8.

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 : 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 options 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

8.4

IBM Stock Options

January 23, 1998: IBM = 99.1875 Calls Strike 90 100 Feb 10.00 2.125 Mar 11.875 4.00 Strike 90 100 Puts Feb 0.5625 4.00 Mar 1.375 5.125

January 28, 1998: IBM = 98.375 90 100 9.125 2.0625 10.75 3.375 90 100 0.50 3.625 1.375 4.875

Effect of Variables on Option Pricing

Variable S0 X T r D c

8.5

+ ? + +

+ ? + +

+ + + +

+ + + +

8.6

American vs. European Options

An American option is worth at least as much as the corresponding European option C c P p

8.7

Upper Bounds for Option Prices

Call options: right to buy one share of stock for a certain price
no matter what happens, the option can never be worth more than the stock C S, 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 exercise price P X, p Xe-rT

8.8

Lower Bounds for Option Prices

Non-dividend paying stocks
Call options:
European: c S Xe r (Tt ); American: C S Xe r (Tt )

Put options:
European: p X er (Tt ) S; American: P X - S

Dividend paying stocks: Call options:

European: c S - D - Xe r (Tt )

Put options:
European: p D + Xe r (Tt ) - S

8.9

Arbitrage Possibilities ?
Calls
Suppose that
c= 3 S = 52 Tt = 1 year r = 5% X = 50 D = 0

Puts
Suppose that
p= 1 S = 48 Tt = 0.25 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

Early Exercise of American Call Options

If a share of stock pays no dividends, 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 SX

8.10

S Xe-r(T-t) + Time Value

8.11

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. Suppose X =$100, T-t = 1 year, 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

8.12

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, 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

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

8.13

Put-call parity relation:

c + Xe -rT = p + S0

8.14

An Arbitrage Opportunity?
Suppose that
c= 3
S = 28 Tt = 0.5 r = 5% X = 30 D= 0

What are the arbitrage possibilities when p = 2.50 ?

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

8.16

Extensions of Put-Call Parity

American options; D = 0

S X < C P < S X e r (Tt )

European options; D > 0

c +D +X e r (Tt ) = p +S American options; D > 0 S D X < C P < S X e r (Tt )