego this insurance and exercise the put early so as to obtain the exercise price immediately. In general, a fall in the stock price, an increase in the risk free rate of interest and decrease in volatility make an early exercise attractive. Since there exist circumstances when it is desirable to exercise an American put option early, it follows that an American put option is worth more than a comparable European option.

Effects of Dividends
If µD¶ is the present value of dividends during the life of the option then we have to calculate the lower bounds for calls and puts. We define Portfolio A & B as follows:  Portfolio A: One European call option plus cash amount equal to D+ Xe-r T  Portfolio B: One share c>=S0-D-Xe-r T

Effects of Dividends
We define Portfolio C & D as follows:  Portfolio C: One European put option plus one share.  Portfolio D: An amount of cash equal to D+ Xe-r T p>=D+ Xe-r T-S0 Adding the present value of dividend, D, to the present value of exercise price has the effect of decreasing the value of a call and increasing the value of a put.

Effects of Dividends
Further, when the dividends are expected, it cannot be said that an American call will not be exercised early. At times, it may be best to exercise an American call immediately prior to an ex dividend date because the dividend may cause the stock price to fall, making the option less attractive. Put call parity of portfolios with dividend for European option is c + D + Xe-r T =p + S0 For American option it is: S0-D-X=<C-P=<S0-Xe-r T

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