Options #1

• Today:
- Overview
O i off option
ti contracts
t t
- Options strategies
- Put-Call Parity
• Investments (Bodie, Kane, and Marcus)
- Chapters 20-21
20 21

11/1/2011 Dastidar 1
 Options

• Options, as their name indicates, give the holder the

right but not the obligation
right, obligation, to do something in the
future
- A stock option:
- the right, but not the obligation, to buy or sell a share of stock at a
time in the future for a given price
- A reall option:
i
- The right to cut down a forest in some point in the future
- The right
g to invest in a fund or start-up
p

11/1/2011 Dastidar 2
 Types of options

• Call options: the right, but not the obligation, to buy a share of
stock at a ggiven pprice

• Put Options: the right, but not the obligation, to sell a share of
stock at a given price

• Exotic options:
p
- Knock-out (or in) options: a call or put option that ceases to exist if the
underlying price crosses a certain barrier
- Digital option: pays off only if underlying is in a certain range.
- Options on options: compound or chooser options

11/1/2011 Dastidar 3
 Option contract specifications

• Underlying asset
- Usually
U ll equity,
it could
ld be
b a bond,
b d an interest
i t t rate,
t a swap, a currency, or anything.
thi

• Exercise price
- Price at which the financial security can be bought or sold

• Payoff/settlement
- What is received upon exercise? Cash or stock?

• Exercise style: when can you exercise your option?

- European (on expiration date) vs. American (any time)

• Expiration
p date: date on which the option
p expires
p

11/1/2011 Dastidar 4
 Payoff structure of an call option

• Let S(T) be the price of the underlying asset at date T, the

expiration date.
date
• What is the value of a call option at expiration C(T) as a
( ) a.k.a. intrinsic value.
function of S(T),
C(T)

K S(T)
( )

11/1/2011 Dastidar 5
 Example: call with K=100

Call option Call Option Payoff, K=100

payoff 35
S(T) max(0,S(T)-K) 30
25
80 0 C(T)
20
90 0 15

100 0 10
5
110 10 0
120 20 80 90 100 110 120 130
S(T)
130 30

11/1/2011 Dastidar 6
 What happens at exercise?

• If an individual equity options is exercised, shares of

stock are actually exchanged
exchanged.
- MSFT $25 call: pay $25 per share

• What about other contracts? Settled in Cash

- Index (Nasdaq 100 & S&P 500) options?
- Interest rate options

11/1/2011 Dastidar 7
 Option terminology

• The payoff of the call at maturity C(T) is:

C( ) = max{0,
C(T) {0 S(T)-K}
S( ) }

- If S(T) > K then

th the
th call
ll is
i “in-the-money”
“i th ”
- If S(T) < K then the call is “out-of-the-money”
- If S(T) = K then the call is “at-the-money”
at the money

• For the writer of the call,

call the payoff is exactly
opposite to the payoff of the buyer

11/1/2011 Dastidar 8
 Put payoffs

• The payoff diagram for a put option at maturity P(T)

as a function of S(T):

•If S(T)>K then the put is

P(T) “out of the money”
•If S(T)<K then the put is
“in the money”
•If S(T)=K then the put is
K S(T) “ t the
“at th money””

P(T) = max{0,K-S(T)}

11/1/2011 Dastidar 9
 Where are they traded?
• Exchange traded options
- Chicago Board of Exchange (CBOE)
- Pacific Exchange (PCX)
- Philadelphia Exchange (PHLX)
- American Stock Exchange (AMEX)
- I
International
i l Securities
S i i Exchange
E h (ISE)

• OTC: over-the-counter

• Why would you prefer to trade on an exchange

- Liquidity
q y and transparency
p y
- Counterparty credit risk
- Standardized contracts

11/1/2011 Dastidar 10
 Exchange listing

• Listing requirements (PHLX)

- $5 per share
- At least 500,000 shares publicly traded
- $3,000,000 market capitalization
- At least 800 different shareholders

• Which exchange?
- Pre-2000, stocks were assigned to exchanges
- 2000: DOJ sued CBOE
CBOE, AMEX
AMEX, PCX
PCX, PHLX for
collusion as they never listed the same option on multiple
exchanges.
- Now
N theyh are li listedd on any (and
( d usually
ll all)
ll) exchanges
h
11/1/2011 Dastidar 11
 Example: October 07, $30 MSFT Call

• Traded at
- CBOE: [Link]
www cboe com
- Phila Ex: [Link]

• Microsoft
Mi ft A
American
i call
ll option
ti

• The owner of option

p has the right
g ((but not the obligation)
g ) to buyy
(“call”) Microsoft stock (from the call writer/seller) for $30 at any
time prior to August 18th (usually the 3rd Friday of the month)

• When is it valuable?

11/1/2011 Dastidar 12
 Example: Oct 07, $22.5 MSFT Put

• The owner of this option has the right (but not the
obligation) to sell (“put”) Microsoft stock to the seller
of the option for $30 at any time prior to August 18th.
• When is this valuable?

11/1/2011 Dastidar 13
 “Exotic” derivatives

• Binary
i call
ll

• Binary put

• Binary range/strangle

• Useful? Options on Fed Funds…

11/1/2011 Dastidar 14
11/1/2011 Dastidar 15
 What to use options for?
• Before pricing options, we need to understand how
they are used
used.

• Portfolio Strategies with Options

1. Directional bets—cheaper than buying stock (??)
2. Straddle: buyy or sell volatility
y
3. Currently hold stock and want to lock in payoffs:
covered call and protective put

11/1/2011 Dastidar 16
 Option and underlying prices

• If you think the stock price is going up, why not just
buy a call instead of the stock price?

• If you think the stock price is falling, why not just buy
a put instead of shorting?

• What are the bid-ask spreads?

- MSFT stock on Nasdaq
- MSFT at the
h money call
ll option
i at CBOE

• What if you’re sure MSFT will go up?

11/1/2011 Dastidar 17
 Straddle

• Consider buying a call and a put on MSFT, both struck

at K=60. What does the ppayout
y look like?

Long call payoff Long put payoff Straddle payoff

=

+
K S(T) K S(T) K
11/1/2011 Dastidar 18
 Straddle payoffs

• When is a straddle position profitable?

- If the
th underlying
d l i moves drastically
d ti ll up or down.
d

• St
Straddles
ddl allow
ll ffor bbets
t on th
the volatility
l tilit off the
th
underlying instead of the direction.

• Straddles are useful for event driven trades

- Announcements:
A t FOMC
FOMC, earnings,
i etc.
t

11/1/2011 Dastidar 19
 Covered call

• Suppose one holds 1 share of Microsoft at $30 and you

believe that $40 is a “sell
sell level
level” for MSFT
MSFT. That is
is, if it
gets to $40, you will sell it.

• Consider writing (selling) a call option expiring in 3

months with an exercise price of $40.
- What do you get? The price of the option (say $5), but now
will lose any income if Microsoft goes over $40.

• What is the payoff diagram?

11/1/2011 Dastidar 20
 Covered call payoff

Stock payoff Written call payoff Covered call payoff

+ =

S(T) S(T) S(T)

=>This looks like a

short put!

11/1/2011 Dastidar 21
 Protective put portfolio

• Suppose an individual holds Cisco at $20 per share

and cannot sell their position for 60 days.
days

• To protect against losses,

losses you purchase put options
with 60 day maturity struck at $15.

• If the stock ends above $15 the put option expires out
of the money. If the stock ends below $15, the option
will
ill pay andd loses
l are minimized.
i i i d

• What
Wh t is
i the
th payoff
ff diagram?
di ?
11/1/2011 Dastidar 22
 Protective put payout

Stock
k payoff
ff Long put payoff
ff Protective
i put payoff
ff

+ =

S(T) S(T)
=>This looks like
a long call!

11/1/2011 Dastidar 23
 Relationships between puts and calls

• What is the difference between the payoff of a call and the

protective put portfolio?

Protective put payoff

Call payoff

• The
Th difference
diff iin the
th payoffs
ff is
i equall to
t K
11/1/2011 Dastidar 24
 Replicating the protective put portfolio

• Let’s buy a call (struck at K) and an asset which pays

$K at maturity for sure,
sure ii.e.
e a bond with the face value
of $K.

• What are the payoffs at time T? Same as the protective

put portfolio?

• By no-arbitrage,
no arbitrage the prices of these two portfolios
should coincide

11/1/2011 Dastidar 25
 What are the payoffs?

• The payoff of a protective put is

=K if ST<K
PT  ST  max(K  ST ,0)
0)  ST
=ST if ST>K

• Compare to a call +K
=K
K if ST<K
K
C T  K  max(ST  K,0)  K
=ST if ST>K

11/1/2011 Dastidar 26
 Put-call parity (European options)

• The payoffs are the same: the prices of these securities

should be the same today.
today

• What
Wh t is
i the
th value
l off K today?
t d ? (Zero
(Z coupon bond)
b d)
- For simplicity, use discrete compounding.

• Implies a relationship between prices of puts, call, zero

coupon bonds and the stock price?
K
P0  S 0  C 0  PV T (K)  C 0 
1  rf

11/1/2011 Dastidar 27
 Put-call parity and arbitrage

• If put-call parity is violated, then there is an arbitrage.

• Example: S0 = $100, K = $100, T=1 year, rf=7.69% (annually

compounded),
p ) C0=$18, and P0 = $10

• Put-Call parity implies

C 0  P0  S 0  PV T (K)
100
 10  100   17 . 14
1  0 .0769

• Put call parity implies that call price is $17.14

$17 14

11/1/2011 Dastidar 28
 The arbitrage trade

• Sell calls at $18, and replicate the call via put-call parity for
$17 14: Pocket $0.86
$17.14: $0 86
• The transactions involved are:
Immediate Cashflow at maturity
Cashflow if ST<100 if ST>100

Sell a call $18 0 -(ST-100)

Buy stock -100 ST ST

Borrow PV of $100 92.86 -100 -100
Buy a put -10
10 100-S
100 ST 0

Net cashflows $0.86 0 0

11/1/2011 Dastidar 29
 Where are we?

• We have some understanding of puts, calls, their uses and their

relationshipp with each other.
- Put-call parity provides the relationship between put and call prices, as
well as the underlying.
- How to find the pput or call pprices to start?

• The main goal of this section is to understand how to find the

price of an option. How to do this?
1. Same no-arbitrage argument as in fixed income.
2. Construct a portfolio such that portfolio payoff = option payoff
3 Option price = portfolio value
3.

• This is exactly the same thing that Black and Scholes did!

11/1/2011 Dastidar 30
 How to price an option?

• What is the fair (i.e. no arbitrage) value of an option?

• How to approach the issue?

- Take the simplest
p option:
p a European
p call option.
p
- Take the simplest model of the stock price and to price it by no-arbitrage.
- Then extend the simple model to more reasonable models.

• Outline
- Form a portfolio consisting the stock and the risk free asset so that the
portfolio has the same payoffs as the option in every state of the world.
- Then, by no arbitrage, the value of the option is the value of the portfolio
that replicates it. We know the cost of this portfolio.

11/1/2011 Dastidar 31
 The simplest model of stock prices

• Simplest model: a 1-period model where the stock price can go

either up or down

uS0, u>1 with probability p

S0
dS0 , d<1 with probability 1-p

• “Binomial”
Binomial model of stock prices
• Impose that d<1<u (u is up and d is down)
- Very often: d=1/u

11/1/2011 Dastidar 32
 Option payoff

• Payoff of the option is CT=max(ST-K,0)

- Assume uS0>K, dS0<K
- Call is in-the-money if stock goes up
• Call
C ll payoff
ff is
i

Cu=max(uS0-K,0)= uS0-K

C0

What is C0? Cd=max(dS0-K,0)=0

11/1/2011 Dastidar 33
 Next

- Pricing Options: 1 period binomial model

11/1/2011 Dastidar 34
 Where are we?

• We have some understanding of puts, calls, their uses and their

relationshipp with each other.
- Put-call parity provides the relationship between put and call prices, as
well as the underlying.
- How to find the pput or call pprices to start?

• What is the fair (i.e. no arbitrage) value of an option?

• How to approach the issue?

- Take the simplest option: a European call option.
- Take the simplest model of the stock price and to price it by arbitrage.
- Then extend the simple model to more reasonable models.

11/1/2011 Dastidar 35
 Pricing by Replication

• How did we price a coupon bond? A portfolio of

zeroes which replicated the payoffs.
payoffs

• How to price options?

- Form a portfolio consisting the stock price and money
invested in the banks and find a portfolio with the same
payoffs as the option in every state of the world.
world
- Then, by no arbitrage, the value of the option is the value of
the portfolio that replicates it

11/1/2011 Dastidar 36
 A Simple Model of Stock Prices

• Si
Simplest
l t model:
d l a 1-period
1 i d model
d l where
h theth stock
t k price
i can go
either up or down

uS0, u>1 with probability p

S0
dS0 , d<1 with probability 1-p

• “Bi
“Binomial”
i l” model
d l off stock
t k prices
i
• Impose that d<1<u (u is up and d is down)
- Very
y often: d=1/u

11/1/2011 Dastidar 37
 Option Payoff

• Payoff of the option is CT=max(ST-K,0)

- Assume uS0>K, dS0<K
- Call is in-the-money if stock goes up
• Call
C ll payoff
ff is
i

Cu=max(uS0-K,0)= uS0-K

C0

What is C0? Cd=max(dS0-K,0)=0

11/1/2011 Dastidar 38
 Replicating portfolio

• Consider now forming a portfolio at time 0 with 

shares of stock and $B in the bank (risk-free)
(risk free)

π 0  S 0  B

• What is the
portfolio
f li worthh πu  uS0  B(1 r)
at time T?
π0
πd  dS0  B(1
(  r))

11/1/2011 Dastidar 39
 How to replicate?

• Can we pick  and B such that the portfolio has the

same payoffs as the option?
• Equate payoffs in both states

" up" state : π u   uS 0  B(1  r)  uS 0  K  C u

" down" state : π d   dS 0  B(1  r)  0  C d

• 2 equations in two unknowns

11/1/2011 Dastidar 40
 Solution

• Solving gives:
uS 0  K

(u - d)S 0
1 ((uS 0  K)d
)
B
1 r u -d
• Intuition:
- Δ>0 implies that to replicate the option, buy stock.
- B<0 implies that you borrow some money to do it.

π 0  S 0  B

11/1/2011 Dastidar 41
 No Arbitrage

• We have a portfolio  that, in every state of the world,

has the same payoffs as the option.
option
- By no-arbitrage they have to have the same price:
C0 =  0
• Thus,

uS0  K 1 (uS0  K)d

C0  ΔS0  B  
(u - d) 1  r u -d
1 1  r - d 
   uS0  K 
1 r  u - d 

11/1/2011 Dastidar 42
 Comparative Statics

• What happens to a call option price when the

parameters change?
h ?
K  C0 
S0  C0 
u  C0 
d  C0 
r  C0 

• These results are very robust and hold for every option
pricing model.
11/1/2011 Dastidar 43
 Example: XOM Call

• Consider a 1-period XOM call option struck at K=60.

• Suppose
S the
h current price
i isi S0=61
61 andd
- u=1.1
- d=0.9
d 09
- r=0.05
• What is the option price?

11/1/2011 Dastidar 44
 Step 1: Draw out the prices

• Stock Prices

$67.10=uS0
S0=$61
$61
$54.90=dS0
• Call prices
and payoffs

max(0,67.10-60)=$7.10
(0 67 10 60) $7 10
C0
max(0,54.90-60)=$0
11/1/2011 Dastidar 45
 Step 2: Find hedge portfolio

• The hedging weights are given by:

67.10  60
  0.582 shares
(1 10 - 0.90)61
(1.10 0 90)61
1 (67.10  60)0.90
B   30 .429
1  0 .05 1.10 - .90

• Again, borrow money and long the stock…

11/1/2011 Dastidar 46
 Step 3: Find the price

• The option’s no-arbitrage price is

π 0  ΔS 0  B
 (0.582)61  30.429
 $5.07

• Does this make sense?

• Check cash-flows at each node:

11/1/2011 Dastidar 47
 How does the replicating portfolio work?

• Consider the following portfolio: write an option and

hedge it: does the replication work?

Action Cost/Proft
Stock= uS0 =(0.582)67.10=39.05
Buy shares of -35.50
35 50 Pay back loan
loan=-31
31.95
95
XOM Option value=-7.10
Borrow from the +$30.43
bank
Write one call +5.07
struck at 60 Stock = dS0=31.95
Pay back loan = -31.95
Total 0 O ti Value=
Option Vl 0

11/1/2011 Dastidar 48
 Observations

1. Does it matter that we assumed the call was worthless in the

downstate?

2. How much does the option

p pprice change
g if the stock pprice
changes by 1%?

3
3. Where
h do d u andd d come ffrom??

4
4. What happened to the probabilities?

11/1/2011 Dastidar 49
 Generalizing the Payoffs (obs. #1)

• Previously, we assumed payoff was zero in the down state. Can

we relax this?

• Assume now that we have a ggeneral derivative security

y that pays
p y
- Zu when the underlying asset goes up to Su
- Zd when the underlying asset goes down to Sd

• This set-up nests calls, puts, etc.

11/1/2011 Dastidar 50
 How to Price? Same Routine

Stock price = uS0

Bank= B(1+rf )
Derivative price = Zu
Stock price = S0
Bank Account=
Account B
Derivative Price = ??

Stock price = dS0

Bank= B(1+rf )
Derivative price = Zd

11/1/2011 Dastidar 51
 Replicating Strategy

• Form a portfolio with  units of the stock and $B worth of the

riskless bond
bond.
• Pick portfolio weights to match derivative payoffs:
" up " :  uS 0  (1  rf )B  Z u
" down ":  dS 0  (1  rf )B  Z d

• Solve these equations

Zu  Zd
for  and B: 
S0 (u  d)
1  Zd u  Zu d 
B  
1  rf  u d 
11/1/2011 Dastidar 52
 Option Price

• If there is no arbitrage then the derivative price must

be equal to:

Z u  Zd 1  Zd u  Z u d 
Z0  S0  B    
u d 1  rf  u d 
• Can pplug
g in ppayoffs
y from calls and pputs to gget the pprice.

11/1/2011 Dastidar 53
 Examples of Z’s

• Call options : ZT=max(0,ST-K)

• Put options:
i ZT=max(0,K-S
(0 ST)
• Digital options: ZT=Z·1[Slow <ST < Shigh]

• Anyy derivative can be fit into this framework

11/1/2011 Dastidar 54
 Hedging Ratios: (Obs #2)

• How does the option price change with the underlying

price?
C 0  ΔS 0  B
• T
Taking
ki theth derivative
d i ti withith respectt to
t the
th stock
t k price
i
implies that

dC 0
 Δ " delta
delta"  hedge ratio
dS 0

11/1/2011 Dastidar 55
 Hedging with 

• The option price formula implies:

B  C 0  ΔS 0

• Therefore, if you hold an option and short  shares of

stock you completely eliminate risk!
For a put, 
- F   Hence,
H iin this
hi case, one would
ld have
h to long
l –
 shares

• C and S change every day – so would 

- Dynamic hedging

11/1/2011 Dastidar 56
 Where do u and d come from? (Obs #3)

• What are u and d related to?

- How much the asset moves: volatility
y

• In practice, u and d typically are assumed to equal to

u  exp( σ t ) and d  1/u
- where  is the asset’s annualized volatilityy
- and t is the time period (in fractions of years) in the binomial

• Where does this come from? Continuous-time models

- If you pick u and d in this manner, then the binomial model (with lots of
time
i steps)) converges to theh Black-Scholes
Bl k S h l price. i

11/1/2011 Dastidar 57
 What happened to the probabilities? (Obs #4)

• In the case of the call, the price didn’t depend on the

probabilities of being in the up or down states:

1  1  rf - d 
C0 
1  rf  u - d  uS 0  K 

• How can this

hi be?
b Have we made
d an error?
- The current prices are unique: they are the only prices that
impose the absence of arbitrage
arbitrage.

11/1/2011 Dastidar 58
 Interpreting the Option Price as a Present Value

• We can rearrange the call price formula:

uS0  K 1 (uS0  K)d

π 0  S0  B   
u -d 1  rf u -d

1 1  rf  d 1   Eq (C )
 (uS0  K)   Cu q  Cd (1  q)  T
1  rf u -d 1  rf uSK   1  rf
 0 0

• Looks like NPV with

1  rf  d
q
u -d
11/1/2011 Dastidar 59
 What about the stock price?

• To price the option, just take expectations of the

payoffs using q “probabilities”
• Can we do this to the stock price? What does it tell us?

Eq (ST )  quS0  (1  q)dS0

1  rf  d u - (1  rf )
 uS0  dS0
u -d u -d
 S0 (1  rf )

11/1/2011 Dastidar 60
 Next Class

• Risk-neutral pricing
• Multi-period
li i d binomial
bi i l models
d l

11/1/2011 Dastidar 61