Day 08 Financial Options

Pricing American options Pricing options on dividend-paying assets Put-call parity (asset with dividends)
Financial Options
António Barbosa
(antonio.barbosa@iscte-iul.pt)
Day 08: 27/Sep/23
António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 1 / 35

Outline
1 Pricing American options
2 Pricing options on dividend-paying assets
3 Put-call parity (asset with dividends)

Outline

To exercise or not to exercise...
The binomial model can also be used to price American options

The only difference relatively to the pricing of European option is
that in every tree node we have to determine the optimal exercise
decision:
exercise immediately, receiving the intrinsic value of that node and
not moving forward in the tree (if the option is exercised it ceases
to exist)
or do not exercise and move forward to the next period in the tree
(the option is still active)

Pricing American put on an asset without dividends (1/5)
Example 1: American put on an asset without dividends

Consider an American put option over 1 share of a company that does
not pay dividends during the live of the option. The option expires in
3 months, and its strike is 100€. The underlying asset has a spot
price of 101€ and a volatility of 40%. The risk-free interest rate is 3%.
Price this option using a 3-step binomial model.


We have
T = 0.25, K = 100, S0 = 101, σ = 0.4, r = 0.03

With n = 3 steps, the time interval between steps is
T 0.25
∆t = = = 0.0833
n 3
The parameters u and d are
√ √
u = eσ ∆t = e0.4 0.0833 = 1.1224
1 1
d= = = 0.8909
u 1.1224
Finally, the risk-neutral probability of an up move is
er∆t − d e0.03×0.0833 − 0.8909
q= = = 0.4820
u−d 1.1224 − 0.8909
Note: we have the price of the underlying asset on top and the price of
the put on the bottom1
The bold put prices indicate early exercise
1
A good exercise is to compute these prices by yourself.

To exemplify, let’s compute the put price at the node (2, 0): second
period and 0 up moves
If the option is not exercised, the payoff in the next period will be
either S3,1 = 10.014 or S3,0 = 28.571; in this case, the expected
discounted value we obtain from not exercising the option immediately
at this node is
p2,0 = e−0.03×0.0833 [0.482 × 10.014 + (1 − 0.482) × 28.571] = 19.578€
But if the option is exercised immediately, the payoff is
K − S2,0 = 100 − 80.172 = 19.828€
Therefore,
 
P2,0 = max K − S2,0 ; p2,0  = max (19.828; 19.578) = 19.828€

| {z } |{z}
exercise no exercise
and it is optimal to exercise the American put at the node (2, 0)

If you try, you will find that early exercise is not optimal at any
other node2
For example, at node (1, 0)

100 − 89.986;
P1,0 = max
e−0.03×0.0833 [0.482 × 5.175 + (1 − 0.482) × 19.828]
= max {10.014; 12.733}
= 12.733
and so early exercise at this node is not optimal

Notice how we have used the early exercise value of node (2, 0) as
one of the possible payoffs next period
2
Obviously, early exercise is not optimal at any node where the option is not
ITM, which immediately rules out nodes (0), (1, 1), (2, 2) and (2, 1).
Put-call parity for American options
There is no such thing!

Outline

Types of dividends
Let’s now consider underlying assets that pay dividends during
the life of the option
We can have two types of dividends:
discrete dividends D, which are paid only at some dates and
whose cash value is known and does not depend on the value of
the asset
continuous dividend yield δ, in which case the asset generates
dividends continuously in the form of extra units of the asset and
not in cash, being the cash value of the dividend unknown
beforehand
this is the case when the underlying asset is a currency, in which
case dividends are actually interest, and δ is the interest rate of
the foreign currency
this is also used as a simplifying assumption when dealing with
options on stock indices (if the index includes many stocks, we
have many dividend payment dates, and it’s almost as if dividends
are paid continuously)
Continuous dividend yield (1/3)
Suppose that at t = 0 we have 1 unit of the asset, and that it has

a dividend yield δ
At t = ∆t we will have eδ∆t units of the underlying asset, being
eδ∆t − 1 the extra units received as dividend
this is true regardless of whether we literally receive the dividend
in more units of the underlying asset (which is the case when the
asset is a currency)
or we receive the dividend in cash (cash amount dependent on the
asset valuation) and use it to immediately buy more units of the
asset (this is what we assume as a simplification when the asset is
a stock index)
The value in cash of the dividends received from t = 0 to t = ∆t
is unkown beforehand and depends on the asset price at the time
they are paid (the higher the price, the higher the dividend)

Taking the growth in the asset position due to the dividend yield
δ into consideration, the replicating portfolio for a call option
becomes
(
c1,1 = S1,1 eδ∆t ∆ + B0 er∆t

c1,0 = S1,0 eδ∆t ∆ + B0 er∆t

∆ = δ∆tc1,1 −c1,0

e (S1,1 −S1,0 )
⇔ c1,0 −S1,0 c1,1
B0 = S1,1
er∆t (S1,1 −S1,0 )
( c1,1 −c1,0
∆ = S eδ∆t (u−d)
⇔ 0
uc1,0 −dc1,1
B0 = er∆t (u−d)
Notice that the only difference is that if we take a position ∆ in

the underlying asset today, next period we have a position eδ∆t ∆

The option price is then

c1,1 − c1,0 uc1,0 − dc1,1
c0 = S0 ∆ + B0 = S0 δ∆t
+ r∆t
S0 e (u − d) e (u − d)
= e−r∆t [qc1,1 + (1 − q) c1,0 ]
where
e(r−δ)∆t − d
q=
u−d
The only difference is then in the risk-neutral probability of an up
move, q

American call on asset with dividend yield (1/4)
Example 2: American call on an asset with dividend yield

Consider an American call over 1 unit of an asset that pays a
dividend yield of 5%. The option expires in 3 months and has a
strike of 100€. The underlying asset has a spot price of 101€ and a
volatility of 40%. The risk-free interest rate is 3%. Price this option
using a 3-step binomial model.


We have
T = 0.25, K = 100, S0 = 101, σ = 0.4, δ = 0.05, r = 0.03
With n = 3 steps, the time interval between steps is
T 0.25
∆t = = = 0.0833
n 3
The parameters u and d are, just like in example 1
√ √
u = eσ ∆t = e0.4 0.0833 = 1.1224
1 1
d= = = 0.8909
u 1.1224
The only thing that changes is the risk-neutral probability of an up
move
e(r−δ)∆t − d e(0.03−0.05)×0.0833 − 0.8909
q= = = 0.4641
u−d 1.1224 − 0.8909

As we can see from the binomial tree, early exercise is optimal in

node(2, 2) (if the option is exercised the call holder will start
receiving the dividend)

127.238 − 100;
C2,2 = max
e−0.03×0.0833 [0.4641 × 42.812 + (1 − 0.4641) × 13.362]
= max {27.238; 26.962}
= 27.238
Notice that, if the dividend yield were δ = 0, then q = 0.482 (as

we determined in example 1)
In that case, the call option would not be exercised in node (2, 2),
since
e−0.03×0.0833 [0.482 × 42.812 + (1 − 0.482) × 13.362] = 27.488 > 27.238 = IV

American put on an asset with dividend yield (1/3)
Example 3: American put on an asset with dividend yield

Repeat example 1, considering now that the asset pays a dividend
yield of 5% (similar to example 2 as well, but for a put instead of a
call).


The dividend yield is high enough to make early exercise at node

(2, 0) sub-optimal (if the option is exercised, the put holder will
stop receiving the dividend)

100 − 80.172;
P2,0 = max
e−0.03×0.0833 [0.4641 × 10.014 + (1 − 0.4641) × 28.571]
= max {19.828; 19.909}
= 19.909

Discrete dividends (1/2)
When we have discrete dividends, what we do is to separate the

price of the underlying asset (S) into two components:
the present value of all dividends to be distributed until
expiration, P V (D) (deterministic component)
the price of the underlying asset deducted of the value of those
dividends, S ∗ = S − P V (D) (stochastic component)
We do this because only the stochastic component should grow
by the up factor u or shrink by the down factor d

We construct a binomial tree just for the stochastic component

S ∗ , just as we did before for S
we start with S0∗ = S0 − P V (D)0 at t = 0
and then use the up and down factors u and d to obtain S1,1
∗
e
S1,0 and so on
∗
After obtaining the tree for S ∗ , we obtain the tree for S by

adding to S ∗ the present value of the dividends that have not
been paid yet, e.g. S1,1 = S1,1
∗ + P V (D) , S
1 1,0 = S1,0 + P V (D)1 ,
∗
S2,0 = S2,0 + P V (D)2 ...

∗
Notice that the tree for S ∗ is just an intermediate step to get the
tree for S; it is the tree for S that really matters to price the
option

American call on asset with discrete dividends (1/4)
Example 4: American call on asset with discrete dividends

Consider an American call on 1 share of a company that pays a
dividend of 1€ in 0.05 years, a dividend of 5€ in 0.2 years and a
dividend of 3€ in 0.45 years. The option expires in 3 months and has
a strike of 100€. The underlying asset has a spot price of 101€ and a
volatility of 40%. The risk-free interest rate is 3%. Price this option
using a 3-step binomial model.

At each node, the top values correspond to S ∗ , and the bottom

values to S = S ∗ + P V (D)

We start by constructing the tree for S ∗
S0∗ = S0 − P V (D)0 = 101 − 1 × e−0.03×0.05 + 5 × e−0.03×0.2 = 95.031

Notice that the dividend of 3€ is paid after the option expires, and so
is not taken into account
The other values in the tree for S ∗ are obtained by multiplying by
u = 1.1224 on the way up, and d = 0.8909 on the way down (the up
and down factors are the same we computed in all previous examples)
Then, we compute P V (D) for each period
P V (D)0 = 1 × e−0.03×0.05 + 5 × e−0.03×0.2 = 5.969

P V (D)1 = 5 × e−0.03×(0.2−0.0833) = 4.983
P V (D)2 = 5 × e−0.03×(0.2−0.1667) = 4.995
P V (D)3 = 0
Finally, we obtain the tree for S by adding P V (D)i to Si,j

∗

It is optimal to exercise the option in node (2, 2), that is,

immediately before the distribution of the big dividend when the
option is deep ITM
American put on asset with discrete dividends (1/2)
Example 5: American put on asset with discrete dividends

Repeat example 4 considering now an American put instead of a call.

American put on asset with discrete dividends (2/2)

Outline

Continuous dividend-yield (1/2)
When the underlying asset pays a continuous dividend-yield δ,

the only difference is that we need to buy just e−δT units of the
underlying asset today in order to have 1 unit T years from now
Therefore, the put-call parity (for European options) when the
underlying asset pays a continuous dividend-yield has S0 e−δT
instead of S0 , that is
c0 + Ke−rT = p0 + S0 e−δT
| {z }
value of long asset position on e−δT units

Continuous dividend-yield (2/2)
t=T
t=0 ST < K ST ≥ K
Long call −c0 0 ST − K
−rT
Risk-free deposit −Ke K K
Portfolio A −c0 − Ke−rT K ST
Long put −p0 K − ST 0
Long asset (e−δT units) −S0 e−δT ST e−δT eδT = ST ST
Portfolio B −p0 − S0 e−δT K ST
If the two portfolios have the same payoff in all circumstances,

then they have to be worth the same, and so
c0 + Ke−rT = p0 + S0 e−δT

In the case of discrete dividends, the difference is that the

underlying asset can be seen as a portfolio of:
an underlying asset with no dividends, worth S0∗ = S0 − P V (D)
and risk-free deposits worth P V (D), corresponding to the
dividends whose value and payment date we know for sure
To neutralize the effect of dividends, we take risk-free borrowings
worth P V (D) and maturity on the dividend payment dates, and
so the put-call parity becomes
c0 + Ke−rT = p0 + S0 − P V (D)


Assume that only one dividend of D is paid, at date t = τ < T
Then, P V (D) = De−rτ
t=T
t=0 t=τ ST < K ST ≥ K
Long call −c0 0 0 ST − K
−rT
Risk-free deposit −Ke 0 K K
Portfolio A −c0 − Ke−rT 0 K ST
Long put −p0 0 K − ST 0
Long asset −S0 D ST ST
Risk-free borrowing P V (D) = De−rτ −D 0 0
Portfolio B −p0 − S0 + P V (D) 0 K ST
If the two portfolios have the same payoff in all circumstances, then
they have to be worth the same, and so
c0 + Ke−rT = p0 + S0 − P V (D)

Day 08 Financial Options

Uploaded by

Copyright:

Available Formats

You might also like

Day 08 Financial Options

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Day 08 Financial Options

Uploaded by

Copyright:

Available Formats

Pricing American options Pricing options on dividend-paying assets Put-call parity (asset with dividends)

Day 08: 27/Sep/23

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 1 / 35

1 Pricing American options

2 Pricing options on dividend-paying assets

3 Put-call parity (asset with dividends)

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 2 / 35

1 Pricing American options

2 Pricing options on dividend-paying assets

3 Put-call parity (asset with dividends)

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 3 / 35

To exercise or not to exercise...

The binomial model can also be used to price American options

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 4 / 35

Pricing American put on an asset without dividends (1/5)

Example 1: American put on an asset without dividends

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 5 / 35

Pricing American put on an asset without dividends (2/5)

T = 0.25, K = 100, S0 = 101, σ = 0.4, r = 0.03

Pricing American put on an asset without dividends (3/5)

Pricing American put on an asset without dividends (4/5)

P2,0 = max K − S2,0 ; p2,0  = max (19.828; 19.578) = 19.828€

and it is optimal to exercise the American put at the node (2, 0)

Pricing American put on an asset without dividends (5/5)

and so early exercise at this node is not optimal

Put-call parity for American options

There is no such thing!

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 10 / 35

1 Pricing American options

2 Pricing options on dividend-paying assets

3 Put-call parity (asset with dividends)

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 11 / 35

Continuous dividend yield (1/3)

Suppose that at t = 0 we have 1 unit of the asset, and that it has

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 13 / 35

Continuous dividend yield (2/3)

c1,0 = S1,0 eδ∆t ∆ + B0 er∆t

Notice that the only difference is that if we take a position ∆ in

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 14 / 35

Continuous dividend yield (3/3)

The option price is then

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 15 / 35

American call on asset with dividend yield (1/4)

Example 2: American call on an asset with dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 16 / 35

American call on asset with dividend yield (2/4)

American call on asset with dividend yield (3/4)

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 18 / 35

American call on asset with dividend yield (4/4)

As we can see from the binomial tree, early exercise is optimal in

Notice that, if the dividend yield were δ = 0, then q = 0.482 (as

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 19 / 35

American put on an asset with dividend yield (1/3)

Example 3: American put on an asset with dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 20 / 35

American put on an asset with dividend yield (2/3)

António Barbosa (ISCTE IBS) Financial Options Day 08: 27/Sep/23 21 / 35