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Lesson 12 Options
RWJLT Chapter 24
In the Headlines
The 10 Largest Trading Losses In History http://newsfeed.time.com/2012/05/11/top-10-biggest-tradinglosses-in-history/slide/all/ March 11, 2012 (and Wikipedia). Excludes Hedge Funds
Trader Name Howie Hubler Jerome Kerviel Brian Hunter Bruno Iksil John Meriwether
Institution Morgan Stanley Societe Generale Amaranth Advisors JP Morgan Chase Long Term Capital Management
Market Credit Default Swaps European Index Futures Gas Futures Credit Default Swaps Interest Rate & Equity Derivatives
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Lecture Outline
1. Derivative Securities Overview 2. Options Basics 3. Options Payoffs 4. Put-Call Parity 5. Determinants of Option Values 6. Not Examinable: Options Valuation: The Binomial Model Options Valuation: The Black-Scholes Model Options and Corporate Finance
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Options Basics
A Call Option is a security that gives its owner (or the holder of the option) the right (but not the obligation) to purchase a given asset (usually a stock) on a given date (or anytime before a given date) at a predetermined price (referred to as the Exercise Price)
European Options - can be exercised only on the expiration date. American Options - can be exercised at any time before expiration. A Put Option, in contrast to a Call Option, gives its owner the right to sell an asset on (or before) a given date at a predetermined price.
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There are four possible positions for option investors: (i) Buy a Call Option, (ii) Sell a Call Option (iii) Buy a Put Option, (iv) Sell a Put Option
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At Maturity Call Option Payoff & Profit vs. Market Price of Stock (for BUYER)
$
If ST > X, If ST X, Payoff = (ST X) Payoff = 0
Payoff: CT = Max{ST X, 0}
450 X
Profit = Payoff Premium
ST
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At Maturity Call Option Payoff & Profit vs. Market Price of Stock (for WRITER)
$
If ST > X, If ST X, Payoff = -(ST X) Payoff = 0
X
options Premium
450
ST
At Maturity Put Option Payoff & Profit vs. Market Price of Stock (for BUYER)
$
If ST < X, If ST > X, Payoff = (X ST) Payoff = 0
450 X
Profit = Payoff Premium
ST
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At Maturity Put Option Payoff & Profit vs. Market Price of Stock (for WRITER)
$
If ST < X, If ST > X, Payoff = -(X ST) Payoff = 0
450
X
options Premium
ST
Payoff Descriptions
In-the-Money (holder of option will gain if option is exercised now)
A Call Option is in-the-money when the current market price of the stock is higher than the exercise price (i.e. S > X). A Put Option is in-the-money when the market price of the stock is lower than the exercise price (i.e. S < X).
At-the-Money (holder of option will neither gain nor lose if option is exercised now)
A Call Option or a Put Option is at-the-money if the market price of the stock is equal to the exercise price of the options (i.e. S = X).
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Example 3 Different Investment Strategies: Stock, Call Options, Call Options + T-Bills
You have $10,000 to invest. You can invest in three different ways. The stock is selling for $100/share. Each Call Option (with a Strike Price of $100) is selling for $10. The risk-free rate is 3%.
Investment All Stocks All Options Calls+T-Bills Strategy Buy stock @ $100 Buy calls @ $10 Buy calls @ $10 & T-bills with 3% yield 100 shares 1,000 options 100 options T-bills Investment $10,000 $10,000 $1,000 $9,000
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$9,500 $0 $9,270
Calls $500 T-Bills $9,270
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Observation: For the same fluctuation in price of the underlying stock, the All Options strategy provides the highest returns volatility while it has the potential to achieve substantial gains (50%), it may also suffer a complete loss!
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Creating a payoff position using a mix of the underlying asset and its options
Any set of payoffs (that depends on the value of some underlying asset), can be constructed with a mix of simple options on that asset By adding and subtracting various combinations of Calls and Puts (at various Exercise Prices), we can create a variety of financial instruments with an endless range of payoff positions.
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Put
Stock+Put
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Put-Call Parity
Consider the following two investments: Investment 1 Protective Put Buy one stock and one Put Option on of the stock with Exercise Price of $50. Investment 2 Call Option + Risk-free securities Buy a Call Option on the same stock with Exercise Price of $50 and T-bills with face value (maturity value) of $50. If we analyze the payoffs of the two investments
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Investment 1 Payoff
S < $50 Payoff = $50 Payoff = S
S $50
$50
(i) Stock (ii) Put Option with Exercise Price of $50
$0 $50
ST
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Investment 2 - Payoff
(i) + (ii): Call Option + T-bills $
S < $50 S $50 Payoff = $50 Payoff = S
$50
(ii) T-bills with maturity value of $50 (i) Call Option with Exercise Price of $50
$0 $50
Note: T-bills and Call Option to have the same maturity date.
ST
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Put-Call Parity
Payoffs of Investment 1 and Investment 2 are identical. Value principle: When two investments have identical payoffs, they must be worth the same value (same PV). Hence: PV(Stock + Put) = PV(Call + Risk-free Security)
S0 + P = C + X / (1 + rf)T
PV of T-bills with maturity value of $X in time T (alternatively, zero-coupon bond with par value of $X)
The above equation is known as the Put-Call Parity. It relates the price of a Call to the price of the corresponding Put on the same stock. If the Put-Call Parity is violated, arbitrage opportunity would arise (i.e. one can buy the cheaper investment and sell the more expensive one simultaneously and make a riskless profit). 12-28
Put-Call Parity
Price of Price of Underlying + Put Stock Price of PV of = + Call Exercise Price
S + P = C + PV(X) P = C + PV(X) S
When the price of a Call Option on a stock is found, the price of the Put Option on the same stock (having the same Exercise Price and maturity date) can be computed using the above relationship.
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Option Values
Intrinsic Value refers to the payoff that could be made if the option was immediately exercised. Call Options: Intrinsic value = Stock Price Exercise Price Put Options: Intrinsic value = Exercise Price Stock Price But in each of the above cases the Intrinsic Value cannot be negative (i.e. it is either ZERO or positive value). Time Value of an Option (not the same as time value of money) the Option Price (value of the option) is usually above its Intrinsic Value, the difference reflects the options time value. Most of the Time Value reflects the volatility value the volatility of the stock increases the chance of the options (whether Put or Call) getting into-the-money.
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Call Option Value before Expiration is highlighted in pink (Intrinsic Value in black)
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Thus the call option which expired in April 2004 and allowed its owner to purchase a share of Amgen stock for $65, was sold for $1.95.
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Non-Examinable
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Options Valuation
We cannot use the traditional discounted cash flow method (DCF) to value options. This is because DCF requires us to: (i) estimate expected future cash flows, and (ii) discount those cash flows at the opportunity cost of capital. An options expected cash flows and relevant risk impact change every time the underlying stocks price changes. Moreover, the underlying stock price changes constantly.
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$45 Consider a call option with exercise price of $57. The call option payoff one year later is either CH or CL:
Thus, to replicate the call options payoff, we need to: Buy 0.4 shares by paying 0.4($50) = $20. Borrow $16 to partially finance the purchase. The net cost of the portfolio that replicates the options payoff is $4. In an (arbitrage-free) equilibrium, this $4 must be the value of the call option. Implication: A call option is like a leveraged portfolio in which the purchase of a stock is partially financed with a risk-free loan.
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Swing in value of call $8 $0 = = = 0.4 Swing of value of underlying stock $65 $45
A call option that is deep in-the-money will have a delta of 1. The value of a call that is assumed to end in-the-money will move dollar for dollar in the same direction as the price of the underlying asset. The delta of a put option is between -1 and 0.
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Non-Examinable
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ln( d1 =
S0 + ) T ( r+ 1 2 ) 2 X T
d 2 = d1
Where: ln ( ) is the natural logarithm function. N (d) denotes the standard normal distribution function. probability that a random draw from a normal dist. will be less than d. T is the number of periods to exercise date. is the standard deviation per period of the stocks logarithmic return (continuously compounded). r the risk-free interest rate (continuously compounded).
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C = (S0 )N(d1 ) Xe
rT
N(d 2 )
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Implied Volatility Using Black-Scholes and the actual price of the option, one can solve for implied volatility.
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ESO Features differ from company to company, but some common ones are:
Typical expiration of 10 years. Cannot be sold or transferred unless the employee dies, then options transfer to the estate. Vesting (waiting) period during which they cannot be exercised. Employee loses the options if he leaves the company.
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Non-Examinable
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Similar to a call option, common stock has limited downside (the worst is zero value) but can enjoy unlimited upside.
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