SUBMITTED TO : PROF.

Sumit Gulati

SUMITTED BY: SAURABH VERSHNEY RAKESH ADHIKARI SUMAN SEN

Intrinsic Value:-The payoff the holder gets by exercising the option is called the intrinsic value of the option. The difference between spot price and exercise price will determine this value. The intrinsic Value is For call option : Max {(S-X),0} For put option: Max {(X-S),0} The value of call option can never fall below its intrinsic value.For example a call for exercise price of Rs 80 on the underlying stock currently trading at Rs 100 would haveintrinsic value 20.This would be the minimum price at which the call would sell.Any price less than Rs 20 presents an opportunity to make immediate profit without taking any risk.If one buys a call at Rs 19(less than Rs 20) and exercises it immediately, the cash outflow would be Rs 99.But the holder can sell the acquired stock at Rs 100 gaining Re 1 immediately.

Time value:-It is the excess of actual value over intrinsic value. Time value= Actual Price-Intrinsic value

BOUNDARY CONDITION FOR OPTION PRICING

Boundary condition is generally used to calculate the miximum and minimum values of an option.The boundary condition tell that the price of an option should not exceed a particular amount or should not be minimum than a particular amout so calculated. For call option Maximum price of the call option , Minimum price of the call option Where

Cmax= S or C S

, Cmin=S-Xe-rt or c s Xe -rt

Xe-rt = present value of the exercise price

T= time remaining for maturity R= risk free rate

For put option A put option as we know is right to sell the underslying security at exercise price X. so the max value to pay is X or Maximum price of the put option

Pmax= Xe

rt

Minimum price of the put option

Pmin=Xe-rt -s

EFFECTS OF DIVIDEND ON LOWER BOUDS.

The options on stock are for maximum 3 month maturity so the effect of dividends on the lower bounds on price of options can be incorporated by adjusting the spot price for the dividend. if the dividend is payable within the expiry of the option, the spot price, of the asset S must be reduced by present value of dividend. Similar adjustment may be made for the lower bound of put prices, where present valuewould be added to the lower bound. Lower bound for call on dividend paying stock

Cmin S-Xe-rt De-rt1 pmin xe-rt s+De-rt

lower bound for put on dividend paying stock

Arbitrage based relationship of option pricing

Arbitrage places lower and upper bounds to the option pricing. we cannot use the concept of arbitrage for determination of exact price we can use it for relative prices of different financial assets such as two calls, two puts, a call , and a put etc. An exposition of arbitrage based arguments is expected to improve the understanding the principal of finance. The concept of arbitrage is central to price determination in economics and finance as it. (A) (B) (C) (D) Makes prices of different assets consistent with each other, Establishes relationship between prices of different assets Makes prices of the same asset to converge in different markets Helps explain differential in prices in different markets and of different assets.

Call option with higher strike price would be priced lower than the one with lower strike price. Strike price A B 90 101 call price/premium 25 28

Arbitrage opportunity Action Seller of call B =101 Cash flow 28

Buyer of call A= 90 Net cash flow Final position of portfolio price (condition) Spot < 90 90< spot< 101 Spot> 101 Cash flow 3 Always positive ( 11+3) 14

-25 3

Status Both call are worthless Call A is ITM and Call B is Worthless Both call are exercised A=(102-90), B=(101-102)

Difference in call or put price can t exceed the difference in strike price Strike price A B 95 101 call price/premium 25 34

Arbitrage opportunity Action Seller of call B =101 Buyer of call A= 95 Net cash flow Final position of portfolio price (condition) Spot < 95 95< spot< 101 Spot> 101 Cash flow 9 Always positive ( 6+9) 15 Status Both call are worthless Call A is ITM and Call B is Worthless Both call are exercised A=(102-95), B=(101-102) Cash flow 34 -25 9

For put Strike price A B 95 101 put price/premium 25 34

Arbitrage opportunity

Action Seller of put B =101 Buyer of put A= 95 Net cash flow Final position of portfolio price (condition) Spot > 101 95> spot> 101 Spot> 95 Cash flow 9 Always positive ( -6+9) 3

Cash flow 34 -25 9

Status Both put are worthless Put B is ITM and Call A is Worthless Both put are exercised A=(95-87), B=(87-101)

Call or put with longer time to maturity must be priced higher than the one with shorter time to maturity. Strike price 65 Action Seller of call with X= 65 ,T=3 m. Buyer of call with X= 65, T= 6m. Net cash flow call t=3 month 22 Cash flow 22 -20 2 call t= 6 month 20

After 3 months (Final position of portfolio ) Price (condition) Spot <65 Spot>65 Cash flow 2 (5+2) 7 Status Call of 3m is worthless Call of 3 month is exercised (70-65)

For put Strike price 65 Action put t=3 month 22 Cash flow put t= 6 month 20

Seller of put with X= 65,T=3 m. Buyer of put with X= 65, T= 6m. Net cash flow After 3 months (Final position of portfolio ) Price (condition) Spot >65 Spot<65 Cash flow 2 (5+2) 7

22 -20 2

Put of 3m is worthless Put of 3 month is exercised (65-60)

Higher the exercise price more valuable is put. Strike price A B Action Seller of the put A=70 Buyer of the put B= 80 Net cash flow Final position of portfolio Price (condition) Spot< 70 70< spot<80 Spot >80 Cash flow (10+3) 13 Always positive 3 Status Both put are ITM A=(65-70),B=(80-65) Put B is ITM of put a is worthless Both put are worth less 70 80 put price/premium 23 20 cash flow 23 -20 3

PUT CALL PARITY

Put Call Parity is a concept identified by Stoll in 1969, that defines the relationship that must exist in European call and put options. Put options, call options and their underlying stock forms an interrelated securities complex in which the combination of any 2 components yields the same profit/loss profile as the 3rd instrument. Under this kind of complex relationship, no combination of 2 components should yield a position with an asymmetric profit/loss profile as the 3rd instrument so that balance is maintained in the system. This balance is known as the Put Call Parity in option trading. The concept of Put Call Parity is especially important when trading synthetic positions.

Example for put call parity Let us take a example and form a portfolio having under mentioned security Buy 1 stock Sell a call for X=100 ,maturity t ,premium p Buy a put for x=100 maturity t premium p

If we examine the position fo this portfolio under various prices of the underlying asset at the time of expiration (from 0 to 200) the total value of the portfolio will remain 100 at all price level. We can also say that: 1. An investor can borrow an amout equivalent to the present value of exercise price to create the portfolio 2. And since the value of the portfolio is certain at expiration date the lenders would lend the money at risk-free rate. 3. This portfolio can be said to be equivalent to a bond which matures to the value equal to that of exercise price and whose maturity coincides with the expiry of options.

s-c+p= PV OF X=X/(1+R)=Xe-rt

PUT CALL PARITY FOR AMERICAN OPTIONS

Put call parity for European options can help establish relationship for American puts and calls. American options provide for early exercise of the option. The Put-Call Parity of American options with dividends is defined as follows

Pa ca+X.e-rt-s

PUT CALL PARITY FOR DIVIDEND PAYING STOCK

Put call parity for dividend paying stock can be define as

C+Xe-rt= p+s-De-rt