Section 4

Financial Derivatives Section 4
Introduction to Option Pricing
Michail Anthropelos anthropel@webmail.unipi.gr http://web.xrh.unipi.gr/faculty/anthropelos/ University of Piraeus
Spring 2011
M. Anthropelos (Un. of Piraeus)
Intro to Option Pricing
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Outline
Factors that Aect Option Prices
Arbitrage Bounds No dividend case The Eect of Dividend
Strategies with Options and further Arbitrage Bounds
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Outline
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Pricing and Assumptions

The option pricing
The question is simple: How should we determine the price of an option? The pricing of options is one of the most important and challenging problem in nance.
Assumptions
Throughout the following sections, we are going to impose the following standard assumptions:
1 2 3
There is no arbitrage opportunity in the market. There are no transaction costs. Borrowing and lending at the same risk-free interest rate is possible.
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Main Factors that Aect Option Pricing
Option pricing... rst steps

We should rst ask which are the main factors that aect the option prices.
Main factors
Price of the underlying asset. Strike price. Risk-free interest rate. Volatility of the underlying asset price. Dividend paid by the underlying asset until maturity. Time to maturity.
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Notation
S(t): K: T t: r: D(t): q: c(t): p(t): C (t): P(t):
Spot price at time t. Strike price. Time to maturity. Risk-free interest rate (continuously compounded). Present value (at time t) of dividend given by the underlying asset until maturity T . Dividend yield given by the underlying asset until maturity. Price of the European call option at time t. Price of the European put option at time t. Price of the American call option at time t. Price of the American put option at time t.
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Option Price vs Spot Price
Intrinsic value of a call option = max{S(t) K , 0}. Call options become more valuable as the spot price increases. Call options become less valuable as the strike price increases. Intrinsic value of a put option = max{K S(t), 0}. Put options become less valuable as the spot price increases. Put options become more valuable as the strike price increases.
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Option Price vs Spot Price
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Option Price vs Strike Price
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Option Price vs Risk-free Interest Rate
As the risk-free interest rate increases, the present value of the strike price decreases. Normally,
The buyer of the call option is going to pay this amount. The buyer of the put option is going to receive this amount.
Hence, an increase in interest rates (ceteris paribus) means: Increase of the call option prices. Decrease of the put option prices.
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Option Price vs Risk-free Interest Rate
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Option Price vs Volatility
The volatility, usually denoted by , is dened so that t is the standard deviation of the return on the asset price in a short length of time t.
What is volatility?
Facts about volatility

Volatility is a measure of the uncertainty (riskness) on the future prices of the underlying asset. As volatility increases, the chances that the stock price will moves substantially (upwards or downwards) increases. The volatility of the price of the underlying asset is its most... interesting feature.
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Option Price vs Volatility, contd
Volatility and option prices

As the volatility increases: the owner of the call benets from price increases but has limited downside risk in the event of price decreases, similarly, the owner of the put benets from the price decreases but has limit downside risk in the event of price increases. As volatility increases both call and put price increase. This eect is more intense for ATM options. (why?)
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Option Price vs Volatility
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Option Price vs Dividend
Dividends reduce the price of the underlying asset on the ex-dividend date. This simply means that: Anticipated dividend is negatively related to the call option. Anticipated dividend is positively related to the put option.
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Option Price vs Dividend
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Option Price vs Time to Maturity
Three simultaneous eects

An increase on the time-to-maturity aects the option prices in three ways:
1
More time to maturity means more (aggregated) volatility. This makes c(t) and p(t) increase. More time to maturity means more interest rate involved. This makes c(t) increase and p(t) decrease. More time to maturity means more dividend paid. This makes c(t) decrease and p(t) increase.
The net result of the above inuences is not known a priori.
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Option Price vs Time to Maturity (example)
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American Call Options and Time to Maturity
The dividend factor

There are two cases: When no dividend is paid, an increase in time to maturity increases the American call option price. In fact, as we will see, there is an equality between the price of the European and the American call, in the case of no dividend. When dividend is paid, an increase in time to maturity increases the American call option price up to ex-dividend day. Theoretically, as we will see, this is the only case to consider the early exercise of an American call.
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American Put Options and Time to Maturity
The dividend factor

Again we have two cases: When no dividend is paid
and the eect of interest rate is greater than the oppositely directed eect of volatility, P decreases which means that an early exercise is preferable. Otherwise, P increases, which means that the early exercise is not protable.
When dividend is paid, the early exercise is preferable after the ex-dividend date.
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A Synopsis
The following table shows the eect on the option prices that an increase of the corresponding factor has (ceteris paribus). Variable S(t) K T r D(t) c(t) p(t) C (t) P(t)
Depends
Depends
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Outline
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Call Option Bounds
Upper bounds
c(t) S(t) and C (t) S(t) If we assume that this is not the case, a clear arbitrage opportunity emerges: Now: Sell the option and buy the stock: c(t) S(t) > 0. At maturity: Total payo = S(T ) max{S(T ) K , 0} > 0.
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Call Option Bounds contd

Lower bounds
c(t) max{S(t) Ke r (T t) , 0} and C (t) max{S(t) Ke r (T t) , 0} It is clear that c(t), C (t) 0, since they are...options. Suppose that c(t) < S(t) Ke r (T t) . This is an arbitrage: Now: Buy the call option, short the stock and invest in risk-free rate Ke r (T t) . This gives S(t) Ke r (T t) c(t) > 0 now. At maturity: Total payo = max{S(T ) K , 0} S(T ) + K 0. Which assumptions have been used for the above bounds?
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Put Option Bounds
Upper bounds
p(t) Ke r (T t) and P(t) K If we assume that p(t) > Ke r (T t) , a clear arbitrage opportunity emerges: Now: Sell the option and invest Ke r (T t) in risk-free interest rate. This gives p(t) Ke r (T t) > 0 now. At maturity: Total payo = K max{K S(T ), 0} > 0. Why K and not Ke r (T t) for the American put option?
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Put Option Bounds contd

Lower bounds
p(t) max{Ke r (T t) S(t), 0} and P(t) max{K S(t), 0} It is clear that p(t), P(t) 0, since they are...options. Suppose that p(t) < Ke r (T t) S(t). This is an arbitrage: Now: Buy the put option, buy the stock and borrow in risk-free rate Ke r (T t) . This gives Ke r (T t) p(t) S(t) > 0 now. At maturity: Total payo = max{K S(T ), 0} + S(T ) K 0. A slight change in the case of American put option price: If P(t) < K S(t), the clear arbitrage opportunity is to buy the option, buy the stock, borrow K and instantly exercise the option and return the money to the bank.
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Option Prices and their Bounds
Put-Call Parity
Two interesting portfolios
We can use non-arbitrage arguments to nd an exact relation between the prices of European call and European put option written on the same asset, strike price and maturity. Consider the following two portfolios: Portfolio A: Portfolio B: Long one European call option written on the stock and invest Ke r (T t) in the free-risk interest until T . Long one European put option and buy one stock at S(t).
The cost of Portfolio A is c(t) + Ke r (T t) . The cost of Portfolio B is p(t) + S(t).
At time T
Payo of Portfolio A is max{S(T ) K , 0} + K . Payo of Portfolio B is max{K S(T ), 0} + S(T ).
M. Anthropelos (Un. of Piraeus) Intro to Option Pricing Spring 2011 28 / 49
Put-Call Parity, contd
Relation between the put and the call prices

Payo of Portfolio A = Payo of Portfolio B The non-arbitrage assumption implies that their costs should be equal, in other words: c(t) + Ke r (T t) = p(t) + S(t) This is the (famous) put-call parity for European options. If we know the price of a European call, we know the price of the similar European put.
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Put-Call Parity, contd
What put-call parity gives:

A clear non-arbitrage relation between the call and the put price. The way to exploit the arbitrage opportunity that emerges if this parity does not hold. A way to extract the risk-free interest rate that is used. And some more that are coming...
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Put-Call Parity for American Options
As we have mentioned, the put-call parity holds only for the European options. It is also possible to derive the following relation between the American options (with no dividend involved): S(t) K C (t) P(t) S(t) Ke r (T t) The proof is left as an exercise.
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Early Exercise of American Calls: No Dividend

Never exercise American call when there is no dividend
It is never optimal to exercise an American call option before maturity if the underlying asset does not give any dividend until the maturity.
Why is that?
Consider for instance an American Call option on a non-dividend-paying stock with one month to maturity and S(0) = $50 and K = $40 (deep in the money). The option owner has the following choices: (A) Exercise the option now and keep the stock until maturity. But it is better to wait and exercise the option at maturity because: He losses interest on $40 for one month (note that there is no dividend given by the stock). There might be a decrease in the stock price below $40.
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Early Exercise of American Calls: No Dividend contd
Why is that? (contd)

(B) Exercise the option now and sell the stock, which results a payo of $10 now. In this case, it is better to just sell the option since: C (t) S(t) Ke r (T t) > S(t) K = $10.
No-dividend means:
Hence, if the underlying asset does not give any dividend until maturity, it holds that: c(t) = C (t)
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Early Exercise of American Puts: No Dividend

It may be optimal to exercise American put even when there is no dividend
Consider for instance an American put option on a non dividend paying stock with one month to maturity and S(t) = $30 and K = $40 (deep in the money). The option owner has the right to exercise the option and get $10 now and invest them until time T . By doing so the option owner: exploits the dierence K S(t), which may be lower afterwards, but losses any further increase of this dierence. Generally, there is a value S (t), and when S(t) is below S (t), the owner exercises the put. It is more attractive to exercise an American put option when: Stock price decreases. Interest rate increases. Volatility decreases.
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Dividend and Lower Bounds

European call
Suppose that the asset is going to give dividend until maturity. c(t) max{S(t) D(t) Ke r (T t) , 0} or c(t) max{S(t)e q(T t) Ke r (T t) , 0} It is clear that c(t) 0, since they are...options. Suppose that c(t) < S(t) D(t) Ke r (T t) . This is an arbitrage: Now: Buy the call option, short the stock and invest in risk-free rate D(t) + Ke r (T t) . This gives S(t) D(t) Ke r (T t) c(t) > 0 now. At maturity: Total payo = max{S(T ) K , 0} S(T ) + K 0.
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Dividend and Lower Bounds

European put
Suppose that the asset is going to give dividend until maturity. p(t) max{D(t) + Ke r (T t) S(t), 0} or p(t) max{Ke r (T t) S(t)e q(T t) , 0} It is clear that p(t) 0, since they are...options. Suppose that p(t) < D(t) + Ke r (T t) S(t). This is an arbitrage: Now: Buy the put option, buy a stock and borrow in risk-free rate D(t) + Ke r (T t) . This gives D(t) + Ke r (T t) p(t) S(t) > 0 now. At maturity: Total payo = max{K S(T ), 0} + S(T ) K 0.
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Dividend and Put-Call Parity

European call
Similar arguments as in the case of no dividend imply that: c(t) + Ke r (T t) = p(t) + S(t) D(t) or c(t) + Ke r (T t) = p(t) + S(t)e q(T t)
American call
Similarly, for the American type: S(t) D(t) K C (t) P(t) S(t) Ke r (T t) The proof of the above is an exercise.
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Dividend and Early Exercise
American call
In the case of dividend, it may be optimal for the call option owner to early exercise his option, since when the dividend is given the price of the underlying asset jumps down and this may send the option out of the money.
American put
When dividend is anticipated, the American put owner usually exercises his option after the dividend is distributed.
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Outline
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Bull and Bear Spreads

The spread
A spread trading strategy involves taking a position in two or more options of the same type. Depending on which stock prices the spread gives prot, the spreads are bull spreads and bear spreads.
The bull spread

The bull spread is created by buying a call option on a stock with certain strike price and selling a call option on the same stock with a higher strick price. This strategy has small cost and anticipates (limited) prot if stock price increases.
The bear spread

The bear spread is created by buying a call option on a stock with certain strike price and selling a call option on the same stock with a lower strick price. This strategy has small cost and anticipates (limited) prot if stock price decreases.
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Bull and Bear Spreads
Call Options with Dierent Strikes
Another arbitrage bound

Note that for strike prices K1 < K2 , it holds that: 0 < c(t; K1 ) c(t; K2 ), where c(t; K1 ) is the European call option price with strike price K1 and c(t; K2 ) is the European call option price with strike price K2 . But we also have an upper bound of this dierence: c(t; K1 ) c(t; K2 ) e r (T t) (K2 K1 )
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Two Call Options with Dierent Strikes contd

Non-arbitrage proof
Suppose that c(t; K1 ) c(t; K2 ) > e r (T t) (K2 K1 ). Here is the emerged arbitrage: Now: Buy call with strike price K2 , short the call with strike price K1 and invest e r (T t) (K2 K1 ) in the bank. This gives now c(t; K1 ) c(t; K2 ) e r (T t) (K2 K1 ) > 0. At maturity there are three possible cases:
1 2 3
If S(T ) < K1 , Payo = (K2 K1 ) > 0. If K1 S(T ) < K2 , Payo = K2 S(T ) > 0. If S(T ) K2 , Payo = 0.
In any case, we start with something positive and end up in something non-negative, i.e., an arbitrage.
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The Buttery Spread

Prot from small stock price movement
The buttery spread involves positions in options with three dierent strike prices. It can be created by: buying a call option with a relatively low strike price K1 , buying a call option with a relatively high strike price K3 and shorting two call options with strike price K2 =
K1 +K3 . 2
A buttery spread leads to a (limited) prot when the stock price stays close to K2 and it has a small cost.
Prot from large stock price movement

A reverse buttery spread gives prot when there is a signicant movement of the stock price in any direction.
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Buttery Spreads
Three Call Options with Dierent Strike Prices
An non-arbitrage inequality
For strike prices K1 < K3 and K2 =
K1 +K3 , 2
it holds that:
c(t; K2 ) 1 (c(t; K1 ) + c(t; K3 )) 2 where c(t; Ki ) is the European call option price with strike price Ki .
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Three Call Options with Dierent Strike Prices

Non-arbitrage proof
Suppose that c(t; K2 ) > 1 (c(t; K1 ) + c(t; K3 )). Here is the emerged arbitrage: 2 Now: Buy call options with strike prices K1 and K3 and short two call option with strike price K2 . This gives now 2c(t; K2 ) c(t; K1 ) c(t; K1 ) > 0. At maturity there are four possible cases:
1 2 3 4
If S(T ) < K1 , Payo = 0. If K1 S(T ) < K2 , Payo = S(T ) K1 > 0. If K2 < S(T ) K3 , Payo = K3 S(T ) > 0. If K3 < S(T ), Payo = 0.
In any case, we start with something positive and end up in something non-negative, i.e., an arbitrage.
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Strip and Strap

A strip
A strip consists of: a long position in a call option. a long position in two put options with the same strike price and the same maturity. It anticipates prot with a large movement of the stock price, especially when it has negative direction.
A strap
A strap consists of: a long position in two call options. a long position in a put option with the same strike price and the same maturity. It anticipates prot with a large movement of the stock price, especially when it has positive direction.
M. Anthropelos (Un. of Piraeus) Intro to Option Pricing Spring 2011 48 / 49
Strip and Strap

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Financial Derivatives Section 4

Introduction to Option Pricing

Michail Anthropelos anthropel@webmail.unipi.gr http://web.xrh.unipi.gr/faculty/anthropelos/ University of Piraeus

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Factors that Aect Option Prices

Arbitrage Bounds No dividend case The Eect of Dividend

Strategies with Options and further Arbitrage Bounds

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Factors that Aect Option Prices

Arbitrage Bounds No dividend case The Eect of Dividend

Strategies with Options and further Arbitrage Bounds

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Pricing and Assumptions

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Main Factors that Aect Option Pricing

Option pricing... rst steps

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

S(t): K: T t: r: D(t): q: c(t): p(t): C (t): P(t):

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Spot Price

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Spot Price

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Strike Price

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Risk-free Interest Rate

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Risk-free Interest Rate

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Volatility

Facts about volatility

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Volatility, contd

Volatility and option prices

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Volatility

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Dividend

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Dividend

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Time to Maturity

Three simultaneous eects

The net result of the above inuences is not known a priori.

M. Anthropelos (Un. of Piraeus)

Intro to Option Pricing

Option Price vs Time to Maturity (example)