Financial Market Theory Tuesday, November 28, 2017 Professor Edwin T Burton

Options Two Kinds Call Options (“right to purchase stock at a fixed price by a fixed date”) Put Options (“right to sell……………) Need not exercise the right (unlike what happens with futures) Option could ‘expire’ worthless and nothing take place Or could ‘exercise’ the option and buy (sell) the stock if call (put) option Priced? Value at maturity Value prior to maturity Black-Scholes Option Pricing Formula Put-Call Parity

Option to buy XYZ stock at 40 by end of February: the “XYZ Feb 40 Call” In the real world stock options are denominated in 100s XYZ Feb 40 permits owner to buy 100 shares of XYZ stock by paying $ 4,000 at any time up to and including the maturity date of the option If the option costs 2 ¼, then it costs $ 225, since it represents the right buy 100 shares This definition is an “American” option A “European” option only permits the exercise of the option on the maturity date If no dividend, the ‘early option’ has no value

Value at Maturity (Expiration Date) Value of option $ 20 $ 40 $ 60 Stock Price at Expiration Date

Value at Maturity (Expiration Date) Value of option Prior to maturity $ 20 At maturity $ 40 $ 60 Stock Price at Expiration Date

Black and Scholes 1973 Article Assume no dividend Two variables matter Interest rates Volatility Expected return does not matter