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Options
Option is an agreement that gives the buyer the right but not the
obligation to buy or sell a given asset (such as a share) to a pre-
determined price at a given time (European type), or within the given
period (American type). An option is equivalent to 100 shares.
The seller on the other hand, is always obliged to deliver or buy the
asset if the buyer so wishes!
NOTATION- definitions
S = ”stock” price, (the actual share price): The underlying asset on
what the contract is signed.
CE = “Call-option premium for price E”: What the buyer pays, the
seller receives.
PE = “Put-option premium for price E”: What the buyer pays, the
seller receives.
1
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
Call options
One buys a call option today at a given E (say $50), and hopes that S
in the future will exceed E + CE in order to profit from that. The
premium to pay is CE. No security is required. Check the figure
below.
22-9
Call Option Payoffs at expiration
60
40 Buy a call
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-40
-60
One receives a CE today and hopes that S in the future will be below E
(say $50), so that the buyer’s call option will be worthless and will not
be exercised. If the price rises > E he looses, because he must sell it at
E.
2
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
say $100, the owner of the call option has the right to buy the stock at
E = $50! Check the figure below.
22-10
Call Option Payoffs at expiration
60
40
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
-60
Put options
Assume that you want to secure your shares (you are afraid of a price
fall, but you do not want to sell the shares now).
You buy a put option today at a given E (say $50). (i) If S falls below
E, you do not care, because you have the right to sell your shares at E
> S. In that case you gain the difference between E - S. (ii) If S does
not fall, you have just lost the premium you have paid, PE. Remember
you are not forced to sell it! No security is required. Check the figure
below.
3
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
22-14
Put Option Payoffs at expiration
60
40 Buy a put
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20
-40
-60
One receives a PE today and hopes that S does not fall below E (say
$50), since the buyer of the put wouldn’t exercise the option in that
case. If S < E, the seller is forced to sell the share at E, despite the fact
that its price is lower (=S).
4
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
22-15
Put Option Payoffs at expiration
60
40
Option payoffs ($)
20
0
0 10 20 30 40 50 60 70 80 90 100
Stock price ($)
-20
-60
Call options
Put options
5
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
Call options
(i) The buyer does not exercise the call option, since 50 < 60. He loses
SEK3750, that seller earns (the premium he received in August).
(ii) The buyer will exercise the call option. He has the right to buy
Ericsson at the price 60, but the option is worth 70 – 60 = 10. He
earns net (70 - 60)x1000 - 3750 = SEK6250. The seller loses that
amount, because he received in August 3750, but he sells the shares
now at 60 despite the fact that their price is 70 (i.e. he buys them at 70
and sells them at 60, so he loses 3750 – 10,000 = SEK6250).
Put options
Assume the X-investor had 1000 Ericsson shares and wanted to hold
them. Assume that he was interested in securing their value at the
lowest, at SEK 50 000.
(ii) The buyer does not exercise the put option, because 70 > 50 (she
can sell her shares if she likes at 70). She loses SEK3200 (i.e. the put
premium), which the seller of put option received in August.
1
The price in October fell to SEK 33!
6
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
(ii) The buyer will exercise the put option. She has the right to sell
Ericsson at 50, but her option is worth 50 - 45 = SEK5. Thus, she
earns net: 5x1000 - 3200 = SEK1800, which the seller loses.
One should never pay more for C than for the S itself! If the premium
C was more expensive than the share S, buy the share! At the extreme,
if S increases by SEK1, the premium C should increase by the same
0
(i.e. the upper limit is a line from the origin with a slope of 45 ). That
can be expressed as:
C≤S (1)
(i) If S > E ⇒ C > 0 (i.e. one will exercise the call option)
(ii) If S < E ⇒ C = 0 (i.e. the call option is worthless)
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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
E
C ≥ max {0, S − (1 + r ) t } (2)´
• If t = 0 ⇒ (1 + r)t = 1, i.e. (2)´ = (2), i.e., the call option is on the
lower limit at maturity day.
• If t > 0 ⇒ (1 + r)t > 1, i.e. (2)´ > (2), or (2)´ is valid as inequality,
i.e. the call option is above the lower limit prior to maturity.
A call option’s path starts from the origin (no premium if S = 0), and
starts to increase before the share price S reaches the exercise price E,
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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
Price of C0
Upper
Lower
limit
limit
Option’s
path
Time value
Real value
E Share price S 0
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Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
22-26
Protective Put Strategy: Buy a Put and Buy
the Underlying Stock: Payoffs at Expiry
Value at Protective Put strategy
expiry has downside protection
and upside potential; the
money you loose from
your stock you get it from
$50 your put
$0
Value of
$50
stock at
expiry
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Covered call
$10
$0
Value of stock at expiry
$30 $40 $50
-$30 Sell a call with
-$40 exercise price of
$50 for $10
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
10
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
These strategies must of course give the same results next year, no
matter if the stock price is S1 = 60 or S2 = 40.
Call option -C 10 0
or,
The solution of the system gives: δ = 1/2 and Y = 18.18 (per share)
11
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
Check now why both strategies give the same future values.
δ = 1/2 = hedge ratio (i.e. the number of shares per option that ensures
that no arbitrage profit is possible. Why?
12
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
Chigh − Clow 10 − 0
δ= = = 0 .5
S high − S llow 60 − 40
K = (1 + r ) ⇒ 40 = 1.1 ⇒ C0 = 6.82
S − nC 50 − 2C
0 0 0
Put-Call Parity
Strategy 1: Buy 100 shares and a put option P50, to insure them.
This strategy ensures that S + P50 is 10, either through option or the
share.
Strategy 2: Buy instead a call option C50. Because you need E kronor
(per share) if you exercise your C50 after 1 year, you must save also
the PV of E, i.e., E
( 1 + r )t
13
Christos Papahristodoulou, Mälardalen University/HST/Economics 23/06/2008
K = (1 + r ) ⇒ 60 = 1.1 ⇒ P0 = 2.273 .
S + nP 50 + 2 P
0 0 0
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