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11-1 Put and Call Options Chapter 11. 11-2 A call option is the right to buy an underlying security at an exercise (strike) price during a stated time.

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Presentation on theme: "11-1 Put and Call Options Chapter 11. 11-2 A call option is the right to buy an underlying security at an exercise (strike) price during a stated time."— Presentation transcript:

1 11-1 Put and Call Options Chapter 11

2 11-2 A call option is the right to buy an underlying security at an exercise (strike) price during a stated time interval. C = Market value of the call option. P = Market value of the underlying asset. E = Exercise price (strike price). Call Options

3 11-3 Expiration Would like to find value here 0 But first need to determine value here

4 11-4 Value of call option at expiration, E = $100 P E e.g., P = 90P = 100P = 110 C = 0C = 0C = P – E e.g., C = 10 out-of-the-moneyat-the-moneyin-the-money

5 11-5 If C < P - E at expiration Suppose P = 110, E = 100, C* = 6. Arbitrage: Buy Call-6 Exercise-100 Sell Underlying+110 Arbitrage Profit+4 Arbitrage Guarantees That C = P – E

6 11-6 Case of C > P – E: Suppose P = 110, E = 100, C** = 17. Arbitrage: Write Call+17 Exercised+100 Buy Underlying-110 Arbitrage Profit+7

7 11-7 Value of call option before expiration, E = $100 P E e.g., P = 90P = 100P = 110 C > 0C > 0C > P – E e.g., C > 10

8 11-8 Arbitrage Feasible call prices C P – E P P E Call Option Bounds

9 11-9 Time 0 Write Call+C Buy Underlying-P C – P > 0 Expiration P E Sell Underlying+P+P = E Call Exercised+E Net+P+E+E Arbitrage if C > P

10 11-10 Expiration Determine Profit or Loss Overlooking Dividends and Interest Take a position 0 Close entire position Profit Profiles

11 11-11 Expiration Buy or Call -4 0 Close: Exercise if in-money. Let expire if out-of-money.

12 Price of underlying at expiration Buy call-4 Exercise call at expiration Sell underlying acquired from exercise Net profit = - C -4 Net profit = – C – E + P Profits or Losses for Call Buyer

13 11-13 P exp E Payoff Function: Buy Call E + c Breakeven – c– c + [P exp – E] 0 – c + –

14 11-14 $ P at Expiration + Profit Call in-money 0 - Loss -4 Call out-of-money 100 E 104 Buy Call Profit Profile for Buying a Call -C -C+ [P–E]

15 11-15 Price of underlying at expiration Write call+4 Sell underlying Buy underlying Net profit = + C Net profit = + C + E – P Profits or Losses for Call Writer

16 11-16 $ P at Expiration + Profit 0 - Loss Write Call $ P at Expiration + Profit Call in-money 0 - Loss Call out-of-money 100 E 104 Profit Profile for Writing a Call +C+C – [P-E]

17 11-17 P exp E Payoff Function: Write Call E + c Breakeven + c+ c – [P exp – E] 0 + c + –

18 11-18 Price of underlying at expiration Buy underlying-100 Write call+4 Sell underlying at exercise price when call is exercised Sell underlying at market+100 price Net profit Profits or Losses from Writing a Covered Call

19 11-19 $ + Profit 0 - Loss C Write covered call Buy underlying security Call in-moneyCall out-of-money 100 E Underlying asset at expiration Profit Profile for Writing a Covered Call Option

20 11-20 Profit 0 Loss +4 Write call Buy underlying security Call in-moneyCall out-of-money 100 E Underlying asset at expiration Buy call Profit Profile for Call Option

21 11-21 Expiration A put option is the right to sell the underlying security at an exercise price during a stated time interval. 0 First, find value at expiration Put Option

22 11-22 Value of put option at expiration, E = $100 P E e.g., P = 90P = 100P = 110 Put = E – PPut = 0Put = 0 e.g., Put = 10 in-the-moneyat-the-moneyout-of-money Put Options

23 11-23 Case of Put < E – P: Suppose P = 90, E = 100, Put* = 6. Arbitrage: Buy Put-6 Exercise+100 Buy Underlying-90 Arbitrage Profit+4 If P < E, There is Arbitrage unless Put = E – P

24 11-24 Case of Put > E – P: Suppose P = 90, E = 100, Put** = 17. Arbitrage: Write Put+17 Exercised-100 Sell Underlying+90 Arbitrage Profit+7

25 11-25 Value of put option before expiration, E = $100 P E e.g., P = 90P = 100P = 110 Put > E – PPut > 0Put > 0 e.g., Put = 10 in-the-moneyat-the-moneyout-of-money

26 11-26 Price of underlying at expiration Buy put -3 Buy underlying Exercise put Net profit = – Put Net profit = – Put + E – P Profits or Losses for Buying a Put Option

27 11-27 P exp E Payoff Function: Buy Put E – Put Breakeven – put– put + [E – P exp ] 0 – put + –

28 11-28 Profit 0 Loss Buy put Put in-moneyPut out-of-money 100 E Underlying asset at expiration Shortsell Profit Profile for Put Option -PUT -PUT + [E-P]

29 11-29 Writing a Put Price of underlying at expiration Write put+3 Sell underlying Put exercised Net profit = + Put Net profit = + Put – E + P

30 11-30 P exp E Payoff Function: Write Put E – put Breakeven + put+ put – [E – P exp ] 0 + put + –

31 11-31 Profit 0 Loss Put in-moneyPut out-of-money 100 E Underlying asset at expiration 97 Profit Profile for Writing a Put +3 +PUT+PUT - [E-P]

32 11-32 Put-Call Parity C = Put + P – E D 0Expiration Present value =.98 = D = E D = 98 $1 E 100

33 11-33 Profit of Put-Call Parity 0Expiration Buy call Cash flows from portfolio Cash flows from call Buy portfolio If cash flows at Expiration are the same for call as for portfolio, then the Time 0 value must be the same.

34 11-34 P E Cash flows at expiration from buying call Call00P – E Cash flows at expiration from buying put, buying underlying and borrowing present value of exercise price PutE – P00 Underlying+P+P+P Loan –E –E –E Put-Call Parity

35 11-35 Implications of Put-Call Parity C= Put + [P – E D] = Put + [Levered position in underlying] 5= 3 + [100 – 98].

36 11-36 ROR on levered Leverage i Lower return from levered Higher return from levered Unlevered Levered ROR unlevered i i = Interest rate

37 11-37 C P – E D Call P E If C = Put + P – E D, then C  P – E D P – E

38 11-38 Arbitrage if C < P – ED Suppose P = 110, E = 100, D =.98. P – E = 10. P – ED = 12.

39 11-39 Suppose C* = 11. Arbitrage: Time 0 Buy Call-11 Short Underlying+110 Lend ED-98 Arbitrage Profit+1

40 11-40 P E Call00P – E Buy Underlying-P-P-P Receive E+E+E+E NetE – P > 0 E – P = 00 Expiration

41 11-41 Call--greater value of call 1.P--greater value of underlying 2.E--lower value of exercise price 3.Greater time to expiration 4.Higher volatility of underlying Factors Affecting the Value of a Call Option

42 11-42 Impact of Longer Remaining Life on the Value of a Call Option C P C 2 has a longer life than C 1 P  ED is higher for C 2 because D 2 < D 1 C2C2 C1C1 P  E P  ED 1 P  ED 2 E

43 11-43 Call Option of Security 1 Prices of underlying Value of call option Probability1/31/31/3 Mean value = (0)(1/3) + (0)(1/3) + (10)(1/3) = 3.33 Call Option of Security 2 Prices of underlying Value of call option Probability1/31/31/3 Mean value = (0)(1/3) + (0)(1/3) + (20)(1/3) = 6.67 Value of a Call

44 11-44 Impact of the Volatility of the Underlying Asset on the Value of a Call Option C P C 2 has greater volatility of underlying asset C2C2 C1C1 P  E P  ED E


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