MODULE 3: OPTION

CONTRACTS

Types of Options
Given the rights & obligations in the
option contract, options are of two
types Call options & Put options
Call option Gives rights without
obligations to its holder to buy the
underlying at a certain price on or
before a certain date
Put option Gives rights without
obligations to its holder to sell the
underlying at a certain price on or
before a certain date

Types of Options
The price specified in the option contract is
called the Strike Price or Exercise Price
The date specified in the option contract is
called the Expiration Date or Maturity Date
Price of an option is called option premium
American option An option contract that
can be exercised on/before the expiration
date
European option An option contract that
can be exercised only on the expiration date
3

Simple Option Strategies

Covered Call
Protective Put

Covered Calls
Objective: To earn additional
return
The investor has a holding of the
underlying asset & WRITES calls
on that
If the call is not exercised the
investor earns an additional return
out of the premium earned on call
written
5

Covered Calls
This option strategy is appropriate for
applying with a buy-and-hold strategy
in the underlying asset
In a stagnant market for the
underlying, this strategy can generate
additional returns for the investor by
way of the premium earned on writing
calls
Important: Strike price & Option
premium of the call option sold
6

Protective Puts
Objective: To protect from a fall
in value of the underlying asset
held
Strategy: Hold the asset & BUY
puts on the asset
Put will compensate any fall in
value of the asset below the
strike price
7

Protective Puts
Alternatively investor can SELL
futures
Futures will close the upside
potential
Protective put will leave the
upside open
Protective puts come with a
cost premium has to be paid
8

Price of an Option
Fundamental issue: What should be
the price of an option (option
premium)?
The price is determined by the
following:
o Intrinsic Value of the option
o Upper & Lower Bounds on the option
prices which is necessary to prevent
arbitrage
9

Intrinsic Value
Expressed from a long position
(holders) perspective
Intrinsic value of an option is the
maximum of zero and the gross
payof it would entail if exercised
immediately
Call option: Intrinsic value = Max (S
K, 0)
Put option: Intrinsic value = Max (K
10

Intrinsic Value
Generally price of any option with
remaining life before expiry is higher than
its intrinsic value because there is some
likelihood that the intrinsic value might
increase further in the remaining time
American options can be exercised at any
time up to the expiry date
Hence for the same intrinsic value
American options are more expensive
than European ones
Excess of an options price over its
11

Intrinsic Value
In-the-money options: Those with +ve
payof to holder (if exercised immediately)
Out-of-the-money options: Those with ve
payof to holder (if exercised immediately)
At-the-money options: Those with 0 payof
In-the-money Call options: Spot price (S) >
Strike price (K)
Out-of-the-money Call options: S < K
In-the-money Put options: S < K
Out-of-the-money Put options: S > K
At-the-money options All types: S = K
12

Upper & Lower Bounds for Prices of Stock

Options

These are the maximum & minimum

limits with in which the option prices
should always remain
If the option prices go beyond these
limits then opportunities for earning
risk-free profits through arbitrage
are created
These limits are applicable to both
European & American options
13

Upper & Lower Bounds for Prices of

Stock Options - Notations
c:

European call
option price

C:

American call
option price

p:

European put
option price

P:

American put
option price

S0:

Stock price today

ST:

K:

Strike price

Stock price at
option maturity

T:

Life of option

D:

Dividends paid
during life of option

Volatility of stock
price

Risk-free rate for

maturity T with
cont. comp.

14

Upper Bound for European Call Prices No

Dividends: Post.1/Eg. 4/p71

1. A European call option on a no-dividend

stock cannot have a higher value than the
current share price. Thus:
c S0
. If this is not true then there will be
opportunities for earning riskless profit by
buying the share & selling the call option
. If the call price is more than share price at a
point of time then the stock is cheaper & the
call is dearer
. So riskless profit can be earned by selling
15
the call & buying the share

Upper Bound for European Call Prices No

Dividends: Post.1/Eg. 4/p71

When call price exceeds the stock

price the trader writes the call
option & buys the share and earns
a gain = Diference between the
call price & stock price at the
current time (M)
Two possibilities at Expiry:
A. Call will not be exercised
B. Call will be exercised
16

Upper Bound for European Call Prices No

Dividends: Post.1/Eg. 4/p71

A. Call will not be exercised at Expiry:

If the call is NOT exercised the trader
can sell the share for a price however
small. Traders overall gain = M + Sale
value of share. This gain is risk-free.
When all traders do these transactions
the call price would fall & current stock
price would rise, wiping out the arbitrage
profit
17

Upper Bound for European Call Prices No

Dividends: Post.1/Eg. 4/p71

B. Call will be exercised at Expiry:

If the call is exercised the trader can sell
the share for a price = Strike price of
call. Trader already has a gain of M
(above). This gain is risk-free.
When all traders do these transactions
the call price would fall & current stock
price would rise, wiping out the arbitrage
profit
18

Lower Bound for European Call Prices- No Dividends:

Post.3/Eg. 5/p72

2. The lowest value of a European call

with no dividends is the Stock Price
Minus the Present Value of Exercise
Price

. If the value of call is less than this

limit then traders can earn arbitrage
profits by the following steps: 1.
Short share (Inflow = S0 ); 2. Buy
call (outflow = call premium): Net
cash inflow = S0 Call premium; 3.
19

Lower Bound for European Call Prices- No Dividends:

Post.3/Eg. 5/p72

Minimum arbitrage profit =

Accumulated amount from
investment Strike price of call
When more & more traders resort
to such arbitrage the call price will
increase & stock price will
decrease in such a manner that
the arbitrage profits will be wiped
out
20

Upper Bound for European Call Prices- With

Dividends: Post.2/Eg.4/p71

3. A European call option on a stock

paying known dividends cannot have a
higher price than the current value of
the share price minus the present
S0expected
Present valuedividend.
of Expected Dividend
valuec of
Thus:
. If not so it will be possible to earn
riskless arbitrage profit by selling the
call, borrowing PV of dividends, buying
the share now, repay debt by the
21

Upper Bound for European Call Prices- With

Dividends: Post.2/Eg.4/p71

In case of an arbitrage the traders

minimum profit = Call price + PV of
dividends Stock price at the
current time
When more & more traders resort to
such arbitrage the call price will
decrease & stock price will increase
in such a manner that the arbitrage
profits will be wiped out
So at equilibrium the call price
22

Lower Bound for European Call Prices - With

Dividends: Post.4/Tab.12/p72

4. The lowest value of a European call with

Known dividends is the Stock Price Minus
the Present Value of Exercise Price Minus
Value
of Dividends:
c the
S 0 Present
Present Value
of Exercise
Price - Present Value of Dividends
. If this lower limit is violated then it will be
possible to earn riskless arbitrage profit by:
1. shorting the stock, 2. use part of the
proceeds to buy the call now, 3. invest part
of the proceeds to generate the dividends,
4. invest part of the proceeds to generate
the exercise price of call, 5. at maturity buy
23

Lower Bound for European Call Prices - With

Dividends: Post.4/Tab.12/p72

In case of an arbitrage the traders

minimum profit = Spot price of
stock Call premium now Present
Value of Exercise price Present
Value of Dividends
When more & more traders resort to
such arbitrage the call price will
increase & stock price will decrease
in such a manner that the arbitrage
profits will be wiped out
24

Upper Bound for European Put Prices No

Dividends: Post.9/Tab.15/p75

5. The value of a European put on a nondividend paying stock cannot exceed

the present value of the exercise price
. If the value of the put is more than the
upper limit then there be opportunities
to earn riskless arbitrage profits
. Arbitrage steps: 1. Sell put 2. Invest
part of sale proceeds to generate the
exercise price of the put 3. At expiry
put is exercised trader pays from the
proceeds of investment
25

Upper Bound for European Put Prices No

Dividends: Post.9/Tab.15/p75

Immediate arbitrage profit =

Premium received on selling Put
Present Value of Strike Price
When more & more traders resort
to such arbitrage the price of put
will decrease such that the
arbitrage profits will be wiped out

26

Lower Bound for European Put Prices No

Dividends: Post. 11/p76

6. The price of a European put on a non-dividend

paying stock cannot be lower than the
diference between the present value of strike
price & the stock price
. If the value of the put is less than the lower limit
then there be opportunities to earn riskless
arbitrage profits: 1. Buy the put 2. Borrow an
amount = Present value of strike price 3. Use
part of this amount to buy the stock 4. At
expiry if put is in the money then it can be
exercised & loan can be repaid by the proceeds;
if out of the money trader can sell the stock at
market price, repay loan & earn extra profits 27

Lower Bound for European Put Prices No

Dividends: Post. 11/p76

Immediate arbitrage profit = Present

value of Strike price Spot price of stock
at time 0 Premium paid for Put
The above profit is the minimum that will
be earned always; if the put ends out of
money the trader can earn additional
profit
When more & more traders resort to such
arbitrage the put price will increase, spot
price of stock will increase such that
arbitrage profits are wiped out
28

Upper Bound for European Put Prices With

Dividends: Post.9/Tab.15/p75

7. The price of a European put on a stock

paying dividends cannot exceed the
present value of the exercise price
(the position remains the same as in
case of stocks with no dividends)
. The maximum loss that the put writer
will sufer in the event that the put is
exercised is only the strike the price
and he can cover this loss by investing
the present value of strike price now
29

Upper Bound for European Put Prices With

Dividends: Post.9/Tab.15/p75

The possibility of the stock paying

dividends is not relevant for pricing the put
because the put writer is neither carrying
the stock nor borrowing it from anybody
For the put writer the strike price & price of
put only matter
Minimum arbitrage profit: Price received on
selling put Present value of strike price
When more & more traders resort to such
arbitrage the price of put will decrease such
that the arbitrage profits will be wiped out
30

Lower Bound for European Put Prices With

Dividends: Post.12/Tab.16/p76

8. The lower limit of the price of a European

put on a stock paying dividends = Present
value of the Strike price Current price of
Stock + Present Value of Dividend
. If the put is priced below this value then
arbitrage will occur as follows: 1. Borrow
an amount = Present Value of Strike price
+ Present Value of Dividend (for
consuming the future dividends now) 2.
Buy Put 3. Buy Stock 4. Repay loan
amount of present value of dividends by
the dividends received in future 4. Repay
31

Lower Bound for European Put Prices With

Dividends: Post.12/Tab.16/p76

The minimum arbitrage profit now

will be = Present Value of Strike Price
+ Present Value of Dividends
Current Stock Price Price of Put
If on expiry the put is out of money
then there will be potential for further
profit in future
When more & more traders resort to
such arbitrage the put price will
increase, spot price of stock will
32

Upper Bound for American Call Prices No

Dividends: Post.5/p73

9. The upper limit of the price of

an American Call on a stock
paying no dividends is the
current price of the underlying
share
The principle is same for both
European & American calls
notwithstanding that American
options can be exercised at any
33

Lower Bound for American Call Prices No

Dividends: Post.7/Tab.13/p74

10. The lower limit of the price of an

American Call on a stock paying no
dividends is the Diference between
current stock price & exercise price
The principle difers from European
calls because American options can
be exercised at any time up to their
expiry; so there is no need to take
the present value of the strike price
in finding the lower limit as in case
34

Upper Bound for American Call Prices With

Dividends: Post.6/p73

11. The upper limit of the price of

an American Call on a stock
paying known dividends is
Current price of the underlying
share Present value of
Expected dividend
The principle is same for both
European & American calls
notwithstanding that American
35

Lower Bound for American Call Prices With

Dividends: Post.6/Eg.6/p74

12. The lower limit of the price of

an American Call on a stock
paying known dividends =
Current price of the underlying
share Strike Price PV
(Expected dividend)
The principle is diferent from
European calls because
American calls can be exercised
36

Upper Bound for American Put Prices No

Dividends: Post.13/Tab.17/p77

13. The upper limit of the price of

an American put paying no
dividends is the Strike price of
the put
The principle difers from
European puts because
American options can be
exercised at any time up to their
expiry; so there is no need to
37

Lower Bound for American Put Prices No

Dividends: Post.15/Tab.18/p77

14. The lower limit of the price of

an American put paying no
dividends = Strike price Stock
price
The principle difers from
European puts because
American options can be
exercised at any time up to their
expiry; so there is no need to
38

Upper Bound for American Put Prices With

Dividends: Post.14/p77

15. The upper limit of the price of

an American put with known
dividends is the Strike price of
the put
The presence of dividends does
not make any diference in the
principle as it is in case of no
dividends
The maximum loss to be borne
39

Lower Bound for American Put Prices With

Dividends: Post.16/p78

16. The lower limit of the price of

an American put with known
dividends = Strike price of the
put Stock price + Present Value
of Dividends
This is same as the case of
European put with dividends
40

Factors Afecting Option

Premiums

Current stock price (S0 )

Strike / Exercise price (K)
Time to expiration (T)
Volatility ()
Risk-free interest rate (r)
Dividends expected during the
life of option

Factors: Current Stock Price (S0 )

The payof of call option, on exercise is
the excess of stock price over the strike
price
The higher the stock price the higher
the call price & vice versa
Payof of put option, on exercise is the
excess of strike price over stock price
The higher the stock price the lower the
put price & vice versa

Factors: Strike /Exercise Price (K)

The payof of call option, on exercise is
the excess of stock price over the strike
price
The higher the strike price the lower the
call price & vice versa
Payof of put option, on exercise is the
excess of strike price over stock price
The higher the strike price the higher the
put price & vice versa

Factors: Time to expiration (T)

American Options:
Both put & call options become more
valuable with an increase in time to
expiration because this increases the
likelihood of the conditions to go in favour of
the holder & against the writer
European Options:
The above may be generally true for
European options as well. However there will
be exceptions when there is a possibility of
known dividends during the life of the option

Factors: Volatility ()
Volatility increases the chances that a stock will
do very well or very bad
A call option holder gains from upside stock
price movements but has limited risk from
downside stock movements
A put option holder gains from stock price
decreases & has limited risk from stock price
increases
Increase in volatility increases the opportunities
of gain for both call & put holders hence
increases value of both call & put options

Factors: Risk-Free Interest Rate (r)

As r increases the expected return of
investors also increases
So for call options the present value of
strike price payable decreases & for put
options also the present value of strike
price receivable decreases
The stock price may/not change
The net efect of increase in r may be rise
in value of call & fall in value of put

Factors: Future Dividends

Dividends reduce stock price on exdividend date
Call prices tend to decrease with size
of future dividends
Put prices tend to increase with size
of future dividends

Put-Call Parity
A. What is it?
B. What is its
significance?

Put-Call Parity
A.

It is a relationship between the

prices of European Call options &
European Put options
B. Because of this relationship the
price of one can be derived on the
basis of the price of the other

Put-Call Parity
The relationship is applicable to
European options only
Both put & call options must be identical
in respect of underlying asset, strike
price & expiry date
The relationship is deduced by creating
portfolios based on call & put options
which are identical in: value / cash flows,
their timing & riskiness

Put-Call Parity
Portfolio A: One European Call plus
Cash amount: Ke-rT to be invested in
risk-free securities
Portfolio B: One European Put plus
one Share
Why ??

Put-Call Parity
Value of Portfolio A at Expiry Date:
ST < K

ST > K

1.Value of riskfree investment

2.Value of Call

ST K

Portfolio = 1 +
2
Value
of Portfolio

ST

A on expiry
= Max(ST , K)

Put-Call Parity
Value of Portfolio B at Expiry Date:
1.Value of
Stock
2.Value of Put
Portfolio = 1
+ 2 of Portfolio
Value

ST < K

ST > K

ST

ST

K - ST

ST

B on expiry
= Max(ST , K)

Put-Call Parity
Both portfolios are worth the same on
maturity expiration of options
Both are European options hence can
not be exercised before expiry date
Hence their value must be equal today
rT
Thus:
c Ke p S0
This is called Put-Call Parity. It provides
a basis for deriving the price of a call
from a put & vice versa, when strike
price & expiry date are same

Eg. 1
The current price of a stock is INR 31, the
strike price is INR 30, the risk-free interest
rate is 10% pa, expiration period is 3 months,
the price of a European call option is INR 3 &
the price of a European put is INR 2.25
What should be the price of put given the
price of call?
What should be the price of call given the
price of put?
Validate the put-call parity relationship.
What are the likely consequences?

Eg. 2
The current price of a stock is INR 31, the
strike price is INR 30, the risk-free interest
rate is 10% pa, expiration period is 3
months, the price of a European call option is
INR 3 & the price of a European put is INR 1
What should be the price of put given the
price of call?
What should be the price of call given the
price of the put?
Validate the put-call parity relationship.
What are the likely consequences?

Put-Call Parity: With Dividends

For European options an amount
of cash equal to the present
value of the dividends during the
lifetime of the option is to be
added to the earlier portfolio A.
So the equation rTbecomes:
c D Ke

p S0

Put-Call Parity: American Options?

For American options there is

a modification of the Put-Call
parity rule. It gives the upper &
lower bounds of the diference
between the prices of
American Call & Put options.
Thus:
S0 K C P S0 Ke-rT

Put-Call Parity: With Dividends

For American options: The term

D, present value of dividends,
has to be subtracted in the
LHS of the diference between
call & put prices
S0 K D C P S0 Ke-rT