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which originally sold the option and which takes on the obligation
to sell 100 ounces of gold in 1 years time in return for receiving
$30,000.00.
At the time when you buy the option, you do not know what the
price of gold will be in 12 months time.
If, in 1 years time the gold price is $250.00 per ounce then you
could buy the 100 oz of gold in the open market for $25,000
instead of buying the gold under the option contract for
$30,000.00. The word option means that you do not have to buy
the gold for $30,000 in 12 months unless you choose to. In this
case you would be paying too much if you did exercise your rights
under the contract and could do better by buying gold in the open
market for $5,000 less. If you do not exercise your right to buy
then the option is said to lapse.
If on the other hand, the price of gold were to go up to $500 per
ounce in 12 months time then you would (and should) exercise
your right to buy gold at a price of $300 per ounce under the terms
of the option contract. You could then sell the gold in the open
market for $500 per ounce and make a profit of $200 per ounce on
100 ounces which is a profit of $20,000.
The date by which you have to choose whether to exercise the
option is called the exercise date or the expiry date or the
maturity date these terms all mean the same thing.
PUT OPTION
Another kind of option is an option to sell an asset / instrument on
some future date for an agreed price. This is called a put option.
For instance you may have bought the right (but not the
obligation) to sell 100 ounces of gold for a price of $350 per
ounce in 12 months time.
2
USES OF OPTIONS
Option contracts are used by banks, investors, governments and
corporations for a range of different purposes.
The main reasons for using them are:
for hedging (the motivation being to reduce financial risk) This
is like buying insurance against financial risk
for speculation (the motivation being to make trading profits
from taking a bet on which way market prices may move) this
is like gambling. There are many different strategies that can be
implemented with options more on this later.
for arbitrage by exploiting differences in prices between
different markets or different instruments we may be able to
make a risk free profit.
Fee income: to make money from selling options for banks
and other option writers, it is like selling an insurance policy
and they want to sell it for more than it is going to cost them (at
least on the average)
INTRINSIC VALUE
The intrinsic value of an option is defined as the payoff from
exercise of the option assuming it could be exercised immediately.
For American options, the time value represents the value of the
opportunity presented by the possibility that the asset will increase
above its current level.
American options can be exercised immediately but European
options cannot be exercised until their maturity date.
Notation
S = market price of the underlying asset
ST = market price of the underlying asset at time T
X = exercise price of the option contract
T = Term to maturity of the option
c = market value of a European call option contract over
S with exercise price X and term to maturity T
p = market value of a European put option contract over
S with exercise price X and term to maturity T
C = market value of American call option contract over
S with exercise price X and term to maturity T
P = market value of American put option contract over S
with exercise price X and term to maturity T
The intrinsic value of a call option is max( S X ,0) because:
If S X then we could
buy the asset for price X by exercising our rights under the
contract
then sell the asset in the market for S
make a profit of S X as a result
If S X then we would
not exercise our rights under the contract and the profit would
be 0.00
This is written more compactly as payoff
Note: Y
max(Y ,0)
max( S
X ,0)
X then we would
not exercise our rights under the contract and the profit would
be 0.00
This is written more compactly by writing payoff
max( X
S ,0)
Example:
Consider an American Put Option with
a term to maturity of 1 year,
the underlying asset is 1000 shares in company XYZ.
exercise price of the option is $1000
Suppose the interest rate is 10% p.a. and the company XYZ has
just gone into liquidation with its liabilities exceeding its assets.
Answer the following questions:
(a) what is the intrinsic value of the put option?
(b) when should you exercise the option should you do it
immediately or should you wait until some later time? Why?
(c) If the option were a European Option then what would the
value of the option be and why?
(d) Why is an American option always worth at least as much as
and possibly more than the equivalent European Option?
6
Answers
(a) the shares of XYZ will have a value of $0.00 they will have
no value. Thus the intrinsic value of the put option is
payoff max( X S ,0) max(1000 0,0) 1000 .
(b) this put option is an american option you can exercise it
immediately and you should exercise immediately. Doing so
gives you an immediate payoff of $1000 now. Delaying the
decision means you receive $1000 at some later time. It is
better to have money now rather than later so exercise
immediately.
(c) If the option were European then you could (and should)
exercise your right to sell the shares in 1 years time for a
price of $1000 and the profit to be had from doing this is
$1000 received at the end of a year. The option is european
and cannot be exercised before then. In this situation the
value of the option is the present value (@ 10%) of $1000
received in 1 years time. This is
$1000.00
1.10
$909.91
10
$value
$1.50
$1.00
$0.50
-$0.50
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
$2.60
$2.80
$3.00
$3.20
$3.40
$3.60
$3.80
$4.00
$4.20
$4.40
$4.60
$4.80
$5.00
$-
-$1.00
spot price
Option Terminology:
In the money
The option is said to be "in the money" if it has a positive intrinsic
value, i.e. if it would be worth exercising (if you could exercise it).
a call is in the money if S > X, while
a put is in the money if S<X
At the money
The option is said to be "at the money" if S=X.
a call is in the money if S = X
a put is also in the money if S=X
11
12
13
effect on call
increases
decreases
decreases
increases
increases
effect on put
decreases
increases
increases
increases
decreases
increases
increases
1
S
var log e T
T
S0
, where
or equivalently,
1
T
var log e
ST
S0
14
Note that
ST
is called the price relative. If you invest $1.00 at
S0
S
time 0, it will grow in value to an amount of T at time T
S0
the ratio
log e
ST
S0
log e
ST
S0
1
is the continuously compounded rate of return
T
15
CALL OPTIONS
It can be shown that for
an american call option
over a non dividend paying stock,
it is never optimal to exercise the option early.
Therefore it follows that American call value = European call
value in this case.
This does not necessarily apply in the case of dividend paying
stocks. American calls on dividend paying stocks may be worth
exercising early.
By dividend paying we mean the stock pays a dividend during the
term of the option.
PUT OPTIONS
For put options over non dividend paying stocks it is sometimes
optimal to exercise the option early. Therefore american put
options have a value that is european put options.
16
S N (d1 ) Xe
rT
N (d 2 )
where
S = "spot price" (i.e. the current price) of the stock
X = the exercise price of the option
r = the risk free interest rate per annum
T = term to maturity of the option
= volatility of the stock
c = value a european call option
d1
d2
1
T
1
T
x
N x
log e
S
X
1
2
log e
S
X
1
2
1
e
2
1 2
z
2
d1
dz
17
0.8
0.6
0.4
0.2
3.74
3.31
2.88
2.45
2.02
1.59
1.16
0.73
0.3
-0.1
-0.6
-1
-1.4
-1.8
-2.3
-2.7
-3.1
-3.6
0
-4
n(x)and N(x)
x value
18
Xe
rT
N ( d 2 ) S N ( d1 )
ST
S0
ST
S0
has a
1
2
2
2. variance
T
3. standard deviation
T
T
10.00
1.052632
9.50
S
log e
log e 1.052632 0.051293
X
1 2
1
0.10
0.202 0.25 0.03
r
T
2
2
T 0.20 0.25 0.10
20
d1
S
X
1
2
T
T
0.081293
0.81293
0.10
d 2 d1
T 0.81293 0.10 0.71293
log e
Step 2:
Calculate (or lookup in tables) the values of N (d1 ) & N (d 2 )
To 4 decimal places these values are:
N (d1 ) 0.7919
N (d 2 ) 0.7621
S N (d1 )
Xe
10.00 0.7919
0.8579
rT
N (d 2 )
Xe
rT
N ( d 2 ) S N ( d1 )
Now that we have the value of N (d1 ) & N (d 2 ) we can compute the
values of N ( d1 ) & N ( d 2 ) using the relationship
N ( x)
N ( x) 1.0
Xe
Xe
rT
rT
N ( d2 )
1 N (d 2 )
9.50 0.975310
p
S N ( d1 )
S
1 N (d1 )
1 0.7621
10.00
1 0.7919
0.1234
22
This is the share price less the present value (at the risk free rate)
of the dividends paid during the life of the option.
We then compute the option price using the Black Scholes
formula but we use the adjusted share price instead of the actual
share price as the spot price input for the calculations.
Example: 4 month call option over IBM
Assume that the valuation assumptions are
0.244949
S = $50.00, X = $45.00, r = 3%,
D = $0.56 paid in 2 months (
Then the adjusted share price is
S'
D e
50.00 0.56 e
2
)
12
0.03 2 /12
$49.44
23
We use this share price instead of $50.00 as the spot price input to
the BS formula. The calculations are as follows:
spot price S
strike price X
term T
volatility v
int rate r
S/X
ln(S/X)
(r+0.5vol^2)T
vol*root(T)
d1
d2
Nd1
Nd2
C
$49.44
$45.00
0.3333
24.49%
3.00%
1.098729
0.094154
0.0200
0.1414
0.8072
0.6658
0.7902
0.7472
$5.7804
24
Se
Xe
qT
rT
N (d1 )
N ( d2 )
Xe
rT
Se
N (d 2 )
qT
N ( d1 )
Where
d1
log e
T
1
log e
T
d2
S
X
S
X
1
2
1
r q
2
r q
d1
c S , X , r , q, , T
d1
d1 S , X , r , q, , T
d2
d1
SN (d1 )
1
T
Xe
log e
rT
N (d 2 ) where
S
X
r q
1
2
25
$50.00
$45.00
0.3333
24.49%
3.00%
2.00%
1.1111
0.1054
0.0133
0.1414
0.8393
0.6979
0.7993
0.7574
$5.9592
26
European
C
P
American
C
P
note that
0 max X S ,0
0 max S X ,0
X
S
27
S, c
28
X, p
29
Xe
rT
rT
rT
30
rT
31
rT
rT
S ,0
Proof:
This result can be derived by comparing 2 portfolios:
1. a European put option with
2. a portfolio made up of of cash equal to the present value of
the exercise price Xe rT and a short (sold) position in one
share.
At maturity
our risk free investment accumulates to Xe
rT
rT
Xe
rT
p S or equivalently c
long
call
short
put
Proof:
Let S and X be 2 numbers. Then
max S X ,0 max X S ,0 S
Because:
if S X then max S
X ,0
if S X then
max S X ,0
0
Xe
rT
long forward
contract
max X
S X
S ,0
max X
S ,0
X S
33
Portfolio 2 =
X ,0)
Xe
call
payoff
rT
cash
rT
max( ST
X ,0)
max( ST , X )
accumulation
factor
X ,0)
S ,0) S
max( S , X )
rT
p S
rT
35
if the stock price gets sufficiently low (e.g. close to zero) the
payoff from exercising early is higher than the possible
payoff from waiting until later to exercise. In the extreme
case where the stock price falls to zero we get X now by
exercising early and with interest this accumulates to Xe rt at
time t. If we wait till later the stock price may recover and the
payoff would be less.
it follows that there are some circumstances where P>p
36
Xe
rT
Xe
rT
p c Xe
rT
37
max S
X ,0
Xe rT
max S
X ,0
Xe rT
0
max S , X
V1
max S , X
max S , X
max X
S ,0
max S , X
max X , S
max S , X
max S , X
V2
put payoff
max S
X ,0
Xe r
max S
X ,0
max S , X
max S , X
Xe r
X
0
max S , X
V1
V2
38
C
C
P S
X P S
P S X
If D denotes the present value of dividends between the current date and
the option expiration date then the put-call parity result needs to be
modified to allow for the fact that options are not dividend protected
(this means that if a dividend is paid no adjustment is made to the terms of
the option resulting from the change in the share price after the dividend
payment).
The relationship for put-call parity then needs to allow for dividends and
becomes
For European options:
c D
Xe
rT
p S
Xe
rT
value of a long
forward contract f
Xe
rT
39
Xe
Portfolio A
rT
p S
Portfolio B
c D
p S
max ST
max ST
VB T
X ,0
max X
X ,0
X
ST ,0
D
De rT
ST
Xe
rT
e rT
max ST , X
De rT
De rT
max X , ST
De rT
We see that the payoff at time T from the 2 portfolios is the same. By the
law of one price the values of the 2 portfolios must be the same at time
t=0 as well. From this it follows that c D Xe rT p S
40
rT
This is an inequality which defines an upper and a lower bound for the
difference C P
Proof: exercise for students to do.
Lower bound for European Call on a dividend paying asset
rT
Proof
consider 2 portfolios:
portfolio A = 1 unit of a European Call plus cash of amount D Xe
invested at rate r for term T in a risk free asset.
rT
ST
value
of 1 unit
of Asset S
De
rT
accumulated
value of dividends
reinvested at rate r
max ST
X ,0
Xe
payoff on 1unit
of the call option
VA T
max ST
X ,0
rT
D e
rT
accumulated value
at time T
of cash invested
De
rT
max ST , X
De
ST it follows that VA T
rT
VB T
If not you could buy portfolio A and short sell B and hold till maturity for
a guaranteed risk free profit.
It follows that VA 0 VB 0 and hence c D Xe
so that c S0 D Xe rT
rT
S0
rT
S0 : Consider 2 portfolios:
Xe
rT
D e
rT
De
rT
accumulated value
at time T
of cash invested
max X
ST ,0
De
value
of asset
payoff on 1unit
of the put option
VA T
ST
max X , ST
De
rT
accumulated
reinvested
dividends
rT
accumulated
reinvested
dividends
since max ST , X
X it follows that VA T
VB T
Xe
rT
42
PART 4:
BS Model and the replicating and self financing portfolio
The B.S. model was based on the idea that you can create a
dynamically adjusted portfolio comprised of a position in the
stock and a position in a risk free bond that will
provide the same payoff as the option at maturity
cost a certain amount of money to establish
not cost any extra money as the portfolio is adjusted over time.
If we need to "rebalance" the portfolio by changing the mix of
bonds and shares then the cost of the new portfolio is provided
by liquidating the old portfolio. The strategy is "self financing"
The model is based on the assumption of perfect markets, along
with some other assumptions:
no taxes
no transaction costs
can borrow or lend any amount of money at the risk free rate
not restrictions on short selling shares or bonds
all assets are perfectly divisible (you can hold fractional or
negative amounts)
stock price follows a continuous process called geometric
brownian motion (no jumps in share price)
The number of units of the underlying share you should hold in
the replicating portfolio is called the "option delta" or the "hedge
ratio"
For a long (i.e. bought) call option the hedge ratio is the
coefficient of S in the BS formula
43
S N (d1 )
Xe
hedge
ratio
rT
N (d 2 )
bond
value
Xe
rT
.N ( d 2 )
S .N ( d1 )
44
Explain how you could construct a sold put synthetically using the
following prices / market information:
$5 call option at a premium of $0.20, (X = $5.00)
$5 put option at a premium of $0.25, (X = $5.00)
and a forward price of $5.00 for the asset
Is there an arbitrage opportunity in these prices?
If so, describe the transactions that would achieve an arbitrage
SOLUTION
c - p = S Xe-rT = f = value of forward contract.
Thus p = c - f, so -p = f c.
Hence we can synthesize a sold put by selling calls and buying the
forward contract (the minus sign means short selling and a plus
sign means a long position).
If the forward price is F = $5 then we can enter into a forward
contract with delivery price X = $5 for no outlay of cash, as either
the holder of a long or the holder of a short position. This means
that f = 0 when X = $5.
Therefore we can do the following and make a risk free profit
(arbitrage profit):
create a synthetic long put position by
selling the forward and buying the call, for a net cost of $0.20
sell the put for $0.25
This creates an up front profit of $0.05 per put option.
At maturity the cashflows on all of the contracts cancel out.
45
Question 2
Redo the above calculations using
(a) a revised volatility of 20%pa (& risk free rate =9%)
(b) a revised interest rate of 19%pa (& volatility of 10%).
Comment on the results
Solution
S0 1.052 e
0.09 2
d2
S0 N
d1
or
G
S0 1.052 e
0.09 2
d2
1.00 N
d1
47
Where
ln
d1
S0
S0 1.052
ln 1.05
0.1 2
1
0.09
0.1
2
0.1
1
0.1
2
0.09
d1 0.1
Calculations:
We shall do the calculation assuming the unit fund has a
(spot) value of $1.00 at the start of the 2 year period i.e.
the investor started off with a $1.00 investment.
The value of the put option with a strike price of $1.1025
is $0.0235, as shown below.
Thus we find that G = P 0.0235 i.e. the guarantee is
going to cost the customer an additional 2.35% on top of
the amount invested
(2) The calculations for 3 sets of valuation assumptions are set
out below.
Looking at the results we see that increasing the volatility
increases the guarantee charge substantially and increasing
the interest rate lowers it. The result is more sensitive to a
change in volatility than to a change in the interest rate.
48
INPUTS
INPUTS
INPUTS
9.00%
10.00%
2.0000
$1.00000
$1.10250
9.00%
20.00%
2.0000
$1.00000
$1.10250
19.00%
10.00%
2.0000
$1.00000
$1.10250
d1
d2
N(d1)
N(d2)
N(-d1)
N(-d2)
C
P
Results
0.65351
0.51208
0.74328
0.69570
0.25672
0.30430
0.10262
0.02351
Results
0.43282
0.14998
0.66743
0.55961
0.33257
0.44039
0.15209
0.07298
Results
2.06772
1.92630
0.98067
0.97297
0.01933
0.02703
0.24709
0.00105
49
50
Scenario:
You are an investor and you have been approached by a
representative (a Mr Devious) of the bank about investing in
this derivative security. Mr Devious is extremely keen on
selling this security to you so much so that you become
suspicious that this is not really such a great deal after all.
Assume that
current gold price is US$340 / oz
5 year AAA rated zero coupon bonds are trading at a yield
of 13.5%pa
5 year at the money 100 oz gold call options are available
in the market at a price of $US24,500
the dealer meets any holding and insurance costs
associated with physical holding of the gold
QUESTION:
Based on the above information determine whether or not
you consider the terms of the repurchase agreement to be
fair to you as the purchaser. (are you being ripped off if you
accept this deal on these terms?)
51
52
max(0, ST -X)
X + 0.6
X + 0.6
= 0.4
= 0.4
X + 0.6
X + 0.6
X if ST < X
ST if ST > X
max(X, ST)
(X + max(X-X, ST -X))
0.60 C
34000
1.1355
This is less than the price being charged by the bullion dealer,
which was $34000.
This means the purchaser could achieve the same payoff more
cheaply by investing in a 5 year zero coupon bond and investing
in an at the money call option on gold.
The repurchase agreement upfront price means the purchaser is
paying too much for the option contract and could do better by
accessing markets directly. Thus the terms of the repo are not
fair to the purchaser.
53