Professional Documents
Culture Documents
By A.V. Vedpuriswar
Introduction
An option contract gives its owner the right, but not the legal
obligation, to conduct a transaction involving an underlying asset at a
predetermined future date (the exercise date) and at a predetermined
price (the exercise or strike price).
An option gives the option buyer the right to decide whether or not the
trade will eventually take place.
The seller of the option has the obligation to perform if the buyer
exercises the option.
To acquire these rights, owner of the option must pay a price called
the option premium to the seller of the option.
Types of options
American options may be exercised at any time up to an
including the contract's expiration date.
European options can be exercised only on the contract’s
expiration date.
If two options are identical (maturity, underlying stock,
strike price, etc.), the value of the American option will
equal or exceed the value of the European option.
The owner of a call option has the right to purchase the
underlying asset at a specific price for a specified time
period.
The owner of a put option has the right to sell the
underlying asset at a specific price for a specified time
period.
In the money, Out of the money
It is the amount that the option owner would receive if the option
were exercised.
An option has zero intrinsic value if it is at the money or out of the
money, regardless of whether it is a call or a put option.
P = Max[0, X – S]
Problem
Solution
If we exercise the option, loss = 3
The stock is 3 out of the money. So it does not have any intrinsic
value.
Problem
A put option has an exercise price of 40 and the underlying stock is
trading at 37. What is the intrinsic value?
Solution
I can buy from the market at 37 and sell to the option writer for 40.
So the intrinsic value is 3.
Problem
I own a call option on the S&P 500 with an exercise price of 900.
During expiration, the index was trading at 912. If the multiplier is
250, what is the profit I make?
Solution
Notionally I can buy at 900 and sell at 912.
Profit = (912 – 900) (250) = $ 3000
Problem
Calculate the lowest possible price for an American put option with
a strike price of 65, if the stock is trading at 63 and the risk free rate is
5%. The expiration of the option is after 4 months.
Solution
The minimum price = 65 – 63 = 2.
Otherwise risk free profits can be made by arbitraging.
Problem
Solution
Present value of strike price = 65/(1+.05)0.33 .
= 63.96
So pay off = 63.96 – 63 = .96
Problem
A $35 call on a stock trading at $38 is priced at $5. What is the time
value?
Solution
Intrinsic value = 38 – 35 = 3
Total value = 5
Time value = 5–3 = 2
Problem
A call option with exercise price 40, has a premium of 3. What is the
pay off if the stock price = 38, 40, 42, 44?
Solution
Stock Price Pay off
38 -3
40 -3
42 -3 + (42 – 40) = - 1
44 -3 + (44 – 40) = 1
Problem
A put option with exercise price 40 has a premium of 3. What is the
pay off if the stock price = 38, 40, 42, 44?
Solution
Stock Price Pay off
38 -3 + (40 – 38) = - 1
40 -3
42 -3
44 -3
A put option with exercise price 40 has a premium of 3. What is the
pay off if the stock price = 38, 40, 42, 44?
Solution:
45
44 4.5
43
2.5
42
41
0.5
40 -3+ (40-38) = -1
44
39 -1
42 -1 .5
38
40 -3 -3 -3
37 -3.5
38
36
35 -5.5
1 2 3 4
Stock price Pa y Off
Problem
Suppose you have bought a $40 call and a $40 put each with premium
of 3. What is the pay off is the stock price = 36, 38, 40, 42, 44?
Solution
Stock Price Pay off
36 -3 + (40 – 36) - 3 = - 2
38 -3 + (40 – 38) – 3 = - 4
40 -3 – 3 =-6
42 -3 – 3 + (42 - 40) = - 4
44 -3 – 3 + (44 – 40) = -2
Suppose you have bought a $40 call and a $40 put each with premium
of 3. What is the pay off is stock price = 36, 38, 40, 42, 44?
Solution:
50
45 4.5
40
2.5
35
30 0.5
25 -3+ (40-38)-3 = - 2
44 -2 -1 .5
20 -2 40 42
36 38
-3-3+ (33-40) = -2
15 -3.5
-4 -4
10 -3+ (40-38)-3 = - 4 -3-3+ (42-40) = - 4
-5.5
5 -6
-3-3=-6
0 -7.5
1 2 3 4 5
Stock price Pa y Off
Problem
A stock trades at 108 and there are two European options currently
available.
Strike Price Premium
Put A 113 4
Put B 118 10
Explain how arbitraging can take place.
Solution
Suppose you bought a put on a stock selling for $60 with a strike
price of $55, for a $5 premium. What is the maximum gain possible?
Solution
Maximum gain = - 5 + (55-0)
Problem
Solution
Covered call means writing a call and buying the stock.
Premium received = 2; Cash paid for buying stock = 40
Maximum gain will be when the option is not exercised and the
stock price reaches 50.
Then stock can be sold for 50 – 40 = 10
So Maximum gain = 10 + 2 = 12
Problem
Bond options are most often based on Treasury bonds because of their
active trading.
Index options settle in cash, nothing is delivered, and the payoff is made
directly to the option holder’s account.
Options on futures sometimes called futures options, give the holder the
right to buy or sell a specified futures contract on or before a given date at
a given futures rice, the strike price.
Call options on futures contracts give the holder the right to enter into the
long side of a future contract at a given futures price.
Put options on futures contracts give the holder the option to take on a
short futures position at a future price equal to the strike price.
Interest rate options
Interest rate options are similar to stock options except that the
exercise price is an interest rate and the underlying asset is a
reference a rate such as LIBOR.
Interest rate options are also similar to FRAs .
Consider a long position in a LIBOR-based interest
rate call option with a notional amount of $1,000,000
and a strike rate of 5%.
If at expiration, LIBOR is greater than 5%, the option
can be exercised and the owner will receive
$1,000,000 x (LIBOR – 5%).
If LIBOR is less than %, the option expires worthless
and the owner receives nothing.
Let’s consider a LIBOR-based interest rate put option with the
same features as the call that we just discussed.
Problem
Solution
(2,000,000) (.05 - .04) (90/360) = $5000
This compensation will be received 90 days after expiration.
Caps
Lower bound. Theoretically, no option will sell for less than its
intrinsic value and no option can take on a negative value.
This means that the lower bound for any option is zero for both
American and European options.
This makes sense because no one would pay a price for the right to
buy an asset that exceeded the asset’s value. It would be cheaper to
simply buy the underlying asset.
Put Option value bounds
Upper bound for put options. The price for an American put option
cannot be more than its strike price.
This is the exercise value in the event the underlying stock price
goes to zero.
Even if the stock price goes to zero, and is expected to stay at zero,
the intrinsic value, X, will not be received until the expiration date.
Valuing call options
A long discount bond priced to yield the risk-free rate that pays X
at option expiration.
c0 – S0 + X / (1+RFR)T ≥ 0
Given two puts that are identical in all respects except exercise
price, the one with the higher exercise price will have at least as
much value as the one with the lower exercise price.
Similarly, given two calls that are identical in every respect except
exercise price, the one with the lower exercise price will have at
least as much value as the one with the higher exercise price.
For American options and in most cases for European options, the longer
the time to expiration, the greater the time value and, other things equal,
the greater the option’s premium (price).
For far out-of-the-money options, the extra time may have no effect, but
we can say the longer-term option will be no less valuable that the
shorter-term option.
The case that doesn’t fit this pattern is the European
put.
The minimum value of an in-the-money European put
at any time t prior to expiration is X/(1+RFR)T-t – St.
While longer time to expiration increases option value
through increased volatility, it decreases the present
value of any option payoff at expiration.
For this reason, we cannot state positively that the
value of a longer European put will greater than the
value of a shorter-term put.
If volatility is high and the discount rate low, the extra time value
will be the dominant factor and the longer-term put will be more
valuable.
Low volatility and high interest rates have the opposite effect and
the value of a longer-term in-the-money put option can be less than
the value of a shorter-term put option.
Put Call Parity
When the put is the money, the call is out of the money, both
portfolios pay X at expiration.
Similarly, when the put is out of the money and the call is in the
money, both portfolios pay S at expiration.
Problem
A stock is selling at $40, 3 month $50 put is selling for $11, a 3
month $50 is selling $1. The risk free rate is 6%. How much can be
made on arbitrage.
Solution
Portfolio 1 : Fiduciary call
Buy Call, Invest in Bond
Investment = 1 + 50/(1+.06).25 = 50.28
Portfolio 2 : Protective put
Buy stock, Buy put
Investment = 40 + 11 = 51
So profit from arbitrage = 51 – 50.28= 0.72
Problem
The current stock price is $52 and the risk free rate is i5%. A
3month $50 put is quoting at $1.50. Estimate the price for a 3 month
$50 call.
Solution
Fiduciary call : C + 50 / (1+.05).25
Protective put : 52 + 1.5
To prevent arbitrage, we write:
C + 50/(1+.05).25 = 52 + 1.5
Or C = 53.5 – 40.39
= 4.11
Problem
The current stock price is $53 and the risk free rate is 5%. A 3 month
European $50 call is quoting $3. What is the price of a 3 month $50
put?
Solution
To prevent arbitrage, we write:
C + 50/(1+.05).25 = 53 + P
Or P = 53 – 3 - 49.39
= 0.61
Options trading in India
If the contract is not traded in the last half an hour, but traded
during any time of the day, then the closing price will be the last
traded price (LTP) of the contract.
If the contract is not traded for the day, the base price of the
contract for the next trading day is arrived at based on Black-
Scholes model of calculation of options premiums.