Introduction to Options

Lecture 14. Introduction to Options

- Textbook Chapters: CH15
- Covered Topics
(1) Option Strategies: Payoffs from Portfolios of Options and Stocks
(2) Option Arbitrage Propositions

Introduction to Options

Announcements
- Due date for Team Project (Portfolio Analysis): April 12th
- HW #2 is assigned on Canvas website. (Due date: March 29th)
- Schedule for Midterm Exam #2: April 5th (covers Chapters 12, 13,
14, 15, and 16).
- Review session will be provided on March 29th.
- Additional office hours on Mondays
Mar. 28th: 10:00AM 12:00PM
April 4th: 10:00AM 12:00PM

Introduction to Options

Review - Payoff Patterns

Introduction to Options

Review - Payoff Patterns

Introduction to Options

Review - Payoff Patterns

Introduction to Options

Option Strategies: Payoffs from Portfolios of Options and Stocks

Pay off patterns of investments can be altered by investing in a
portfolio of options and stocks.
* Option Strategy #1: The Protective Put
Consider the following combination:
One share of stock, purchased for S0
One put, purchased for P with exercise price X
- This option strategy is often called a "protective put" strategy of
"portfolio insurance."
Total payoff for the protective put
= stock profit + put profit = ST S0 + max(X ST , 0) P0

Introduction to Options

Option Strategies: Payoffs from Portfolios of Options and Stocks

Total payoff for the protective put
= stock profit + put profit = ST S0 + max(X ST , 0) P0
= ST S0 + X ST P0 = X S0 P0
if ST X
ST S0 P0
if ST > X

Option Payoffs

Introduction to Options

Option Strategies: Payoffs from Portfolios of Options and Stocks

* Option Strategy #2: Spreads
: Buy and write calls with different exercise prices.
When the bought call has a low exercise price and the written call has
a higher exercise price, the combination is called a "bull spread."
As an example, suppose you bought a call (for $4) with an exercise
price of $40 and wrote a call (for $2) with an exercise price of $50.
This bull spread gives a profit of
max (ST 40, 0) 4 (max(ST 50, 0) 2)
= 4 + 2 = 2
if ST 40
= ST 40 4 + 2 = ST 42
if 40 ST 50
= ST 40 4 (ST 50 2) = 8 if ST 50

Introduction to Options

Option Strategies: Payoffs from Portfolios of Options and Stocks

Introduction to Options

Option Arbitrage Propositions

- The big assumption on option pricing models (which we will learn
in succeeding chapters)
: Arbitrage restrictions on option pricing
(Option price should be determined so that it cannot be used to obtain
arbitrage profit. No free lunch!)
We have seven propositions concerning the arbitrage restrictions.
Throughout, we assume that there is a single risk-free interest rate
which determines bond prices. We also assume that this risk-free rate
is continuously compounded, so that the present value of a riskless
security which pays off X at time T is given by Xe-rT.

Introduction to Options

Option Arbitrage Propositions

Proposition 1: Consider a call option written on a stock which pays
no dividends before the option's expiration date T. Then the lower
bound on a call option price is given by:
C0 Max(S0 Xe-rT, 0)
Suppose that the riskless interest rate is 10%, and we have an
American call option with maturity T = 1/2 (half year) with X = 80
written on a stock whose current stock price S0 = 83.
A naive approach to determine a lower bound on this option's price
would be to state that it is worth at least $3, since it could be
exercised immediately with a profit of $3.
Proposition 1 shows that the options value is at least 83 80e-0.100.5
= 6.90.

Introduction to Options

Option Arbitrage Propositions

Option
Proposition1

Proposition 1 is also applied to European options.

(the options value is at least 83 80e-0.100.5 = 6.90.)

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 1
Standard arbitrage proofs are built on the consideration of the cash
flows from a particular strategy. In this case, the strategy is the
following.
At time 0 (today):
- Buy one share of the stock
- Borrow the PV of the option exercise price X
- Write a call on the option
At time T:
- Call buyer exercises the option if this is profitable.
- Repay the borrowed funds.

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 1 (Contd)
This strategy produces the following cash-flow table.

Note that at time T, the cash flow resulting from your portfolio is
either negative or zero.

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 1 (Contd)
Since your portfolio (combination of purchasing a stock, borrowing
X,
and writing a call) has only non-positive payoffs in the future, it must
have a positive initial cash flow (so that there is no arbitrage
opportunity).
This shows that C0 S0 + Xe-rT > 0 or C0 > S0 Xe-rT.
In addition, call option price cannot be negative, thus
C0 Max(S0 Xe-rT, 0).
Consequence of proposition 1: In many cases, the early-exercise
feature of an American call option is worthless; this means that an

Introduction to Options

Option Arbitrage Propositions

Proposition 2: Consider an American call option written on a stock
which will not pay any dividends before the options expiration date
T.
Then it is never optimal to exercise the option before its maturity.
Proof of Proposition 2
Suppose the holder of the option is considering exercising it early, at
some date t < T. The only reason to consider such early exercise is
that St X > 0, where St is the price of the underlying stock at time t.
However, by Proposition 1, the market value of the option at time t is
at least St Xe-r(Tt), where r is the risk-free rate of interest.
Since St Xe-r(Tt) > St X, it follows that the options holder is better
off selling the option in the market than exercising it.

Introduction to Options

Option Arbitrage Propositions

If we assume that St = 83 for all t and X = 80, so that we can exercise
the call option to get payoff of $3,
When t = 0, option price C0 Max(S0 Xe-r(Tt), 0) = 6.902. sell it
When t = 0.1, C0 Max(S0 Xe-r(Tt), 0) = $6.137. sell it
When t = 0.2, C0 Max(S0 Xe-r(Tt), 0) = $5.364. sell it
When t = 0.3, C0 Max(S0 Xe-r(Tt), 0) = $4.584. sell it
When t = 0.4, C0 Max(S0 Xe-r(Tt), 0) = $3.796. sell it
When t = 0.5 (on expiration date), C0 = $3. indifferent
Proposition 2 means that many American call options can be priced as
if they were European calls. Note that this is not true for American
puts, even if the underlying stock pays no dividends. (We will see this

Introduction to Options

Option Arbitrage Propositions

Proposition 3 (Put bounds): The lower bound on the value of a put
option is
P0 Max(0, Xe-rT S0).
Proof of Proposition 3: The proof of this proposition has the same
form as the proof of the previous theorem. We set a table of strategies.

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 3 (Contd)
At time 0

- Short-sell one share of the stock

- Lend the PV of the option exercise price X
- Write a put option
At time T - Put buyer exercises the option if this is profitable.
- Receive the funds lent.
Since the strategy has only negative or zero payoffs in the future, it
must have a positive cash flow today, so that we can conclude that
P0 + S0 Xe-rT > 0.
Combined with the fact that in no case can a put value be negative,
this proves the proposition.

Introduction to Options

Option Arbitrage Propositions

Proposition 4 (Put-Call Parity): Let C0 be the price of a European
call with exercise price X written on a stock whose current price is S0.
Let P0 be the price of a European put on the same stock with the same
exercise price X. Suppose both put and call have exercise date T, and
the continuously compounded interest rate is r. Then,
C0 + Xe-rT = P0 + S0
Proof of Proposition 4
The proof is similar in style to that of the two previous propositions.
We consider a combination of the four assets (the put, the call, the
stock, and a bond), and show that the pricing relation on the next slide
must hold.

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 4 (Contd)

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 4 (Contd)
Since the strategy has future payoffs which are zero no matter what
happens to the price of the stock, it follows that the initial cash flow
of the strategy must also be zero. This means that
C0 Xe-rT + P0 + S0 = 0
which proves the proposition.
Put-call parity states that the stock price S0, the price of a call C0 with
exercise price X and the price of a put P0 with exercise price X, are
simultaneously determined with the interest rate r.

Introduction to Options

Option Arbitrage Propositions

Following is an illustration which uses the call price C0, the option
exercise price X, the current stock price S0, and the interest rate r to
compute the price of a put w/ exercise price X and time to maturity T.

Option Put-Call
Parity

Introduction to Options

Option Arbitrage Propositions

Proposition 5 (Call option price convexity): Consider three European
calls, all written on the same non-dividend paying stock and with the
same expiration date T. We suppose that the exercise prices on the
calls are X1, X2, and X3, and denote the associated call prices by C1,
C2, and C3. We further assume that X2 = (X1 + X2) / 2. Then
C1 C3
C2
2
It follows that the call option is convex function of the exercise price.
Proof of Proposition 5
To prove the proposition, we consider the following strategy of three
calls with exercise prices X1 < X2 < X3. We suppose one call each with
exercise price X1 and X3 is purchased and that two calls with exercise
price X are written. Such a strategy is commonly called a

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 5 (Contd)

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 5 (Contd)
Since the payoffs in the future are all non-negative, the initial cash
flow must be negative.
2C2 C1 C3 0
C1 C3
C2
2
Proposition 6 (Put price convexity) Consider three European puts, all
written on the same non-dividend paying stock and with the same
expiration date T. We suppose that the exercise prices on the calls are
X1, X2, and X3, and denote the associated put prices by P1, P2, and P3.
We further assume that X2 = (X1 + X2) / 2. Then the put price is a
convex function of the exercise price.

Introduction to Options

Option Arbitrage Propositions

Proposition 6 (Put price convexity) Contd
P1 P3
P2
2
< In-class Practice > Prove Proposition 6.
Action
Buy put with X1
Buy put with X3
Write two puts with X2
Total

At Time 0
Cash Flow

ST < X1

At time T
X1 ST < X2 X2 ST < X3

X3 ST

Introduction to Options

Option Arbitrage Propositions

Proposition 7 (Call option bounds with a known future dividend)
Consider a call with exercise price X and maturity date T. Suppose
that at some time t < T, the stock will, with certainty, pay a dividend
D. Then the lower bound on the call option price is given by
C0 Max(S0 De-rt Xe-rT, 0)
Proof of Proposition 7
The proof involves only a minor modification of the proof of
Proposition 1.
(See the next slide.)

Introduction to Options

Option Arbitrage Propositions

Proof of Proposition 7 (Contd)

Introduction to Options

Option Arbitrage Propositions

< In-class Practice >
The current stock price of ABC Corp. is $50. Prices for six-month
calls on ABC are given in the table below. Draw a profit diagram of
the following strategy: Buy one 40 call, write two 50 calls, buy one
60 call, and write two 70 calls.