7.

Properties of
Stock Option Prices

Chapter 7
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.2
Effect of Variables on Option
Pricing (Table 7.1, page 169)

Variable c p C P
S0 + – + –
X – +? – +
T

? + +
+ + + +
r + – + –
D – + – +
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.3

Assumptions
• There are no transaction costs
• All trading profits are subject to the
same tax rate
• Borrowing and lending at the risk-free
interest rate is possible

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.4
Notation
• c : European call • C : American Call option
option price price
• p : European put • P : American Put option
option price price
• S0 : Stock price today • ST :Stock price at time T
• X : Strike price • D : Present value of
• T : Life of option dividends during option’s
• : Volatility of stock life
price • r : Risk-free rate for
maturity T with cont comp

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.5

American vs European Options

An American option is worth
at least as much as the
corresponding European
option

C c
P p

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.6
Upper Bounds
• Stock price is an upper bound to the
American or European call
c ≤ So and C ≤ So, if this would not
hold, an easy arbitrage profit would be available
by buying the stock and selling the call option.
• Strike price is an upper bound to the
American or European put
p ≤ X and P ≤ X
• For European put
 rT
p  Xe
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.7

Lower bound
• European calls on non-dividend-paying
stock

 rT
S o  Xe

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.8
Calls: An Arbitrage
Opportunity?
• Suppose that
c =3 S0 = 20
T =1 r = 10%
X = 18 D=0

• Is there an arbitrage opportunity?

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.9

LBEurCall  S0  Xe rT  20  18e 0,1  3,71

What if the price of a European Call is
c  3,00$ and arbitrageur buys the call and
shorts the stock
$20  $3  $17 and invests on r for a year

17e  17e rT 0,1

 18,79

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.10
If the stock price is greater than 18,
arbitrageur exercises the option,
closes short and makes a profit of $0,79.
$18,79  $18  $0,79
If the stock price is less than 18,
(for ex. 17) the stock is bought in
the market and a short position is
closed out with even greater profit
of 1,79.

$18,79  $17  $1,79

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.11

Portfolio A: 1 Eur Call + Xe-rT

Portfolio B: 1 share of stock
Cash in A is invested in r and will grow to X in time T
If ST>X, c is exercised and A =ST
If ST<X, c is worthless and A =X

At time T portfolio A is worth max (ST, X)

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.12

Portfolio B is worth ST at time T

Portfolio A is worth at least as portfolio B at time T
Hence, A must be worth at least as B today
 rT
c  Xe  S0
 rT
c  S 0  Xe

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.13
Lower Bound for European Call
Option Prices; No Dividends
(Equation 7.1, page 172)
Since c must be non negative i.e. c ≥ 0

c  max So  Xe   rT
,0 

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.14

Lower bound
• European puts on non-dividend-paying
stock

 rT
Xe  S0

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 Puts: An Arbitrage 7.15

Opportunity?
• Suppose that
p =1 S0 = 37
T = 0.5 r =5%
X = 40 D =0

• Is there an arbitrage
opportunity?

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.16

LBEurPut  Xe rT  S0  40e 0,050,5  37  2,01

What if the price of a European Put is
p  1,00$ and arbitrageur borrows $38 for six
months and buys a put and the stock
$37  1$  $38 at the end of six months
arbitrageur will have to pay
0, 0505
38e  $38,96
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.17
If the stock price is bellow 40,
arbitrageur exercises the option,
Sells the stock and makes a profit of $1,04.
$40,00  $38,96  $1,04
If the stock price is greater than 40,
(for ex. 42) the option is discarded
and the stock is sold in the market
with even greater profit of 3,04.

$42,00  $38,96  $3,04

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.18

Portfolio C: 1 Eur Put +1 share

Portfolio D: cash of Xe-rT

If ST<X, p is exercised at T and C =X

If ST>X, p is worthless and C =ST

At time T portfolio C is worth max (ST, X)

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.19

Assuming cash is invested at r, D is worth X at T

Portfolio C is worth at list as portfolio D at time T

Hence, C must be worth at least as D today
 rT
p  S0  Xe
 rT
p  Xe  S0

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
Lower Bound for European Put7.20
Prices; No Dividends
(Equation 7.2, page 173)
Since p must be non negative i.e. p ≥ 0

p  max (Xe -rT - S0, 0)

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.21
Put-Call Parity; No Dividends
(Equation 7.3, page 174)
• Consider the following 2 portfolios:
– Portfolio A: European call on a stock + PV of the
strike price in cash
– Portfolio C: European put on the stock + the stock
• Both are worth MAX(ST , X ) at the maturity of the
options
• They must therefore be worth the same today
– This means that
c + Xe -rT = p + S0
This relationship is known as put-call parity
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.22
Arbitrage Opportunities
• Suppose that
c =3 S0 = 31
T = 0.25 r = 10%
X =30 D =0
• What are the arbitrage
possibilities when
p = 2.25 ?
p =1?

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.23

Early Exercise

• Usually there is some chance that an

American option will be exercised
early
• An exception is an American call on
a non-dividend paying stock
• This should never be exercised early

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.24

An Extreme Situation
• For an American call option:
S0 = 50; T = 0.083; X = 40; D = 0
Should you exercise immediately?
• What should you do if
1 You want to hold the stock for the next 3
months?
2 You do not feel that the stock is worth
holding for the next 3 months?
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.25
Reasons For Not Exercising a
Call Early
(No Dividends )

• No income is sacrificed
• We delay paying the strike price
• Holding the call provides
insurance against stock price
falling below strike price

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.26
Should Puts Be Exercised
Early ?
Are there any advantages to
exercising an American put
when
S0 = 60; T = 0.25; r=10%
X = 100; D = 0

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.27
The Impact of Dividends on
Lower Bounds to Option Prices
(Equations 7.5 and 7.6, page 179)

 rT
c  S0  D  Xe
 rT
p  D  Xe  S0

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
 7.28

Extensions of Put-Call Parity

• American options; D = 0
S0 - X < C - P < S0 - Xe -rT
Equation 7.4 p. 178
• European options; D > 0
c + D + Xe -rT = p + S0
Equation 7.7 p. 180
• American options; D > 0
S0 - D - X < C - P < S0 - Xe -rT
Equation 7.8 p. 180

Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull