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Options Risk management role

American vs European options Recall the role of fwds …

Kellogg’s might use a futures contract on corn to ensure a
“reasonable” price at the end of the harvest season. Also
Type of options available avoiding the consequences of a drought driving corn prices to
astronomical levels.
Similarly the farmer/seller of the contract ensures that he
Option payoffs at expiry
gets a “reasonable” price even if there is a huge price fall.
Neither Kellogg’s nor the farmer wants to be in the weather
prediction business.

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Time Value and Intrinsic Worth Three simple bounds on option prices

One of the peculiar features of options is they come with

premiums
Just like we found a simple tool (the fwd price) to analyze
whether the forwards/futures are under valued or over
valued, we will develop some intuition about when an option Why premiums? Can’t we have a zero value
is under/over valued and how it affects our decision making
contract when the contract begins?
We start with breaking up an option premium into two parts

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One of the most frequently used results related to Consider two portfolios:
options. Portfolio A: Long stock, long put with strike K,
Relates the prices of call options to otherwise maturity T.
identical put options. Portfolio B: Long call with strike K and maturity T,
"Otherwise identical" ⇒ Same underlying, T, Strike. investment of PV (K ).
Costs of these portfolios today:
Portfolio A: PE + S
Portfolio B: CE + PV (K )

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PCP Uses When the early exercise feature is available

Long call = Long put + Long underlying + Borrowing of PV (K )
Long put = Long call + Investment of PV (K ) + Short underlying
Long underlying = Long call + Short put + Investment of PV (K )
Investment of PV (K ) = Long underlying + Long put + Short call
Consider a call option on a non-dividend paying
stock:
Strike – 125; spot – 150; premium – 26.95

You buy this option and by the end of the day, the
stock price moves to 160 and the option price
moves to 36.50.
Should you exercise?

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Early Exercise: Summary

Suppose you had bought the option with the  Early exercise realizes an option's intrinsic value.
intention of buying the asset  So early exercise is suboptimal if the option value is
Will you then exercise ? strictly greater than its intrinsic value.
 For calls:
 No dividends  Early exercise is never optimal.
You’re a “good” predictor of the markets and you’re  With dividends: Early exercise may be optimal.
doubly sure that the price is going to go down from  For puts, early exercise may be optimal whether or not
here. dividends exist.
Will you then exercise ?

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Try this

A person owns a Call option of Cipla at a strike of How does volatility – the uncertainty anticipated in
450 and the underlying is trading at 472. the price of the underlying – affect option prices?
How much does he gain by exercising immediately? An example
If the strike had been 480, should he exercise given
the fact that Cipla is going to pay dividends before
the expiry date of the option?

Problems from Ch10: 9, 10, 13, 14

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