Derivatives - Options CH 20 & 21

Derivatives Options
Chapters 20 & 21
Finance 367
Derivatives
Derivatives securities or just Derivatives are securities
whose prices are derived from the prices of other
securities. Also called Contingent Claims because their
payoffs are contingent on the prices of other securities.
Derivatives can be powerful tools for hedging, but also for
speculation.
Major types of derivatives:
Options
Futures
Swaps
2015 J. David Miller
Option Contracts
An option is a right or obligation to receive or deliver an
underlying security at a specified price on or before a
specified date.
Call option gives the right to buy (bullish)
Put option gives the right to sell (bearish)
Strike or Exercise Price is the price set for calling (buying)
or putting (selling) an asset. This is a factor in determining
whether the option has any intrinsic value.
The cost of buying the option is called the Premium. The
premium is quoted as the price per share. Usually 100
opitons per options contract.
Option Contracts (contd)

The person who sells the option to someone else is called
the option writer. You would say that a person writes an
option.
The person buying the option will pay the premium to the
writer of the option.
The option premium can be thought of as the fee that the
buyer pays the writer for giving them the option.
All option contracts must have both a buyer and a writer.
Option Contract Example

It is currently April 1. An investor purchases a Call Option
on IBM stock that will expire on June 1. The premium on
the option is $3 and the Strike Price or Exercise Price is
$75.
This investor now has the right to purchase 100 shares of
IBM stock from the option writer for $75 per share. The
investor has this option until June 1.
If the investor does not exercise (or sell) the contract on or
before June 1, it will expire and become worthless.
Option Contracts Value

The value of an option consists of two parts, the Intrinsic
Value and the Time Value.
Intrinsic Value exists when the market price exceeds the
strike price (for a call option) or is less than the strike price
(for a put option).
For example, the market price is $80 and the Strike Price is
$75. The option buyer will exercise the option and buy 100
shares for $75 per share and then sell them at the market
price of $80 per share.
An option that has intrinsic value is said to be in the
money
An option does not have intrinsic value is said to be out of
the money
Option where Strike Price = Market Price is at the money
Option Contracts Value (contd)

The Time Value of an option contract is a value that
represents the time until the option expires. The longer
until expiration, the greater the time value of an option.
Option Premium = Intrinsic Value + Time Value
Option contracts can be traded up to expiration.

Expiration dates are normally on the Saturday
following the third Friday of the exercise Month
American Options can be exercised before or at
expiration.
European Options can only be exercised at expiration.
Options Trading
A large percentage of options are traded on organized
exchanges. These are standardized contracts and provide
standardized maturities.
Other the counter options may be tailored to the needs of a
trader, but at a higher cost compared to exchange traded
options.
The Chicago Board Options Exchange and the
International Securities Exchange Options Clearing Corp.
guarantee performance.
Options traded on these exchanges are traded directly
with the Option Clearing Corp. The OCC effectively
matches option buyers with option writers to eliminate its
risk.
Options Trading (contd)

Because the exchange guarantees the performance of the
contracts, it requires the option writer to provide margin.
More margin money is required if the option being sold is in
the money, because it is more likely that the option will be
exercised.
The margin requirements can be satisfied if the option
writer owns the underlying shares and they are being held
by a broker.
Options Quotes
Other Listed Options

An Index Option is a call or put option based on a stack
market index such as the S&P 500 or New York Stock
Exchange Index. There are options that cover many broad
market indexes as well as industry specific indexes.
The call and put writer does not have to deliver the index or
the stocks in the index, if the option is exercised. Cash
settlement is used. The writer pays the buyer the
difference between the index value price and the exercise
price.
Other Listed Options (contd)

Futures Options holder has right to buy or sell a futures
contract using a futures price as the exercise price. Cash
settlement is used.
Foreign currency options quoted in dollar per unit of
foreign currency.
Interest Rate options traded on fixed income securities
like Treasuries, CDs. Options on several interest rate
futures are also traded.
Corporation Issued Options

Companies can issue securities whose value is derived
from the value of the stock price. While these are not
derivatives, they have many similarities.
Warrant long term option to buy stock at a fixed price
Right short term option to buy at a fixed price
Bond Call Option option written by the bond investor (who
demands a higher coupon and yield compared to an
equivalent straight bond) and is held by the issuer
(Company)
Convertible Bond option can be exercised to trade the
bond for shares of the issuing company
Value of Call Options at Expiration

The value of an call option = ST X if ST > X
= 0 if ST < or = X
Where ST is the Stock Price and X is the Strike Price
The payoff to the holder of call options cannot be negative
because the option will not be exercised when the stock
price is less than the strike price.
Call Option with $80 Exercise Price

The value at expiration to a call holder with $14 premium
Income
Long Call Example

An investor purchases a July Call on Dow Chemical stock
with a strike (exercise) price of $85. The investor pays a
premium of $1.37. If Dow Chemical rises to $91.37 and the
investor thinks that it will go no higher? What will be her
profit?
Exercise the call and buy the stock at $85 per share. Sell
the stock in the market for $91.37.
Profit = $91.37 $85 - $1.37 = $5 per share
Long Call Example II

An investor purchases a July Call on Dow Chemical stock
with a strike (exercise) price of $85 per share. The investor
pays a premium of $1.37 per share.
At what price for Dow Chemical stock, will the buyer of the
option break even?
Strike Price + Premium = $85 + $1.37 = $86.37
Exercise option and buy stock at $85.00. Sell at market
for $86.37.
Profit = $86.37 - $85 - $1.37 = 0
Call Option with $80 Exercise Price

The value at expiration to a call writer with $14 premium
Value of Put Options at Expiration

The value of an put option = 0 if ST > or = X
= X - ST if ST < X
Where ST is the Stock Price and X is the Strike Price
The payoff to the holder of put options cannot be negative
because the option will not be exercised when the stock
price is greater than the strike price.
Put Option with $80 Exercise Price

The value at expiration to a put holder with $14 premium
Income
Long Put Example

An investor purchases a March Put on IBM stock with a
strike (exercise) price of $120. The investor pays a
premium of $2.15 per share. If IBM falls to $112.45 and the
investor thinks that it will not fall anymore, what should he
do and what is his profit?
Buy the stock at $112.45 at the market and exercise the put
option to sell the stock for $120.
Profit = $120 $112.45 - $2.15 = $5.40
Long Put Example

An investor purchases a March Put on IBM stock with a
strike (exercise) price of $120. The investor pays a
premium of $2.15. If IBM rises to $128 just before
expiration, what should the investor do and what will be his
profit?
The stock price is above the strike price, so the investor will
lose money if he exercises the option. He will let the option
expire worthless.
Loss = $2.15 for the premium paid.
Short Put Example

An investor believes that Microsoft stock will not go down in
the next several months. She writes a May Put on
Walgreens stock with a strike (exercise) price of $100. The
investor receives a premium of $2.75 per share. If
Walgreens rises to $108 what will be the profit (loss) to the
writer of the option?
The stock price is above the strike price, so the option will
expire worthless. The investors profit will be the premium
of $2.75
Short Put Example II

An investor believes that Microsoft stock will not go down in
the next several months. She writes a May Put on
Walgreens stock with a strike (exercise) price of $100. The
investor receives a premium of $2.75.
If the stock price fell to $89 and the buyer of the option
exercised, what will be the gain(loss) to the option writer?
Option seller will buy the stock for $100 from the purchaser
and then sell it at market for $89.
The gain will be $89 - $100 + $2.75 = -$8.25
or a loss of $8.25 per share.
Options vs. Holding Stock

Buying call options is a bullish strategy and buying put
options is a bearish strategy. Writing puts is also a bullish
strategy, whereas writing calls is a bearish strategy.
Buying a call option can be viewed as substitute for the
purchase of the shares of a stock.
A comparison of bullish strategies will make this clearer.
Because purchasing one call option contract allows us to
control the equivalent of 100 shares of stock, we have
several investment choices to make.
Options vs. Holding Stock II

Suppose we believe that a $90 stock is undervalued and it
will rise over the next 6 months. However, it could also fall
in price, so we must consider our investment options. We
have $9,000 to invest. We are considering a six-month
maturity call option with exercise price of $90 that sells for
$10.
Strategy A: Invest entirely in stock. Buy 100 shares of
stock at $90 per share
Strategy B: Invest entirely in at-the-money options. Buy
900 calls, each selling for $10. This is 9 contracts.
Strategy C: Purchase 100 call options for $1,000. Invest
the remaining $8,000 in 6-month T-bills to earn 2% interest.
Options vs. Holding Stock III

When the option expires in six-months, the different
investment options will be worth:
Each of these portfolios involves the same $9,000 initial

investment.
Note: these are the payout values but not your profit/loss
values. You must consider premiums to find your P&L.
Options vs. Holding Stock IV

The rates of return on the three investment options are:
Note: these are the payout values but not your profit/loss
values. You must consider premiums to find your P&L.
Options vs. Holding Stock V
Note:
The call option acts like a leveraged investment in the stock
The option can act as insurance. Strategy C cannot be
worth less than $8,160, but has upside potential
While options can be used to speculate, investors can use
them to reduce risk.
Call and Put Comparison
Max Gain
Max Loss
Buy Call
Unlimited
Premium
Sell (write) Call
Premium
Unlimited
Breakeven
Max Gain
Max Loss
Buy Put
Strike Price less

Premium
Premium
Sell (write) Put
Premium
Strike Price less

Premium
Breakeven
Strike Plus Premium
Strike Less Premium
Options Strategies
Because calls and puts can be combined with stock, an
unlimited number of combinations with different payoffs can
be created.
Some investment strategies involve combining one call or
put with stock while others involve buying both calls and
puts along with stock.
Combinations can also be created using different exercises
prices and maturities to change the risk reward
characteristics.
The use of strategies to limit the risk of a portfolio is called
risk management.
Protective Put
If you want to invest in a stock, but are unwilling to take
losses beyond a specific point, you might consider
investing in the stock in combination with a put option.
The combination of the investment in the stock and the put
option limits downside risk, while retaining most of the profit
potential.
The value of the protective put investment can be
calculated as
Protective Put Payoff Chart

In combination
Protective Put vs. Stock Investment
This shows the return on a Protective Put Strategy

versus investment in stock alone
Protective Put Example

An investor purchases shares of AMD for $75 per share.
She believes that AMD will go up in price, but wants to limit
her loss to $10 per share. To hedge her risk, she
purchases a put option on AMD stock with an exercise
price of $67 per share. She pays the option premium of $2
per share.
If the AMD stock price rises to $85 per share and she sells
her stock, what will her profit (loss) be?
Because the stock price is higher than the option strike
price, she will let the option expire.
$85 sales price - $75 purchase price - $2 option premium
equals $8 per share.
Protective Put Example II

An investor purchases shares of AMD for $75 per share.
She believes that AMD will go up but wants to limit her loss
to $10 per share. To hedge her risk, she purchases a put
option on AMD stock with an exercise price of $67 per
share. She pays the option premium of $2 per share.
If the AMD stock price falls to $60 per share, what will she
do and what will her profit (loss) be?
She will exercise her option to sell the stock for $67 per
share. $67 sales price - $75 purchase price - $2 option
premium equals -$10. Her loss will only be $10 per share.
Covered Call
A covered call position is the purchase of a share of stock
with the simultaneous sale of a call on that stock. The sale
of a call is also called writing an option.
The option that is written is covered because the potential
obligation to deliver the stock is covered by the stock held
in the portfolio. The strike price on the option will be set at
the level the investor is willing to sell the stock.
Writing an option without an offsetting stock position is
called naked option writing.
The payoff of a covered call
Covered Call Payoff Chart

In combination
Profit
Some investment managers will write a covered call rather than selling a stock
so they can boost income from the premium. They forfeit capital gains if the
stock price rises above the exercise price, but if they planned to sell the stock at
the exercise price, the written call guarantees the stock sale will occur, while
adding to their profit with the premium received.
Covered Call Example

Julia purchased a share of Intel stock last year for $40 per
share and now believes that the stock will reach $60 per
share in the next month. She plans to sell at that price and
wants to make an additional profit on her sale. Because
Julia is willing to sell at that price, she writes a call option
with a strike price of $60. She receives $3 in option
premium per share.
If the Intel stock price rises to $65 per share and the
purchaser of the option exercises, what will Julias profit
(loss) be?
$60 sales price when option is exercised - $40 purchase
price + $3 option premium received equals $23 profit per
share. If Julia did not write the option and sold the stock at
$60, she would have made a $20 profit per share.
Straddle
A straddle position is one that allows the investor to profit
based on how much the price of the underlying security
moves, regardless of the direction of the price move.
A put and a call are purchased on a single stock, with the
same strike price and time until expiration.
The investor profits if the stock price moves a great deal
away from the strike price. However, the direction does
not matter. The intent is to profit from or hedge the
volatility of the underlying security.
Long Straddle Payoff Chart

In combination
A short straddle can be created by writing both a call and put

Short Straddle Payoff Chart
Profit
Profit
0
ST
Payoff
A short straddle can be created by writing both a call

and put at the same exercise price.
Straddle Payoffs
Long Straddle
Short Straddle
Max Gain
Max Loss
Unlimited on
profitable side
less both
premiums
Both Premiums
Max Gain
Max Loss
Premium on both
sides
Unlimited on
either side less
both premiums
Straddle Example
John believes that Allied Waste Inc. stock is going to be extremely
volatile in the next month because the of the trouble the company is
having. The stock is currently trading at $10. John believes that the
stock could either go down or up a great deal depending on whether
the company can get the financing required to stay in business. To
profit from this volatility, John buys a call option and a put option on
Allied Waste both with a strike price of $10. He pays $1 premium on
the call option and a $2 premium on the put.
If the stock price rises to $19, what will his profit (loss) be?
He exercises the call option and buys the shares from the
option writer for $10 per share and then sells them at
market for $19. He allows the put option to expire
worthless.
His profit is $19 sale price - $10 purchase price - $1 call
option premium - $2 put option premium = $6 per share.
Straddle Example II
John believes that Allied Waste Inc. stock is going to be extremely
volatile in the next month because the of the trouble the company is
having. The stock is currently trading at $10. John believes that the
stock could either go down or up a great deal depending on whether
the company can get the financing required to stay in business. To
profit from this volatility, John buys a call option and a put option on
Allied Waste both with a strike price of $10. He pays $1 premium on
the call option and a $2 premium on the put.
If the stock price rises to $11 just before the options expire, what will
his profit (loss) be?
He exercises the call option and buys the shares from the
option writer for $10 per share and then sells them at market
for $11. He allows the put option to expire worthless.
His return is $11 sale price - $10 purchase price - $1 call
option premium - $2 put option premium = $2 loss per share.
Long Strangle Payoff Chart

A strangle is similar to a straddle in that both a call and a put are used.
However, with a strangle, the exercise price on the two options is not
the same. The exercise prices that are chosen with a strangle are both
out of the money. For a long strangle, you would buy one out-of-themoney call and one buy out-of-the-money put.
Payoff
Profit
Profit
0
A short version of this strategy also exists.

ST
Spreads
A bullish spread position is one where a call is purchased
and a call is written on the same underlying security but at
different strike prices.
The investor profits from a rise in the price of the underlying
security, but only up to a point. The difference in the strike
prices determines the level of profits that are possible. The
income from the call that was written helps offset the cost
of the call that was purchased.
Spreads Payoff Chart

In combination
A bearish spread can be created using put options rather than call options
Spread Example
Jeff believes that the price of True Religion Jeans stock,
currently trading at $57, will go up in price but only to $67 in
the next two months. He buys a call option with a strike
price of $57 and writes a call at $67. The premium on the
call he purchased is $1.50 per share and the premium he
receives from the call he writes is $1 per share.
If the stock rises to $70 per share before expiration and the
purchaser of the call that Jeff wrote exercises, what will Jeff
do and what will his profit (loss) be?
Jeff will exercise his option to purchase shares at $57 and
sell them to the purchaser of the call option he wrote for
$67. His profit is $67 sale price - $57 purchase price $1.50 call option Jeff purchased premium + $1 option
premium he wrote = $9.50 per share.
Collars
Collars are very rare among speculators but are common
among investors who already have stock in a company.
Collars allow an investor to sell their stock at a
predetermined range of prices while also preventing or
limiting the loss from a fall in the stock price.
Collars involve the selling of a call option at one stock price
and using the proceeds to purchase at put option at a lower
price. The cost to the investor is essentially zero as the
option premiums cancel each other out.
This strategy is known as a collar because it brackets the
value of a portfolio between two bounds.
Collar Example
Judy is an executive at IBM and has recently been awarded
a significant amount of IBM stock, which is currently trading
at $100. She believes that IBM stock will go up in the next
three months, but knows that technology stocks can fall
quickly if bad news is released. Judy cannot afford to lose
this award, but she would also like to try to get $10 more
per share for her stock ($110). She does not want to sell
for anything less than $90.
She sells a call option with a strike price of $110 for a $5
premium. Using the $5 she buys a put option with a strike
price of $90. Her cost in the trade is $0.
Regardless of what happens to the price of IBM stock, Judy
will receive between $90 and $110 if she decides to sell her
shares before the options expire.
Collar Example Graph
Image from http://web.streetauthority.com/terms/options/6.asp
A Note on Options
There are many more options strategies which we wont
discuss here. They have names such as butterflies,
condors, and strangles.
A good source for more information is the Options Industry
Council. http://www.optionseducation.org/strategy/
Options have a value of their own which depends on both
the intrinsic value and the time value of the option.
While many options are not exercised until close to their
maturity, profits can be made on options WITHOUT
EXERCISING THEM.
Options can be sold to other investors for prices which are
determined according to complex valuation models. We
will look at those models next.
Other Strategies (NOT ON TEST)
Married Put
Options Valuation
Option valuation can be a highly quantitative issue, but we
are going to start by identifying the features of an option
that affect market value.
We will follow with a simple pricing model, followed by the
famous/infamous Black-Scholes Model.
We will conclude with a discussion of the applications of
options to risk management.
Intrinsic and Time Value

The intrinsic value of an option is the gain that could be
attained by immediate exercise of an in-the-money option.
For call options, this is market price of stock exercise
price
For put options this is exercise price market price of stock
The time value is the difference between an options price
and its intrinsic value.
Premium of an option = Time Value + Intrinsic Value
Intrinsic and Time Value II

Most of an options time value is a type of volatility value.
The holder of the option can choose not to exercise the
option but hold it until expiration, it has the potential to
create a profit.
As the stock price rises on a call option, it becomes more
likely that the option will be exercised. As it becomes more
likely to be exercised, its volatility value decreases as a
percentage of overall value.
Determinants of Option Value

1- Stock price an increase in the price of the stock
increases the value of a call option and decreases the
value of a put option.
2- Exercise price an increase in the exercise price
decreases the value of a call option and increases the
value of a put options.
3- Stock price volatility - an increase in the volatility of the
stock increase the value of both a call and a put option
Determinants of Option Value

4- Time to expiration an increase in the time to expiration
increases the value of a call option and increases the value
of a put option
5- Interest rate an increase in interest rates increases the
value of a call option and decreases the value of a put
option
6- Stock dividend a higher dividend payout lowers the
value of a call option and may raise the value of a put
option
Put / Call Parity

In many cases, put prices can be derived from the call
prices. Prices of European put and call options are linked
together in an equation known as the put-call parity
relationship.
C P S0
1 r
Where
C = call premium P = put premium
X = exercise price
S0 = dollars initially invested in stock
Rf = interest rate on debt
T = time to expiration (as a fraction of a year)
This formula tells us that difference between the call and

put values is equal to the difference between the stock
price and the present value of the exercise price.
Put / Call Parity Example

What is the approximate put premium when the exercise
price on an option is $100, the stock price is $105 and the
call premium is $20? Assume that the interest rate on debt
is 11.1% per year and the time to expiration is one year.
C P S0
1 r
f
C P = 105 (100 / (1.111))

20 - P = 105 - 90
20 - P = 15
P=5
Put / Call Parity Mispricing

We can use the Put/Call Parity relationship to determine if
options are priced correctly. If we find that an option is
incorrectly priced, we can profit from it based on the
assumption that the prices will move back into parity.
The strike price on a call option with one year until maturity
is $100, the stock price is $105 and the call premium is $20
when interest rates are 11.1%. The premium on a put
option with the same strike price and maturity is $4. How
can we profit from this?
We found on the previous example that the price of the put
should be $5. This means that the put option is
underpriced, therefore we should purchase the put option.
When the prices return to parity, we can sell it to make $1
profit.
Put / Call Parity Mispricing Example

The strike price on a call option with one year until maturity
is $75, the stock price is $70 and the call premium is $5
when interest rates are 10%. The premium on a put option
with the same strike price and maturity is $4. How can we
profit from this and what will be the profit if prices return to
parity?
5 - p = 70 - (75 / (1.1))
P = 3.18
The put should be priced at $3.18, but is selling for $4.
This put is overpriced, so we should sell the put. When it
returns to parity, we can buy it back for $3.18 and make a
profit of $4 - $3.18 = $0.82
Binomial Option Pricing

We can begin to get an understanding of call option pricing
by using a relatively simple, but powerful pricing model
called binomial pricing.
Suppose a stock currently sells for $100 per share and the
price will either increase by a factor of u=1.2 (u=up)to $120
or fall by a factor of d = .9 (d=down) or $90
We can draw a tree showing what could happen
$120
$100
$90
Initial
End of period

Now suppose a call option on the stock has a strike price
of $110 with one year to expiration. The interest rate is
10%. At the end of the year, the payoff to the holder of the
call option will either be zero (if it falls) or $10 (if it goes up)
based on the performance of the stock.
$10
C0
$0
Initial
End of period
For this option, in the best case scenario we receive $10.

How much should this option cost?
Replicating Portfolio
In Finance, when an investment is difficult to value or
doesnt have a clear value, one way we attempt to value
these assets is to create a portfolio with the same return as
the difficult to value asset.
We can then value the assets in the replicating portfolio to
get an idea of the value of the difficult to value assets.
This is the first way we will value the derivative.

To find the value of the previous option, compare it to a
portfolio consisting of one share of stock and borrowing the
PV of the future stock price where the option has no value.
Buy a share of stock for $100 and borrow $81.82 = (PV of
$90 at 10% or 90/1.1. $90 will be repaid in one year)
The cash outlay to create this portfolio = -100 + 81.82 =
-$18.18 or a $18.18 outflow.
If the stock goes up to $120, then you pay back the loan of
$90, so you have ($120-$90) = $30
Or
Stock goes down to $90, then you pay back the loan of $90
and you have ($90-$90) = $0.

If the stock goes up to $120, then you pay back the loan of $90, so you
have (120-90) = $30
Or
Stock goes down to $90, then you pay back the loan of $90 and you
have (90-90) = $0.
The $30 payoff is three times the $10 option payoff, so three options
would replicate the payoff of the portfolio. The three options to one
share is called the hedge ratio.
stock = $120
pay back loan of $90 netting $30
$30 times one-third = $10
(buy stock)
-$100.00
(take out loan) + 81.82
-$18.18
One-third = -$6.06
Stock Price
stock = $90
pay back loan of $90
netting $0
Payoff from three calls equal one share of stock, so one call = $6.06
Binomial Option Pricing V

$30
$10
$18.18
$0
$0
Call Option
Portfolio
A portfolio made up of one share of stock and writing 3 call

options is perfectly hedged. (the portfolio value is the same
whether the stock rises or falls)
Stock Value
less obligation
from 3 calls
written
$120 $90
-30 $0
$90
An investor has formed a riskless$90
portfolio
with a payout of
$90, so the value must be equal to the PV of $90 or $82.18
which in turn should equal $100-3C = 81.82; C = 6.06
A Second Method of Valuation

We can find the number of shares that can be hedged or
protected by one option. The formula for the hedge ratio
can be written as:
where Cu or Cd refers to the call options value when the

stock goes up or down and uS0 and dS0 are the stock
prices in the two states.
The hedge ratio is the ratio of the possible swings in the
possible end-of-period values of the option and the stock.
If an investor writes one option and holds H shares of
stock, the value of the portfolio will be unaffected by the
stock price.
Hedge Ratio Example

We have one share of stock selling for $60. In one year,
the stock will either be selling for $78 (u=1.3) or $54 (d=.9).
The interest rate is 8%. A call option on this stock has a
strike price of $72. What is the hedge ratio and how much
should each option cost?
If stock goes up, the option will generate $6 (Cu=$6) in
income and if the stock price falls, it will generate $0
(Cu=$0).
=
($6-$0) / ($78 - $54) = 1/4
So the hedge ratio is . It will take four options to hedge

the portfolio.
Hedge Ratio Example

We want to create a portfolio of stock and options that will
have the same value regardless of the changes in the stock
price. So whether the stock price is ends up at $78 or
down at $54, our portfolio value should be the same.
We know that we will need 4 options for every 1 share of
stock. Lets create a portfolio that will have the value of
$54 regardless of changes in the stock price.
$78
$6
$60
C
$0
Call Option
$54
Portfolio
Hedge Ratio Example

We want to create a portfolio of stock and options that will
have the same value regardless of the changes in the stock
price. So whether the stock price is ends up at $78 or
down at $54, our portfolio value should be the same.
We know that we will need 4 options for every 1 share of
stock. Lets create a portfolio that will have the value of
$54 regardless of changes in the stock price.
Buy one share for $60 and write 4 options at price C. We
want the value of our portfolio one year from today to equal
$54, so today it should equal the present value of $54 or
$54/1.08 = $50. We can now determine how much the
options should cost to make this portfolio work.
$60 4C = 54/1.08. C=$2.5
Hedge Ratio Example

Lets see what happens with our portfolio if the stock price
goes up or down.
We buy one share for $60 and sell 4 options for $2.50
each. Our cost to create this is $60 - (4 x $2.50) = $50.
If the stock ends at $54, then our one share is worth $54
and the options we sold wont be exercised. Our portfolio
is worth $54.
If the stock ends at $78, then our one share is worth $78
and the option buyer will exercise the options at $72. Our
cost is $6 per option times 4 options = $24. The value of
our portfolio is $78 - $24 = $54.
This proves that our portfolio was perfectly hedged and that
the options were worth $2.50 a piece.
In Search of a Simplified Process

If you want to think of process of creating the replicating
portfolio as a formula.
1) Find the Hedge Ratio.
2) Create an equality by setting (the current stock price
minus the numbers you sold) equal to (the present value of
the stock in its down state).
3) Solve for the value of the options you sold.
Using the previous example:
$60 4C = 54/1.08
C=$2.5
Generalizing Two-State Approach

If it seems unrealistic to only have two possible values for a
stock a year in the future, we can increase the realism by
breaking the time period into multiple parts, with a new step for
each unit of time.
Over a six month period a stock could increase by 10% or
decrease by 5%. The stock initially selling for $100 could follow
these possible paths over period of a year.
$121
$110
$104.50
$100
$95
$90.25
6 Months
6 Months
Generalizing Two-State Approach

There are now three possible end-of-year values for the
stock and three for the option
Cuu
Cu
Cud
C
Cd
Cdd
We could use Cuu and Cud to find the value of Cu. Using
Cud and Cdd we then find the value for Cd. Then we find C
using Cu and Cd.
Two-State Example
Risk Free Rate = 5% over 6 months (10.25% annual rate).
Assume X=$110. When the stock price is 121, Cuu is $121$110 or 11 (value at expiration). When the stock is at
$104.50, Cud is worth zero. Value Cu.
121
Cuu
110
Cu
104.50
100
95
Cud
C
Cd
90.25
Cdd
Hedge Ratio = (cuu cud) / (uuSo udSo)

= (11 - 0)
/ (121 - 104.5) = 2/3
So for every 2 shares of stock, I need to write 3 call options.
Two-State Example
6 month Risk Free Rate = 5%. Assume X=$110. When the stock
price is 121, Cuu is $121-$110 or 11 (option value at expiration).
When the stock is at $104.50, Cud is worth zero. Value Cu.
121
Cuu
110
Cu
104.50
100
95
Cud
C
Cd
90.25
Cdd
Buy 2 shares of stock at uSo and write 3 options.

If stock ends at 121, then our portfolio value equals (2 x 121) = 242
minus (3 options cost of $11 per option = 33) = $209
If stock ends at 104.50, the our portfolio value equals (2 x 104.5) = 209
minus (3 options which wont be exercised = 0) = $209
Two-State Example
This portfolio must have current market value of $209.
Since the risk free rate over the 6-month period is 5%, then
the cost of the portfolio is
2 *110 3cu = 209/1.05
Cuu
Cu = $6.984.
We now have the value for Cu
Cu
Cud
C
Cd
Cdd
Then find Cd using the same process. Once we have the

value for Cu and Cd, it becomes a simple one-stage
problem to find the value of C. (Like our previous example)
Black-Scholes Option Valuation

The Black-Scholes Pricing Formula is another method for valuing an
option which uses the stock price, the strike price, the risk-free rate,
the time to expiration and the standard deviation of the stock return.
The formula for European-style call option is:
Dividend paying stock
Non-Dividend paying stock
What does it all mean?

The formula looks scary, but can be straightforward with
one simplification.
N(d) is the probability that the call option will expire in the
money. If d1 and d2 are = 1, which means that the option
will expire in the money, the formula simplifies to:
which means that the option cost is a function of the stock
price, the strike price, the risk free rate and time until
maturity.
What does it all mean? II

On the other hand, if d1 and d2 are = 0, this means that the
option will expire out of the money. The formula simplifies
to C0 = 0, which makes sense because options that expire
out of the money are worthless.
Standard
Normal
Curve
-3
-2
-1
Cumulative
Normal
Distribution
+1
+2
+3
1.0
0.5
N(d)
N(d) is a probability which fits a cumulative distribution

Black-Scholes Hedge Ratios

The Black-Scholes hedge ratio for a call = N(d1)
The Black-Scholes hedge ratio for a put = N(d1)-1
Lets work through an example.
Black-Scholes Example
What is the current call option value for an option that will
expire in three months according to the Black-Scholes
Formula if the underlying stock price is currently $100, the
exercise price is $95, the 3-month interest rate is 10% and
the standard deviation of the returns of the stock is 0.50?
T = .25
d1 = [ln(100/95) + (0.10 + (0.5)2/2)*0.25] / (0.5* (0.25)1/2)
=(0.0513 + 0.0563) / 0.25 = .43
d2 = 0.43 - (0.5* 0.251/2) = 0.18
We must use the cumulative probability table to look up the
probabilities for d1 and d2
Black-Scholes Example II
You might have to estimate a little.

d1 =.43
d2 =.18
N(d1) = 0.6664
N(d2) = 0.5714
Black-Scholes Example III
N(d1) = 0.6664
N(d2) = 0.5714
C0 = 100 * 0.6664 95e-0.10*0.25 * 0.5714
=66.64 95 * 0.9753 * 0.5714
= 66.64-52.94
= 13.70
The call option premium is $13.70
Using Black-Scholes
The hedge ratio, also known as delta (), is the number of
shares of stock that can be hedged by holding one option.
Recall that the formula for calculating the hedge ratio is:
The call hedge ratio will be positive and less than 1 while
the put hedge ratio will be negative and less than 1 in
absolute value.
Call is the number of shares of the underlying stock that the
investor can hedge with a written call option.
Put is the number of shares of the underlying stock that the
investor can hedge with an owned put option
Volatility and the VIX

Many times, investors will use Black-Scholes with known
stock prices and known option prices in the market to solve
for the standard deviation, , necessary for the observed
option price to be consistent with the model. They are
solving for the implied volatility. Basically, how much
volatility is the market expecting based on the pricing of the
option.
One measure of implied volatility is actually traded by itself
in the markets. The Chicago Board Options Exchange
Volatility Index, call the VIX, is a popular measure of the
implied volatility of the S&P 500 index options.
The VIX is a weighted blend of prices for a range of options
on the S&P 500 index.
Volatility and the VIX (contd)

The VIX is often referred to as the Fear Index, because it
represents one measure of the markets expectation of
volatility over the next 30 day period.
High values correspond to a more volatile market and
therefore more costly options.
The VIX can be used to help measure the markets
expectations of volatility in the short term future.
You can track the VIX using Yahoo! Finance. VIX Yahoo
Finance Ticker is ^VIX (^ is shift+6 on most keyboards)
There is even an ETF that you can use to make money or
help hedge the volatility of your portfolio. Its ticker is VXX.
Using Hedge Ratio in Another Way

We can use the hedge ratio to tell us how sensitive option
prices are to movements in the underlying stock price.
The hedge ratio is .6 and an investor writes 100 options
and holds 60 shares of stock.
(The hedge ratio is the number of shares of stock that can
be hedge by holding one option. 0.6 shares can be hedged
by holding one option. If the investor multiplies each side
by 100, 60 shares can be hedged by 100 options)
A $1 increase in the stock price would result in a $60 gain
in the stock. Loss on the options would be 100 * .6 = $60
This is a hedged position where total wealth is unchanged
by changes in the stock price.
Using the Hedge Ratio Example

There are two portfolios. The hedge ratio on some call
options is .6. Which portfolio has more dollar exposure to
IBM price movements? Use the hedge ratio (H).
Portfolio 1: 750 IBM Calls + 200 Shares of IBM
Portfolio 2: 800 IBM shares
Each option changes in value by H dollars for each dollar
change in the stock price. So if H=.6 then the 750 IBM
calls are equivalent to 750 * .6 = 450 shares in terms of
their response to the stock price of IBM.
Portfolio 1 has the equivalent of 450 + 200 shares = 650
shares of IBM. Portfolio 2 has dollar movements
equivalent to 800 shares of IBM.
Portfolio 2 has more dollar sensitivity to price.
Option Elasticity
Another important concept is option elasticity, which is the
percentage increase in an options value given a 1%
increase in the value of the underlying security.
While the options in the previous example have less Dollar
Sensitivity than a share of stock, that does not mean that
they are less volatile in the rate of return.
For a stock selling for $120 and a hedge ratio of .6, an
option with an exercise price of $120 may sell for $5. If the
stock price increases to $121, the call price would be
expected to increase by only $0.60 to $5.60.
However, the percentage increase in the option value is
$0.60 / $5.00 = 12%, while the percentage stock
price increase is only $1 / $120 = 0.83%.
Option Elasticity (contd)

The percentage increase in the option value is
$0.60 / $5.00 = 12%, while the percentage stock rise
increase is only $1 / $120 = 0.83%.
Option elasticity measures the sensitivity of change in
option price to change in the stock price.
So for the example above, the option elasticity would be

12% / 0.83% = 14.4%
For every 1% increase in the stock price, the option price
increases by 14.4%.
Option Elasticity Example

A share of Microsoft (Ticker: MSFT) stock is selling for $75 and
its hedge ratio is .5. A call option with exercise price $75 is
selling for $4. If the stock price increases to $77, the call price
would be expected to increase by how much? For a 1%
increase in the stock price, by what percentage will the option
price increase?
Step 1) Find the dollar change. Hedge ratio of .5 means that

for a $1 change in the stock price, the option will increase by
$0.50. The stock changed by $2, so the option price increased
by $1 to $5.
Step 2) The option elasticity = ($1/$4)/($2/$75) = (25%)/
(2.6667%) = 9.375. So a 1% increase in stock price will cause a
9.375% increase in the price of the option.

Derivatives - Options CH 20 & 21

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Derivatives - Options CH 20 & 21

Hochgeladen von

Copyright:

Verfügbare Formate

Derivatives Options

2015 J. David Miller

Option Contracts (contd)

2015 J. David Miller

Option Contract Example

2015 J. David Miller

Option Contracts Value

Option Contracts Value (contd)

Option contracts can be traded up to expiration.

Options Trading (contd)

2015 J. David Miller

2015 J. David Miller

Other Listed Options

2015 J. David Miller

Other Listed Options (contd)

2015 J. David Miller

Corporation Issued Options

Value of Call Options at Expiration

2015 J. David Miller

Call Option with $80 Exercise Price

2015 J. David Miller

Long Call Example

2015 J. David Miller

Long Call Example II

Call Option with $80 Exercise Price

2015 J. David Miller

Value of Put Options at Expiration

2015 J. David Miller

Put Option with $80 Exercise Price

2015 J. David Miller

Long Put Example

2015 J. David Miller

Long Put Example

2015 J. David Miller

Short Put Example

2015 J. David Miller

Short Put Example II

Options vs. Holding Stock

2015 J. David Miller

Options vs. Holding Stock II

Options vs. Holding Stock III

Each of these portfolios involves the same $9,000 initial

Options vs. Holding Stock IV

Options vs. Holding Stock V

Call and Put Comparison

Sell (write) Call

Strike Price less

Sell (write) Put

Strike Price less

2015 J. David Miller

Strike Plus Premium

Strike Less Premium

2015 J. David Miller

Protective Put Payoff Chart

2015 J. David Miller

Protective Put vs. Stock Investment

This shows the return on a Protective Put Strategy

Protective Put Example

Protective Put Example II

2015 J. David Miller

2015 J. David Miller

Covered Call Payoff Chart

Covered Call Example