Properties of Stock
Options Chapter
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.1
Notation
c: European call C: American Call
option price option price
p: European put P: American Put
option price option price
S0 : Stock price S :Stock price at option
T
today maturity
K : Strike price D: Present value of
T: Life of option dividends during option’s
: Volatility of stock life
r : Risk-free rate for
price
maturity T with cont comp
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.2
Effect of Variables on Option
Pricing (Table 9.1, page 206)
Variable c p C P
S0 + – + –
K – +? – +
T ? + +
+ +– + +
–
r + +
D – + – +
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.3
American vs European Options
An American option is worth
at least as much as the
corresponding European
option
Cc
Pp
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.4
Upper and Lower Bounds on
Options Prices
Upper Bounds:
No matter what, the call option can never
be worth more that the stock
S0 c and S0 C
If this is not true, an arbitrageur could
easily make a riskless profit by buying
the stock and selling the call option
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.5
Upper and Lower Bounds on
Options Prices
Upper Bounds:
No matter what, the put option can never
be worth more that the strike price
K p and K P
Ke-rT p
If this is not true, an arbitrageur could
easily make a riskless profit by writing
the option and investing the proceeds
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.6
Lower Bounds in Call Options
c S0 - Ke-rT
Suppose that
c=3 S0 = 20
T=1 r = 10%
K = 18 D=0
Then, S0 - Ke-rT = 3.71
Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.7
Lower Bounds in Call Options
If c=3 < S0 - Ke-rT, an arbitrageur can short the stock
and buy the call to provide a cash inflow of
20-3=17.
If invested for 1 year the $17 grows to $18.79
At maturity, if the stock price is greater than $18, the
arbitrageur exercises the option for $18, closes out
the short position, and makes a profit of
$18.79-$18=$0.79
If the stock price is lower than $18, the stock is
bought in the market and the short position is closed
out. If the stock price is $17, the arbitrageur gains:
$18.79-$17=$1.79
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.8
Lower Bounds in Call Options
Consider the following two portfolios:
Portfolio A: one European call option plus
one amount of cash equal to Ke-rT,
Portfolio B: one share
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.9
Lower Bounds in Call Options
Portfolio A
1. The cash, if invested at r, grows to K.
2. If ST>K the option is exercised and the
portfolio worth ST.
3. If ST<K the call expires worthless and the
portfolio is worth K.
Hence, at time T, portfolio A is worth
max(ST,K )
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.10
Lower Bounds in Call Options
Portfolio B
1. Portfolio B is worth ST at time T.
Hence, portfolio A is always worth as much as,
and can be worth more than portfolio B. This
must also be true today. Thus:
c + Ke-rT S0 or
c S0 - Ke-rT
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.11
Lower Bounds in Put options
p Ke -rT–S0
Suppose that
p =1 S0 =
37 T = 0.5 r =5%
K = 40 D =0
then, Ke -rT–S0 = 2.01
Is there an arbitrage
opportunity?
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.12
Lower Bounds in Put Options
If p=1 < Ke-rT - S0,an arbitrageur can borrow $38 for 6
months to buy both the put and the stock.
At the end of the 6 months he pays back $38.96
At maturity, if the stock price is below $40, the
arbitrageur exercises the option to sell the stock for
$40, repays the loan, and makes a profit of
$40-$38.96=$1.04
If the stock price is greater than $40, the arbitrageur
discards the option, sells the stock, and repays the
loan. If for example the stock price is $42:
$42-$38.96=$3.04
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.13
Lower Bounds in Put Options
Consider the following two portfolios:
Portfolio C: one European put option plus
one share,
Portfolio D: an amount of cash equal to Ke-rT
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.14
Lower Bounds in Put Options
Portfolio C
1. If ST<K the option is exercised and the
portfolio becomes worth K.
2. If ST>K the put expires worthless and the
portfolio is worth ST.
Hence, at time T, portfolio C is worth
max(ST,K )
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.15
Lower Bounds in Call Options
Portfolio D
1. Assuming the cash is invested at r, portfolio D
is worth K at time T.
Hence, portfolio C is always worth as much as,
and can be worth more than portfolio D. This
must also be true today. Thus:
p + S0 Ke-rT or
p Ke-rT - S0
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.16
Put-Call Parity; No Dividends
(Equation 9.3, page 212)
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 , K ) at the maturity of the
options
They must therefore be worth the same today. This
means that
c + Ke -rT = p + S0
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.17
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?
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.18
Put-Call Parity
From Put-Call Parity:
c + Ke -rT = p + S0 or
p = c + Ke -rT - S0 = 1.26
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.19
Arbitrage when p=2.25
1. Buy call for $3
2. Short Put to realize $2.25
3. Short the stock to realize $31
4. Invest $30.25 for 3 months
If ST > 30, receive $31.02 from investment,
exercise call to buy stock for $30.
Net profit = $1.02
If ST < 30, receive $31.02 from investment,
put exercised: buy the
stock for $30.
Net profit = $1.02
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.20
Arbitrage when p=1
1. Borrow $29 for 3 months
2. Short call to realize $3
3. Buy put for $1
4. Buy the stock for $31.
If S > 30, call exercised: sell stock for $30.
T
Use $29.73 to repay the
loan. Net
profit = $0.27
If S < 30, exercise put to sell stock for $30.
T
Use 29.73 to repay the
loan. Net profit =
Options, Futures, and Other Derivatives 6 Edition, Copyright © John C. Hull 2005 9.21
$0.27
th
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 6th Edition, Copyright © John C. Hull 2005 9.22
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
you want to hold the stock for the next 3
months?
you do not feel that the stock is worth holding
for the next 3 months?
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.23
Reasons For Not Exercising a
Call Early (No Dividends)
No income is sacrificed
Payment of the strike price is
delayed
Holding the call provides insurance
against stock price falling below
strike price
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.24
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
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.25
The Impact of Dividends on
Lower Bounds to Option Prices
(Equations 9.5 and 9.6, pages 218-219)
Consider the following two portfolios:
Portfolio A: one European call option plus
one amount of cash equal to D+Ke-rT,
Portfolio B: one share
Then, using the similar arguments as before:
rT
c S 0 D Ke
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.26
The Impact of Dividends on
Lower Bounds to Option Prices
(Equations 9.5 and 9.6, pages 218-219)
Consider the following two portfolios:
Portfolio C: one European put option plus
one share,
Portfolio D: an amount of cash equal to D+ Ke-rT
Then, using the similar arguments as before:
pDKe rT S0
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.27
Put-Call Parity; Dividends
(Equation 9.7, page 219)
Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of the
strike price in cash + D
Portfolio C: European put on the stock + the stock
Both are worth max(ST , K ) at the maturity of the
options
They must therefore be worth the same today. This
means that
c + D + Ke -rT = p + S0
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 9.28
