Investments
Lesson 5:
Options
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( textbook: chapter 20, 21)
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Outline
• Option definition & Value of Options at
Expiration
• Option Strategies
• Put – Call Parity
• Option Valuation
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Option
Terminology
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Option Terminology
• Buy - Long
• Sell - Short
• Call
• Put
• Key Elements
• Exercise or Strike Price
• Premium or Price
• Maturity or Expiration
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• A call option gives its holder the right to purchase an asset for
a specified price, called the exercise or strike price, on or before
some specified expiration date.
(See example 20.1 page 659)
• A put option gives its holder the right to sell an asset for
a specified exercise or strike price on or before some
expiration date.
(See example 20.2 page 659)
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Market and Exercise Price
Relationships
In the Money - exercise of the option would be
profitable.
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option would not be
profitable.
Call: market price<exercise price
Put: exercise price<market price
At the Money - exercise price and asset price are equal.
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American vs. European Options
American - the option can be exercised at any time before expiration or
maturity.
European - the option can only be exercised on the expiration or
maturity date.
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Value of Options at
Expiration
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Payoffs and Profits at Expiration -
Calls
Notation
Stock Price = ST Exercise Price = X
Payoff to Call Holder
(ST - X) if ST >X
0if ST < X
Profit to Call Holder
Payoff - Purchase Price
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Payoffs and Profits at Expiration -
Calls
Payoff to Call Writer
- (ST - X) if ST >X
0 if ST < X
Profit to Call Writer
Payoff + Premium
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Figure 20.2 Payoff and Profit to Call Option
at Expiration
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Figure 20.3 Payoff and Profit to Call Writers
at Expiration
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Payoffs and Profits at Expiration -
Puts
Payoffs to Put Holder
0 if ST > X
(X - ST) if ST < X
Profit to Put Holder
Payoff - Premium
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Payoffs and Profits at Expiration -
Puts
Payoffs to Put Writer
0 if ST > X
-(X - ST)if ST < X
Profits to Put Writer
Payoff + Premium
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Figure 20.4 Payoff and Profit to Put Option
at Expiration
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Option Strategies
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Option Strategies
Protective put
Covered calls
Straddle
Spreads
Collars
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Option Strategies
Protective put: investing in a stock and purchasing a put option
on the stock
Covered calls: the purchase of a share of stock with a
simultaneous sale of a call option on that stock
Straddle: buying a call and a put on a stock, each with the
same exercise price, X, and the same expiration date, T
Spreads: A combination of two or more call options or put
options on the same asset with differing exercise prices or
times to expiration
Collars: strategy that brackets the value of a portfolio
between two bounds
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Option Strategies-Spreads
Spreads - A combination of two or more call
options or put options on the same asset with
differing exercise prices or times to expiration.
Vertical or money spread:
Same maturity
Different exercise price
Horizontal or time spread:
Different maturity dates
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Protective Put
Investing in a stock and purchasing a put option on the
stock
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Table 20.1 Value of a Protective Put
Position at Option Expiration
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Figure 20.6 Value of a Protective Put
Position at Option Expiration
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Figure 20.7 Protective Put versus Stock
Investment (at-the-money option)
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Covered Calls
The purchase of a share of stock with a
simultaneous sale of a call option on that stock
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Table 20.2 Value of a Covered Call Position
at Expiration
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Figure 20.9 Value of a Covered Call
Position at Expiration
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Straddle
Buying a call and a put on a stock, each
with the same exercise price, X, and the
same expiration date, T
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Table 20.3 Value of a Straddle at Option
Expiration
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Figure 20.9 Value of a Straddle at
Expiration
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Spreads
A spread is a combination of two or more call
options (or two or more puts) on the same stock
with differing exercise prices or times to maturity.
Some options are bought, whereas others are
sold, or written.
A money spread involves the purchase of one
option and the simultaneous sale of another with a
different exercise price.
A time spread refers to the sale and purchase
options with differing expiration dates.
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Table 20.4 Value of a Bullish Spread
Position at Expiration
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Figure 20.10 Value of a Bullish Spread
Position at Expiration
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Collars
Strategy that brackets the value of a portfolio
between two bounds
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Put Call Parity
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Put Call Parity
C + X / (1 + rf)T = S0 + P
If the prices are not equal arbitrage will
be possible.
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Put Call Parity - Disequilibrium
Example
Stock Price = 110 Call Price = 17
Put Price = 5 Risk Free = 5%
Maturity = 1 yr X = 105
C + X / (1 + rf)T > S0 + P
117 > 115
Since the leveraged equity is less expensive, acquire
the low cost alternative and sell the high cost
alternative.
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Table 20.5 Arbitrage Strategy
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Option valuation
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Option Values
• Intrinsic value - profit that could be made if the option was
immediately exercised.
• Call: stock price - exercise price
• Put: exercise price - stock price
• Time value - the difference between the option price and the intrinsic
value.
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Table 21.1 Determinants of Call Option
Values
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Binomial Option Pricing
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Binomial Option Pricing: Text Example
Page 735/1041
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Binomial Option Pricing: Text
Example
120 10
100 C
90 0
Stock Price Call Option Value
X = 110
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Binomial Option Pricing: Text
Example
Alternative Portfolio 30
Buy 1 share of stock at $100
Borrow $81.82 (10% Rate) 18.18
Net outlay $18.18
Payoff 0
Value of Stock 90 120 Payoff Structure
Repay loan - 90 - 90 is exactly 3 times
Net Payoff 0 30 the Call
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Binomial Option Pricing: Text
Example
30 30
18.18 C
0 0
3C = $18.18
C = $6.06
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Replication of Payoffs and Option
Values
Alternative Portfolio - one share of stock and 3 calls written (X = 110)
Portfolio is perfectly hedged
Stock Value 90 120
Call Obligation 0 -30
Net payoff 90 90
Hence 100 - 3C = 81.82 or C = 6.06
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Why three call option?-The hedge
ratio
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Why three call option?-The hedge
ratio
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Arbitrage if the option is mispriced
What if the option is underpriced?
Reverse the arbitrage strategy
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Valuation of Put option
Excersice 9,10: page 766,767/1041
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Valuation of Put option
Range of stock price: 80 – 130; range of Put option value 0 – 30
The hedge ratio = (30 – 0)/(130 – 80) = 3/5
The strategy: Buy 3 stocks at price of $100 and buy 5 put options
The payoffs:
Initial CFs S = 80 S = 130
Three stocks -300 240 390
5 put options -5P 150 0
300 + 5P 390 390
The value of the Portfolio = 390/1.1 = 354.545 = 300 + 5P
P = (354.545 – 300)/5 = $10.91
Put – Call Parity: S0 + P = PV(X) + C
C = S0 + P – PV(X) = 100 + 10.91 – 110/1.1 = $10.91
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