Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.
7)
Economics BEE3032: Futures and Options
Week 5
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Table of Contents
1 Options (Ch. 9, Sec. 9.1 to 9.5)
2 Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Motivation
Derivative: Claim Whose Payoff is a Function of Another’s
Warrants, Options
Calls vs. Puts
American vs. European
Terms: Strike Price K, Time to Maturity T
St =Stock Price
K = Strike Price
Ct =Call Price
Pt = Put Price
At Maturity T, payoff
CT = max[0, ST − K]
PT = max[0, K − ST ]
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Motivation
Put Options as Insurance
Asset Insured = Stock
Current Asset Value = St
Term of Policy = T
Maximum Coverage = K
Deductible = max[0, ST − K]
Insurance Premium = Pt
Differences
Early exercise
Marketability
Dividends
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Payoff Diagrams
7
Call Option
6
ff
yo
5
Pa
t
4
ofi
Payoff / profit
Pr
3
1
Stock Price
0
10 15 20 25
-1
-2
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Payoff Diagrams
7
Call Option
6
4
Payoff / profit
3
At the Money
2
1 Out of the Money
Stock Price
0
10 15 20 25
-1 In the Money
-2
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Payoff Diagrams
Put Option
10
Pa
yo
8 ff
Pr
ofi
t
Payoff / profit
Stock Price
0
10 15 20 25
-2
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Payoff Diagrams
Put Option
10
8
Payoff / profit
At the Money
2
Out of the Money
Stock Price
0
10 15 20 25
In the Money
-2
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Payoff Diagrams
7
Long Call 10
6
5 8
Long Put
4
Payoff / profit
Payoff / profit
6
3
2 4
1
2
0
10 15 20 25
Stock Price
Long Put Stock Price
0
-1
Short Call 10 15 20 25
-2 -2
4 4
2 2
Stock Price Stock Price
0 0
10 15 20 25 10 15 20 25
Payoff / profit
Payoff / profit
-2 -2
-4 Short Call -4
Short Put
-6 -6
-8 -8
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Payoff Tables
Stock Price = S, Strike Price = K
Call option (price = C)
if S < K if S = K if S > K
Payoff 0 0 S−K
Profit −C −C S−K −C
Put option (price = P)
if S < K if S = K if S > K
Payoff K −S 0 0
Profit K −S−P −P −P
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Option Strategies
Trading Strategies
Options can be combined in various ways to create an
unlimited number of payoff profiles.
Examples
Buy a stock and a put
Buy a call with one strike price and sell a call with another
Buy a call and a put with the same strike price
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Other Option-Like Securities
Corporate Liabilities:
V =Value of the company’s assets
B = Face value of corporate bonds
Equity ≡ max[0, V − B] ≡ E
| {z }
Call with strike B
= V − B + max[0, B − V ]
| {z }
Put with strike B
Debt ≡ min[V, B] ≡ D
= B − max[0, B − V ]
| {z }
Short Put with strike B
V = Debt + Equity
Equity: hold call or protected levered put
Debt: issue put and (riskless) lending
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Other Option-Like Securities
Other Examples of Derivative Securities:
Asian or ”Look Back” Options
Callables, Convertibles
Futures, Forwards
Swaps, Caps, Floors
Real Investment Opportunities
Patents
Tenure
etc.
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Put-Call Parity
(Ch. 10, Sec. 10.4 and 10.7)
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Put-Call Parity
S0 + p = Ke−rT + c
Conditions:
European
Same underlying asset
Same strike price K
Same maturity date T
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Put-Call Parity (European Options, no dividends)
Protective Put Fiduciary Call
Time (Stock + Put) (Bond + Call)
0 - Pay S0 for stock X -Invest Ke−rT for T periods in a zero-coupon bond
- Pay p for put option on stock X -Pay c for call option on stock X
with strike price K and maturity T with strike price K and maturity T
Cost: S0 + p Cost: Ke−rT + c
If ST > K
-Sell stock for ST - Collect K
- Payoff of put is 0 - Payoff of call is ST − K
Cash Inflow: ST + 0 = ST Cash Inflow: K + (ST − K) = ST
T If ST < K
-Sell stock for ST - Collect K
- Payoff of put is K − ST - Payoff of call is 0
Cash Inflow: ST + (K − ST ) = K Cash Inflow: K + 0 = K
If ST = K
-Sell stock for ST - Collect K
- Payoff of put is 0 - Payoff of call is 0
Cash Inflow: ST = K Cash Inflow: K = ST
Therefore, S0 + p = Ke−rT + c
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Arbitrage Opportunities if Put-Call Parity Does Not Hold
Example. S0 =£31, r =0.10, call price= £3. Both put and call have strike
price of £30 and three months to maturity. A three-month put price should cost
p = 30e−0.1×3/12 + 3 − 31 = 1.26
Time Three-month put price = £2.25 Three-month put price = £1
t - Buy call for £3 -Short call to realize £3
- Short put to realize £2.25 -Buy put for £1
- Short the stock to realize £31 - Buy the stock for £31
- Invest 31 + 2.25 - 3 = £30.25 for 3 months -Borrow 3 - 1 - 31 = £29 for 3 months
If ST > 30
-Receive 30.25e0.1×3/12 = £31.02 from investment - Call exercised: sell stock for £30
- Exercise call to buy stock for £30 - Use 29e0.1×3/12 = £29.73 to repay loan
Profit: £31.02 - £30 = £1.02 Profit:£30 - £29.73 = £0.27
T = 3 months If ST < 30
-Receive 30.25e0.1×3/12 = £31.02 from investment - Exercise put to sell stock for £30
- Put exercised: buy stock for £30 - Use 29e0.1×3/12 = £29.73 to repay loan
Profit: £31.02 - £30 = £1.02 Profit: £30 - £29.73 = £0.27
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Put-Call Parity (European Options, with dividends)
Protective Put Fiduciary Call
Time (Stock + Put) (Bond + Call)
0 - Pay S0 for stock X -Invest Ke−rT + D for T periods
in a zero-coupon bond
- Pay p for put option on stock X -Pay c for call option on stock X
with strike price K and maturity T with strike price K and maturity T
Cost: S0 + p Cost: Ke−rT + D + c
If ST > K
-Sell stock for ST - Collect K + DerT
- Receive DerT - Payoff of call is ST − K
- Payoff of put is 0
Cash Inflow: ST + DerT Cash Inflow: ST + DerT
T If ST < K
-Sell stock for ST - Collect K + DerT
- Receive DerT - Payoff of call is 0
- Payoff of put is K − ST
Cash Inflow: K + DerT Cash Inflow: K + DerT
If ST = K
-Sell stock for ST - Collect K + DerT
- Receive DerT - Payoff of call is 0
- Payoff of put is 0
Cash Inflow: ST + DerT = K + DerT Cash Inflow: K + DerT = ST + DerT
Therefore, S0 + p = Ke−rT +D+c
Options (Ch. 9, Sec. 9.1 to 9.5) Put-Call Parity (Ch. 10, Sec. 10.4 and 10.7)
Put-Call Parity and Capital Structure Arbitrage
Recall:
Equity ≡ max[0, V − P V (B)] ≡ c
Debt ≡ min[V, P V (B)]
= P V (B) − max[0, P V (B) − V ] ≡ P V (B) − p
V = Debt + Equity = c + (P V (B) − p)
Rearranging this equation,
V + p = P V (B) + c
We recover the put-call parity equation
c is and p are options with strike price B