Chapter 3: Principles of Option Pricing

Well, it helps to look at derivatives like atoms.  Split them

one way and you have heat and energy - useful stuff.  Split
them another way and you have a bomb.  You have to
understand the subtleties.

Kate Jennings
Moral Hazard, Fourth Estate, 2002, p. 8

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 1

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Important Concepts in Chapter 3

 Role of arbitrage in pricing options

 Minimum value, maximum value, value at expiration and
lower bound of an option price
 Effect of exercise price, time to expiration, risk-free rate
and volatility on an option price
 Difference between prices of European and American
options
 Put-call parity

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 2

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
“Arbitrage opportunities are quickly
eliminated by investors”
 Game 1:
 No entry fee
 3 red balls + 3 blue balls
 If you draw a red ball, you receive nothing
 If you draw a blue ball, you receive TL10
 Would you play? (Answer: YES)
 Game 2:
 Entry fee = TL4
 3 red balls + 3 blue balls
 If you draw a red ball, you receive nothing
 If you draw a blue ball, you receive TL10
 Would you play? (Suppose answer = YES)
 Game 3:
 Entry fee > TL4
 3 red balls + 3 blue balls
 If you draw a red ball, you receive nothing
 If you draw a blue ball, you receive TL20
 Would you play? (Answer SHOULD BE = YES)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 3

 Basic Notation and Terminology

 Symbols
 S0 (stock price)

 X (exercise price)
 T (time to expiration = (days until expiration)/365)
 r (see below)
 ST (stock price at expiration)
 C(S0,T,X), P(S0,T,X)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 4

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Basic Notation and Terminology (continued)
 Computation of risk-free rate (r)
 Date: May 14. Option expiration: May 21
 T-bill bid discount = 4.45, ask discount = 4.37
 Average T-bill discount = (4.45+4.37)/2 = 4.41

 T-bill price = 100 - 4.41(7/360) = 99.91425

 T-bill yield = (100/99.91425)(365/7) - 1 = 0.0457
 So 4.57 % is risk-free rate for options expiring May 21
 Other risk-free rates: 4.56 (June 18), 4.63 (July 16)
 See Table 3.1 for prices of DCRB options

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 5

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing
 Minimum Value of a Call
 C(S0,T,X) 0 (for any call)

 For American calls:

 C (S ,T,X)  Max(0,S - X)
a 0 0

 Concept of intrinsic value: Max(0,S0 - X)

Proof of intrinsic value rule for DCRB calls


 Concept of time value

 See Table 3.2 for time values of DCRB calls

 See Figure 3.1 for minimum values of calls

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 6

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)
 Maximum Value of a Call
 C(S0,T,X) S0

Intuition
 See Figure 3.2, which adds this to Figure 3.1
 Value of a Call at Expiration
 C(ST,0,X) = Max(0,ST - X)

 Proof/intuition
 For American and European options
 See Figure 3.3

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 7

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)
 Effect of Time to Expiration
 Two American calls differing only by time to
expiration, T1 and T2 where T1 < T2.
 C (S ,T ,X)  C (S ,T ,X)
a 0 2 a 0 1
 Proof/intuition

 Deep in- and out-of-the-money

 Time value maximized when at-the-money
 Concept of time value decay
 See Figure 3.4 and Table 3.2
 Cannot be proven (yet) for European calls

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 8

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)
 Effect of Exercise Price
 Effect on Option Value

 Two European calls differing only by strikes of X

1
and X2. Which is greater, Ce(S0,T,X1) or Ce(S0,T,X2)?
 Construct portfolios A and B. See Table 3.3.
 Portfolio A has non-negative payoff; therefore,
• Ce(S0,T,X1)  Ce(S0,T,X2)
• Intuition: show what happens if not true
 Prices of DCRB options conform

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 9

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)
 Effect of Exercise Price (continued)
 Limits on the Difference in Premiums
 Again, note Table 3.3. We must have

• (X2 - X1)(1+r)-T  Ce(S0,T,X1) - Ce(S0,T,X2)

• X2 - X1 Ce(S0,T,X1) - Ce(S0,T,X2)
• X2 - X1 Ca(S0,T,X1) - Ca(S0,T,X2)
• Implications
 See Table 3.4. Prices of DCRB options conform

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 10

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)
 Lower Bound of a European Call
 Construct portfolios A and B. See Table 3.5.
 B dominates A. This implies that (after rearranging)
 C (S ,T,X)  Max[0,S - X(1+r)-T]
e 0 0
 This is the lower bound for a European call

 See Figure 3.5 for the price curve for European calls

 Dividend adjustment: subtract present value of

dividends from S0; adjusted stock price is S0´
 For foreign currency calls,
 C (S ,T,X)  Max[0,S (1+)-T - X(1+r)-T]
e 0 0

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 11

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)

 American Call Versus European Call

 C (S ,T,X)  C (S ,T,X)
a 0 e 0
 But S - X(1+r)-T > S - X prior to expiration so
0 0
 C (S ,T,X)  Max(0,S - X(1+r)-T)
a 0 0
 Look at Table 3.6 for lower bounds of DCRB calls

 If there are no dividends on the stock, an American call

will never be exercised early. It will always be better
to sell the call in the market.
 Intuition

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 12

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Call Option Pricing (continued)

 Early Exercise of American Calls on Dividend-Paying

Stocks
 If a stock pays a dividend, it is possible that an
American call will be exercised as close as possible to
the ex-dividend date. (For a currency, the foreign
interest can induce early exercise.)
 Intuition
 Effect of Interest Rates
 Effect of Stock Volatility

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 13

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing
 Minimum Value of a Put
 P(S0,T,X) 0 (for any put)

 For American puts:

 P (S ,T,X)  Max(0,X - S )
a 0 0

 Concept of intrinsic value: Max(0,X - S0)

Proof of intrinsic value rule for DCRB puts


 See Figure 3.6 for minimum values of puts

 Concept of time value
 See Table 3.7 for time values of DCRB puts

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 14

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)
 Maximum Value of a Put
 P (S ,T,X)  X(1+r)-T
e 0
 P (S ,T,X)  X
a 0
 Intuition
 See Figure 3.7, which adds this to Figure 3.6
 Value of a Put at Expiration
 P(S ,0,X) = Max(0,X - S )
T T
 Proof/intuition
 For American and European options
 See Figure 3.8

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 15

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 Effect of Time to Expiration

 Two American puts differing only by time to
expiration, T1 and T2 where T1 < T2.
 Pa(S0,T2,X)  Pa(S0,T1,X)
Proof/intuition


 See Figure 3.9 and Table 3.7

 Cannot be proven for European puts

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 16

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)
 Effect of Exercise Price
 Effect on Option Value

 Two European puts differing only by X and X .

1 2
Which is greater, Pe(S0,T,X1) or Pe(S0,T,X2)?
 Construct portfolios A and B. See Table 3.8.
 Portfolio A has non-negative payoff; therefore,
• Pe(S0,T,X2)  Pe(S0,T,X1)
• Intuition: show what happens if not true
 Prices of DCRB options conform

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 17

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 Effect of Exercise Price (continued)

 Limits on the Difference in Premiums
 Again, note Table 3.8. We must have

• (X2 - X1)(1+r)-T  Pe(S0,T,X2) - Pe(S0,T,X1)

• X2 - X1 Pe(S0,T,X2) - Pe(S0,T,X1)
• X2 - X1 Pa(S0,T,X2) - Pa(S0,T,X1)
• Implications
 See Table 3.9. Prices of DCRB options conform

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 18

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 Lower Bound of a European Put

 Construct portfolios A and B. See Table 3.10.
 A dominates B. This implies that (after rearranging)
 P (S ,T,X)  Max(0,X(1+r)-T - S )
e 0 0

This is the lower bound for a European put



 See Figure 3.10 for the price curve for European

puts
 Dividend adjustment: subtract present value of
dividends from S to obtain S´

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 19

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 American Put Versus European Put

 Pa(S0,T,X)  Pe(S0,T,X)

 Early Exercise of American Puts

 There is always a sufficiently low stock price that will
make it optimal to exercise an American put early.
 Dividends on the stock reduce the likelihood of early
exercise.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 20

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 Put-Call Parity
 Form portfolios A and B where the options are
European. See Table 3.11.
 The portfolios have the same outcomes at the options’
expiration. Thus, it must be true that
 S + P (S ,T,X) = C (S ,T,X) + X(1+r)-T
0 e 0 e 0

 This is called put-call parity.

 It is important to see the alternative ways the
equation can be arranged and their interpretations.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 21

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 Put-Call parity for American options can be stated only

as inequalities: N
C a (S'0 , T, X)  X   D j (1  r)
t j

j1

 S0  Pa (S'0 , T, X)
 C a (S'0 , T, X)  X(1  r) T

 See Table 3.12 for put-call parity for DCRB options

 See Figure 3.11 for linkages between underlying asset,
risk-free bond, call, and put through put-call parity.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 22

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Principles of Put Option Pricing (continued)

 The Effect of Interest Rates

 The Effect of Stock Volatility

Summary
See Table 3.13.

Appendix 3: The Dynamics of Option Boundary Conditions: A Learning Exercise

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 23

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 24

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide 5) (Return to text slide 7)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 25

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 26

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 27

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 28

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 29

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide 8) (Return to text slide 9)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 30

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 31

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 32

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 33

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 34

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 35

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide 13) (Return to text slide 15)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 36

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 37

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 38

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 39

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide 16) (Return to text slide 17)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 40

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 41

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 42

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 43

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 44

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 45

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 46

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 (Return to text slide)

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 3: 47

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.