Lecture Slides

15.
415x Foundations of Modern Finance

Leonid Kogan and Jiang Wang
MIT Sloan School of Management
Lecture 11: Options, Part 1

Key concepts
■ Introduction: option types
■ Payoffs of European options
■ Option strategies
■ Corporate securities as options
■ Pricing bounds for European options
■ Put-Call parity for European options
■ Early exercise of American options
■ Binomial model: single period
■ Binomial model: multiple periods
©2020 Kogan and Wang 2

Key concepts

Introduction to option types
■ Option types:
■ Call: The right to buy an asset (the underlying asset) for a given price
(strike price, or exercise price) on or before a given date (expiration
date, or maturity date).
■ Put: The right to sell an asset for a given price on or before the
expiration date.
■ Exercise styles:
■ European: Owner can exercise the option only on expiration date.
■ American: Owner can exercise the option on or before expiration date.

4
Introduction to option types
■ Key elements in defining an option:
■ Underlying asset and its price 𝑆𝑆,
■ Exercise price (strike price) 𝐾𝐾,
■ Expiration date (maturity date) 𝑇𝑇 (today is 0),
■ European or American.

5
Key concepts

Example: a European call option
■ A European call option on IBM with exercise price $100.
■ It gives the owner (buyer) of the option the right (not the obligation) to buy
one share of IBM at $100 on the expiration date.
■ The option’s payoff depends on the share price of IBM on the expiration
date.
European options on stocks are typically settled by

physical delivery: the buyer of the option receives
shares of the stock if the option is exercised. We
convert the value of this transaction into dollars and
think about the payoff of the option at expiration as
the corresponding cash flow.

Example: a European call option
IBM Price at T Action Payoff

< 80 Not Exercise 0
80 Not Exercise 0
90 Not Exercise 0
100 Not Exercise 0
110 Exercise 10
120 Exercise 20
130 Exercise 30
𝑆𝑆𝑇𝑇 Exercise 𝑆𝑆𝑇𝑇 − 100
■ Observations:
■ The payoff of an option is never negative; sometimes, it is positive.
■ Actual payoff depends on the price of the underlying asset:

𝐶𝐶𝐹𝐹𝑇𝑇 call = max[0, 𝑆𝑆𝑇𝑇 − 𝐾𝐾]
Payoff diagrams (strike price = 100)
Buying a call Buying a put

150 150
100 100
Payoff
Payoff
50 50
0 0
0 50 100 150 200 0 50 100 150 200
Asset Price Asset Price
0 0
0 50 100 150 200 0 50 100 150 200
-50 -50
Payoff
Payoff
-100 -100
-150
Selling a call -150 Selling a put
Payoff diagrams
■ The underlying asset and the bond (with face value $100) have the
following payoff diagrams
Asset Bond
200 200
Payoff
Payoff
100 100
0 0
0 100 200 0 100 200
Asset Price Asset Price

Net option payoff
■ The net payoff of an option must include its cost.
■ Example: a European call on IBM shares with an exercise price of $100

and maturity of three months is trading at $5.
■ The 3-month interest rate, not annualized, is 1%.
■ At maturity, the call's net payoff is as follows.
IBM Price Action Payoff Net payoff

< 80 Not Exercise 0 −5.05
80 Not Exercise 0 −5.05
110 Exercise 10 4.95
120 Exercise 20 14.95
𝑆𝑆𝑇𝑇 Exercise 𝑆𝑆𝑇𝑇 − 100 𝑆𝑆𝑇𝑇 − 100 −5.05

Net option payoff
50
30
break-even
Payoff underlying value
10
50 100 150
-10
Asset Price
The break-even point is given by 𝑆𝑆𝑇𝑇 at which Net Payoff is zero:

𝑇𝑇
Net payoff = max[𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0] − 𝐶𝐶 1 + 𝑟𝑟
= 𝑆𝑆𝑇𝑇 − 100 − 5 1 + 0.01
=0
or
𝑆𝑆𝑇𝑇 = $105.05

Key concepts

Option strategies: protective put
Buy the underlying stock, and buy a put with a strike price of $50:
Buy stock Buy a put
70 25
60 20
Payoff
Payoff
15
50
10
40 5
30 0
30 40 50 60 70 30 40 50 60 70
Stock price at maturity Stock price at maturity
Stock + put
70
60
Payoff
50
40
downside protection
30
30 40 50 60 70
Stock price at maturity

Option strategies: bull spread
Buy a call with a strike price of $45, and write a call with a strike price of $55:
Buy a Call(40) Write a Call(55)

40 0
30 30 40 50 60 70
-5
Payoff
Payoff
20
-10
10
0 -15
30 40 50 60 70
-20
Call(40) - Call(55)
20
15
Payoff
10
5 limited upside participation
0
30 40 50 60 70

Option strategies: straddle
Buy a call with a strike price of $50, and buy a put with a strike price of $50:
Buy a Call(50) Buy a Put(50)

30 30
Payoff
Payoff
20 20
10 10
0 0
30 40 50 60 70 30 40 50 60 70
Call(50) + Put(50)
25
20
Payoff
15
benefit from large
10
stock price moves
5
0
30 40 50 60 70

Option strategies: straddle
Buy a call with a strike price of $50, and buy a put with a strike price of $50:
Buy a Call(50) Buy a Put(50)

30 30
Payoff
Payoff
20 20
10 10
0 0
30 40 50 60 70 30 40 50 60 70
Call(50) + Put(50)
25
lose money if the stock
20
price
does not move far enough
Payoff
15
10 to cover the initial cost of
5 Call(50) + Put(50)
0
30 40 50 60 70

Key concepts

Corporate securities as options
■ Consider a firm with debt in its capital structure.
Balance sheet, market values

Assets $30 $25 Bond
$5 Equity
Total $30 $30
■ Firm bond has a face value of $50.
■ Default is likely: if the firm’s assets are worth less than $50 when the bond
matures, the firm will be unable to afford its debt.
■ In that event, the assets are turned over to the bondholders, and the
equity is worth zero.

■ Consider the value of the stock, and a call on the underlying assets of the
firm with an exercise price of $50:
Asset value Value of the stock Value of a call on the
assets, strike = $50
⋮ ⋮ ⋮
$20 $0 $0
$40 $0 $0
$50 $0 $0
$60 $10 $10
$80 $30 $30
$100 $50 $50
⋮ ⋮ ⋮
■ The stock gives the same payoff as a call option written on firm’s assets.
■ Equity is essentially a call option on the firm’s assets, strike price equal to
face value of debt.
■ Many corporate securities can be viewed as options.
■ Equity (𝐸𝐸 ): A call option on the firm’s assets (𝐴𝐴) with the exercise price
equal to its bond’s redemption value.
■ Debt (𝐷𝐷 ): A portfolio combining the firm’s assets (𝐴𝐴) and a short position in
the call with the exercise price equal to its bond’s face value (𝐹𝐹 ):
𝐴𝐴 = 𝐷𝐷 + 𝐸𝐸 ⇒ 𝐷𝐷 = 𝐴𝐴 − 𝐸𝐸
𝐸𝐸 ≡ max 0, 𝐴𝐴 − 𝐹𝐹
𝐷𝐷 = 𝐴𝐴 − 𝐸𝐸 = 𝐴𝐴 − max 0, 𝐴𝐴 − 𝐹𝐹

■ Warrant: Call options on the firm’s stock, with stock dilution as a result of
exercise.
■ Convertible bond: A portfolio combining straight bonds and a call on the

firm’s stock with the exercise price related to the conversion ratio.
■ Callable bond: A portfolio combining straight bonds and a short position in

a call on these bonds.

Key concepts

Preliminaries
■ For convenience, we refer to the underlying asset as stock. It could also

be a bond, foreign currency or some other asset.
■ Notation:
■ S : Price of stock now;

■ ST : Price of stock at T;
■ B : Price of discount bond of par $1 and maturity 𝑇𝑇 (𝐵𝐵 ≤ 1);
■ C : Price of a European call with strike 𝐾𝐾 and maturity 𝑇𝑇;
■ P : Price of a European put with strike 𝐾𝐾 and maturity 𝑇𝑇.
■ For our discussion:
■ Consider only European options, exercised only at maturity.

■ Assume the underlying stock pays no dividends.

Basic properties of options
■ If an option is exercised now, the resulting cash flow is called its exercise
value.
■ For a call, its exercise value is 𝑆𝑆 − 𝐾𝐾, where 𝑆𝑆 is the current stock price;
■ For a put, its exercise value is 𝐾𝐾 – 𝑆𝑆.
■ An option is deemed to be:
■ In the money (ITM) if its exercise value is positive;
■ At the money (ATM) if its exercise value is zero;
■ Out of the money (OTM) if its exercise value is negative.

Price bounds
■ European options on a non-dividend paying stock.
1. The payoff of call can never be negative: 𝐶𝐶 ≥ 0.
2. The payoff of stock dominates that of call: 𝐶𝐶 ≤ 𝑆𝑆.
Payoff
upper bound
𝐾𝐾 Stock
Call
𝐾𝐾 𝑆𝑆𝑇𝑇
lower bound

Price bounds (cont’d)
3. Lower bound: 𝐶𝐶 ≥ 𝑆𝑆 − 𝐾𝐾 𝐵𝐵
■ Strategy 1: Buy a call;

■ Strategy 2: Buy a share of stock by borrowing K B.
■ The payoff of Strategy 1 dominates that of Strategy 2.
Payoff
Call
Strategy 1
𝐾𝐾 𝑆𝑆𝑇𝑇
Strategy 2
■ Since 𝐶𝐶 ≥ 0, we have:
𝐶𝐶 ≥ max[0, 𝑆𝑆 − 𝐾𝐾𝐾𝐾]

Price bounds (cont’d)
4. Combining the above, we have:

max[𝑆𝑆 − 𝐾𝐾𝐾𝐾, 0] ≤ 𝐶𝐶 ≤ 𝑆𝑆
Option Price
Upper
Bound
Option
Price
Lower
Bound
𝐾𝐾𝐾𝐾 Stock Price

Key concepts

Put-call parity for European options
Portfolio 1: A call with strike K=$100 and a bond with par of $100;
Portfolio 2: A put with strike $100 and a share of the underlying asset.
Portfolio 1 Portfolio 2
300 300
Underlying
Bond 200
Payoff
200 Asset
Payoff
100 100 Put

Call
0 0
0 100 200 300 0 100 200 300
Underlying price Underlying price
𝐶𝐶 + 𝐵𝐵𝐵𝐵 = 𝑃𝑃 + 𝑆𝑆
Their payoffs are identical, so must be their prices:
This is called the put-call parity.

Key concepts

American options, early exercise
■ American options are worth more than their European counterparts.
■ Without dividends and with positive interest rates (𝐵𝐵𝑡𝑡 ≤ 1), never exercise
an American call early.
■ If exercise at 𝑡𝑡 < 𝑇𝑇 , collect 𝑆𝑆𝑡𝑡 − 𝐾𝐾
■ If sell the option at 𝑡𝑡 instead, collect at least the price of a European call,
which is
𝐶𝐶 𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 ≥ max 0, 𝑆𝑆𝑡𝑡 − 𝐾𝐾𝐵𝐵𝑡𝑡 ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾
■ Better to sell than exercise, thus early exercise is never optimal!
■ By the law of one price:

𝑐𝑐 𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 = 𝐶𝐶(𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡)

American options, early exercise
■ Without dividends, it can be optimal to exercise an American put early.
■ Example. A put with a strike of $10 on a stock with price of zero.
■ Exercise now gives $10 today;
■ Exercise later gives $10 later.
■ Better to exercise now (assuming positive interest rate).

Key concepts

Option pricing models
■ In order to have a complete option pricing model, we need to make

additional assumptions about the price process of the underlying asset
(stock).
■ We assume that prices do not allow arbitrage.

■ A benchmark model – price follows a binomial process.
𝑆𝑆𝑢𝑢𝑢𝑢
𝑆𝑆0
𝑆𝑆𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑

Binomial option pricing model
0 1
S, BT ; C0 = ? S1, 1; C1= Max [S1−K, 0]
■ Determinants of option value:
1. price of underlying asset 𝑆𝑆,
2. strike price 𝐾𝐾,
3. time to maturity 𝑇𝑇,
4. interest rate 𝑟𝑟,
5. volatility of underlying asset 𝜎𝜎.

A European call on a stock
■ Current stock price is $50;
■ There is one period to go;
■ Stock price will either go up to $75 or go down to $25;
■ There are no cash dividends;
■ The strike price is $50;
■ One period borrowing and lending rate is 10%.

A European call on a stock
■ The stock and bond present two investment opportunities:
Stock Bond
75 1.1
50 1
25 1.1
■ The option’s payoff at expiration is:
25
𝐶𝐶0
0
■ What is C0, the value of the option today?

Replicating portfolio
■ Form a portfolio of stock and bond that replicates the call’s payoff:
■ a shares of the stock;
■ b dollars in the riskless bond.
such that:
75𝑎𝑎 + 1.1𝑏𝑏 = 25
25𝑎𝑎 + 1.1𝑏𝑏 = 0
■ Unique solution: 𝑎𝑎 = 0.5 and 𝑏𝑏 = −11.36.

Replicating portfolio
■ Replication strategy:
■ buy half a share of stock and sell $11.36 worth of bond;
■ payoff of this portfolio is identical to that of the call;
■ market value of the call must equal the current cost of this “replicating
portfolio” which is
50 0.5 − 11.36 = 13.64
■ Number of shares needed to replicate one call option is called the option’s
hedge ratio or delta.
■ In the above problem, the option’s delta is 𝑎𝑎 = 0.5.

Key concepts

■ Multiple periods:
112.5
75
37.5
𝑆𝑆 = 50
37.5
25
12.5
■ European call price process (strike price = 50):
𝐶𝐶𝑢𝑢𝑢𝑢 = 62.5
𝐶𝐶𝑢𝑢
𝐶𝐶𝑢𝑢𝑢𝑢 = 0
𝐶𝐶0
𝐶𝐶𝑑𝑑𝑑𝑑 = 0
𝐶𝐶𝑑𝑑
𝐶𝐶𝑑𝑑𝑑𝑑 = 0
■ The terminal value of the call is known.
■ 𝐶𝐶𝑢𝑢 and 𝐶𝐶𝑑𝑑 denote the option value next period when the stock price goes
up and goes down, respectively.
■ Compute the time-0value working backwards: first 𝐶𝐶𝑢𝑢 and 𝐶𝐶𝑑𝑑 and then 𝐶𝐶0 .

Period 1, “up” node
Start with Period 1:
■ Suppose the stock price goes up to $75 in period 1.
■ Construct the replicating portfolio at node (𝑡𝑡 = 1, up):
112.5𝑎𝑎 + 1.1𝑏𝑏 = 62.5

37.5𝑎𝑎 + 1.1𝑏𝑏 = 0
■ Unique solution: 𝑎𝑎 = 0.833, 𝑏𝑏 = – 28.4.
■ The cost of this portfolio: (0.833)(75) – 28.4 = 34.075.
■ By Law of One Price, 𝐶𝐶𝑢𝑢 = 34.075 – same as the initial cost of the
replicating portfolio.

Period 1, “down” node
■ Suppose the stock price goes down to $25 in period 1. Repeat the above
for node (𝑡𝑡 = 1, down):
112.5𝑎𝑎 + 1.1𝑏𝑏 = 0
37.5𝑎𝑎 + 1.1𝑏𝑏 = 0
■ The replicating portfolio: 𝑎𝑎 = 0, 𝑏𝑏 = 0.
■ The call value at the lower node next period is 𝐶𝐶𝑑𝑑 = 0.

Period 0
■ Now go back one period, to period 0:

■ The option's value next period is either 34.075 or 0:
𝐶𝐶𝑢𝑢 = 34.075
𝐶𝐶0
𝐶𝐶𝑑𝑑 = 0
■ If we can construct a portfolio of the stock and bond to replicate the value
of the option next period, then the cost of this replicating portfolio must
equal the option’s present value.

Period 0
𝐶𝐶𝑢𝑢 = 34.075
𝐶𝐶0
𝐶𝐶𝑑𝑑 = 0
■ Find a and b so that:
75𝑎𝑎 + 1.1𝑏𝑏 = 34.075

25𝑎𝑎 + 1.1𝑏𝑏 = 0
■ Unique solution: 𝑎𝑎 = 0.6815, 𝑏𝑏 = −15.48.
■ The cost of this portfolio: (0.6815)(50) – 15.48 = 18.60.
■ The present value of the option must be 𝐶𝐶0 = 18.60.

Option replication
112.5
75 [62.5]
[(0.833,−28.4); 34.075]
37.5
50 [0]
[(0.6815, −15.48); 18.60]
37.5
25 [0]
[(0,0); 0]
12.5
[0]
■ Period 0: Spend $18.60 and borrow $15.48 at 10% interest rate to buy
0.6815 shares of the stock.

Option replication
112.5
75 [62.5]
[(0.833,−28.4); 34.075]
37.5
50 [0]
[(0.6815, −15.48); 18.60]
37.5
25 [0]
[(0,0); 0]
12.5
[0]
■ Period 1, “up node”: the portfolio value is 34.075. Re-balance the portfolio
to include 0.833 stock shares, financed by borrowing 28.4 at 10%.
■ One period later, the payoff of this portfolio exactly matches that of the
call: 62.5 for 𝑆𝑆𝑢𝑢𝑢𝑢 = 112.5 and 0 for 𝑆𝑆𝑢𝑢𝑢𝑢 = 37.5.
■ Period 1, “down node”: the portfolio becomes worthless. Close out the
position.
■ The portfolio payoff one period later is zero.

■ Bottom line:
■ Replication strategy gives payoffs identical to those of the call.
■ Initial cost of the replication strategy must equal the call price.

■ What we have used to calculate option’s value:
■ current stock price,
■ magnitude of possible future changes of stock price ― volatility,
■ interest rate,
■ strike price,
■ time to maturity.

■ What we have not used:
■ probabilities of upward and downward movements,
■ investor's attitude towards risk.
■ Questions on the Binomial Model:
■ What is the length of a period?
■ Price can take more than two possible values.
■ Trading takes place continuously.
■ Response: The length of a period can be arbitrarily small.

Key concepts

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15.

415x Foundations of Modern Finance

Lecture 11: Options, Part 1

■ Introduction: option types

■ Payoffs of European options

■ Corporate securities as options

■ Pricing bounds for European options

■ Put-Call parity for European options

■ Early exercise of American options

■ Binomial model: single period

■ Binomial model: multiple periods

©2020 Kogan and Wang 2

■ Introduction: option types

■ Payoffs of European options

■ Corporate securities as options

■ Pricing bounds for European options

■ Put-Call parity for European options

■ Early exercise of American options

■ Binomial model: single period

■ Binomial model: multiple periods

©2020 Kogan and Wang 3

■ European: Owner can exercise the option only on expiration date.

■ American: Owner can exercise the option on or before expiration date.

©2020 Kogan and Wang 4

■ Key elements in defining an option:

■ Underlying asset and its price 𝑆𝑆,

■ Exercise price (strike price) 𝐾𝐾,

■ Expiration date (maturity date) 𝑇𝑇 (today is 0),

©2020 Kogan and Wang 5

■ Introduction: option types

■ Payoffs of European options

■ Corporate securities as options

■ Pricing bounds for European options

■ Put-Call parity for European options

■ Early exercise of American options

■ Binomial model: single period

■ Binomial model: multiple periods

©2020 Kogan and Wang 6

■ A European call option on IBM with exercise price $100.

European options on stocks are typically settled by

©2020 Kogan and Wang 7

IBM Price at T Action Payoff

■ The payoff of an option is never negative; sometimes, it is positive.

■ Actual payoff depends on the price of the underlying asset:

Buying a call Buying a put

©2020 Kogan and Wang 10

■ The net payoff of an option must include its cost.

■ Example: a European call on IBM shares with an exercise price of $100

■ The 3-month interest rate, not annualized, is 1%.

■ At maturity, the call's net payoff is as follows.

IBM Price Action Payoff Net payoff

©2020 Kogan and Wang 11

The break-even point is given by 𝑆𝑆𝑇𝑇 at which Net Payoff is zero:

©2020 Kogan and Wang 12

■ Introduction: option types

■ Payoffs of European options

■ Corporate securities as options

■ Pricing bounds for European options