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    Properties of Option

    Uploaded by

    Nitu Yadav
    The document discusses key properties and relationships involving stock options, including: 1) It defines the notation used for different types of call and put options, and outlines how the underlying stock price, strike price, time to maturity, volatility, and risk-free rate affect European and American option prices. 2) American options are worth at least as much as equivalent European options due to the ability to exercise early. 3) Put-call parity relates European call and put prices, the stock price, strike price, and risk-free rate. 4) Arbitrage opportunities may exist if observed option prices violate the theoretical minimum or maximum prices based on the underlying variables.

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    Properties of Option

    Uploaded by

    Nitu Yadav
    51 views17 pages
    The document discusses key properties and relationships involving stock options, including: 1) It defines the notation used for different types of call and put options, and outlines how the underlying stock price, strike price, time to maturity, volatility, and risk-free rate affect European and American option prices. 2) American options are worth at least as much as equivalent European options due to the ability to exercise early. 3) Put-call parity relates European call and put prices, the stock price, strike price, and risk-free rate. 4) Arbitrage opportunities may exist if observed option prices violate the theoretical minimum or maximum prices based on the underlying variables.

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    The document discusses key properties and relationships involving stock options, including: 1) It defines the notation used for different types of call and put options, and outlines how the underlying stock price, strike price, time to maturity, volatility, and risk-free rate affect European and American option prices. 2) American options are worth at least as much as equivalent European options due to the ability to exercise early. 3) Put-call parity relates European call and put prices, the stock price, strike price, and risk-free rate. 4) Arbitrage opportunities may exist if observed option prices violate the theoretical minimum or maximum prices based on the underlying variables.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    51 views17 pages

    Properties of Option

    Uploaded by

    Nitu Yadav
    The document discusses key properties and relationships involving stock options, including: 1) It defines the notation used for different types of call and put options, and outlines how the underlying stock price, strike price, time to maturity, volatility, and risk-free rate affect European and American option prices. 2) American options are worth at least as much as equivalent European options due to the ability to exercise early. 3) Put-call parity relates European call and put prices, the stock price, strike price, and risk-free rate. 4) Arbitrage opportunities may exist if observed option prices violate the theoretical minimum or maximum prices based on the underlying variables.

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    Properties of Stock

    Options
    Notation
     c : European call  C: American Call
    option price option price
     p : European put  P :American Put option
    option price price
     S0 : Stock price  ST :Stock price at option
    today maturity
     K : 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
    Effect of Variables on Option
    Pricing

    Variable c p C P
    S0 + – + –
    K – +? – +
    T ? + +
     + + + +
    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  S0 –Ke -rT
    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  Ke –S0
    -rT
    Put-Call Parity; No Dividends

     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
    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
    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?
    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
    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
    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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