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**Properties of Stock Options
**

Chapter 8

Notation • c : European call option price • p : European put option price • S0 : Stock price today • • • X : Strike price T : Life of option σ: Volatility of stock price 8.2 • C : American Call option • • • price P : American Put option price ST :Stock price at option maturity D : Present value of dividends during option’s life r : Risk-free rate for maturity T with cont comp • .

8.3 Assumptions • There are no transaction costs • All trading profits (net of trading losses) are subject to the same tax rate • Borrowing and lending are possible at the risk-free rate of interest • Interest rates are continuously compounded .

00 2. 1998: IBM = 99.75 3. 1998: IBM = 98.375 90 100 9.625 1.1875 Calls Strike 90 100 Feb 10.875 4.8.375 90 100 0.0625 10.375 4.00 Mar 1.125 2.125 January 28.00 Strike 90 100 Puts Feb 0.5625 4.50 3.125 Mar 11.375 5.4 IBM Stock Options January 23.875 .

5 + – ? + + – – + ? + – + p C + – + + + – – + + + – + P .Effect of Variables on Option Pricing Variable S0 X T σ r D c 8.

European Options An American option is worth at least as much as the corresponding European option C≥ c P≥ p .6 American vs.8.

p ≤ Xe-rT . the option can never be worth more than the exercise price P ≤ X.8.7 Upper Bounds for Option Prices • Call options: right to buy one share of stock for a certain price – no matter what happens. c ≤ S • Put options: right to sell one share of stock for a certain price – no matter what happens. the option can never be worth more than the stock C ≤ S.

S • Dividend paying stocks: – Call options: • European: c ≥ S .S . American: P ≥ X .8 Lower Bounds for Option Prices • Non-dividend paying stocks – Call options: • European: c ≥ S – Xe –r (T–t ).8.D .Xe –r (T–t ) – Put options: • European: p ≥ D + Xe –r (T–t ) . American: C ≥ S – Xe –r (T–t ) – Put options: • European: p ≥ X e–r (T–t ) – S.

8.25 r = 5% X = 50 D = 0 • Is there an arbitrage possibility ? – Check lower and upper bounds • Is there an arbitrage possibility ? – Check lower and upper bounds .9 Arbitrage Possibilities ? Calls • Suppose that – c= 3 – S = 52 – T–t = 1 year – r = 5% – X = 50 – D = 0 – – – – – – Puts • Suppose that p= 1 S = 48 T–t = 0.

Early Exercise of American Call Options If a share of stock pays no dividends.10 S – Xe-r(T-t) + Time Value . it is never optimal to exercise the American call option early Strategies for realizing the gain in an I n-the-M oney Am erican Option Strategy Exercise the option early Sell the option Gain S–X 8.

T-t = 1 year. • Suppose X =$100.11 Early Exercise of an American Put Option (non dividend and dividend stocks). • Early exercise of an American put option will be optimal if the price of the stock option falls sufficiently below the exercise price. r =20% – S = $10 – S = $20 • You must weigh the benefits of early exercise with profits you may be giving up by selling the stock today instead of later .8.

8. we can solve for a put premium and vice versa • Consider the following 2 portfolios (same time to maturity and strike price for each option): – Portfolio A: European call on a stock + present value of the strike price in cash – Portfolio B: European put on the stock + the stock .12 Put-Call Parity (No Dividends ) • We have shown two option premiums – premiums for calls – premiums for puts • Put-call parity for European options – if we know the premium on for a call option.

13 Put-call parity relation: c + Xe -rT = p + S0 .Put-Call Parity for European Options (no dividends) Portfolios Portfolio 1: Call + present value of strike c + Xe-rT Portfolio 2: Put + Share of stock p+S ST < = X ST > X 8.

14 An Arbitrage Opportunity? • Suppose that – c= 3 – – – – – S = 28 T–t = 0.8.50 ? .5 r = 5% X = 30 D= 0 • What are the arbitrage possibilities when p = 2.

8.15 An Arbitrage Opportunity? Action Buy Put Buy Stock Sell Call Borrow present value of strike Cash Flows Cash flow Today S(T-t) < = X S(T-t) > X .

D > 0 S –D –X < C –P < S –X e –r (T–t ) .16 Extensions of Put-Call Parity • American options. D = 0 S –X < C –P < S –X e –r (T–t ) • European options.8. D > 0 c +D +X e –r (T–t ) = p +S • American options.

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