Anida Meki Devsa Olovi

INTERNATIONAL BURCH UNIVERSITY

INTRODUCTION TO DERIVATIVES AND TRADING

TECHNIQUES

PROFESSOR: DR. SANEL HALILBEGOVI

COURSE MATERIAL

2015/2016
Anida Meki Devsa Olovi

CONTENTS
CHAPTER 01 INTRODUCTION .................................................................................................................. 4
BUSINESS RISK VS FINANCIAL RISK .......................................................................................................... 4
DERIVATIVES ............................................................................................................................................ 4
Derivative Markets and Instruments................................................................................................... 4
Various types of derivative contracts are:....................................................................................... 4
OPTIONS .................................................................................................................................................. 5
Forward Contracts vs Future Contracts............................................................................................... 5
SWAPS AND OTHER DERIVATIVES ........................................................................................................... 6
The Underlying Asset........................................................................................................................... 6
SOME IMPORTANT CONCEPTS IN FINANCIAL AND DERIVATIVE MARKETS ............................................ 6
Risk Preference .................................................................................................................................... 6
Short Selling ......................................................................................................................................... 7
Repurchase Agreements ..................................................................................................................... 7
Return and Risk ................................................................................................................................... 7
Market Efficiency................................................................................................................................. 7
CHAPTER 2 ............................................................................................................................................... 8
STRUCTURE OF OPTIONS MARKETS ........................................................................................................ 8
OPTION TERMINOLOGY........................................................................................................................... 8
DEVELOPMENT OF OPTIONS MARKETS .................................................................................................. 8
CALL OPTIONS ......................................................................................................................................... 8
PUT OPTIONS ........................................................................................................................................... 9
MARKETS USED TO TRADE OPTIONS ....................................................................................................... 9
Over the counter options markets ...................................................................................................... 9
Listing requirements............................................................................................................................ 9
Contract size ........................................................................................................................................ 9
Exercise price ....................................................................................................................................... 9
DETERMINANTS OF CALL OPTION PREMIUMS ........................................................................................ 9
Influence of the Market Price.............................................................................................................. 9
Influence of the Stocks Volatility ...................................................................................................... 10
Influence of the Call Options Time to Maturity ......................................................................... 10
DETERMINANTS OF PUT OPTION PREMIUMS ....................................................................................... 10
Anida Meki Devsa Olovi

Influence of the Market Price ........................................................................................................ 10

Influence of the StocksVolatility ....................................................................................................... 10
Influence of the Put Option's Time to Maturity ................................................................................ 10
BUYING A CALL OPTION ........................................................................................................................ 11
SELLING A CALL OPTION ........................................................................................................................ 11
BUYING A PUT OPTION.......................................................................................................................... 12
SELLING A PUT OPTION ......................................................................................................................... 12
PLACING AN ORDER............................................................................................................................... 13
Stop-Loss Order ................................................................................................................................. 13
Stop-Buy Order .................................................................................................................................. 13
CHAPTER 03 ........................................................................................................................................... 14
PRINCIPLES OF OPTION PRICING ........................................................................................................... 14
IMPORTANT CONCEPTS IN CHAPTER 03 ............................................................................................... 14
BASIC NOTATION AND TERMINOLOGY ................................................................................................. 14
COMPUTATION OF RISK-FREE RATE (r) ................................................................................................. 14
Example ............................................................................................................................................. 15
PRINCIPLES OF CALL OPTION PRICING .................................................................................................. 15
Minimum Value of a Call ................................................................................................................... 15
Example ......................................................................................................................................... 16
Maximum Value of a Call................................................................................................................... 17
Value of a Call at Expiration .............................................................................................................. 17
EFFECT OF TIME TO EXPIRATION........................................................................................................... 17
EFFECT OF EXERCISE PRICE .................................................................................................................... 18
Limits on the Difference in Premiums ............................................................................................... 18
CHAPTER 04 ........................................................................................................................................... 19
OPTION PRICING MODELS: THE BINOMIAL MODEL .............................................................................. 19
ONE-PERIOD BINOMIAL MODEL............................................................................................................ 19
Example ............................................................................................................................................. 19
Hedge portfolio ............................................................................................................................. 20
Anida Meki Devsa Olovi

CHAPTER 01
INTRODUCTION

In the course of running the business, decisions are made in the presence of risk.

BUSINESS RISK VS FINANCIAL RISK

The risks that are related to the underlying nature of the business and deal with such matters
as the uncertainty of future sales or the cost of inputs. These risks are called business risk.
Another class of risks deals with uncertainties such as interest rates, exchange rates, stock
prices, and commodity prices. These are called financial risks.

DERIVATIVES
A derivative is a financial instrument whose return is derived from the return on another
instrument. It means that their performance depends on how other financial instruments
perform. Derivatives can be based on:
Real assets are physical assets and include agricultural commodities, metals, and
sources of energy.
Financial assets are stocks, bonds/loans, and currencies.

Derivative Markets and Instruments

And assets is an item of ownership having positive monetary value. A liability is an item of
ownership having negative monetary value. The term ''instrument'' is used to describe either
assets or liabilities. Instrument is more general term, vague enough to encompass the
underlying asset or liability of derivative contracts. A contract is enforceable legal agreement.
A security is tradeable instrument representing a claim on a group of assets.
In the contrast to the markets for assets1, derivative markets are markets for contractual
instruments whose performance is determined by the way in which another instrument or
asset performs. Derivatives are actually contracts. Like all contracts, they are agreements
between two parties a buyer and a seller in which each party does something for the other.
These contracts have a price, and buyers try to buy as cheaply as possible while sellers try to
sell as dearly as possible.

Various types of derivative contracts are:

options
forward and future contracts
swaps and other instruments

1
In the market for assets, payment is made immediately, although credit arrangements are sometimes used.
Because of these characteristics, we refer to these markets as cash markets or spot markets.
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OPTIONS
An option is a contract between two parties that gives one party, the buyer, the right to buy or
sell something from or to the other party, the seller, at a later date at a price agreed upon
today.

Option terminology
Price/premium sum of money that buyer pays to seller. They are selling/buying according
to contract.
Call/Put option An option to buy something is call option, while an option to sell
something is called put option.
Exchange-traded option is an option traded on a regulated exchange where the terms of
each option are standardized by the exchange. The contract is standardized.
Over-the-counter option - options are not traded on exchanges and allow for the
customization of the terms of the option contract.

Forward Contracts vs Future Contracts

Fundamentally, forward and futures contracts have the same function: both types of contracts
allow people to buy or sell a specific type of asset at a specific time at a given price.

However, it is in the specific details that these contracts differ. First of all, futures
contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts,
on the other hand, are private agreements between two parties and are not as rigid in their
stated terms and conditions. Because forward contracts are private agreements, there is always
a chance that a party may default on its side of the agreement. Futures contracts have clearing
houses that guarantee the transactions, which drastically lowers the probability of default to
almost never.

Secondly, the specific details concerning settlement and delivery are quite distinct. For
forward contracts, settlement of the contract occurs at the end of the contract. Futures
contracts are marked-to-market daily, which means that daily changes are settled day by day
until the end of the contract. Furthermore, settlement for futures contracts can occur over a
range of dates. Forward contracts, on the other hand, only possess one settlement date.

Lastly, because futures contracts are quite frequently employed by speculators, who bet on the
direction in which an asset's price will move, they are usually closed out prior to maturity and
delivery usually never happens. On the other hand, forward contracts are mostly used by
hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset
or cash settlement will usually take place.

Options on futures are called commodity options or futures options. It's a contract between
two parties giving one party the right to buy or sell a futures contract from the other at a later
date at a price agreed upon today.
Anida Meki Devsa Olovi

SWAPS AND OTHER DERIVATIVES

Swap is a contract in which two parties agree to exchange a series of cash flows. E.g. One
party is currently receiving cash from one investment but would prefer another type of
investment in which the cash flows are different. The party contracts the swap dealer, a firm
operating in the over the counter market, who takes the opposite side of the transaction. The
firm and the dealer, in effect, swap cash flow streams. Depending on what later happens to
prices or interest rates, one party might gain at the expense of the other. In another type of
agreement, a firm might elect to tie the payments it makes on the swap contract to the price of
a commodity, called a commodity swap. Alternatively, a firm might buy an option to enter
into a swap, called swaption.

Another firm may choose to purchase an option whose performance depends not on how one
asset performs but rather on the better or worse performing of two, or even more than two,
assets, and this is called an alternative option. Some of these types of contracts are referred to
as hybrids because they combine the elements of several other types of contracts. Participants
in financial markets constantly create new and useful products to meet the diverse needs of
investors. This process is called financial engineering.

The Underlying Asset

The derivative derives its value from the performance of something else. That ''something
else'' is often referred to as the underlying asset. The underlying asset must me a stock, bond,
currency, or commodity, all of which are assets. Example.2

SOME IMPORTANT CONCEPTS IN FINANCIAL AND DERIVATIVE MARKETS

Risk Preference

Risk preference is your tendency to choose a risky or less risky option. Generally, economists
and financial professionals apply the concept of risk preference to investors and economics,
but you can also apply risk preference to any decision you make that involves risk. Several
types of risk preference exist, and the associated risk involved generally depends on the
decision maker and for whom the decision maker takes the risk.

A risk-seeking preference applies to a person willing to take higher risks to achieve

above-average returns. The person making this type of decision should weigh all the
factors involved in the risk and assess these risks against the probabilities of different
outcomes.
A person who is reluctant to take on a risk has a risk aversion. This kind of personality
almost always chooses the safer investment instead of taking a chance on the
probability of failure. To someone with a risk-averse preference personality, the
guarantee has more weight than any other possible outcome.
An individual with risk-neutral preference does not care about the risks involved in the
decision making. She is only concerned about the end result. A risk-neutral individual
will choose the assets with the highest possible gains or returns without taking into
account possible outcomes.

2
An option on a stock gives the holder the right to buy or sell the stock for a specified amount (strike price) at a
certain date in the future (expiration). The underlying asset for the stock option contract is the company's stock.
Anida Meki Devsa Olovi

Short Selling

Short selling is the sale of a security that is not owned by the seller, or that the seller has
borrowed. Short selling is motivated by the belief that a security's price will decline, enabling
it to be bought back at a lower price to make a profit. Short selling may be prompted by
speculation, or by the desire to hedge the downside risk of a long position in the same security
or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling
should only be used by experienced traders who are familiar with its risks. Example.3

Repurchase Agreements

A repurchase agreement (repo) is a form of short-term borrowing for dealers in government

securities. The dealer sells the government securities to investors, usually on an overnight
basis, and buys them back the following day.

For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for
the party on the other end of the transaction, (buying the security and agreeing to sell in the
future) it is a reverse repurchase agreement.

Return and Risk

Return is the numerical measure of investment performance. Two main measures of return:

Dollar return measures investment performance as total dollar profit or loss. Dollar return
for stock is the dollar profit from the change in stock price plus any cash dividends paid.
Percentage return measures investment performance per dollar invested. Its percentage
increase in the investors wealth that results from making the investment.

Risk is uncertainty of future returns. Risk includes the possibility of losing some or all of the
original investment.

Market Efficiency

Market efficiency is the characteristic of the market in which the prices of the instruments
trading therein reflect their true economic values to investors. In an efficient market prices
fluctuate randomly and investors cannot consistently earn returns above those that would
compensate them for the level of risk they assume.

3
Consider the following short-selling example. A trader believes that stock SS which is
trading at $50 will decline in price, and therefore borrows 100 shares and sells them. The
trader is now short 100 shares of SS since he has sold something that he did not own in the
first place. The short sale was only made possible by borrowing the shares, which the owner
may demand back at some point. A week later, SS reports dismal financial results for the
quarter, and the stock falls to $45. The trader decides to close the short position, and buys 100
shares of SS at $45 on the open market to replace the borrowed shares. The traders profit on
the short sale excluding commissions and interest on the margin account is therefore $500.
Anida Meki Devsa Olovi

CHAPTER 2

STRUCTURE OF OPTIONS MARKETS

OPTION TERMINOLOGY
An option is a contract between two parties that gives one party, the buyer, the right to buy or
sell something from or to the other party, the seller, at a later date at a price agreed upon
today.

The buyer pays the seller a fee called premium, which is the option price. The writer grants
the buyer the right to buy or sell the asset at a fixed price.
An option to buy asset is a call option, while an option to sell asset is called put option.
The fixed price at which the option buyer can either buy or sell the asset is called the exercise
or strike price, or something like striking price.
In addition, the option has a definite life. The right to buy or sell the asset at a fixed price
exists up to a specific expiration date.

American-style stock options can be exercised at any time until the expiration date. In
contrast, European-style stock options can be exercised only just before expiration (3rd
Friday in month).

DEVELOPMENT OF OPTIONS MARKETS

Early origins
The current system of option markets traces its origins to the nineteenth century, when puts
and calls were offered on shares of stock.

Put and Call Brokers and Dealers Association

Than, in early 1900s, a group of firms calling itself the Put and Call Brokers and Dealers
Association created an options market. If someone wanted to buy an option, a member of the
association would find a seller willing to write it.

Chicago Board Options Exchange

In 1973, a revolutionary change occurred in the options world. The worlds oldest and largest
exchange for the trading of commodity futures contracts, organized an exchange exclusively
for trading options on stocks, Chicago Board Options Exchange. It was a central marketplace
for options

CALL OPTIONS

A call option grants the owner the right to purchase a specified financial instrument (such as a
stock) for a specified price (exercise price or strike price) within a specified period of time.
A call option is said to be in the money when the market price of the underlying security
exceeds the exercise price, at the money when the market price is equal to the exercise price,
and out of the money when it is below the exercise price.
Anida Meki Devsa Olovi

PUT OPTIONS
The second type of option is known as a put option. It grants the owner the right to sell a
specified financial instrument for a specified price within a specified period of time. As with
call options, owners pay a premium to obtain put options. A put option is said to be in the
money when the market price of the underlying security is below the exercise price, at the
money when the market price is equal to the exercise price, and out of the money when it
exceeds the exercise price.

MARKETS USED TO TRADE OPTIONS

The Chicago Board Options Exchange (CBOE), is the most important exchange for trading
options. It serves as a market for options on more than 2,000 different stocks. The options
listed on the CBOE have a standardized format. As the popularity of stock options increased,
various stock exchanges began to list options. In particular, the American Stock Exchange
(acquired by NYSE Euronext in 2008), the Nasdaq, and the Philadelphia Stock Exchange
(acquired by Nasdaq in 2008) list options on many different stocks.

Over the counter options markets

Some specialized option contracts are sold over the counter rather than on an exchange,
whereby a financial intermediary (e.g.commercial bank) finds a counterparty or serves as the
counterparty. These over-the-counter arrangements are more personalized and can be tailored
to the specific preferences of the parties involved. Such tailoring is not possible for the more
standardized option con- tracts sold on the exchanges.

Listing requirements
Each exchange has its own requirements concerning the stocks for which it creates options.
One key requirement is a minimum trading volume of the underlying stock, since the volume
of options traded on a particular stock will normally be higher if the stock trading volume is
high. The decision to list an option is made by each exchange, not by the firms represented by
the options contracts.

Contract size
A standard exchange-traded stock option contract provides exposure to 100 individual stocks.
If an investor purchases one contract, it actually represents options to buy 100 shares of
stocks. An exception occurs when either a stock splits or the company declares a stock
dividend. In that case, the number of shares represented by a standard contract is adjusted to
reflect the change in the companys capitalization.

Exercise price
The goal when establishing the exercise price is to provide an option that will attract trading
volume.

DETERMINANTS OF CALL OPTION PREMIUMS

Influence of the Market Price

The higher the existing market price of the underlying financial instrument relative to the
exercise price, the higher the call option premium, other things being equal. A stocks value
has a higher probability of increasing well above the exercise price if it is already close to or
above the exercise price. Thus a purchaser would be willing to pay a higher premium for a
call option on such a stock.
Anida Meki Devsa Olovi

Influence of the Stocks Volatility

The greater the volatility of the underlying stock, the higher the call option premium, other
things being equal. If a stock is volatile, there is a higher probability that its price will increase
well above the exercise price. Thus a purchaser would be willing to pay a higher premium for
a call option on that stock.

Influence of the Call Options Time to Maturity

The longer the call options time to maturity, the higher the call option premium, other things
being equal. A longer time period until expiration allows the owner of the option more time to
exer- cise the option. Thus there is a higher probability that the stock s price will move well
above the exercise price before the option expires.

DETERMINANTS OF PUT OPTION PREMIUMS

Influence of the Market Price

The higher the existing market price of the underlying stock relative to the exercise price, the
lower the put option premium, all other things being equal. A stocks value has a higher
probability of decreasing well below the exercise price if it is already close to or below the
exercise price. Thus a pur- chaser would be willing to pay a higher premium for a put option
on that stock. This influence on the put option premium differs from the influence on the call
option premium because, from the perspective of put option purchasers, a lower market price
is preferable.

Influence of the StocksVolatility

The greater the volatility of the underlying stock, the higher the put option premium, all other
things being equal. This relationship also held for call option premiums. If a stock is volatile,
there is a higher probability of its price deviating far from the exercise price. Thus a purchaser
would be willing to pay a higher premium for a put option on that stock because its market
price is more likely to decline well below the options exercise price.

Influence of the Put Option's Time to Maturity

The longer the time to maturity, the higher the put option premium, all other things being
equal. This relationship also held for call option premiums. A longer time period until
expiration allows the owner of the option more time to exercise the option. Thus there is a
higher probability that the stocks price will move well below the exercise price before the
option expires.
Anida Meki Devsa Olovi

BUYING A CALL OPTION

P, Profit is unlimited, Loss is limited to 0

SELLING A CALL OPTION

P, Profit is limited to premium, Loss is unlimited
Anida Meki Devsa Olovi

BUYING A PUT OPTION

P, Profit is limited to 0, Loss is limited to premium

SELLING A PUT OPTION

P, Profit is limited to premium, Loss is limited to 0
Anida Meki Devsa Olovi

PLACING AN ORDER
A market order to buy or sell a stock means to execute the transaction at the best possible
price.
A limit order differs from a market order in that a limit is placed on the price at which a
stock can be purchased or sold.

Example: Creo stock is currently selling for $55 per share. If an investor places a market
order to purchase (or sell) the stock, the transaction will be executed at the prevailing price at
the time the transaction takes place. For example, the price may have risen to $55.25 per
share or declined to $54.75 by the time the transaction occurs. Alternatively, the investor
could place a limit order to purchase Creo stock only at a price of $54.50 or less. The limit
order can be placed either for the day only or for a longer period. Other investors who wish
to sell Creo stock may place limit orders to sell the stock only if it can be sold for $55.25 or
more. The advantage of a limit order is that it may enable an investor to obtain the stock at a
lower price. The disadvantage is that there is no guarantee the market price will ever reach
the limit price established by the investor.

Stop-Loss Order
A stop-loss order is a particular type of limit order. The investor specifies a selling price that
is below the current market price of the stock. When the stock price drops to the specified
level, the stop-loss order becomes a market order. If the stock price does not reach the
specified minimum, the stop-loss order will not be executed. Investors generally place stop-
loss orders either to protect gains or to limit losses.

Example: Paul bought 100 shares of Bostner Corporation one year ago at a price of $50 per
share. Today, Bostner stock trades for $60 per share. Paul believes that Bostner stock has
additional upside potential and does not want to liquidate his position. Nonetheless, he would
like to make surethat he realizes at least a 10 percent gain from the stock transaction. He
therefore places a stop-loss order with a price of $55. If the stock price drops to $55, the stop-
loss order will convert to a market order and Paul will receive the prevailing market price at
that time, which will be about $55. If Paul receives exactly $55, his gain from the transaction
would be 100 shares ($55-$50)=$500. If the price of Bostner stock continues to increase,
the stop-loss order will never be executed.

Stop-Buy Order
A stop-buy order is another type of limit order. In this case, the investor specifies a purchase
price that is above the current market price. When the stock price rises to the specified level,
the stop-buy order becomes a market order. If the stock price does not reach the specified
maximum, the stop-buy order will not be executed.

Example:Karen would like to invest in the stock of Quan Company, but only if there is some
evidence that stock market participants are demanding that stock. The stock is currently
priced at $12. She places a stop-buy order at $14 per share, so if demand for Quan stock is
sufficient to push the price to $14, she will purchase the stock. If the price remains below $14,
her order will not be executed.
Anida Meki Devsa Olovi

CHAPTER 03

PRINCIPLES OF OPTION PRICING

IMPORTANT CONCEPTS IN CHAPTER 03

Role of arbitrage in pricing options
Minimum value, maximum value, value at expiration and lower bound of an option price
Effect of exercise price, time to expiration, risk-free rate and volatility on an option price
Difference between prices of European and American options
Put-call parity

BASIC NOTATION AND TERMINOLOGY

The following symbols are used throughout the chapter:
S0 = stock price today (time 0 = today)
X = exercise price; strike price
T = time to expiration
r = risk-free rate
ST = stock price at options expiration
C(S0,T,X) = price of call option in which stock price is S0, the time to expiration is T, and the
exercise price is X
P(S0,T,X) = price of a put option in which stock price is S0, the time to expiration is T, and the
exercise price is X

Ca(S0,T,X) American call

Ce(S0,T,X) European call
If there is no a or e subscript, the call can be either an American or a European call.
C(S0,T,X1) and C(S0,T,X2) X1 X2
Subscript of the lower exercise price (1) is smaller than that of the higher exercise price (2).
C(S0,T1,X) and C(S0,T2,X) T1 T2
Identical rule applies for subscript of time to expiration.

COMPUTATION OF RISK-FREE RATE (r)

The risk-free rate, r, is the rate earned on a riskless investment. An example of such an investment is a
U.S. Treasury bill4. All T-bills mature on a Thursday. However, most exchange-listed stock options
expire on the third Friday of the month. Due to this comparable maturity, we can use the rate of return
on a T-bill as a proxy for the risk-free rate.

ATTENTION
The T-bill is purchased at less than its face value. The difference between the purchase price and the face value
is called the discount. If the investor holds the bill to maturity, it is redeemed at face value. Therefore, the
discount is the profit earned by the bill holder.

4
A Treasury bill, or T-bill, is a security issued by the U.S. government for purchase by investors. T-bills with
original maturities of 91 and 182 days are auctioned by the Federal Reserve each week; T-bills with maturities
of 365 day are auctioned every four week. All T-bills mature on a Thursday.
Anida Meki Devsa Olovi

Example
In the table below are presented bid5 and ask6 discounts for several T-bills for the business day of May
14th. Find the return on a T-bill, that you can use as proxy for the risk-free rate, for options expiring on
May 21st.

Maturity Bid Ask

20/5 4.45 4.37
17/6 4.41 4.37
15/7 4.47 4.43

Table 1 T-bill bid and ask discounts

As we have noted earlier, options expire on the third Friday of the month. One of the T-bills matures
on May 20th (Thursday); therefore the following day is Friday with the expiration date for options May
21st.
First, we need to find the T-bill discount from par value, as shown below:

find average of bid and ask discounts: (4.45 + 4.37) / 2 = 4.41

T-bill discount 4.41 (7 / 360) = 0.08575 using the fact that option has 7 days until maturity
(May 21 May 14) be careful not to take T-bill maturity day (which is in this case May 20)

Second, T-bill purchase price we will get by subtracting discount from the face value.

100 0.08575 = 99.91425

The yield on our T-bill is based on the assumption of buying it at 99.91425 and holding it for 7 days, at which
time it will be worth 100.

Seven-days-return would therefore be: (100 99.91425) / 99.91425 = 0.000858

If we repeated this transaction every seven days for a full year, the return would be:

(100 / 99.91425)365/7 1 = 0.0457

Thus, we would use 4.57 percent as our proxy for the risk-free rate for options expiring May 21.

Following the same procedure describe for the May T-bill gives us risk-free rates of 4.56 and 4.63 for
the June and July expirations, respectively. The times to expiration are 7 days for the May options, 35
days for the June options, and 63 days for the July options.

PRINCIPLES OF CALL OPTION PRICING

In this section we will formulate rules that enable us to better understand how call options are priced.
It is important to keep in mind that our objective is to determine the price of a call option prior to its
expiration date.

Minimum Value of a Call

A call option is an instrument with limited liability. If the call holder sees that it is beneficial to
exercise it, the call will be exercised. If exercising it will decrease the call holders wealth, the holder

5
The bid price represents the maximum price that a buyer or buyers are willing to pay for a security.
6
The ask price represents the minimum price that a seller or sellers are willing to receive for the security.
Anida Meki Devsa Olovi

will not exercise it. The option cannot have negative value, because the holder cannot be forced to
exercise it. Therefore,

C(S0,T,X) 0 (for any call).

For an American call, the statement that a call option has a minimum value of zero is denominated by
a much complex statement:

Ca(S0,T,X) Max (0, S0 X).

This expression Max (0, S0 X) means The minimum value of a call would be the maximum value of the two
arguments zero or S0 X.

The minimum value of an option is called its intrinsic value7, sometimes referred to as parity value,
parity, or exercise value. Intrinsic value8 is positive for in-the-money calls and zero for out-of-the-
money calls.

Example
To prove the intrinsic value rule, consider the AAPL call options.
Time
Price of calls value
Exercise Intrinsic Premium - Premium - Premium -
price value May June July May June July
120 5.94 8.75 15.40 20.90 2.81 9.46 14.96
125 0.94 5.75 13.50 18.60 4.81 12.56 17.66
130 0.00 3.60 11.35 16.40 3.60 11.35 16.40

Table 2 AAPL call options

Current stock price is $125.94.

Scenario 1: Exercise/strike price is $120.
Minimum price of the call/intrinsic value of call option is:

Max (0, 125.94 120) = 5.94

If the call was priced at less than $5.94 lets say $3, an option trader could buy the call for $3, exercise it
meaning he would purchase the stock for $120 and then sell the stock for $125.94. This arbitrage transaction
would result in immediate profit of $2.94 (5.94 3) per each share. All investors would do this, which would
drive up the options price. When the price of the option reached $5.94, the transaction would no longer be
profitable. Thus, $5.94 is the minimum price of the call.

Scenario 2: Exercise/strike price is $130.

Minimum value will be zero.
Max (0, 125.94 130) = 0

Conclusion:
Now look at all AAPL calls. Those with an exercise price $120 have a minimum value of 5.94. All
three calls (May, June, and July) with an exercise price of $120 indeed do not have prices less than
$5.94.

7
In finance, intrinsic value refers to the value of a company, stock, currency or product determined through
fundamental analysis without reference to its market value.
8
Intrinsic value is the value holder receives from exercising the option.
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The calls with an exercise price of $125 have minimum values of 0.94 and do not have prices less than
$0.94. The calls with an exercise price of $130 have minimum values of 0. All those options obviously
have nonnegative values.

The intrinsic value concept applies only to an American call, because a European call can be exercised
only on the expiration day. If the price of a European call were less than Max (0, S0 X), the inability
to exercise it would prevent traders from engaging in the mentioned arbitrage that would drive up the
calls price.

The price of an American call normally exceeds its intrinsic value. The difference between the price
and the intrinsic value is called the time value or speculative value of the call, which is defined as:

Ca(S0,T,X) - Max (0, S0 X).

The time value reflects what traders are willing to pay for the uncertainty of the underlying stock.
Table 2 shows the intrinsic values and time values of the AAPL calls. Note that the time values
increase with the time to expiration.

Maximum Value of a Call

A call option has a maximum value:

C(S0,T,X) S0.

The most someone can expect to gain from the call is the stocks value less the exercise price. Even if
the exercise price were zero, no one would pay more for the call than for the stock. However, one call
that is worth the stock price is one with an infinite maturity.

Value of a Call at Expiration

The price of a call at expiration is given as:

C(ST,0,X) = Max (0, ST X).

Because no time remains in the options life, the call price contains no time value. At expiration, an
American option and a European option are identical instruments. Therefore, this rule holds for both
types of option.

EFFECT OF TIME TO EXPIRATION

Consider two American calls that differ only in their times to expiration. One has a time to expiration
of T1 and a price of Ca(S0,T1,X); the other has a time to expiration of T2 and a price of Ca(S0,T2,X).
Remember that T2 is greater than T1. Which of these two options will have the greater value?

Normally, the longer-lived call is worth more, due to the fact that time is working for the holder of
that call. Price of the underlying asset can change significantly (increase more than in a short-term
period) and therefore ensure holder more profit.
Therefore,
Ca(S0,T2,X) Ca(S0,T1,X).

The time value of a call option varies as well with the time to expiration and the proximity of the stock
price to the exercise price. Investors pay for the time value of the call based on the uncertainty of the
future stock price. If the stock price is very high, the call is said to be deep-in-the-money and the time
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value will be low. If the stock price is very low, the call is said to be deep-out-of-the-money and the
time value likewise will be low. The time value will be low because at these extremes, the uncertainty
about the call expiring in- or out-of-the-money is lower. It is almost sure that the price will unlikely
oscillate. However, the uncertainty is greater when the stock price is near the exercise price and it is at
this point that the time value is higher. When exercise price is closest to the stock price, the time value
is the highest for the call. (See Table 2)

EFFECT OF EXERCISE PRICE

Consider two European calls that are identical in all respect except that the exercise price of one is X 1,
and that of the other is X2. Recall that X2 is greater than X1. Which price is greater Ce(S0,T,X1) or
Ce(S0,T,X2)?
Ce(S0,T,X1) Ce(S0,T,X2)

We can explain the statement above by an example:

current stock price is: $125.95
exercise price/strike price X1 = $120
exercise price/strike price X2 = $123
condition fulfilled: X1 X2

Call with the lower strike price X1 is more expensive because it would be more beneficial for the call
holder in case he/she chooses to exercise the call.

Limits on the Difference in Premiums

For two options differing only in exercise price, the difference in the premiums cannot exceed the
difference in the exercise price:
X2 - X1 Ce(S0,T,X1) - Ce(S0,T,X2)
X2 - X1 Ca(S0,T,X1) - Ca(S0,T,X2).

The intuition behind this result is simple: The advantage of buying an option with a lower exercise
price over one with higher exercise price will not be more than difference in the exercise prices.

For example, if you own the AAPL June 125 call and are considering replacing it with the June 120
call, the most you can gain by the switch is $5. Therefore, you would not pay more than an additional
$5 in order to replace you 120 with 125.
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CHAPTER 04

OPTION PRICING MODELS: THE BINOMIAL MODEL

This chapter examines the first of two general types of option pricing models.
A model is a simplified representation of reality that uses certain inputs to produce an output, or
result. An option pricing model is a mathematical formula or computational procedure that uses the
factors as inputs to determine the options price. The output is theoretical fair value of the option.
Obtaining the theoretical fair value is a process called option pricing.

This chapter will examine a simple model called the binomial option pricing model, which is more of
a computational procedure than a formula.

ONE-PERIOD BINOMIAL MODEL

Assume that the options life is one unit of time. This time period can be as short or as long as
necessary. If the time period is one day and the option has more than one day remaining, we will need
a multi-period model. For now, we will assume that the options life is a single time period.

The model is called binomial model. It allows the stock price to go either up or down. The probability
of an up or down movement is governed by the binomial probability distribution. Because of this, the
model is also called a two-state model.

The best way to describe how this option pricing model works is by example.

Example
Consider a stock A currently priced at $100. One period later it can go up to $125, or down to $80.
Assume a call option with an exercise price of $100, that is based on stock A as its underlying asset.
With the risk-free rate of 7% find the current call option price. Also, find the return on hedge portfolio.

The inputs are summarized as follows:

S = 100 d = 0.80
X = 100 r = 0.07
u = 1.25
Notation:
u = 1 + return if the stock goes up (stock went up to $125 from $100, which is 25% increase,
meaning that we will add 0.25 to 1 1 + 0.25 = 1.25)
d = 1 return if the stock goes down (stock went down from $100 to $80, which is 20%
decrease, meaning that we will subtract 0.20 from 1 1 - 0.20 = 0.80)

Step 1: Find the price of the call when the stock goes up
We will use the formula:
Cu = Max [0, uS X]
Cu = Max [0, 1.25 * 100 100]
Cu = Max [0, 25]
Cu = 25
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Step 2: Find the price of the call when the stock goes down
We will use the formula:
Cd = Max [0, dS X]
Cd = Max [0, 0.80 * 100 100]
Cd = Max [0, -20]
Cd = 0
Step 3: Find the hedge ratio
The formula for C is developed by constructing a riskless portfolio of stock and options. A riskless
portfolio should earn the risk-free rate. The riskless portfolio is called a hedge portfolio and consists of
h shares of stock for a single written call. Thus, the portfolio value is assets minus liabilities, or simply
net worth.

The hedge ratio, h, is:

h = (Cu Cd) / (uS dS)
h = (25 0) / (125 80)
h = 0.556

The hedge requires 0.556 shares of stock for each call.

Step 4: Find the value of p

p stands for probability
p = (1 + r d) / (u d)
p = (1.07 0.80) / (1.25 0.80)
p = 0.6

Step 5: Find the call option price

Plug all previous findings into formula for C:
C = [p*Cu + (1 p)*Cd] / (1 + r)
C = (0.6*25 + 0.4*0) / 1.07
C = $14.02

Thus, the theoretical fair value of the call is $14.02. Given the stock price, we can obtain the option
price. However, stock prices are priced independently from the option prices.

Hedge portfolio
Consider a hedge portfolio consisting of a short position in 1,000 calls and a long position in 556
shares of stock. The number of share is determined by the hedge ratio of 0.556 shares per written call.
short position 1,000 calls this means that investor writes 1,000 calls at $14.02 (price we have
already calculated)
long position 556 shares this means that investor buys 556 shares at $100 per share

The current value of this portfolio is:

556 * ($100) 1000 * ($14.02) = $41,580.

The net cash outlay is $55,600 - $14,020 = $41,580. This total represent the assets (the stock) minus
the liabilities (the calls), and thus is the net worth, or the amount the investor must commit to the
transaction.
Also, we will take into consideration two scenarios, when the stock prices goes up, and when the stock
price goes down.
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Scenario 1: the stock price goes up to $125

The value of portfolio will be:
556 * ($125) 1000 * ($125 100) = $44,500.
If the stock goes up to $125, the call will be exercise for a value of $125 - $100 = $25. The stock will
be worth $69,500. Thus, the portfolio will be worth $44,500.

Scenario 2: the stock price goes down to $80

The value of portfolio will be:
556 * ($80) 1000 * ($80 100) = $44,480.
If the stock goes down to $80, the call will expire out-of-the-money. The portfolio will be worth 556*
($80) = $44,480.

These two values of the portfolio, from two scenarios, at expiration are essentially equal, because $20
difference is due only to the rounding off of the hedge ratio.

The return on this hedge portfolio is:

rh = (value of portfolio from the scenario / current value of portfolio) 1

rh = (44,500 / 41,580) 1 0.07

The return on this hedge portfolio is 7% which is the risk-free rate. The original investment of $41,580
will have grown to $44,500 a return of about 7 percent, the risk-free rate.
However, if the call price were not $14.02, an arbitrage opportunity would exist.