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Properties of Stock Options

Chapter 11: Hull and Basu

PGDM/Financial Derivatives/Option Properties/ Sanjay Dhamija


Notation
c: European call option ST: Stock price at option
price maturity
p: European put option
price D: PV of dividends paid
during life of option
S0: Stock price today
K: Strike price
T: Life of option
r Risk-free rate for
maturity T with cont.
s: Volatility of stock comp.
price

PGDM/Financial Derivatives/Option Properties/


Sanjay Dhamija
Effect of Variables on Option
Pricing
Variable c p
S0 + −
K − +
T + +
s + +
r + −
D − +

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Upper bounds for call option
Call option
European : c  S0;
If not True
Sell call option and buy stock to make riskless
profit

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Upper bounds for put option
Put option
European : p  Ke –rT;
If not True
Sell put option and invest the proceeds of sale at
risk free rate of interst

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Lower Bound for European Call
Option Prices; No Dividends

c  S0 –Ke -rT

• If not true, buy call and short stock


to make riskless profit

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Illustration I
Details regarding RIL stock and call option
are given below:

c = Rs. 70 S0 = Rs. 1000


T = 3 months r = 10%
K = Rs. 940 D=0
Is there an arbitrage opportunity?
If yes, how to take advantage?
PGDM/Financial Derivatives/Option Properties/ Sanjay
Dhamija
Illustration I
c  S0 –Ke –rT
= Rs. 83.21
As Call option is mispriced in market, buy call
option and sell stock to take advantage of the
mispricing

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Lower Bound for European Put
Prices; No Dividends

p  Ke -rT–S0
• If not true, buy put and buy stock
to make riskless profit

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Illustration II

Suppose that
p= 10 S0 = 1000
T = 2 Months r =10%
K = 1040 D =0

Is there an arbitrage opportunity?

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Illustration II
p  Ke –rT -S0
= Rs. 22.81
As Put option is mispriced in market, buy put
and stock to take advantage of the mispricing
at a total outflow of Rs.1010.

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Lower and Upper Bonds -
European Option
Upper Bound Lower Bound
Call Option c  So c  max (S0 –Ke –rt,0)

Put Option p  Ke –rT; p  max (Ke -rT–S0 ,0)

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Put-Call Parity: No Dividends
Value of a European Call with a certain
exercise price and exercise date can be
deduced from the value of European put with
the same exercise price and exercise date and
vice versa.
c + Ke -rT = p + S0

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Put-Call Parity: No Dividends
Consider the following 2 portfolios:
Portfolio A: European call on a stock +
zero-coupon bond that pays K at time T
Portfolio C: European put on the stock
+ the stock

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Values of Portfolios
ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total ST K
Portfolio C Put Option 0 K− ST
Share ST ST
Total ST K

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
The Put-Call Parity Result
Both are worth max(ST , K ) at the maturity of
the options
They must therefore be worth the same
today. This means that

c + Ke -rT = p + S0

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija
Illustration III
Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D=0

What are the arbitrage possibilities


when:
a) p = 2.25 ?
b) p = 1.00 ?
PGDM/Financial Derivatives/Option Properties/ Sanjay
Dhamija
The Impact of Dividends

 rT
c  S 0  D  Ke
 rT
p  D  Ke  S0

c + D+ Ke -rT = p + S0
D is the present value of dividends during the life of
the option
PGDM/Financial Derivatives/Option Properties/ Sanjay
Dhamija
Learning
Factors influencing the option pricing
Lower and Upper bounds of call and put
options
Put –call parity
c + Ke -rT = p + S0

PGDM/Financial Derivatives/Option Properties/ Sanjay


Dhamija