FIN 4003 Financial Derivatives

Lecture 7

Properties of Stock
Options
Learning Outcomes

After this class, you should be able to

 Understand the effect of different
Variables on Option Pricing
 Understand the upper bound and
lower bound for option prices
 Understand and apply the put-call-
parity

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Notation
c: European call C: American call
option price option price
P: American put
p: European put
option price
option price
ST: Stock price at
S0: Stock price today
option maturity
K: Strike price D: PV of dividends
T: Life of option paid during life of
option
s: Volatility of stock
price r Risk-free rate for
maturity T with
continuous
compounding 3
Effect of Variables on Option Pricing

Variable c p C P
S0 + − + −
K − + − +
s + + + +
r + − + −
D − + − +
T ? ? + +

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Stock Price and Strike Price
 If a call option is exercised at some future
time, the payoff will be ST - K.
 Hence the value of a call option is
decreasing in strike price.
 When current price is higher, the price at
the option maturity is likely to be higher.
So the value of a call option is increasing
in current price.
 Thus, the value of a put option is
increasing in strike, and decreasing in
current price 5
Volatility

 Volatility measures the uncertainty of the

return realized on an asset.
 An increase in volatility means higher
chances for a stock to perform very well
or very poorly.
 The owner of a call benefits from price
increases but has limited downside risk,
which results in higher value in options.
 Usually volatility increases when the
forecast period is longer. 6
Risk-Free Interest Rate
 If interest rate increases and the current
stock price remains the same, then
⚫ the expected future price must be
higher.
⚫ the present value of any future cash
flow received by the holder of the option
decreases.
 However, it is likely that higher interest
rate leads to lower current stock prices.

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Risk-Free Interest Rate
o Usually the future price effect dominates
the effect via discount rate and current
stock prices.
o Hence we expect higher values in call
options and lower value in put options at
the expiration date.

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Dividends

 With no dividend payment adjustment in

the strike price, dividend payment will
imply lower stock prices at the expiration
date, which leads to lower value in call
options, and higher value in put options.
 If there is dividend payment adjustment,
the value of an option does not change.

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Time to Expiration
 Each time you want to exercise a short-life
American option, you can always exercise
the long-life one.
 Hence, both put and call American options
become more valuable as the time to
expiration increases.
 If there is no dividend payment, European
call and put options are usually more
valuable as the time to expiration increase
due to the volatility argument. Otherwise, it
is hard to tell. 10
Prices of Options on Non-
Dividend-Paying Stocks
 Assumptions:
⚫ There are no transaction costs.

⚫ There are no effects on tax

payments.
⚫ Borrowing and lending are possible
at the risk-free rate.

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Upper Bounds for European Calls

 If c > S0, an arbitrageur can write a call

option and buy the stock.
⚫ When ST > K, the present value of the
payoff is c – S0 + Ke–rT > 0;
⚫ when ST ≤ K, the present value of the
payoff is c – S0 + STe–rT > 0.
 Due to arbitrage forces, we have c ≤ S0.
 Similar argument suggests C ≤ S0.

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 Lower Bound for European Calls:
 Portfolio A: one call (with a contract size of
one share) & Ke–rT in cash
Portfolio B: one share currently traded at S0
 The payoff of portfolio A is max{ST, K} at
time T;
 The payoff of portfolio B is ST at time T.
 So portfolio A must have a higher present
value than portfolio B, i.e. c + Ke–rT ≥ S0.
 Thus we have:
c  max(S0 –Ke –rT,0)
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Calls: An Arbitrage Opportunity?

 Suppose that
c=3 S0 = 20
T=1 r = 10%
K = 18 D=0

 Is there an arbitrage opportunity?

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Calls: An Arbitrage Opportunity?
Upper Bounds for European Puts

 If p > Ke–rT, an arbitrageur can write a put

option and deposit the money.
⚫ When ST ≥ K, the present value of the
payoff is p > 0;
⚫ when ST < K, the present value of the
payoff is p + (ST – K) e–rT> 0.
 Due to arbitrage forces, we have p ≤ Ke–rT.
 Similar argument suggests P ≤ K.

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Lower Bound for European Puts:
 Portfolio C: one put (with a contract size of
one share) & one share at S0
Portfolio D: Ke–rT in cash
 The payoff of portfolio C is max{ST, K} at
time T;
 The payoff of portfolio D is K at time T.
 So portfolio C must have a higher present
value than portfolio D, i.e. p + S0 ≥ Ke–rT.
 Thus we have:
p  max(Ke –S0,0)
-rT

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Puts: An Arbitrage Opportunity?
 Suppose that
p= 1 S0 = 37
T = 0.5 r =5%
K = 40 D =0
 Is there an arbitrage opportunity?

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Puts: An Arbitrage Opportunity?

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Put-Call Parity: No Dividends
 Consider the following 2 portfolios:
⚫ Portfolio A: European call on a stock +
zero-coupon bond that pays K at time T
⚫ Portfolio C: European put on the stock +
the stock
 Both are worth max(ST , K ) at the maturity of
the options
 They must therefore be worth the same today.
This means that c + Ke -rT = p + S0

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Put-Call Parity: No Dividends

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Arbitrage Opportunities
 Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D= 0
 What are the arbitrage possibilities
when
p = 2.25 ?
p=1?

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Arbitrage Opportunities

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American Options

 An American option is worth at least as

much as the corresponding European option,
i.e. C ≥ c, and P ≥ p.
 The bounds computed above can apply to
American options.
 While American options may be exercised
early, the put-call parity does not hold.
Instead, we have S0 – K ≤ C – P ≤ S0 – Ke–rT.

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 Early Exercise of American Calls
 For an American call option:
S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
 What should you do if
⚫ You want to hold the stock for the next 3
months?
⚫ You do not feel that the stock is worth
holding for the next 3 months?

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Early Exercise of American Calls

 An American call on a non-dividend paying

stock should never be exercised early,
because C ≥ S0 – Ke–rT > S0 – K.
 If you want to exercise the call early and
hold the stock until time T, you would be
better off if you wait and exercise the call
at time T.

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Early Exercise of American Calls

 If you want to exercise the call early and

sell the stock before time T, you would be
better off if you just sell the call.
 Without any possibility of early exercise,
we must have C = c.

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Reasons For Not Exercising a Call
Early (No Dividends)
 No income is sacrificed
 You delay paying the strike price
 Holding the call provides insurance
against stock price falling below strike
price

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Should Puts Be Exercised Early ?

Are there any advantages to

exercising an American put when

S0 = 60; T = 0.25; r=10%

K = 100; D = 0

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Reasons For (Not) Exercising a
Put Early (No Dividends)
 You delay receiving the strike price
 When you are holding the stock, a put
provides insurance, which guarantees that
the stock can be sold at least at the strike
price, K.

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Early Exercise of American Puts

 An American put on a non-dividend

paying stock might be exercised early,
when K – S0 > P (≥ p ≥ Ke–rT – S0).
 The actual bound for the American put is
max{K – S0, p} ≤ P ≤ K

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Bounds for European or American
Call Options (No Dividends)

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Bounds for European and American
Put Options (No Dividends)

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The Impact of Dividends on Lower
Bounds to Option Prices

−rT
c  S0 − Ke −D
− rT
p  Ke − S0 + D

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Extensions of Put-Call Parity
 European options, D > 0
c + D + Ke −rT = p + S0

 American options, D > 0

S0 − D − K < C − P < S0 − Ke −rT

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