OPTIONS THEORY

Basic Concepts

A. Objectives: our principal objectives are as follows:

i. to understand how basic put and call options are priced in a
competitive market
ii. to understand how the use of such securities can allow investors to
reduce their portfolio’s risk
iii. to understand how to employ options pricing theory to assist in the
pricing of complex securities

B. Fundamental Notions:

1. Generally speaking, the purchase of an options contract gives the

buyer a right to buy (call options contract) or right to sell (put
options contract) some other asset under pre-specified terms and
circumstances. This underlying asset can, in principle, be
anything with a well-defined value of price; we will consider
options on:

 Individual stocks
 Portfolios of stocks (indexes)
 Futures contracts
 Bonds
 Currencies
 Other options, etc.

Note that options contracts do not represent an obligation to buy or

sell, unlike the case of futures contracts. Thus, they must have value
which is positive, or at worst, zero.

2. “American” vs. “European” style options

i. “American” style options allow the right to exercise (i.e. the

right to buy or sell) at any time on or before a pre-specified
future date (the expiration date).
ii. “European” style options allow the right of exercise only at
the pre-specified expiration date.

Remark 1: Most of our discussion will be in the context of European

call options. If the underlying asset does not provide any cash
payments (i.e., no “dividends”), however, it can be shown that it
never pays to exercise an American call option prior to expiration. In
this case, American and European call options are essentially the

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 same and are priced identically. The same is not true for puts; for
example, it may pay to exercise an American put on a non-dividend
paying stock prior to expiration.

3. In most of what we do, we will assume that the fact of an options

contract being written on some underlying asset does not
influence the price process of the underlying asset itself.

In general, this will not be the case: in principle, the introduction of

trading in an options contract could either increase of decrease the
price of the underlying asset.

4. The context of all out pricing discussions will be the perfect

market assumptions underlying CAPM.

C. Call and Put Options: Review of Basic Concepts

1. Call options on individual stocks (European)

a. Definition: A European call option contract gives the owner

the right to buy a pre-specified number of shares of a pre-
specified stock (the underlying asset) at a pre-specified
price (strike or exercise price) at a pre-specified future date
(expiration date).

For an American option, we would allow exercise “on or

before” an expiration date.

b. Payoff on a European call at the time of expiration: three

representations

i. Payoff Diagram

45 Price of underlying asset

E ST

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 ii. Algebraic representation

CT  max 0, ST  E
where ST denotes the price of the underlying stock at expiration date
T in the future.

iii. Payoff table

“Events”
ST  E ST  E
Value of call at 0 ST  E
expiration

c. A related measurement: profit/loss to the purchase of a

European call, computed vis-a-vis the expiration date:

i. profit/loss diagram

Value (payoff) to call at expiration

45 Price of underlying asset

E ST
Profit/loss at expiration
C

ii. Algebraic representation

Profit/loss  max 0, ST  E  C

where C denotes the price of the call.

iii. Profit/loss table

“Events”
ST  E ST  E
Profit/loss -C  ST  E   C

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The purchase of call on an individual asset represents an investment with limited losses
and unlimited potential gains.

Remark 2: These simple profit/loss representations are somewhat misleading for the
following tow reasons:

i. The time value of money is ignored: the cost of the call is paid prior to the
payoff at expiration.
ii. Taxes and transaction costs are ignored; these should be included if a
complete profit/loss accounting is to be achieved.

d. For the writer of the call, the payoff is exactly opposite to

that of the buyer:

E ST

45

Payoff to writer
of the call

This represents a “contingent obligation” for which the writer is compensated by

the price of the call.

e. Notice that the payoffs to the writer and buyer of the call
are perfectly negatively correlated; i.e. the options related
wealth positions of the buyer and writer always sum to
zero. For this reason, options are not included in the market
portfolio “M” as they are in zero net supply.

f. Writing “covered calls.” Suppose you own XYZ stock and

decide to write call on the shares you own. Let us examine
your wealth at expiration.

Expiration
ST  E ST  E
Stock ST ST
Call 0   ST  E 

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Total ST E

If the option is worthless you have increased your income by the price of the call
you sold. If the stock price rises, your upside wealth potential is limited to C+E;
i.e., what you gain on the stock you lose on the option.

So current income is obtained in exchange for possible or expected wealth

potential. Portfolio managers who do not expect much variation in a stock’s price
over the short term sometimes write call options to increase returns.

g. Terminology: let St be the current price of the underlying asset at some

time t (which may differ from the expiration date.)

Define: parity value of the call = max {0, St-E} 0

Generally speaking, calls will sell for more than their parity value; we define call
premium as:
call premium  Ct  max 0, S t  E  0
where Ct is a current call value.

2. Put Options Contracts (European)

a. Definition: a European put options contract gives the buyer the right to
sell a pre-specified number of shares of the underlying asset at a pre-
specified price (exercise price) at a pre-specified future date (expiration).

American puts can be exercised “on or before an expiration date.

b. Payoff to the put ownership at expiration: three representations

i. Payoff Diagram

Put payoff at expiration

45 Price of underlying asset

E ST

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 ii. Algebraic representation

PT  max 0, E  ST 

iii. Payoff table

“Events”
ST  E ST  E
Value of put at E  ST 0
expiration

c.Related measures: profit and loss (same qualifications as in the case of calls).

i. Profit/loss diagram:

Profit/loss
at expiration

E -P

45 E Price of underlying asset

ST

ii. Algebraic representation:

Profit/loss  max 0, E  ST   P

iii. Payoff table

“Events”
ST  E ST  E
Profit/loss to put  E  ST   P -P
ownership

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 d. Clearly, the ownership of a put on a stock is similar to a short position in the
stock without the risk of the stock’s price rising (i.e., losses are bounded
above by the cost of the put).

e. As with calls, the net position in puts sums to zero across all market
participants; puts thus also are not elements of “M”.

f. The return relationships of the put and underlying asset are fundamentally
different. This makes puts ideal vehicles (instruments) for insuring against price
declines. Consider the fundamental hedge: {1 share of stock, 1put on the same
stock with exercise price E}.

Payoff Table: Fundamental Hedge

“Events”
ST  E ST  E
Stock ST ST
Put E  ST 0
Total E ST

The portfolio’s value is thus bounded below by the exercise value E.

The "Fundamental Hedge" is our first instance of the purchase of insurance

against- price declines. However,

1. The purchase of such insurance is not, in and of itself, value creating if the puts
are purchased at their fair market value.

2. The acquisition of the puts means that the overall portfolio's return is no longer
normally distributed and its value no longer log normal. Thus our mean-
variance portfolio analysis goes "out the window."

(g) terminology:
put parity value = max {O, E - St}
put premium over parity = PT -max {O, E - ST}

(h) Remark: Suppose you own a portfolio of many stocks (well diversified, of
course) and you wish to insure its value against large declines in the market.
One possibility would be to buy individual puts on each stock -if they were
traded. Alternatively, you could buy puts on the S+P 500. Presumably, your
portfolio would decline in value if and only if the S+P 500 index declined (you
are well diversified, after all).

This would approximately ensure the value of your portfolio against large losses.
This is one form of Portfolio Insurance.

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 We have seen that the purchase of put options can be used to ensure against
declines in asset values. Sometimes we can reduce the cost of such insurance by
simultaneously writing covered calls.

(i) This is the sense of a "collar."

A collar is a portfolio with the following composition:

(i) the underlying asset (a stock or perhaps a portfolio)
(ii) a call written on the asset with exercise price Ec
(iii) a purchased put written on the asset with exercise price Ep, where
Ep<Ec.

The idea is to sell of some of the upward potential (in the form of the written call)
in order to pay for the purchase of the insurance (the put).

Diagrammatically we have,

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 Suppose we decide to construct a very '"tight" collar by selecting our options so
that Ec = Ep.

This special case defines the fundamental expression for "put/call parity" for
European options.

D. Joint Pricing Relationships on Puts and Calls: Put-Call Parity for European
Options:
1. Consider the following portfolio:

For a given stock:

i. buy 1 share of the stock
ii. write on call on the stock with exercise price E
iii. buy one put on the stock with the same exercise price E
iv. Borrow PV(E), where E is the common exercise price in (ii)
and (iii)

Let us value this portfolio at expiration:

Cost today Value at expiration

ST  E ST  E
Buy one share -St ST ST
Write one call Ct 0 E  ST
Buy one put -Pt E  ST 0
Borrow PV(E) PVt(E) -E -E
Total  S t  Ct  Pt  PVt  E  0 0

In all states this portfolio pays zero cash. Hence, in the absence of arbitrage
opportunities, it must sell for a zero price. (The reverse position: buying a call,
selling a put, selling a share and making a loan will also give a zero cash payment
in all states of nature.)
 S t  Ct  Pt  PVt  E   0
or
Ct  Pt  S t  PVt ( E )
or
Pt  Ct  S t  PVt ( E )

This is referred to as put-call parity.

Remark (1): This relationship depends on an absence of transactions costs and the
assumption that borrowing and lending rates are identical. Neither assumption is
verified is actual fact. Thus this relationship must be viewed as an approximation.

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The Exercise of American Option

American call options on non-dividend paying stocks will never be exercised

prior to expiration and thus may be priced as European call options using, e.g., the Black
Scholes formula.

It would be sufficient to show that the traded price of the call prior to expiration
will always exceed its payoff if exercised. Thus no investor would exercise prior to
expiration: they would rather sell the call unexercised.

It would, in turn, be sufficient to guarantee the above assertion by showing that its
contradiction leads to an arbitrage opportunity.

So suppose not; i.e.

C(S, T, E) < S -E

But then

C(S, T, E) + E < S.

But this cannot be true as it identifies an arbitrage opportunity: buy the call,
immediately exercise, and receive the profit

S -(E + C(S, T, E)).

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