LECTURE SEVEN

PROPERTIES OF STOCK OPTIONS

CHAPTER 10

1
 Factors affecting option prices
• Current stock price, S0

• Strike price, K

• Time to expiration, T

• Volatility of the stock price, σ

• Risk-free interest rate, r

• Dividends that are expected to be paid, D

2
 Payoff Profiles – at Maturity

3
 American vs European Options

An American option is worth at least as much as the

corresponding European option

Cc

P p

4
 Effect of variables on option pricing
Summary of the effect on the price of a stock option of
increasing one variable while keeping all others fixed

European European American American

Variable call put call put
Current stock price + - + -
Strike price - + - +
Time to expiration ? ? + +
Volatility + + + +
Risk-free rate + - + -
Dividends - + - +
+ indicates that an increase in the variable causes the option price to increase.
– indicates that an increase in the variable causes the option price to decrease.
? indicates that the relationship is uncertain.

Table 10.1, page 225

5
 Effect of changes in stock price, strike price,
expiration date, volatility and risk-free interest rate
on option prices.
Data:
• S0 = 50
• K = 50
• R = 5%
• σ = 30 %
• T=1
• In the slides below, we change the value of one variable while
holding those of other variables unchanged.

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 Stock price and strike price – Impact on call option
Figure 10.1 (a) & (c), p.226.
• For a call option, the payoff on exercise is the amount by which the
stock price exceeds the strike price
• Call options become more valuable as the stock price increases and
less valuable as the strike price increases

7
 Stock price and strike price – Impact on Put options
Figure 10.1 (b) & (d) p. 226.
• For a put option, the payoff on exercise is the amount by which the
strike price exceeds the stock price
• Put options become less valuable as the stock price increases and
more valuable as the strike price increases

8
Derivagem
 Time to expiration (Figure 10.1 (e) & (f), p.226)
• Put and call American options become more valuable as the time to
expiration increases
• Put and call European options become more valuable as the time to
expiration increases, however, this is not always the case

10
Time to Maturity
For longer TTMs, there is a greater chance for a call to be in-
the-money

 TTM , C

and TTM , C

For a put, this is not so clear. This is because:

(a) Longer TTM  greater time value

BUT

(b) Present value of income from sale (using the put)

decreases as TTM 
8.11
 Impact of Time to Maturity
For a European put:

- Early exercise is not possible

- Two effects (a & b in previous slide) act in opposite directions;

effect is indeterminate (at this stage).

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 Impact of Time to Maturity
For an American put:

- This is not a problem; it may be optimal to exercise and American

put early.

- Exercise now: Income = K – S

- Exercise later: Maximum income = PV (K) (i.e. When S =0).

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 Early Exercise
- Early exercise would be justified if:
- - the stock price fell to zero (the option would be worth K and could
never be more valuable).
- - more generally, if:
Income now ≥ income later
K- S ≥ PV (K)

- This condition is sufficient (but not necessary) to cause early

exercise (i.e. Early exercise may take place without this condition).

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 Early Exercise
At this point, it is not possible to indicate when early exercise would
take place.
Necessary conditions are that:
- It is in the money and
- The value of an equivalent European put must be lower than the
intrinsic value of the American put.
i.e. PE < K - S

15
 Volatility – Impact on call & put options. Figure 10.2
(a) & (b), p.227.
• The values of both calls and puts increase as volatility increases
• The owner of a call benefits from price increases but has limited
downside risk in the event of price decreases (option premium).
• The owner of a put benefits from price decreases but has limited
downside risk in the event of price increases (option premium).

16
 Risk-free interest rate – Impact on call & put
options. Figure 10.2 (c) & (d), p.227.
• An increase in the interest rate and accompanying decrease in the
stock price decrease the value of a call option and increase the
value of a put option
• A decrease in the interest rate and accompanying increase in the
stock price increase the value of a call option and decrease the
value of a put option

17
 Dividends
• The value of a call option is negatively related to the size of any
anticipated dividends

• The value of a put option is positively related to the size of any

anticipated dividends

18
 Assumptions
• There are no transactions costs

• All trading profits are subject to the same tax rate

• Borrowing and lending are possible at the risk-free interest rate

19
 Notation
• S0: Current stock price
• K: Strike price of option
• T: Time to expiration of option
• ST: Stock price on the expiration date
• r: Risk-free rate for maturity T (cont. comp.)
• C: Value of American call option
• P: Value of American put option
• c: Value of European call option
• p: Value of European put option

20
 Upper and lower bounds for option prices
• If an option price is above the upper bound or below the lower
bound, there are profitable opportunities for arbitrageurs

• To exploit arbitrage opportunity:

• If boundary is violated:
– Sell the ‘overvalued’ side
– Buy the ‘undervalued’ side
– Invest surplus at t=0 or alternatively,
– Borrow deficit at t=0 at risk free rate
• Result is positive income with no risk.

21
 Upper bounds
• An American or European call option gives the holder the right to
buy one share for a certain price. The option can never be worth
more than the stock

• So, stock price is an upper bound to the option price:

c ≤ S0 and C ≤ S0 10.1

• If this were not true, an arbitrageur could make a riskless profit by

buying the stock and selling the call option

22
 Upper bounds
• An American put option gives the holder the right to sell one share
for K. The option can never be worth more than K

P≤K (10.2)
• A European put option at maturity cannot be worth more than the
present value of K today

p ≤ Ke-rT (10.3)

• If this were not true, an arbitrageur could make a riskless profit by

writing the option and investing the proceeds at the risk-free
interest rate

23
Lower bounds for calls
Non-dividend-paying stocks

A lower bound for the price of a European call option is:

S0 - Ke-rT
Example: S0=$20, K=$18, r=10% per annum, call price=$3 and T=1
year.

S0 - Ke-rT = 20 - 18e-0.1 = $3.71

What opportunities are there for an arbitrageur?

24
 Lower bounds for calls
Non-dividend-paying stocks (Contd.)
The strategy:
Now:
Short the stock and buy the call to provide a cash inflow of
$20-$3= $17.
Invest for one year at 10% to grow to $18.79 (Cont. compounding).

End of the year:

if S0 > K, option exercised for $18 -> profit = $18.79 - $18 = $0.79.

If S0 < K, stock is bought in the market and option closed out, the
profit = $18.79 - $17 = $1.79 (assuming stock price is $17).

25
 Lower bounds for calls
Non-dividend-paying stocks
• Portfolio A: One European call option plus a zero-coupon bond that
provides a payoff of K at time T. Portfolio A is worth:
max(ST, K)
• Portfolio B: One share of the stock worth ST at time T. In the absence
of arbitrage opportunities, portfolio A is worth as much as (can be
more than) portfolio B at time zero. Hence,
c + Ke -rT≥ S0
or c ≥ S0 − Ke-rT
Because the call value cannot be negative, this means that c ≥ 0 and
therefore:

c ≥ max(S0 − Ke-rT, 0) (10.4)

26
 Lower bounds for calls
Non-dividend-paying stocks

Example: S0=$51, K=$50, T=0.5, r=12% per annum.

A lower bound for the option price is:

S0 − Ke-rT = 51 – 50e-.12*0.5= $3.91

27
 Lower bounds for puts
Non-dividend-paying stocks
For a European put option on a non-dividend paying stock, a lower
bound for the price is:

Ke-rT – S0
Example: S0=$37, K=$40, r=5% per annum, put price=$1.00, and
T=0.5 years, so that:

Ke-rT – S0 = 40e-0.05*0.5 – 37 = $2.01

What opportunities are there for an arbitrageur?

28
 Lower bounds for puts
Non-dividend-paying stocks (Cont.)
At t=0:
Borrow $38 to buy both the put ($1) and the stock ($37).

At t=1:
Repayment in six months: 38 e0.05* 0.5 = $38.96.
If S0 < K, exercise the option and sell the stock for $40.
Profit = $40-$38.96=$1.04.

If S0 > K , discard the option and sell the stock and

Profit = S0 - $38.96 > $1.04.

29
 Lower bounds for puts
Non-dividend-paying stocks
• Portfolio C: One European put option plus one share. Portfolio C is
worth:

max(ST, K)
• Portfolio D: An amount of cash equal to Ke-rT (or equivalently a
zero-coupon bond paying off K at time T). So, it can be shown that:

p ≥ Ke-rT − S0
• Because the put value cannot be negative, this means that p ≥ 0
and therefore:

p ≥ max(Ke-rT − S0, 0) (10.5)

30
 Lower bounds for puts
Non-dividend-paying stocks
Example : S0=$38, K=$40, T=0.25, r=10% per annum.

A lower bound for the option price is:

Ke-rT − S0 = 40e-.10*0.25 − 38 = $1.01

31
 Put–call parity
European put and call options that have the same K and T
• Portfolio A: One European call option plus a zero-coupon bond that
provides a payoff of K at time T
• Portfolio C: One European put option plus one share of the stock
(no dividends). Both portfolios are worth:

max(ST, K)
• Portfolio A is worth c and Ke-rT today, Portfolio C is worth p and S0
today, so:
c + Ke-rT = p + S0
• If this were not true, there would be arbitrage opportunities

32
 Put–call parity
Values of portfolio A and portfolio C at time T

ST > K ST < K

Portfolio A Call option ST − K 0

Zero-coupon bond K K

Total ST K

Portfolio C Put Option 0 K− ST

Share ST ST

Total ST K

Table 10.2, page 233

33
 Put–call parity

c+Ke-rT =p+S0 (10.6)

Example: S0=$31, K=$30 (for both put and call), r=10% per annum,
c=$3.00, p=$2.25 and T=0.25 years, so that:

C + Ke-rT = 3 + 30e-0.10*0.25 = $32.26

P + S0 = 2.25 + 31 = $33.25

What opportunities are there for an arbitrageur?

If p=$1.00, are there any arbitrage opportunities?

34
 Put-Call Parity - Arbitrage
In the above example, portfolio C is overpriced relative to portfolio A.
So, buy the securities in A and short the securities in C.

At t= 0: Buy call and short both put and stock

To generate -3+2.25 +31 = $30.25 upfront which grows to
30.25 e0.1*.25 = $31.02 (in three months).

At t=1: Either call (S>K)or put (K>S) will be exercised. The

arbitrageur ends up buying 1 share for $30 to close out the short
position. The profit = $31.02 -$30 = $1.02.

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 American options

When there are no dividends, it can be shown that:

S0 – K ≤ C – P ≤ S0 – Ke-rT (10.7)
Example: S0=$19, K=$20, r=10% per annum, C=$1.50, and T=5
months, so that:
19 – 20 ≤ C – P ≤ 19 - 20e-0.10*5/12
1 ≥ P – C ≥ .18
Because C=$1.50, P must lie between $1.68 (lower bound) and $2.50
(upper bound).

36
 Calls on non-dividend-paying stock

C ≥ S0 − Ke-rT
Given r > 0, it follows that C > S0 – K
If it were optimal to exercise early, then C would equal S0 – K
• It can never be optimal to exercise an American call on a non-
dividend-paying stock early because of:
• the insurance that it provides
• the time value of money

37
 Calls on non-dividend-paying stock
Bounds
max(S0 − Ke-rT, 0) ≤ c, C ≤ S0

Bounds for European and

American call options when there
are no dividends

Figure 10.3, page 237

38
 Calls on non-dividend-paying stock
Bounds

max(S0 − Ke-rT, 0) ≤ c, C ≤ S0

Variation of price of an American

or European call option on a non-
dividend-paying stock with the
stock price S0.
As r or T or σ increases the line
relating the call price to the stock
price moves in the direction
indicated by the arrow.
Figure 10.4, page 237

39
 Puts on a non-dividend-paying stock
It can be optimal to exercise an American put option on a non-
dividend-paying stock early.
• The early exercise of a put option becomes more attractive as:
• S0 decreases
• r increases
• volatility decreases

40
 Puts on a non-dividend-paying stock
Bounds
Bounds for a European put option when there are no dividends:

max(Ke-rT − S0, 0) ≤ p ≤ Ke-rT

Bounds for an American put option on a non-dividend-paying stock:

max(K − S0, 0) ≤ P ≤ K

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 Puts on a non-dividend-paying stock
Bounds
Bounds for European (left) and American (right) put options when
there are no dividends

Figure 10.5, page 238

42
 Puts on a non-dividend-paying stock
Bounds
Variation of price of an American
put option with stock price.

The line relating the put price to the

stock price moves in the direction
indicated by the arrows when

r ↓, σ ↑ and T ↑ .
Figure 10.6, page 239

When early exercise is optimal, the

value of the option is K- S0.

43
 Puts on a non-dividend-paying stock
Bounds
Variation of price of a European
put option with the stock price

Figure 10.7, page 239

44
 Effect of dividends
• Portfolio A: One European call option plus an amount of cash equal
to D + Ke-rT
• Portfolio B: One share

c ≥ S0 - D - Ke-rT
• Portfolio C: One European put option plus one share
• Portfolio D: An amount of cash equal to D + Ke-rT

p ≥ D + Ke-rT - S0

45
 Put-call parity

c + D + Ke-rT = p + S0

S0 – D – K ≤ C – P ≤ S0 – Ke-rT

46