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In this chapter, we provide an introduction to options. This chapter is organized into the following sections: 1. Options and Options Markets 2. Options Pricing 3. The Option Pricing Model 4. Speculating with Options 5. Hedging with Options

Chapter 12

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**Options and Options Markets
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Options Options are specialized financial instruments that give the purchaser the right but not the obligation to do something. That is, the purchaser can do something if he/she wants to, but he/she does not have to do it. Options are a relatively new financial instruments dating back to the 1970¶s. IBM Example: IBM common stocks trades at $120, an investor has an option to buy a IBM stock for $100 through August in the current year.

Chapter 12

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**Options and Options Markets
**

There are two classes of options referred to as put and call options. You may purchase or sell either a call option or a put option. Put and call options each give buyers and sellers different rights and responsibilities as follows: Call Options The buyer of a call option has the right but not the obligation to purchase a pre-specified amount of a prespecified asset at a pre-specified price during a prespecified time period. The seller of a call option has the obligation to sell a prespecified amount of a pre-specified asset at a pre-specified price if asked to do so during a pre-specified time period.

Chapter 12

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**Options and Options Markets
**

Put Options The buyer of a put option has the right but not the obligation to sell a pre-specified amount of a pre-specified asset at a pre-specified price during a pre-specified time period. The seller of a put option has the obligation to purchase a pre-specified amount of a pre-specified asset at a prespecified price if asked to do so during a pre-specified time period.

Chapter 12

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**Options and Options Markets Terminology
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The Premium The buyer of an option pays the seller of the option a premium on the day that the agreement is entered into. The Strike Price or the Exercise Price The pre-specified price is referred to as the strike or the exercise price. Expiration The amount of time specified in the options contract. Exercise The option buyer elects to utilize his/her right.

± In the case of a call option, the buyer utilizes his/her right to buy the stock. ± In the case of a put option, the buyer utilizes her/his right to sell the stock.

Chapter 12

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Chapter 12 6 . Writing an Option The act of selling an option. Covered Call Writing call options against stock that the writer owns. American Options American options can be exercised any time prior to maturity.Options and Options Markets Terminology Option Writer The seller of an option. European Options European options can be exercised only on the maturity date. Naked Option Writing a call option on a stock that the writer does not own.

Option buyers and sellers only obligations are to the OCC. If an option is exercised. Chapter 12 7 . the OCC matches buyers and sellers.Options and Options Markets Terminology Intrinsic Value The value of an option if it is exercised immediately. and manages the completion of the exercise process. Option Clearing Corporation (OCC) Oversees the conduct of the market and helps to make the market orderly.

50 Chapter 12 8 .Call Option Example You buy a call option on 100 shares of IBM stock with a strike price of $50 per share and a premium of $2.50 per share. The option has 3 months to maturity.50 premium on the day they enter into the agreement.50 The buyer pays the seller a $2. the price of IBM stock is $49. Timeline: 0 1 2 3 -$2. Suppose that at the time you enter into the contract.

± The purchaser of the option loses the $2. ± The purchaser of the option loses the $2.50 per share premium. Suppose that after three months. Suppose that after three months the price of IBM stock has gone down to $47 per share. the buyer will not exercise his/her right to purchase the shares for $50 per share. Chapter 12 9 . gone down. B. the buyer will not exercise her/his right to purchase the shares for $50 per share.Call Option Example After three months the stock price will have either gone up. A.50 per share. ± The option will expire worthless: that is. the price of IBM stock has stayed at $49. or stayed the same. ± The option will expire worthless: that is.50 per share premium.

Thus the purchaser makes a profit Chapter 12 10 .Call Option Example C. Suppose that after three months. the price of IBM stock has gone up to $70 per share. ± The purchaser of the option will exercise his/her right to purchase 100 shares for $50 per share. ± The purchaser will then go to the market to sell his/her share of stock for $70 per share. In this case. the buyer of the call option will exercise his option.

The option has 3 months to maturity. Timeline: 0 1 2 3 -$2.50 Chapter 12 11 . the price of IBM stock is $50.50 premium on the day they enter into the agreement.50 The buyer pays the seller a $2.50 per share.Put Option Example You buy a put option on 100 shares of IBM stock with a strike price of $50 per share and a premium of $2. Suppose that at the time you enter into the contract.

± The purchaser of the put option makes a profit B. the buyer will purchase the stock for $45 in the market and sell it using the put option for $50. gone down.Put Option Example After three months the stock price will have either gone up.50 per share premium. A. the price of IBM stock has stayed at $50. Chapter 12 12 . Suppose that after three months. Suppose that after three months the price of IBM stock has gone down to $45 per share. ± The purchaser of the option loses the $2. or stayed the same. ± The option will expire worthless: that is. ± The buyer of option will exercise her/his option to sell the stock for $50.50 per share. the buyer will not exercise her/his right to sell the shares for $50 per share. ± Thus.

± The purchaser of the option loses $2. Suppose that after three months. ± The option will expire worthless: that is. In this case. the price of IBM stock has gone up to $70 per share.Put Option Example C. Chapter 12 13 . the buyer will not exercise his/her right to sell the shares for $50 per share.50 per share premium. the buyer of the put option will not exercise his/her option.

liffe ( Amsterdam. & L don) Chapter 12 14 .Option Exchanges Table12.1 Principal Options Exchanges and Option Traded Exchange Option Traded Panel 1: Options Exchanges in the United States Chicago Board Options Exchange (CBOE) Options on n i i a toc s Long er Options on n i i Options on toc n exes Options on nterest ates a toc s American Stock Exchange (AMEX) Options on n i i a toc s Long er Options on n i i a toc s Options on toc n exes Options on Exchange ra e F n s Options on n i i a toc s Long er Options on n i i Options on toc n exes Options on Foreign C rrenc Options on n i i a toc s Long er Options on n i i Options Options Options Options Options Options Options Options a toc s Philadelphia Stock Exchange (PHLX) Pacific Exchange (PSE) a toc s International Securities Exchange (ISE Boston Options Exchange (BOX) Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) New York Mercantile Exchange (NYMEX) New York Board of Trade (NYBOT) Kansas City Board of Trade (KCBT) Minneapolis Grain Exchange (MGE) on n i i a toc s on n i i a toc s on t res tra e at the on t res tra e at the on t res tra e at on t res tra e at the on t res tra e at the on t res tra e at the C E C O EX O KC GE Panel 2: Key Options Exchanges Outside the United States Eurex (Ger an an ¡ it er an ) ¥ ¦ ¢ Options on in i i a stoc s Options on t res aris & Lon on) ¢ © Euronext ( r sse s § ¨ ¦ ¢ © £ ¤ ster a ¢ Options in i i a stoc s Options on toc n exes Option on nterest rates Options on futures © Euronext. Paris.

1 here Chapter 12 15 .Option Quotations Insert igure 12.

Thus. a call price can be expressed using: C(S. t) Chapter 12 16 . E.Option Pricing ive factors affect the price of options on stocks without cash dividends: Factor Name S E T r tock Price ercise Price i e Voati it of Under ine tock tandard Deviation isk ree nterest ates Call Put Option Option + + + + + + + This section considers the effects of the first three factors.

E. Chapter 12 17 . regarding the relationship between the exercise price (E) and the stock price (S).Pricing Call Options at Expiration First principle of option pricing At expiration. Two possibilities may arise. This quantity is referred to as the intrinsic value of the option: C(S. S E S>E Where t = 0. S . whichever is greater. a call option must have a value that is equal to zero or to the difference between the stock price and the exercise price. 0) = max(0.E) If this condition does not hold. an arbitrage opportunity exists.

S-E) Max(0. the call option has no value. The option is about to expire. Max(0.Pricing Call Options at Expiration First Possibility: S E Example: A call option with an exercise price of $80 on a stock trading at $70. 70-80) = 0 Chapter 12 18 . If an option is at expiration and the stock price is less than or equal to the exercise price.

Pricing Call Options at Expiration Second Possibility: S > E If the stock price is greater than the exercise price. the call option must have a price equal to the difference between the stock price and the exercise price. Max(0. An arbitrageur would make the following trades: Transaction Buy a call option Exercise the option to buy the stock Sell the stock Net Cash Flow Chapter 12 Cash Flow $ -5 -40 50 $ 5 19 . S-E) = S ± E If this relationship did not hold. Example 1: Consider a call option that is selling with an exercise price of $40 on a stock trading at $50. there would be an arbitrage opportunity. The option is selling for $5.

An arbitrageur would make the following trades: Transaction Write a call option Buy the stock Initial Cash Flow Cash Flow $ 15 . The arbitrageur¶s transactions are: Transaction Initial cash flow eliver stock Collect exercise price Net Cash Flow Cash Flow -$ 35 0 $40 $ 5 Chapter 12 20 . The option is about to expire.Pricing Call Options at Expiration Example 2: A call option with an exercise price of $40 on a stock trading at $50. The option is now selling $15.50 -$35 If owner of the call option exercises the option.

principle 1 must hold. The arbitrageur¶s transactions are: Initial cash flow Sell Stocks Net Cash Flow -$ 35 $50 $ 15 In order for these arbitrage opportunities not to exist. Chapter 12 21 .Pricing Call Options at Expiration If the owner of the call option allows the option to expire.

2 Here Chapter 12 22 . We can graph the payoff on these options as demonstrated in igure 12. Insert igure 12.2.raphical Analysis of Option alues and Profits Expiration Assume a call and a put option both with $100 striking price.

Trades had taken place for the options with premiums of $5 on each of the put and call options.3 illustrates the alternatives outcomes.3a here Chapter 12 23 . Insert igure 12. igure 12.Option alues and Profits Expiration Assume a call and a put option both with $100 striking price.

Option alues and Profits Expiration Insert igure 12.3b here Chapter 12 24 .

C(S. 0. This is because the buyer of the call option can convert his/her option into the stock and sell it. the exercise price. That is. igure 12.4 presents these boundaries. we can establish bounds for the price of an option. The bounds for the price of a call option are a function of the stock price. ) = S Combining principle #1 and #2. Chapter 12 25 . establish upper and lower limits for the price of the option. and the time to expiration.Pricing Prior to Maturity Second principle of option pricing: A call option with a zero exercise price and an infinite time to maturity must sell for the same price as the stock.

4 here Chapter 12 26 .A Call Option with Zero Exercise Price and an Infinite Time until Expiration Insert igure 12.

Relationship Between Option Prices Third principle of option pricing If two call options are alike. The relationship can be defined as follows: If E1 < E2. Chapter 12 27 . E1. except the exercise price of the first is less than that of the second. t) If this relationship does not hold. C(S. t) C(S. E2. an arbitrage profit can be earned. then the option with the lower exercise price must have a price that is equal to or greater than the price of the option with the higher exercise price.

5a creates an arbitrage opportunity and figure 12. An arbitrageur would make the following trades: Transaction Sell the option with the $100 exercise price Buy the option with the $90 exercise price Net Cash Flow Cash Flow $10 -5 $5 igures 12. The second option has an exercise price of $90 and sells for $5.Relationship Between Option Prices Example: You have two identical options. Chapter 12 28 .5b graphs the combined positions. The first option has an exercise price of $100 and sells for $10.

Relationship Between Option Prices Insert figure 12.5a here Insert figure 12.5b here Chapter 12 29 .

$5 .Relationship Between Option Prices Consider the profit and loss position on each option and the overall position for alternative stock prices that might prevail at expiration.$5 0 + $5 +$10 +$15 +$25 For E = $100 For Both +$10 +$10 +$10 +$10 + $5 0 . Profit or Loss on the Option Position Stock Price at Expiration 80 90 95 100 105 110 120 For E = $90 . Chapter 12 30 .5c.$10 + $5 + $5 +$10 +$15 +$15 +$15 +$15 The result is graphed in figure 12.

a positive profit is earned.Relationship Between Option Prices Insert figure 12. Chapter 12 31 .5c here Notice in figure 12. In order to avoid this arbitrage principle 3 must hold.5c that regardless of the ultimate stock price.

Chapter 12 32 . t2. t1. If t1 > t2. E) If the option with the longer period to expiration sold for less than the option with the shorter time to expiration. the option with the longer time to expiration must sell for an amount equal to or greater than the option that expires earlier.Relationship Between Option Prices Fourth principle of option pricing (expiration date principle) If there are two options that are otherwise alike. C(S. there would also be an arbitrage opportunity. E) C(S.

The first option has a time to expiration of 6 months and trades for $8.Relationship Between Option Prices Example: Two options on the same stock both having a striking price of $100. The second option has 3 months to expiration and trades for $10. igure 12.6 illustrate this Chapter 12 33 . An arbitrageur would make the following transactions: Transaction Buy the 6-month option for $8 Sell the 3-month option for $10 Net Cash Flow Cash Flow -$ 8 $10 $ 2 The option with the longer time to expiration must be worth more than the option with the shorter time to expiration.

6 here Chapter 12 34 .Relationship Between Option Prices Insert figure 12.

000 pure discount bond maturing in one year. current value $10.000 or $11. One option contract. with a current value of $8. Over the next year.000) The risk-free rate of interest is 12%.000. with an exercise price of $100/share ($10.2 illustrates the impact of price changes on each portfolio.000/ entire contract) Table 12. A $10. Chapter 12 35 .929 (P with 12% interest rate).Call Option Prices and Interest Rates Example: Assume that a stock now sells for $100. its value can change by 10% in either direction (100 shares equal to $9. Assume two portfolios: Portfolio A Portfolio B 100 shares of stock. A call option exists with a striking price of $100/share and expiration one year from now.

000 $10. Portfolio B is worth $1. If the stock price goes down.071 (1.Call Option Prices and Interest Rates Table 12.2 Portfolio Values in One Year Stock Price Change +10% Portfolio A Stock Portfolio B Maturing Bond Call Option $11. This implies that the value of the option should be at least: u (E) Present Value $10. Portfolios A and B have the same value. If the stock price goes up.000 B10% $9.000 more than Portfolio A.000 $1.000 = $1.000 - Chapter 12 36 .000 0 Portfolio B is the best portfolio to hold.000 $10.12) C u $10.

the higher the value of call option. E. C(S.Call Option Prices and Interest Rates Fifth principle of option pricing Other things being equal. So the higher the interest rate.000 = $1.E at expiration or: C uS r s t l (E) The call price must be greater than or equal to the stock price minus the present value of the exercise price. sing the data from previous example. the greater must be the price of a call option. r1) C(S.000 $10. t. t. now assume that interest rates goes up to 20%. E.20) Chapter 12 37 . Thus. the interest rate principle can be expressed as: If r1 > r2. r2) Recall that the price of the call must be either zero or S . The new value of the option should be: C u $10.667 (1. the higher the risk-free rate of interest.

Thus the sixth principle can be stated as: If 1 > 2. 2) Other things being equal. E. t.Prices of Call Options and The Riskiness of Stocks Sixth principle of option pricing (the risk principle) The riskier the stock on which an option is written. the greater will be the value of a call option. Chapter 12 38 . 1) C(S. C(S. a call option on a riskier good will be worth at least as much as a call option on a less risky good. t. E. r. r.

000 $10.000 B20% $8. $10.000 $1. Table 12.000 B10% $10.000 $2.000 $10.000 0 Stock Price Change +20% Portfolio A Stock Portfolio B Maturing Bond Call Option $12.000 0 Chapter 12 39 . the call option must be worth at least $1.3 shows the impact that stock price changes have on option prices.Prices of Call Options and The Riskiness of Stocks Table 12.071.3 Portfolio Values in O ne Year Stock Price Change +10% Portfolio B Maturing Bond Call Option In Portfolio B.

To reflect this. E. t. Chapter 12 40 . plus the value of the insurance policy (I) inherent in the option or: C(S. ) = S .Present alue(E) I Option pricing models can be used to determined the insurance policy value. Holding the options insures that the worst outcome from the investment will be $10.3. The insurance character of the option can be seen by comparing the payoffs from Portfolio A and B from Table 12.000. options have an inherent insurance policy.Option Pricing Model Recall that the price of an option must be at least as great as the stock price minus the present value of the exercise price. r. the value of the option must be equal to the stock price minus the present value of the exercise price. However.

Option Pricing Model (OPM) The Black and Scholes Option Pricing Model (OPM) assumes that stock prices follow a stochastic process or Wiener process. Where a stochastic process is a mathematical description of the change in the value of some variable through time. igure 12.7 shows a graph of the path that stock prices might follow if they followed a Wiener process. Wiener process shows that the changes over any given time interval are distributed normally. Chapter 12 41 .

7 here Chapter 12 42 .Option Pricing Model (OPM) Insert figure 12.

Option Pricing Model (OPM) The Black-Scholes OPM is given by: C = SN(d1) . N (d 2 ) ! cumulative normal probability values of d1 and d 2 Where S -E t r = = = = = stock price exercise price time to expiration risk-free interest rate variability of the stock Chapter 12 43 .5W 2 t d1 ! W t ? A d 2 ! d1 W t N (d1 ). If we know the value of the following variables: ln( S / E ) r .E -rt N(d2) The Black-Scholes OPM can be used to calculate the theoretical price of an option.

15 Chapter 12 44 .1)(1) ! 1.5W 2 t W t ln(100 / 100) ! ?12 .5(.1 d 2 ! d1 W t d 2 ! 1.Option Pricing Model (OPM) Example: assume the following values: S E t r = = = = = $100 $100 1 year 12% 10% Step 1: calculate the values for d1 and d2.25 .1)(1) d1 ! ? A d1 ! d1 ! 0 . 1 (.25 (.01)A . ln( S / ) r .1250 ! 1.

$100 (.15) = .E -rt N(d2) C = $100 (.$77.25) = .$100 -(. Chapter 12 45 .44 .8944 = N(1.8749) C = $89.44 .2 that option value was $10.12)(1) (.8749) C = $89.8944) .84 Recall form Table 12.8749 Step 3: calculate the call option price using OPM C = S N(d1) .71.84 The value of the option is $11. The difference is due to the value of the insurance policy that is captured by the Black-Scholes OPM.Option Pricing Model (OPM) Step 2: calculate N(d1) and N(d2) The cumulative normal probability can be obtained from tables that are widely available or by using the excel function: ³=normsdist(d)´ Using a standardized normal probability distribution table N(d1) N(d2) = N(1.8869) (.60 = $11.

we can infer the corresponding value of a put option by utilizing a concept called Put-Call Parity.The alue of Put Options and Put-Call Parity While the Black-Schole OPM applies to call options. The Put-Call Parity tells us that the value of a put option can be computed as follows: P! E S C t .

12) Chapter 12 46 . suppose a stock is trading for $100 per share.$100 + $11. we have computed the value of a call option with a $100 striking price to be $11. The value of the put option is computed as: P $100 .13 (1.84 $1. The interest rate is 12%. Using the Black-Scholes OPM.84.1 r For example.

spreads and straddles. straps. what would be the effect of a 1% change in stock prices? What are the speculating opportunities? Original Values 1% Increase S = $100 C = $11.95 Options can be used to take very low risk speculative positions by using options in combinations.84 S = $101 C = $12. including combinations called strips. Chapter 12 47 . The combinations are virtually endless.73 1% Decrease S = $99 C$10.Speculating with Options Using our prior calculations.

P u ts. T ab le 12.5 shows the payoff on the straddle at various stock prices. The call trades for $40 and the put for $7. both with an exercise price of $100. the investor buys both call and put options. Table 12. To buy a straddle.5 P ayo ffs fo r C alls. an d a S trad d le at E xp iratio n Stock Price at Expiration $50 $80 $83 $85 $90 $95 $100 $105 $110 $115 $117 $120 $150 Call Profit/Loss B$10 B$10 B$10 B$10 B$10 B$10 B$10 B$ 5 0 +$ 5 +$ 7 +$10 +$40 Put Profit/Loss +$43 +$13 +$10 +$ 8 +$ 3 B$ 2 B$ 7 B$ 7 B$ 7 B$ 7 B$ 7 B$ 7 B$ 7 Straddle Profit/Loss +$33 +$ 3 0 B$ 2 B$ 7 B$12 B$17 B$12 B$ 7 B$ 2 0 +$ 3 +$33 Note: Profit/Loss figures reflect the amounts paid for the instruments: Call = $10 Put = $7 Straddle = Call + Put = $17 Chapter 12 48 . Consider a call and put option.Speculating with Options A straddle is a combination of positions involving a put and a call option on the same stock.

9.Speculating with Options The payoff is graphically displayed in Figure 12. Insert figure 12.9 here Chapter 12 49 .

000 shares (100 contracts) B $118.000 Stock Price Rises by 1%: S = $101 C = $12.84 8. at $11.6 A H edged P ortfolio Original Portfolio: S = $100 C = $11.6 shows a hedged portfolio.944 shares of stock $885. Consider an original portfolio comprised of 8.73 8. Table 12.044 Stock Price Falls by 1%: S = $99 C = $10.944 shares of stock selling at $100 per share and assume that a trader sells 100 option contracts.300 Total Value $776.000 shares (100 contracts) B $127.95 8.84.944 shares of stock $894. or options on 10.944 shares of stock $903.400 Total Value $776.400 A short position for options on 10.456 A short position for options on 10. The entire portfolio would have a value of $776. Table 12. Chapter 12 50 .000.956 Notice that by hedging.500 Total Value $775. the value of the portfolio did not change as a result of the change in stock prices.000 shares.000 shares (100 contracts) B $109.Hedging with Options Options can be used to control risk.344 A short position for options on 10.

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