CHAPTER 3

Introduction to Options

Derivative Securities
Tunis Business School
 Study Objectives
1. Define Options.
2. Describe the characteristics of Options.

3. Calculate the payoffs and profits to option owners and writers (sellers).
4. Establish the Call-Put Parity relationship.
 Definition
• An Option provides to its holder the right but
not the obligation to buy (Call) or to sell (Put) a
certain quantity of an asset, called the
underlying, before (American Options) or at
(European Options) a fixed date, called the
maturity (or the expiry date) (T), and through
a fixed price, called the strike price (or the
exercise price) (K).
• This right is acquired after the payment of a
premium.
 Option Terminology
• Buy - Long
• Sell - Short
• Call
• Put
• Key Elements
– Exercise or Strike Price
– Premium or Price
– Maturity or Expiration
 Exercise
• A stock is worth initially at the Spot market
100 $ . You bought a Call having this stock as
underlying , a maturity of 1 month and a strike
price of 100 $.
• Find analytically and graphically, the pay-off at
maturity as well as the profit depending on
the following ST.
• ST 80; 90; 100; 102; 110; 120
• The premium paid initially to acquire the Call
is 2$.
 Exercise
• A stock is worth initially at the Spot market
100 $ . You bought a Put having this stock as
underlying , a maturity of 1 month and a strike
price of 101 $.
• Find analytically and graphically, the pay-off at
maturity as well as the profit depending on
the following ST.
• ST 80; 90; 99; 100; 101; 110; 120
• The premium paid initially to acquire the Put is
2$.
Market and Exercise Price Relationships
In the Money - exercise of the option would be
profitable
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option would not be
profitable
Call: market price<exercise price
Put: exercise price<market price
At the Money - exercise price and asset price are equal
Figure 20.1 Stock Options on IBM
 American vs. European Options

American - the option can be exercised at any

time before expiration or maturity
European - the option can only be exercised on
the expiration or maturity date
 Payoffs and Profits at Expiration - Calls

Notation
Stock Price = ST Exercise Price = X
Payoff to Call Holder
(ST - X) if ST >X
0 if ST < X
Profit to Call Holder
Payoff - Purchase Price
Payoffs and Profits at Expiration - Calls

Payoff to Call Writer

- (ST - X) if ST >X
0 if ST < X
Profit to Call Writer
Payoff + Premium
Figure 20.2 Payoff and Profit to Call Option
at Expiration
Figure 20.3 Payoff and Profit to Call Writers
at Expiration
Payoffs and Profits at Expiration - Puts

Payoffs to Put Holder

0 if ST > X
(X - ST) if ST < X

Profit to Put Holder

Payoff - Premium
Payoffs and Profits at Expiration – Puts
Continued
Payoffs to Put Writer
0 if ST > X
-(X - ST) if ST < X

Profits to Put Writer

Payoff + Premium
Figure 20.4 Payoff and Profit to Put Option
at Expiration
 Exercise
• You detain initially a stock that you wish sell in 1 month.
You want to hedge your position through an Option having
a maturity of 1 month and a strike price of 100$ and a
premium of 3$. This stock is worth initially at the Spot
market 100 $.
• 1- What are the features of the option to buy?
• 2- Find analytically and graphically, the profits at maturity
on the initial position, on the option as well as on the total
(hedged) position depending on the following ST.
• ST 80; 90; 97; 100; 103; 110; 120
• 3- Find the breakeven points on the initial position, on the
option as well as on the total (hedged) position.
 Exercise 2
• A farmer has a short position on 100 tons of wheat (that
he needs as seeds). A ton of wheat is worth initially at the
Spot market 300 $. Fearing an unfavorable evolution of
prices, he decided to hedge his position through an Option
having a maturity of 2 months and a strike price of 301$
and a premium of 3$.
• 1- What are the features of the option to buy?
• 2- Find analytically and graphically, the profits at maturity
on the initial position, on the option as well as on the total
(hedged) position depending on the following ST.
• ST 280; 290; 297; 300; 301; 304; 310; 320
• 3- Find the breakeven points on the initial position, on the
option as well as on the total (hedged) position.
Table 20.1 Value of Protective Put Portfolio
at Option Expiration
Figure 20.6 Value of a Protective Put Position
at Option Expiration
Figure 20.7 Protective Put versus Stock
Investment (at-the-money option)
Table 20.2 Value of a Covered Call Position at
Expiration
Figure 20.8 Value of a Covered Call Position
at Expiration
 Put Call Parity

If the prices are not equal, arbitrage will

be possible
X
C  S0  P
(1  rf )T
 Put Call Parity - Disequilibrium Example

Stock Price = 110 Call Price = 17

Put Price = 5 Risk Free = 5%
Maturity = 1 yr X = 105
X
C  S0  P
(1  rf )T

117 > 115

Acquire the low cost alternative and sell the high cost
alternative
 Put Call Parity - Disequilibrium Example

A stock is worth initially 100$. This stock is the

underlying of a European Call and Put, having a same
maturity of 2 years and the same strike price K=101$.
The annual risk-free interest rate is 4%. Initially the
Call is worth 10$.
1- Find the theoretical price of the Put.
2- The Put is worth 2$. Construct the relevant strategy.
3- The Put is worth 4 $. Construct the relevant strategy.
 Put Call Parity - Disequilibrium Example

A stock is worth initially 100$. This stock is the

underlying of a European Call and Put, having a same
maturity of 3 months and the same strike price
K=101$.
Initially the Call is worth 2$ and the Put is worth 2$.
1- Find the annual risk-free interest rate.
2- The annual risk-free interest rate is 5%. Construct the
relevant strategy.
3- The annual risk-free interest rate is 3%. Construct the
relevant strategy.
Table 20.5 Arbitrage Strategy
 Exotic Options

• Asian Options
• Barrier Options
• Look-back Options
• Binary Options
• Compound Options
• …
 Exercise

A speculator sold a Put covering 10 kg of gold, having

a maturity of 1 month, a strike price of 32000$ and a
premium of 500$ (Per kg).
1- What are the expectations of a the speculator?
2- The total profit generated by this Put to the
speculator is 4000$. Find the spot price at maturity
of 1 kg of gold (ST).