Fundamentals of Financial Options

Outline

Background
Option Payoffs at Expiration
Combinations
Put-Call Parity
Factors Affecting Option Values
Options and Corporate Finance

Text Reference: Chapter 14, excluding Section 14.5

AFM 274 Financial Options: Outline 1
Background
a financial option is a contract that gives its owner the right
to buy or sell an asset at a specified price (known as the
exercise price or the strike) on or before a specified date
(known as the expiration date)
a contract which gives the right to buy (sell) an asset is a call
(put) option
there are options available on almost any kind of asset
(stocks, stock indexes, bonds, currencies, commodities, etc.),
but we will focus on the case where the underlying asset is a
share of common stock
if the owner of the contract (also referred to as the holder of
the contract) decides to buy or sell at the specified price, this
is called exercising the option
the other party in the contract (the option seller or writer) is
obligated to fulfill the terms of the contract and trade with
the option holder at the agreed upon terms
AFM 274 Financial Options: Background 2
Background (Cont’d)

an American / European (circle correct) option allows the

holder to exercise the option at any time up to and including
the expiration date
an American / European (circle correct) option allows the
holder to exercise the option only on the expiration date
the option buyer or holder is said to have a long position in
the contract
the option seller or writer has a short position in the contract
the option premium is the price of the option (this
compensates the writer for the risk of loss if the option holder
decides to exercise)
options are traded on financial exchanges and in the
over-the-counter market

AFM 274 Financial Options: Background 3

Background (Cont’d)
quotes for options traded on the Chicago Board Options
Exchange can be found at
www.cboe.com/DelayedQuote/QuoteTable.aspx
quotes will contain a label such as “17 Aug 72.50”: this
indicates an expiration date in August of 2017 and a strike
price of $72.50
the actual expiration date is the Saturday following the third
Friday of the expiration month
open interest is the total number of contracts of a particular
option that have been written
exchange-traded options are written on 100 shares of stock,
but the quoted price and the strike price are per share
example: suppose the 17 Aug 72.50 call option on Procter &
Gamble (PG) is quoted at a price of $5.60. It would cost $560
to buy this contract, which then allows you to buy 100 shares
of PG until August 19, 2017 at a price of $72.50 per share.
AFM 274 Financial Options: Background 4
Background (Cont’d)

if the strike price of an option is equal to the current price of

the underlying stock, the option is said to be:
if the holder of the option would receive a positive payoff from
exercising it immediately, the option is:
if the immediate payoff from exercising the option would be
negative, the option is:
a call option is in-the-money (out-of-the-money) if the stock
price is higher (lower) than the strike price
a put option is in-the-money (out-of-the-money) if the stock
price is lower (higher) than the strike price
example: consider an option with a strike price of $40, and
suppose that the stock price is currently $50. If this is a call,
it is in-the-money. If this is a put, it is out-of-the-money.

AFM 274 Financial Options: Background 5

Background (Cont’d)

options can be used for insurance:

if we own an asset, having a put option on it guarantees that
we will be able to sell it for at least the strike price
if we intend to buy an asset sometime in the future, owning a
call option on it guarantees that we will not have to pay more
than the strike price to acquire the asset
alternatively, options can be used for speculation:
a bet that the stock will decrease:
a bet that the stock will increase:
some notation:
expiration date: T
stock price at time t: St
strike price of option: K
value of call option at time t: Ct
value of put option at time t: Pt

AFM 274 Financial Options: Background 6

Call Option Payoffs at Expiration: Long Position
consider a long position in a call option:
if ST > K , the option payoff at expiration is positive (and
equal to ST − K )
if ST ≤ K , the option payoff at expiration is zero
therefore CT = max(ST − K ,0)
for example, assume K = $30:
Payoff ($)

50

40

30

20

10

0 ST
0 10 20 30 40 50 60 70

AFM 274 Financial Options: Option Payoffs at Expiration 7

Call Option Payoffs at Expiration: Short Position
financial options are a zero sum game, so if the option holder
receives a positive payoff, the option writer gets a negative
payoff
at expiration, the payoff for a written call option is
−CT = − max(ST − K ,0)
with K = $30, the call option writer’s payoff at expiration is:
0 10 20 30 40 50 60 70
0 ST

-10

-20

-30

-40

-50

Payoff $
AFM 274 Financial Options: Option Payoffs at Expiration 8
Put Option Payoffs at Expiration: Long Position
consider a long position in a put option:
if ST < K , the option payoff at expiration is positive (and
equal to K − ST )
if ST ≥ K , the option payoff at expiration is zero
therefore PT = max(K − ST ,0)
for example, assume K = $30:
Payoff ($)

50

40

30

20

10

0 ST
0 10 20 30 40 50 60 70

AFM 274 Financial Options: Option Payoffs at Expiration 9

Put Option Payoffs at Expiration: Short Position

at expiration, the payoff for a written put option is

−PT = − max(K − ST ,0)
with K = $30, the put option writer’s payoff at expiration is:

0 10 20 30 40 50 60 70
0 ST

-10

-20

-30

-40

-50

Payoff $

AFM 274 Financial Options: Option Payoffs at Expiration 10

Option Profits at Expiration

option payoffs do not give a complete picture since they do

not consider the initial premium paid to buy the option
suppose the current price of a stock is $30 and the following
premia apply for options expiring in 1 year:
Strike Price Call Option Premium Put Option Premium
$27.50 $5.95 $2.39
$30.00 $4.69 $3.54
$32.50 $3.66 $4.91

in order to compare dollars at the same point in time, assume

that the options are held until expiration and the effective
annual risk-free interest rate is 4%, then subtract the future
value (1 year from now) of the option premia from the option
payoffs to measure the option profits

AFM 274 Financial Options: Option Payoffs at Expiration 11

Option Profits at Expiration
calculate the “break-even” stock price at expiration, i.e. the
value of ST for which the option profits are zero for the call
and put options with K = $30:

AFM 274 Financial Options: Option Payoffs at Expiration 12

Option Profits at Expiration (Cont’d)
plotting profit vs. ST for the call options:
15

K = $27.50
10 K = $30.00
K = $32.50
Profit on Expiration Date ($)

15 20 25 30 35 40 45
0

-5

-10

-15
Stock Price on Expiration Date ($)

AFM 274 Financial Options: Option Payoffs at Expiration 13

Option Profits at Expiration (Cont’d)
plotting profit vs. ST for the put options:
15

10
Profit on Expiration Date ($)

15 20 25 30 35 40 45
0

K = $27.50
K = $30.00
-5 K = $32.50

-10

-15
Stock Price on Expiration Date ($)

AFM 274 Financial Options: Option Payoffs at Expiration 14

Risk and Reward With Options
call options are similar to levered positions in a stock in that
they amplify risk and expected return
consider the call with K = $30 above which had a premium of
$4.69, and calculate the rate of return from holding this call
option until expiration for ST = $20 and ST = $40:

AFM 274 Financial Options: Option Payoffs at Expiration 15

Risk and Reward With Options
put options also magnify risk and expected return, but for
short positions in the underlying stock
consider the put with K = $30 above which had a premium of
$3.54 and calculate the rate of return from holding this put
option until expiration for ST = $20 and ST = $40:

AFM 274 Financial Options: Option Payoffs at Expiration 16

Combinations
different options can be combined into a portfolio to create an
unlimited variety of payoff patterns
a straddle is a combination that is long a call option and long
a put option on the same underlying stock with the same
expiration date and the same strike price
consider a straddle using the example from above with a stock
that is currently selling for $30:
a 1-year call with K = $30 has an initial premium of $4.69
(and, assuming an effective annual risk-free interest rate of
4%, the future value after 1 year of this premium is $4.88)
a 1-year put with K = $30 has an initial premium of $3.54
(and the future value after 1 year of this premium is $3.68)
complete the following table:
ST $15 $25 $30 $35 $45
Call option payoff 0 5 15
Put option payoff 0 0 0
Straddle payoff 0 5 15
Straddle profit -8.55 -3.55 6.45
AFM 274 Financial Options: Combinations 17
Straddle Payoff and Profit

call payoff
35 put payoff
straddle payoff
30
straddle profit
25
Payoff/Profit ($)

20

15

10

0
5 10 15 20 25 30 35 40 45 50 55 60 65
-5

-10

Stock Price at Expiration ($)

AFM 274 Financial Options: Combinations 18

Protective Put
suppose that you own a stock that is currently worth $25 and
you want to ensure that you will be able to sell it for at least
$20 after 6 months
a protective put position can be taken through buying a
6-month put option struck at $20:
Payoff ($)

40

30

20

stock
10
put (K = $20)

overall payoff

0 ST
0 10 20 30 40
AFM 274 Financial Options: Combinations 19
Put-Call Parity
consider the case of European options, and assume that there
are no dividends paid by the underlying stock
suppose you buy one share of stock, buy one put option on
the stock, and sell one call option on the stock (same K , T ):
• the payoffs at T are:
ST ≤ K ST > K
buy stock
buy put
sell call
overall payoff

AFM 274 Financial Options: Put-Call Parity 20

Put-Call Parity (Cont’d)
expressing put-call parity in terms of the call option:

Ct = St + Pt − PV(K )

put-call parity implies that any investment strategy involving a

European call option can also be done using a European put
option

what if the underlying asset pays dividends before T ? Let the

present value as of the current time t of dividends paid
between t and T be PV(Div). Subtract this present value
from the current stock price to get (again, in terms of the call
option):
Ct = St − PV(Div) + Pt − PV(K )
there are generalizations of put-call parity for American
options, but we will not be covering them in this course
AFM 274 Financial Options: Put-Call Parity 21
Factors Affecting Option Values

call (put) option values increase (decrease) with the price of

the stock
option values increase with the volatility of the stock
a number of properties of option values can be demonstrated
using no-arbitrage arguments:
calls and puts cannot have negative values
since an American option offers the same rights as an
otherwise equivalent European option (plus the additional
flexibility of being able to exercise before T ), an American
option cannot be less valuable than its European counterpart
the highest possible payoff for a put option is the strike: this
occurs if the stock price goes to zero ⇒ a put option cannot
be worth more than the strike

AFM 274 Financial Options: Factors Affecting Option Values 22

Factors Affecting Option Values (Cont’d)
some additional properties of option values based on
no-arbitrage arguments:
the most valuable call would be for a strike of zero: in this
case, the holder could acquire the stock at zero cost, so the
option would be worth the stock price ⇒ a call option cannot
be worth more than the underlying stock
the intrinsic value of an option is what its value would be if it
were just about to expire: an American option cannot be
worth less that its intrinsic value since it can be exercised
immediately to receive a payoff equal to its intrinsic value
the time value of an option is the difference between the
current option value and its intrinsic value: American options
cannot have negative time value (since they cannot be worth
less than their intrinsic values)
an American option with a later expiration date cannot be
worth less than an otherwise identical American option with an
earlier expiration date

AFM 274 Financial Options: Factors Affecting Option Values 23

Factors Affecting Option Values (Cont’d)
no-arbitrage also implies that the value of a European call
option on a stock which will not pay any dividends before the
option expiration date T must be at least equal to the current
stock price less the present value of the strike:
• we have to show that Ct ≥ St − PV(K )

AFM 274 Financial Options: Factors Affecting Option Values 24

Options and Corporate Finance
the components of a firm’s capital structure can be viewed as
options on the firm’s assets
suppose a firm has a single issue outstanding of a zero-coupon
bond with a total face value of F that must be paid at date T
if the value of the firm’s assets at that time VT exceeds F , the
bond holders are paid in full and the equity holders receive
VT − F
if VT ≤ F , the bond holders take over the firm’s assets and
the equity holders receive nothing
the payoff for the equity holders is max(VT − F ,0), the same
as a call option on the firm’s assets with a strike price of F
Value ($)
firm’s assets

equity payoff

VT
F
AFM 274 Financial Options: Options and Corporate Finance 25
Options and Corporate Finance (Cont’d)

the bond holders receive whichever is smaller, VT or F

this can be written in two equivalent ways:

min(VT ,F ) = VT − max(VT − F ,0) (1)

= F − max(F − VT ,0) (2)

the first expression above for min(VT ,F ) implies that the

holders of risky debt are in the same position as owning the
firm but having sold a call option to the equity holders with a
strike price of F
the second expression above implies that the debt holders are
in the same position as having a risk-free zero-coupon bond
with a face value of F and having sold a put option on the
firm’s assets with a strike price of F to the equity holders

AFM 274 Financial Options: Options and Corporate Finance 26

Corporate Debt: Two Interpretations

Value ($) (1) Value ($) (2)

firm’s assets

risk-free debt
debt payoff F debt payoff

VT VT
F F
sold put

sold call

AFM 274 Financial Options: Options and Corporate Finance 27

Additional Observations
since risky debt equals risk-free debt less a put option on the
firm’s assets, credit risk can be eliminated by buying the same
put option to provide downside protection
this is the essence of a credit default swap (CDS): the
protection buyer pays a premium to the seller of the put and
receives a payment to compensate for the loss if the firm
defaults on its debt
option insights can be used to value risky debt and to
determine credit spreads—see text example 14.10
since equity holders are in the position of owning a call option
on the firm’s assets, they can have an incentive to prefer
riskier strategies to increase the value of the option
debt holders are short an option (either a call or a put,
depending on the interpretation) on the firm’s assets, and so
they would prefer lower risk strategies in order to reduce the
value of this option
AFM 274 Financial Options: Options and Corporate Finance 28