TUTORIAL 7
OPTION PROPERTIES
Effect of variables on Option pricing
Put-Call parity: No dividend
• Portfolio A: European call on a stock with the strike price of K + zero-
coupon bond worth Ke-rT (the bond pays K at time T)
• Portfolio C: European put on the stock with the strike price of K + the
stock currently priced S0
→ 2 portfolios offering the same pay-offs at time T → costs must be
the same today.
Put-Call parity: No dividend
Put-Call parity: No dividend
Put-Call parity: dividend-paying stock
Bounds for European or American Call Options (No
Dividends)
Bounds for European and American Put
Options (No Dividends)
Should Put/Call be exercised early?
• It is never optimal to exercise an American call option on a non-
dividend-paying stock before the expiration date.
• It can be optimal to exercise an American put option on a non-
dividend-paying stock early. At any given time during its life, the put
option should always be exercised early if it is sufficiently deep in the
money.
11.1
What is a lower bound for the price of a 4-month call option on a non-
dividend-paying stock when the stock price is $28, the strike price is
$25, and the risk-free interest rate is 8% per annum?
• Lower bound for call = Max(0; S0 – Ke-rt)
• The lower bound is:
28 − 25𝑒−0.08×0.3333 = $3.66
11.2
What is a lower bound for the price of a 1-month European put option
on a non-dividend paying stock when the stock price is $12, the strike
price is $15, and the risk-free interest rate is 6% per annum?
• Lower bound for European put = Max(0; Ke-rt - S0)
• The lower bound is:
15 𝑒−0.06×0.08333 − 12 = $2.93
11.4
"The early exercise of an American put is a trade-off between the time
value of money and the insurance value of a put." Explain this statement
Answer:
An American put when held in conjunction with the underlying stock
provides insurance. It guarantees that the stock can be sold for the strike
price, K. If the put is exercised early, the insurance ceases. However, the
option holder receives the strike price immediately and is able to earn
interest on it between the time of the early exercise and the expiration
date
11.6
The price of a non-dividend paying stock is $19 and the price of a three-
month European call option on the stock with a strike price of $20 is $1.
The risk-free rate is 4% per annum. According to the put-call parity,
what is the price of a three-month European put option with a strike
price of $20?
Answer:
• S0 = $19; c = $1; K = $20; r = 4%
• Put call parity: c + Ke-rT = p + S0
→p = c + Ke-rT - S0 = 1 + 20*e-0.04*3/12 – 19 = $1.8
Price of the European put is $1.8
11.10
A 4-month European call option on a dividend-paying stock is currently selling for $5. The stock
price is $64, the strike price is $60, and a dividend of $0.80 is expected in 1 month. The risk-
free interest rate is 12% per annum for all maturities. What opportunities are there for an
arbitrageur?
• To establish whether there is arbitrage the call option should be within its bounds and since
it is selling for $5 is the lower bound satisfied. This bound is: c >= max (0, S0 – PVD – Ke-rT)
• We have, lower bound = S0 – D – Ke-rT = 64 – 0.8*e-0.12*1/12 – 60*e-0.12*4/12 = $5.56
• Since c = 5 < lower bound = $5.56 → arbitrage opportunity: buy call option, short stock
t=0 t = T: St =< 60 t = T: St > 60
Long call -5 0 - 60
Short stock 64 - St 0
Invest $0.79 in 1 month - 0.79 Pay 0.8 dividend after 1 month
Invest $58.21 for 4 months 58.21 (=64 – 5 – 0.79) +60.59 +60.59
Total CFs 0 $60.59 – St >= 0.59 0.59
11.11
A one-month European put option on a non-dividend-paying stock is currently
selling for $2.50. The stock price is $47, the strike price is $50, and the risk-free
interest rate is 6% per annum.
a. What is a lower bound for this option?
b. Which transactions should an arbitrageur take?
Answer:
• p = $2.5; S0 = $47; K = $50; r = 6%; t = 1/12
a. The lower bound for put option:
Max (0; Ke-rt – S0) = Max (0; 50e-0.06*1/12 – 47) = $2.75
b. The price of the put option in the market is currently smaller than its
theoretical lower bound, therefore it is underpriced (cheap). We should buy
this option and short ( Ke−rT − S0 )
11.11
A one-month European put option on a non-dividend-paying stock is currently selling
for $2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate
is 6% per annum.
a. What is a lower bound for this option?
b. Which transactions should an arbitrageur take?
Answer: p = $2.5; S0 = $47; K = $50; r = 6%; t = 1/12
Actions t=0 t = 1/12
St <= 50 St > 50
Buy put -2.5 50 – St 0
Buy stock -47 St St
Borrow for 1 month 49.5 -49.75 -49.75
Total 0 0.25 St – 49.75
The value of the profit is at least $0.25.
11.13
The price of a European call that expires in 6 months and has a strike price of $30 is
$2. The underlying stock price is $29, and a dividend of $0.50 is expected in 2
months and again in 5 months. Risk-free interest rates (all maturities) are 10%.
What is the price of a European put option that expires in 6 months and has a strike
price of $30?
• Given Put call parity with dividends:
c + Ke-rT = p + S0 – PVD
p = c + Ke-rT - S0 + pVD
The put price is $2.51
11.15
The price of an American call on a non-dividend-paying stock is $4. The stock price
is $31, the strike price is $30, and the expiration date is in 3 months. The risk-free
interest rate is 8%. Derive upper and lower bounds for the price of an American put
on the same stock with the same strike price and expiration date
We have:
31 – 30 ≤ 4 – P ≤ 31 – 30*e00.08*3/12
1 ≤ 4 - P ≤ 1.59
2.41 ≤ P ≤ 3
11.23
The prices of European call and put options on a non-dividend-paying
stock with an expiration date in 12 months and a strike price of $120
are $20 and $5, respectively. The current stock price is $130. What is
the implied risk-free rate?
• Given Put call parity:
c + Ke-rT = p + S0
e-r = (p + S0 – c)/K
r = - ln ((5 + 130 – 20)/120))= 0.0426 = 4.26%