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Stock Options: Pricing & Arbitrage Insights

1. The document discusses key properties and relationships for pricing European and American stock options, including the impact of variables like the stock price, strike price, time to maturity, volatility, risk-free rate, and dividends. 2. No arbitrage relationships exist, such as put-call parity, that equate the values of a call and put with the same strike and expiration. 3. Early exercise of American options is generally not advantageous for calls but can be for puts when the stock price is below the strike price.

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Shashank Tyagi
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126 views20 pages

Stock Options: Pricing & Arbitrage Insights

1. The document discusses key properties and relationships for pricing European and American stock options, including the impact of variables like the stock price, strike price, time to maturity, volatility, risk-free rate, and dividends. 2. No arbitrage relationships exist, such as put-call parity, that equate the values of a call and put with the same strike and expiration. 3. Early exercise of American options is generally not advantageous for calls but can be for puts when the stock price is below the strike price.

Uploaded by

Shashank Tyagi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

PROPERTIES OF STOCK OPTIONS

NOTATIONS

c: European call C: American call option


option price price
P: American put option
p: European put price
option price
ST: Stock price at option
S0: Stock price today maturity

K: Strike price D: PV of dividends paid


during life of option
T: Life of option
r Risk-free rate for
s: Volatility of stock maturity T with cont.
price comp.
EFFECT OF VARIABLES ON OPTION
PRICING

Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
s + + + +
r + − + −
D − + − +
AMERICAN VS EUROPEAN OPTIONS
An American option is worth at least as much as the
corresponding European option
Cc
Pp
CALLS: AN ARBITRAGE OPPORTUNITY?

 Suppose that
c=3 S0 = 20
T=1 r = 10%
K = 18 D=0
 Is there an arbitrage opportunity?
LOWER BOUND FOR EUROPEAN CALL
OPTION PRICES; NO DIVIDENDS

c  max(S0 –Ke –rT, 0)


PUTS: AN ARBITRAGE OPPORTUNITY?

 Suppose that

p= 1 S0 = 37
T = 0.5 r =5%
K = 40 D =0
 Is there an arbitrage opportunity?
LOWER BOUND FOR EUROPEAN PUT PRICES; NO DIVIDENDS

p  max(Ke -rT–S0, 0)
PUT-CALL PARITY: NO DIVIDENDS

 Consider the following 2 portfolios:


 Portfolio A: European call on a stock + zero-coupon bond that
pays K at time T
 Portfolio C: European put on the stock + the stock
VALUES OF PORTFOLIOS

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
THE PUT-CALL PARITY RESULT (
 Both are worth max(ST , K ) at the maturity of the
options
 They must therefore be worth the same today. This

means that

c + Ke -rT = p + S0
Arbitrage Opportunities
 Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D=0
 What are the arbitrage possibilities when

p = 2.25 ?
p=1?
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
AN EXTREME SITUATION

 For an American call option:


S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
 What should you do if
 Youwant to hold the stock for the next 3 months?
 You do not feel that the stock is worth holding for the next 3
months?
REASONS FOR NOT EXERCISING A
CALL EARLY (NO DIVIDENDS)
 No income is sacrificed
 You delay paying the strike price

 Holding the call provides insurance against stock


price falling below strike price
BOUNDS FOR EUROPEAN OR AMERICAN
CALL OPTIONS (NO DIVIDENDS)
SHOULD PUTS BE EXERCISED EARLY ?

Are there any advantages to exercising an


American put when
S0 = 60; T = 0.25; r=10%
K = 100; D = 0
BOUNDS FOR EUROPEAN AND AMERICAN
PUT OPTIONS (NO DIVIDENDS)
THE IMPACT OF DIVIDENDS ON
LOWER BOUNDS TO OPTION PRICES

rT
c  S0  D  Ke
rT
p  D  Ke  S0
EXTENSIONS OF PUT-CALL PARITY
 American options; D = 0
S0 − K < C − P < S0 − Ke−rT

 European options; D > 0


c + D + Ke −rT = p + S0

 American options; D > 0


S0 − D − K < C − P < S0 − Ke −rT

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