Option Pricing and Bounds

Banikanta Mishra
Xavier Institute of Management
 Bounds on Option Prices
Call price cannot exceed the Stock Price;
if it does, one can make money by writing covered calls.
Similarly, price of a put cannot exceed PV of exercise price X;
if it does, write a put and deposit the premium @ RF rate.
Therefore, the price of a European put can’t exceed PV of X.
European C must at least be S0 - PV(X) [ -D if dividends there];
or else, short the share, buy a call, and lend PV(X) at t=0,
receive X, exercise call to pay X and get the share to deliver
or receive X, buy the share at cheaper S, deliver it, pocket X-S
European P must at least be PV(X) - S0; [+D if dividends there]
or else, buy the share, buy a put, and borrow PV(X)
2
 Bounds, in Brief
c =< S0 (or else, buy the stock and sell the call)

c >= S0 - X e-rt (or else, short share, buy call, lend X e-rt)

c >= S0 - X e-rt - D
p = < X e-rt (or else, sell the put and lend proceeds @r)
p >= X e-rt - S0 (or else, buy share, buy put, borrow X e-rt)

p >= X e-rt - S0 + D
It does not pay to exercise an American call before maturity.
It may pay to exercise an American put before maturity.
3
 Put-Call Parity
Inv at t=0 CF at t=T
ST > X ST < X

Buy Stock S0 ST ST

Buy a Put P 0 X - ST

Net S0 + P ST X

Buy a Call C ST - X 0

Lend X e-rt X e-rt X X

Net C + X e-rt ST X
Law of One Price => S0 + P = C + X e-rt
4
Squared/Hedged Put-Call Position
Buy a Share -S0
Write a Call +C
Borrow PV(X) +PV(X)
Buy a Put -P
=> You will have no CF at maturity
As you either exercise put to get X and repay loan OR
Deliver your share against the call exercise, get X, repay loan
=> -S0 + C + PV(X) - P = 0 => C = P + S0 - PV(X)
American C - P must lie between S0 - X and S0 - PV(X)
5
 Valuing a Call Option
Given Data

Strike Price of the European Call = $320

Expiration Date of the European Call = T

Current Price of the Underlying Asset = $300

Price of the Underlying Asset at T: SH ($340) or SL ($260)

Risk-free Rate between now and T = 4.00%

6
 Computing Call Price C
t=0 (now) t=T
Action Taken Cash Flow Action Taken Cash Flow
STRATEGY-1 If ST=340 If ST=260
Buy ONE Share -300 Sell the Share 340 260

SL 260 +250 Repay -260 -260

Borrow 
1  R 1  4% [ 250 x (1 + 4%) ]
TOTAL CF -50 +80 0

STRATEGY-2

Buy ONE Call @X=320 -C Exercise if optimal +20 0

(Do NOT Exercise)
How many calls will have equal CF at T with Strategy-1? FOUR
Buy FOUR Calls @X=320 -4C Exercise if optimal +80 0
Law of One Price suggests that 4C = 50 => C = 12.50
7
 t=0 t = Qtr End
Action CF Action CF
S = 34 S = 26
Buy 1 kg
of wheat
@ S0 -30 Sell it 34 26
Write Call
on 1 kg Honor
@ X = 32 +C Contract -2 0
x 4 calls +4C If Needed -8 0
Borrow S0 +25 Repay -26 -26
@ 4% p.q.
Net CF 4C - 5 0 0
Law of One Price (No Arbitrage Condition) => 4C = 5 => C = 1.25
8
 Risk Neutral World
t=0 t = Qtr End
Action Inv Action CF
S = 34 S = 26
Probability p 1-p
Buy 1 kg of 30 +34 +26
wheat @spot
Investment = 30 Expected CF = [(p x 34)] + [(1-p) x 26]
Risk Neutrality ====================>
= 30 x ( 1 + 4%) = 31.20
=> p = 0.65
Buy 1 call C Exercise +2 0
@ X=32 if worth it
Investment C x ( 1 + 4%) = [p x 2] + [(1-p) x 0] = 1.30
=> C = 1.30 / (1+4%) = 1.25
9
 Equivalent Portfolios
t=0 t = Qtr End
Action Beta Action CF
S = 34 S = 26
Buy 1/4 kg of $7.50 bw Sell it 8.5 6.5
wheat @spot
Borrow $6.25 @4% 0 Repay -6.5 -6.5
CF -1.25 2.0 0.0
Portf b  (7.50 / 1.25) bw

Buy 1 call @ X=32 bc Exercise 2.0 0.0

if worth it
Since the two above strategies have identical CFs, their bs are equal
=> (7.50 / 1.25) bw = bc => bc = 6.0 bw
10
 Risk Averse World
t=0 t = Qtr End
Action Inv Action CF
S = 34 S = 26
Probability p 1-p
Buy 1 kg of 30 +34 +26
wheat @spot
Investment = 30 Expected CF = [(p x 34)] + [(1-p) x 26]
bw= 0.5
kM-RF = 2% = 30 x ( 1 + ks)
ks = 4% + (0.5 x 2%) = 5% => 30 x ( 1 + ks) = 31.50 => p = 0.6875
Buy 1 call C Exercise +2 0
@ X=32 if worth it
Investment C x ( 1 + kc)= [p x 2] + [(1-p) x 0]=1.375
bc = 6.0 x bw = 3.0 => kc = 4% + (3.0 x 2%) = 10% => C = 1.375 / (1 + 10%) = 1.25
11
 Factors Affecting Option Prices
Call Put

Exercise Price - +

Current Stock Price D, G + -

Time to Expiration Q + +

Volatility l or u + +

Riskfree Intrest-Rate r + -

Dividends - +
12
 The Binomial Model
Portfolio: Portfolio Value
Long D shares
uS0
Short 1 option
 Value = DS0 –f fu D uS0 – fu
Equal iff

S0 fu  fd
D
f uS 0  dS 0
dS0
D dS0 - fd
fd

Should equal PV of which equals e-RT (D uS0 – fu) = e-RT (D dS0 – fd)
e RT  d
=> f = e-RT [p fu + (1-p) fd] where p 
ud
13
 Volatility Matching
uS0
p*
Expected Share Price =
S0 p* uS0 + (1-p*) dS0

e   DT  d
1-p* => p
dS0 ud
Expected Future Value S0 eDt

s Dt
p* u2 + (1-p*) d2 - [p* u + (1-p*) d]2 = s2 Dt => u  e and d  e  s Dt

14
 RN Valuation: Another Example
To value a one-year call @X=230.

Now Date 1
S = 200 280 or 180
Write 1 Call (X = 230) -50 0
Buy 1/2* Shares @ 200 140 90
Borrow Rs.75 @RF=20% -90 -90
Total CF: C - 25 0 0
No Arbitrage => C - 25 = 0 => C = 25
* (50 - 0) / (280 - 100) = 1/2
15
 Binomial Model: Matching bs
Write 1 Call (X = 230) Beta = bc => Wtd Beta = -bc (C/I)
Buy 1/2 Shares @ 200 Beta = bs => Wtd Beta = bs (100/I)
Total Investment = I Overall Beta= -bc (C/I) + bs (100/I)

Lend Rs.75 @RF=20% Beta = bF => Wtd Beta = bF = 0

=> bc = bs (100 / C) = 4 bs if C = 25

16
 Inferring C in an RN World
Now Date 1
S = 200 280 or 180
p 1-p
Expected Share Price = p x 280 + (1-p) 180
Must = S x (1 + RF) = 240
=> p = 0.6 1-p = 0.4
Expected Loss from writing a call= p x 50 + (1-p) 0
= 30
C = Call Price = PV of 30 = 25
17
 C in a Risk-Averse World
Now Date 1
S = 200 280 or 180
0.7 0.3
Expected Share Price = 0.7 x 280 + 0.3 x 180
= 250
Must = 200 x (1 + RRRs)
So, RRRs = 25%
=> RPs = bs (RM - RF) = 5% => bc (RM - RF) = 20%
=> RRRc= RF+ 20% = 40% => C= Exp Loss / (1+40%)
Expected Loss from writing a call= 0.7 x 50 + 0.3 x 0 = 35
=> C = 35 / 1.40 = 25

18