Session 2: Options I

C15.0008 Corporate Finance

Topics
Summer 2006
Outline
Call and put options
The law of one price
Put-call parity
Binomial valuation
Options, Options Everywhere!
Compensationemployee stock options
Investment/hedgingexchange traded and OTC
options on stocks, indexes, bonds, currencies,
commodities, etc., exotics
Embedded optionscallable bonds, convertible
bonds, convertible preferred stock, mortgage-
backed securities
Equity and debt as options on the firm
Real optionsprojects as options
Example..
Options
The right, but not the obligation to buy (call) or sell
(put) an asset at a fixed price on or before a given
date.
Terminology:
Strike/Exercise Price
Expiration Date
American/European
In-/At-/Out-of-the-Money
An Equity Call Option
Notation: C(S,E,t)
Definition: the right to purchase one share
of stock (S), at the exercise price (E), at or
before expiration (t periods to expiration).
Where Do Options Come From?
Publicly-traded equity options are not
issued by the corresponding companies
An options transaction is simply a
transaction between 2 individuals (the
buyer, who is long the option, and the
writer, who is short the option)
Exercising the option has no effect on the
company (on shares outstanding or cash
flow), only on the counterparty
Numerical example
Call option
Put option
Option Values at Expiration
At expiration date T, the underlying (stock) has market
price S
T

A call option with exercise price E has intrinsic value
(payoff to holder)



A put option with exercise price E has intrinsic value
(payoff to holder)
) , 0 max(
if 0
if
payoff E S
E S
E S E S
T
T
T T
=

s
>
=
) , 0 max(
if 0
if
payoff
T
T
T T
S E
E S
E S S E
=

>
<
=
Call Option Payoffs
Payoff
S
T
E
Long Call
Payoff
S
T
E
Short Call
Put Option Payoffs
Payoff
S
T
E
Long Put
Payoff
S
T
E
Short Put
E
E
Other Relevant Payoffs
Payoff
S
T
Stock
Payoff
S
T
Risk-Free Zero Coupon Bond
Maturity T, Face Amount E
E

The Law of One Price
If 2 securities/portfolios have the same payoff
then they must have the same price
Why? Otherwise it would be possible to make an
arbitrage profit
Sell the expensive portfolio, buy the cheap
portfolio
The payoffs in the future cancel, but the
strategy generates a positive cash flow today
(a money machine)
Put-Call Parity
Stock + Put
Payoff
S
T
E
Payoff
S
T
E
E
=
Payoff
S
T
E
Call +Bond
Payoff
S
T
E
E
=
Put-Call Parity
Payoffs:
Stock + Put = Call + Bond

Prices:
Stock + Put = Call + Bond
Stock = Call Put + Bond
S = C P + PV(E)
Introduction to binomial trees
What is an Option Worth?
Binomial Valuation
Consider a world in which the stock can take on
only 2 possible values at the expiration date of the
option. In this world, the option payoff will also
have 2 possible values. This payoff can be
replicated by a portfolio of stock and risk-free
bonds. Consequently, the value of the option must
be the value of the replicating portfolio.
Payoffs
Stock
100
137
73
Bond (r
F
=2%)
100
102
102
Call (E=105)
C
32
0
1-year call option, S=100, E=105, r
F
=2% (annual)
1 step per year
Can the call option payoffs be replicated?
Replicating Strategy
Buy share of stock, borrow $35.78 (at the risk-free rate).
Cost
(1/2)100 - 35.78 = 14.22
Payoff
()137 - (1.02) 35.78 = 32
Payoff
()73 - (1.02) 35.78 = 0
The value of the option is $14.22!
Solving for the Replicating Strategy
The call option is equivalent to a levered position in the
stock (i.e., a position in the stock financed by borrowing).
137 H - 1.02 B = 32
73 H - 1.02 B = 0
H (delta) = = (C
+
- C
-
)/(S
+
- S
-
)
B = (S
+
H - C
+
)/(1+ r
F
) = 35.78

Note: the value is (apparently) independent of probabilities
and preferences!
Multi-Period Replication
Stock
100
80
125
100
156.25
64
Call (E=105)
0
51.25
0
C
+
C
-
1-year call option, S=100, E=105, r
F
=1% (semi-annual)
2 steps per year
Solving Backwards
Start at the end of the tree with each 1-step binomial
model and solve for the call value 1 period before the
end




Solution: H = 0.911, B = 90.21 C
+
= 23.68
C
-
= 0 (obviously?!)

125
100
156.25
0
51.25
r
F
= 1%
C
+
The Answer
Use these call values to solve the first 1-step binomial
model




Solution: H = 0.526, B = 41.68 C = 10.94
The multi-period replicating strategy has no intermediate
cash flows

100
80
125
0

23.68

r
F
= 1%
Building The Tree
S
S
+
S
-
S
--
S
+-
S
++
S
+
= uS
S
-
= dS
S
++
= uuS
S
--
= ddS
S
+-
= S
-+
= duS = S
The Tree!
u =1.25, d = 0.8
100
80
125
100
156.25
64
Binomial Replication
The idea of binomial valuation via
replication is incredibly general.
If you can write down a binomial asset
value tree, then any (derivative) asset
whose payoffs can be written on this tree
can be valued by replicating the payoffs
using the original asset and a risk-free,
zero-coupon bond.
An American Put Option
What is the value of a 1-year put option with
exercise price 105 on a stock with current price
100?

The option can only be exercised now, in 6 months
time, or at expiration.

o = 31.5573% r
F
= 1% (per 6-month period)
Multi-Period Replication
Stock
100
80
125
100
156.25
64
Put (E=105)
5
0
41
P
+
P
-
Solving Backwards
125
100
156.25
r
F
= 1%
5
0
P
+
H = -0.089, B = -13.75 P
+
= 2.64
80
64
100
41
5
P
-
r
F
= 1%
H = -1, B = -103.96 P
-
= 23.96 25!! -------
The put is worth more dead (exercised) than alive!
The Answer
100
80
125
25.00

2.64

r
F
= 1%
H = -0.497, B = -64.11 P = 14.42
Assignments
Reading
RWJ: Chapters 8.1, 8.4, 22.12, 23.2, 23.4
Problems: 22.11, 22.20, 22.23, 23.3, 23.4,
23.5
Problem sets
Problem Set 1 due in 1 week