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# Lecture 21: Options Markets

Options

• With options, one pays money to have a choice in the future • Essence of options is not that I buy the ability to vacillate, or to exercise free will. The choice one makes actually depends only on the underlying asset price • Options are truncated claims on assets

Options Exchanges

• Options are as old as civilization. Option to buy a piece of land in the city • Chicago Board Options Exchange, a spinoff from the Chicago Board of Trade 1973, traded first standardized options • American Stock Exchange 1974, NYSE 1982

Terms of Options Contract • Exercise date • Exercise price • Definition of underlying and number of shares .

Two Basic Kinds of Options • Calls. a right to buy • Puts. a right to sell .

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Two Basic Kinds of Options • American options – can be exercised any time until exercise date • European options – can be exercised only on exercise date .

the writer must abide by buyer’s choice • Buyer puts up no margin. naked writer must post margin .Buyers and Writers • For every option there is both a buyer and a writer • The buyer pays the writer for the ability to choose when to exercise.

In and Out of the Money • In-the-money options would be worth something if exercised now • Out-of-the-money options would be worthless if exercised now .

Exercise Price = 20 25 20 15 Intrinsic Value Call 10 5 0 0 5 10 15 20 25 30 35 40 45 -5 Stock Price .

Exercise Price = 20 20 15 Intrisnic Value Put 10 5 0 0 5 10 15 20 25 30 35 40 45 -5 Stock Price .

Put-Call Parity Relation • Put option price – call option price = present value of strike price + present value of dividends – price of stock • For European options. otherwise there would be arbitrage profit opportunities . this formula must hold (up to small deviations due to transactions costs).

Put Call Parity Relation Derivation 45 40 35 30 25 Stock Price 20 Intrinsic Value Put Intrinsic Value Call Exercise Price 15 10 5 0 0 -5 Stock Price 5 10 15 20 25 30 35 40 45 .

Limits on Option Prices • Call should be worth more than intrinsic value when out of the money • Call should be worth more than intrinsic value when in the money • Call should never be worth more than the stock price .

r=5%. T=1.sigma=.Exercise Price = 20.3 25 20 15 Call Price 10 Intrinsic Value of Call Call Price (Black Scholes) 5 0 0 5 10 15 20 25 30 35 40 45 -5 Stock Price .

Binomial Option Pricing • Simple up-down case illustrates fundamental issues in option pricing • Two periods. two possible outcomes only • Shows how option price can be derived from no-arbitrage-profits condition .

Cont. • S = current stock price • u = 1+fraction of change in stock price if price goes up • d = 1+fraction of change in stock price if price goes down • r = risk-free interest rate .Binomial Option Pricing.

• C = current price of call option • Cu= value of call next period if price is up • Cd= value of call next period if price is down • E = strike price of option • H = hedge ratio.Binomial Option Pricing. number of shares purchased per call sold . Cont.

will be worth uHS-Cu • If price goes down.Hedging by writing calls • Investor writes one call and buys H shares of underlying stock • If price goes up. worth dHS-Cd • For what H are these two the same? Cu − C d H= (u − d ) S .

then solve for C 1 + r − d Cu u − 1 − r Cd C=( )( )+( )( ) u − d 1+ r u − d 1+ r .Binomial Option Pricing Formula • One invested HS-C to achieve riskless return. hence the return must equal (1+r) (HS-C) • (1+r)(HS-C)=uHS-Cu=dHS-Cd • Subst for H.

Formula does not use probability • Option pricing formula was derived without regard to the probability that the option is ever in the money! • In effect. such as housing. this formula may be subject to large errors . the price S of the stock already incorporates this probability • For illiquid assets.

integral of normal bell-shaped curve) =normdist(x. for European options only • Black-Scholes continuous arbitrage is not really possible. continuous trading. transactions costs. 0 for density. σ2 the variance of one-period price change (as fraction) and N(x) the standard cumulative normal distribution function (sigmoid curve.standard_dev.1) Excel (x. 1 for cum.1. mean.Black-Scholes Option Pricing • Fischer Black and Myron Scholes derived continuous time analogue of binomial formula.) . a theoretical exercise • Call T the time to exercise.0.

Black-Scholes Formula C = SN(d1 ) − EN(d 2 ) where S ln( ) + rT + σ 2T / 2 E d1 = σ T S ln( ) + rT − σ 2T / 2 E d2 = σ T .

“options leer” or “options smirk” . • σ depends on strike price. σ tends to be higher for puts or calls with low strike price.Implied Volatility • Turning around the Black-Scholes formula. “options smile” • Since 1987 crash. one can find out what σ would generate current stock price.

1992-2004 400 350 300 250 200 150 100 50 0 5/7/1990 9/19/1991 1/31/1993 6/15/1994 10/28/1995 3/11/1997 7/24/1998 12/6/1999 4/19/2001 9/1/2002 1/14/2004 5/28/2005 .VIX Implied Volatility Weekly.

Monthly. Jan 1992-Jan 2004 400 7 350 6 300 5 250 4 200 3 1 50 2 1 00 1 Im plied Actual 50 0 1 990 1 992 1 994 1 996 1 998 Y ear 2000 2002 2004 0 2006 .Implied and Actual Volatility Monthly Jan 1992-Jan 2004 Im plied Volatility & Actual Volatility.

1871-2004 30 25 20 1 5 1 0 5 0 1 860 1 880 1 900 1 920 1 940 Y ear 1 960 1 980 2000 2020 .Actual S&P500 Volatility Monthly1871-2004 Six-Month Moving Standard Deviation of S&P 500 Price Change.

then. should anyone use options to hedge? .Using Options to Hedge • To put a floor on one’s holding of stock. Doing the latter costs nothing • Why. one can buy a put on same number of shares • Alternatively. one can just decide to sell whenever the price reaches the floor • Doing the former means I must pay the option price.

people inordinately attracted to small probabilities of winning big • Margin requirements are circumvented by options . appears to be a win-win situation (Shefrin) • Buying an option is a way of attaining a more leveraged. risky position • Lottery principle in psychology.Behavioral Aspects of Options Demand • Thaler’s mental categories theory • Writing an out-of-the-money call on a stock one holds.

but price of option may be way below half the price of the stock. if stock price is way above the exercise price. delta is roughly a half.Option Delta • Option delta is derivative of option price with respect to stock price • For calls. if option is at the money. delta is nearly one and one pays approximately stock price minus pdv of exercise price. if stock price is way below exercise price. like buying stock with credit pdv(E) . delta is nearly zero • For calls. • For calls.

Volatility of Call Return / Volatility of Stock Return. Exercise Price = 20 25 20 dln(call price)/dln(stock price) 15 10 5 0 0 5 10 15 20 Stock Price 25 30 35 40 45 .