IFM2 - Options

The Models for Analysing & Evaluating the
Financial Assets II
Derivative
Van Quy NGUYEN
Actuary program - NEU
February 21, 2024
Van Quy NGUYEN IFM course February 21, 2024 1 / 131

Options
Options
Option Strategies
Put-Call Parity
Comparing Options

Call Options

Call Options
Call Option: a contract where the buyer has the right to buy,
but not the obligation to buy an underlying asset at a specific
time in the future and at a specific price.
Expiration/Expiry date
Strike price / Exercise price: price agreed upon in advance of
underlying asset.
At expiration, if the asset price is lower than Exercise price at
the expiration, nothing happens; If the price is higher, the buyer
pays the strike price and receives the asset.
Example
Suppose that s&R price is $1100, the buyer will pay $1020 and
receive the index. If the S&R price is $900, the buyer walks away.

Call Options
Cash settlement:
If ST > K : the buyer of the Call Option receives ST − K ;
If ST < K : the buyer of the Call Option receives nothing.
Payoff of Call:
Payoff on a long call: max (0, ST − K )
Payoff on a short call: −max (0, ST − K )
Premium of Call: a payment at time of purchase the buyer
pays the seller.
Profit of Call:
Profit on a long call: max (0, ST − K ) − FV (Premium)
Profit on a short call: −max (0, ST − K ) + FV (Premium)

Call Options
Example
An investor purchases a 6-month call option on a stock with strike
price 50. The investor pays 3.35 as premium. At the end of 6
months, the price of the stock is 60. The risk-free annual effective
interest rate is 5%. Calculate the investor’s payoff and profit.
Solution:
The investor’s payoff: 60 − 50 = 10;
The investor’s profit: 10 − 3.35(1.050.5 ) = 6.567

Call Options
Profit of a long Call is the

same graph as Payoff
translated downwards by the
premium accumulated with
interest.
Profit of a short Call is the
same graph translated
upwards by the premium
accumulated with interest.

Call Options
Exercise styles: governs the time at which exercise can occur.

European-style option: exercise could occur only at expiration;
American-style option: exercise at any time during the life of
the option;
Bermudan-style option: exercise during specified periods, but
not for the entire life of the option.

Call Options
The Moneyness of an Option: describes whether the option

payoff would be positive if the option were exercised
immediately.
At-the-money : S0 = K ;
In-the-money : S0 > K , exercising the option would result in a
positive cash settlement;
Out-of-the-money : S0 < K , exercising the option would
result in a negative cash settlement.
A call option can act as insurance against the rise in price of an
asset that one need in the future.
The one who short a call option may have an unlimited potential
loss.

Put Options

Put Options
Put Option: a contract where the buyer has the right, but not
the obligation to sell an underlying asset at a specific time in the
future and at a specific price.
At expiration, if the asset price is higher at the expiration,
nothing happens; if the price is lower, the writer pays the owner
the strike price and receives the asset.
Example
Suppose that the put buyer agrees to pay $1020 for the S&R index in
6 months. If in 6 months the S&R price is $1100, the buyer will pay
$1020 and receive the index. If the S&R price is $900, the buyer
walks away.

Put Options
Cash settlement:
If ST < K : the buyer of the Put Option receives K − ST from
the writer;
If ST > K : the buyer of the Put Option receives nothing.
Payoff of Put:
Payoff on a long put: max (0, K − ST )
Payoff on a short put: −max (0, K − ST )
Premium of Put: a payment at time of purchase the buyer
pays the seller.
Profit of Put:
Profit on a long put: max (0, K − ST ) − FV (Premium)
Profit on a short put: −max (0, K − ST ) + FV (Premium)

Put Options

Put Options
There are many exercise styles: American, European, and

Bermudan.
A put option is in-the-money if S0 < K and out-of-the-money if
S0 > K .
A put option is short with respect to the underlying asset. One
can short a put option, and in that case is long relative to the
underlying asset.
A put option is insurance against a drop in price of the
underlying asset.
The one who short a put option may have a big potential loss,
the bounded loss is the strike price.

Put Options
Example
Consider a European put option on a stock index without dividends,
with 6 months to expiration and a strike price of 1, 000. Suppose that
the annual nominal risk-free rate is 4% convertible semiannually, and
that the put costs 74.20 today.
Calculate the price that the index must be in 6 months so that being
long in the put would produce the same profit as being short in the
put.

Put Options
Example
Solution:
The profit for being long is:
max (0, K − ST ) − FV (Premium) = 1000 − S − 74.20(1.02)
The profit for being short is:
−max (0, K − ST ) + FV (Premium) = −1000 + S + 74.20(1.02)
Equating these, we get:
2S = 2000 − 2(74.20)(1.02) −→ S = 924.32

Option Strategies

Options Strategies
Options Strategies: Combine options and other assets, for hedging,

speculation, or other reasons.
Options with Underlying Assets;
Synthetic Forwards;
Combine Options: Bear Spreads, Bull Spreads, and Collars;
Straddles, Strangles, and Butterfly Spreads.

Options with Underlying Assets

Strategies involving buying/selling an option and the underlying

asset (stock);
The option offsets the stock: if we buy the stock, the option is
short in the stock; and if we sell the stock, the option is long in
the stock;
Four variations:
1 Long put, long stock
2 Long call, short stock
3 Short call, long stock
4 Short put, short stock

Insurance strategies - Long put, long stock:

If you own a stock, you may buy a put: The put guarantees that
you will be able to sell the stock for at least the strike price;
If ST > K : sell it for ST ;
If ST < K : exercise the put option.
Floor: The put, in the presence of the underlying stock (it sets
a floor for the price you get selling the stock).
The profit for being long a put and a stock:
(
ST − FV (S0 + P), ST > K
max(K −ST , 0)+ST −FV (S0 +P) =
K − FV (S0 + P), ST < K

Insurance strategies - Long put, long stock:

Example
An investor buys a non-dividend paying stock for 65. To protect the
investment, the investor buys a 1-year floor at 55, with premium 2.
The annual effective risk-free interest rate is 0.04. Calculate the
investor’s profit if the stock price at the end of one year is (a) 75 and
(b) 45.
Solution: If S1 = 75, the put expires worthless and the investor
receives 75. The profit is 75 − 67(1.04) = 5.32.
If S1 = 45, the investor exercises the option and receives 55 for the
stock. The profit is 55 − 67(1.04) = −14.68

Insurance strategies - Long call, short stock:

If you short a stock, you may buy a call: The call guarantees
that you will be able to buy back the stock for at most the strike
price.
If ST < K : buy it back for ST ;
If ST > K : exercise the call option.
Cap: The call, in the presence of the underlying short stock (it
caps the price for buying the stock).
The profit for being long a call and short a stock:
(
FV (S0 − C ) − K , ST > K
FV (S0 −C )+max(ST −K , 0)−ST =
FV (S0 − C ) − ST , ST < K

Insurance strategies - Long call, short stock:
Example
An investor buys a three-month cap of 60 on a stock. The price of
the call option is 3.69. The current price of the stock is 50. The
annual effective risk free rate is 0.04.
Determine the range of prices for the stock at the end of three
months for which the investor makes a positive profit.
Solution: The profit of the investor:
(50 − 3.69)(1.04)0.025 − 60 = 46.77 − 60 < 0, ST > 60

(50 − 3.69)(1.04)0.025 − ST , ST < 60
Profit > 0 when ST < 46.77.

Covered written call - Short call, long stock:

If one writes a call: unbounded liability (stock price increase);
The profit of being short a call and long a stock:
(
FV (C − S0 ) + K , ST > K
FV (C −S0 )−max(ST −K , 0)+ST =
FV (C − S0 ) + ST , ST < K

Covered written put - Short put, short stock:

If one writes a put: liability up to the strike price;
The profit of being short a put and a stock:
(
FV (P + S0 ) − ST , ST > K
FV (P + S0 ) − (K − ST )+ − ST =
FV (P + S0 ) − K , ST < K

Example
The price of a nondividend paying stock is 65. A market-maker writes
a 1-year put option on the stock with strike price 60 for a premium of
3. To hedge this put option, the market-maker sells the stock short.
The annual effective risk-free interest rate is 0.03. Calculate the profit
of the market-maker if at the end of the year the stock price is (a) 75
and (b) 50.
Solution: The market-maker initially receives 65 + 3 = 68 for the
stock and put option.
If S1 = 75 : the option is worthless and the market-maker pays 75 to
buy back the stock. Profit is 68(1.03) − 75 = −4.96.
If S1 = 50 : the put option is exercised and the market-maker pays 60
for the stock. Profit is 68(1.03) − 60 = 10.04.

Synthetic Forwards

Synthetic Forwards
Long a European call + short a European put expiring at time T
for strike price K : the payoff will be
max(ST − K , 0) − max(K − ST , 0) = ST − K
If K = F0,T : synthetic forward. The initial payment must be 0:

C (S, K , T ) = P(S, K , T );
If K ̸= F0,T : off-market forward. To buy an off-market forward,
the buyer must pay the present value of F0,T − K ,
C (S, K , T ) − P(S, K , T ) = e −rT (F0,T − K )
= S0 e −δT − Ke −rT
C (S, K , T ) − S0 e −δT = P(S, K , T ) − Ke −rT
Equivalent strategies: Long call + short stock = Long put +

short cash (lend money).
Synthetic Forwards
Example
A stock index’s current price is 1300. It pays continuous dividends at
a rate of 0.02. The continuously compounded risk-free interest rate is
0.05. Calculate the price for a one-year off-market forward with price
1310.
Solution: The forward price is
S0 e (r −δ)T = 1300e 0.05−0.02 = 1339.59
The price of the off-market forward is
e −rT (1339.59 − 1310) = e −0.05 (29.59) = 28.15

Combine Options

Combine Options
Option strategies involving two options:

Buying an option and selling another option of the same kind
(both calls or both puts): Spreads;
Buying an option of one kind and selling one of the other:
Collars;
Buying/selling two options of different kinds: Straddles,
Strangles.

Bull Spreads

Bull Spreads
Bull spreads: buy a K1 -strike call/put and sell a K2 -strike call/put,
K2 > K1 .
The payoff of Bull spreads with call:

0,
 K2 > K1 > ST
+ +
(ST − K1 ) − (ST − K2 ) = ST − K1 , K2 > ST > K1

K2 − K1 , ST > K2 > K1

The payoff of Bull spreads with put:


K1 − K2 , K2 > K1 > ST

+ +
(K1 − ST ) − (K2 − ST ) = ST − K2 , K2 > ST > K1

0, ST > K2 > K1


Bull Spreads
Bull spreads with call and put, of strike prices 40 and 60.
Bull spread pays off if the stock move up in price, but subject to
a limit.
80
Payoff with Call 20
Payoff with Put
60 ST
40 20 40 60 80 100
−20
20
−40
ST
20 40 60 80 100 −60

Bear Spreads

Bear Spreads
Bear spreads: sell a K1 -strike call/put and buy a K2 -strike call/put,
K2 > K1 .
The payoff of Bear spreads with call:

0,
 K2 > K1 > ST
+ +
(ST − K2 ) − (ST − K1 ) = K1 − ST , K2 > ST > K1

K1 − K2 , ST > K2 > K1

The payoff of Bear spreads with put:


K2 − K1 , K2 > K1 > ST

+ +
(K2 − ST ) − (K1 − ST ) = K2 − ST , K2 > ST > K1

0, ST > K2 > K1


Bear Spreads

Ratio Spreads

Ratio Spreads
Ratio Spread: buying n of one option and selling m of another

option of the same type where m ̸= n.
It is possible to select m and n to make the net initial cost of
this strategy zero.
Example
An investor buys a ratio spread of 1-year European calls. He buys 1
call option with strike price 40 and sells 2 call options with strike
price 50. Option prices are 10 and 5 correspondingly.
Determine the investor’s profit if the ending price of the underlying
stock is (a) 35, (b) 45, (c) 55.

Ratio Spreads
Example
Solution: C(S,40,1)=2C(S,50,1), then there is no initial cost.
The profit = payoff = (S1 − 40)+ − 2(S1 − 50)+
If S1 = 45 : only the 40-strike option pays off, and the profit is 5;
If S1 = 55 : all options pay off; the investor receives 15 and pays
2(5) = 10 for a profit of 5;
If S1 = 65 : the investor receives 25 and pays 2(15) = 30 for a profit
of −5.

Box Spreads

Box Spreads
Box spreads: a four-option strategy consisting of buying a bull

spread with strikes K1 and K2 (K2 > K1 ) and buying a bear
spread with strikes K2 and K1 ;
If both spreads use the same type of option, one spread cancels
out the other spread;
To make the box spread interesting, the bull and bear spreads
should be of different types (bull spread with calls and bear
spread with puts).
Strike Bull Spread Bear Spread
K1 Buy call Sell put
K2 Sell call Buy put
European options box spread = an agreement to buy the stock
for K1 and sell it for K2 , with definite payoff K2 − K1 .

Box Spreads
Example
Consider a box spread consisting of the following 1-year European
options: a long call and short put with strike price 40 and a short call
and long put with strike price 60. The continuously compounded
risk-free rate is 4%. What is the price of this box spread?
Solution: The long call and short put result in buying the asset for
40, and the short call and long put result in selling the asset for 60,
so the investor receives a net of 20 at the end of the year. The
present value of 20 is 20e −0.04 = 19.22.

Collars

Collars
Collars: buying one option and selling an option of the other

kind;
A collar of buying a K1 -strike put and selling a K2 -strike call,
K2 > K1 , has payoff:

K1 − ST , K2 > K1 > ST

+ +
(K1 − ST ) − (ST − K2 ) = 0, K2 > ST > K1

K2 − ST , ST > K2 > K1

Collar width: K2 − K1 ;

Collars
Collared stock: One own a stock and buy the the collar with
strikes below and above the current stock price: K2 > S0 > K1 ;
The payoff on a collared stock:

K1 , K2 > K1 > ST

+ +
(K1 − ST ) − (ST − K2 ) + ST = ST , K2 > ST > K1

K2 , ST > K2 > K1


Collars
Zero-cost collar: the collar with net cost of 0;
Example
An investor owns a non-dividend paying stock with current price 50.
The investor buys a zero-cost 1-year collar consisting of a put option
with strike price 50 and a call option with strike price 55. The annual
effective risk-free rate is 0.05. Calculate the investor’s profit if the
price of the stock at the end of the year is (a) 45, (b) 52, (c) 60.
Solution: The profit of zero-cost collared stock = the payoff -
FV (S0 ).
(a) 50 − 50(1.05) = −2.5; (b) 52 − 50(1.05) = −0.5; (c)
55 − 50(1.05) = 2.5.

Speculating on Volatility

Strategy of non-directional speculations: the holder does not

care whether the stock goes up or down, but only how much it
moves.
Straddles, Strangles, and Butterfly Spreads.

Straddles: strategy of buying a call and a put with the same

strike price K = S0 (at-the-money options) and time to
expiration T ;
The payoff of a straddle:
(ST − K )+ + (K − ST )+ = |ST − S0 |
The payoff is growing with the absolute change in stock price, so

this is a bet on volatility: the more volatile the stock price, the
higher the expected gain.


Strangle: buy a put with strike price K1 and buy a call with
strike price K2 with K1 < S0 < K2 ;
The payoff of a strangle:

K1 − ST ,
 K2 > K1 > ST
+ +
(K1 − ST ) + (ST − K2 ) = 0, K2 > ST > K1

ST − K2 , ST > K2 > K1

The strangle can lower the initial cost comparing with straddle.

Butterfly spreads: a written straddle with additional purchased

options to limit the maximum loss;
A symmetric butterfly spread: a long put with strike price
K − c and a long call with strike price K + c, where K is the
strike price of the straddle and c is any positive constant:
Long put, strike price K1 = K − c
Short put, strike price K2 = K
Short call, strike price K2 = K .
Long call, strike price K3 = K + c.
Equivalent portfolio:
bull spread of puts with strikes K1 and K2 ;
bear spread of calls with strikes K2 and K3

An Equivalent portfolio can be created by replacing the puts

with calls or the calls with puts, for ex.
Long call, strike price K1 = K − c
2 Short call, strike price K2 = K
Long call, strike price K3 = K + c.
Strategy can be with only one type of asset !!!

Payoff of a symmetric butterfly spread:
(K − c − ST )+ − (K − ST )+ − (ST − K )+ + (ST − K − c)+



 −c, ST < K − c

S − K ,
T K − c < ST < K
=


 K − ST , K < ST < K + c
−c,

ST > K + c

An asymmetric butterfly spread is constructed with the

following rules:
1 Purchase n bull spreads with strike prices K1 and K2 .
2 Purchase m bear spreads with strike prices K3 and K2 .
3 K1 < K2 < K3
4 n and m selected so that there is no payoff for ST ≤ K1 or
ST ≥ K3 .
Payoff of the portfolio:
n(K2 − K1 ) − m(K3 − K2 ) = 0
n K3 − K2
=
m K2 − K1

Example
A butterfly spread of calls has strike prices 35, 40, 55, It consists of n
bull spreads and m bear spreads. Determine m and n.
Solution.
We have
n 55 − 40
= =3
m 40 − 35

Put-Call Parity

Put-Call Parity
Suppose you bought a European call option and sold a European

put option, both having the same underlying asset, the same
strike, and the same time to expiry.
At time T , one of the two options is sure to be exercised, unless
the price of the asset at time T happens:
If ST > K you exercise the call option you bought. You pay K
and receive the asset.
If K > ST , the counterparty exercises the put option you sold.
You receive the asset and pay K .
If ST = K , it doesn’t matter whether you have K or the
underlying asset.
=⇒ You pay K and receive the underlying asset.

Put-Call Parity
Two ways to receive ST at time T :

Buy a call, sell a put at time 0, and pay K at time T ;
Enter a forward agreement to buy ST , and at time T pay F0,T ,
the price of the forward agreement.
By the no-arbitrage principle, these two ways must cost the
same:
C (K , T ) − P(K , T ) + Ke −rT = F0,T e −rT
Put-Call Parity:
C (K , T ) − P(K , T ) = e −rT (F0,T − K )

Stock Put-Call Parity
The Put-Call Parity for a non dividend paying stock,

F0,T = S0 e rT :
C (K , T ) − P(K , T ) = S0 − Ke −rT
Example
A non dividend paying stock has a price of 40. A European call
option allows buying the stock for 45 at the end of 9 months. The
continuously compounded risk-free rate is 5%. The premium of the
call option is 2.84.
Determine the premium of a European put option allowing selling the
stock for 45 at the end of 9 months.


Example
Solution:
C (K , T ) − P(K , T ) = S0 − Ke −rT
2.84 − P(K , T ) = 40 − 45e −(0.05)(0.75)
2.84 − P(K , T ) = 40 − 45(0.9631) = −3.3437
P(K , T ) = 2.84 + 3.3437 = 6.1837

The Put-Call Parity for a dividend paying stock:
C (K , T ) − P(K , T ) = S0 − PV0,T ( Divs ) − Ke −rT

= S0 e −δT − Ke −rT
Example
A stock’s price is 45. The stock will pay a dividend of 1 after 2
months. A European put option with a strike of 42 and an expiry
date of 3 months has a premium of 2.71. The continuously
compounded risk-free rate is 5%.
Determine the premium of a European call option on the stock with
the same strike and expiry.

Example
Solution:
C (K , T ) − P(K , T ) = S0 − PV0,T ( Divs ) − Ke −rT

C (42, 0.25) − 2.71 = 45 − (1)e −0.05/6 − 42e −0.05(0.25)
= 45 − 0.9917 − 42(0.9875) = 2.53
C (42, 0.25) = 2.71 + 2.53 = 5.24

Example
You are given.
(i) A stock’s price is 40;
(ii) The continuously compounded risk-free rate is 8%;
(iii) The stock’s continuous dividend rate is 2%;
A European 1-year call option with a strike of 50 costs 2.34.
Determine the premium for a European 1-year put option with a
strike of 50.
Solution:
C (K , T ) − P(K , T ) = S0 e −δT − Ke −rT
2.34 − P(K , T ) = 40e −0.02 − 50e −0.08 = −6.9478
P(K , T ) = 2.34 + 6.9478 = 9.2878

Synthetic stocks

Synthetic stocks
Stock with continuous dividends:
S0 = C (K , T ) − P(K , T ) + Ke −rT e δT

Synthetic a stock = Buy e δT call option + Sell e δT put option

+ Buy a Treasury for Ke (δ−r )T ;
At T , the Treasury will be worth for Ke δT , one of the options
will be exercised, we will pay Ke δT to get e δT shares of stock;
This is equivalent to buying 1 share of the stock originally and
reinvesting the dividends.

Synthetic stocks
Stock with discrete dividends:
S0 = C (K , T ) − P(K , T ) + PV ( dividends) + Ke −rT

| {z }
amounnt to lend
Synthetic a stock = Buy a call + Sell a put + Lend

PV (dividends) + Ke −rT ;
At T , we have K + the accumulated value of the dividends, one
of the options will be exercised, so K will be exchanged for one
share of stock.

Synthetic Treasuries

Stock with continuous dividends:
Ke −rT = S0 e −δT − C (K , T ) + P(K , T )
Synthetic Treasury: Buy e −δT shares of the stock + Buy a put

+ Sell a call, the total cost of this is Ke −rT ;
At T , sell the stock for K (since one option will be exercised);
This is equivalent to investing in a T -year Treasury bill with
maturity value K .

Stock with discrete dividends (assumed to be fixed in advance:
Ke −rT + PV (dividends) = S0 − C (K , T ) + P(K , T )
Synthetic Treasury: Buy a stock + Buy a put + Sell a call, the

total cost of this is Ke −rT + PV (dividends);
At T , sell the stock for K (since one option will be exercised),
and receive the accumulated of the dividends;.
This is equivalent to investing in a T -year Treasury bill with
maturity value K + CumV (dividends).

Synthetic options
Based on put-call parity, an option is mispriced: arbitrage

opportunity;
Suppose the price of a European call based on put-call parity is
C , but the price it is actually selling at is C ′ < C , and assume
the price of the put is correct (based on some models): buy the
underpriced call option and sell a synthesized call option;
Synthesized call option = Sell e −δt shares of the underlying
stock + Sell a European put option with strike price K and
expiry t, + Lend Ke −rt at the risk-free rate;
C (S, K , t) = Se −δt + P(S, K , t) − Ke −rt

Currency Put-Call Parity

Currency Put-Call Parity
Put-Call Parity with currency:
C (x0 , K , T ) − P (x0 , K , T ) = x0 e −rf T − Ke −rd T
C (x0 , K , T ): premium of the call option on currency with spot

exchange rate x0 to purchase it at exchange rate K at time T ;
P (x0 , K , T ): premium of the put option on currency with spot
exchange rate x0 to sell it at exchange rate K at time T ;
rf : foreign risk-free rate;
rd : domestic risk-free rate.

Currency options
Example
You are given:
(i) The spot exchange rate for dollars to pounds is 1.4$/£;
(ii) The continuously compounded risk-free rate for dollars is 5%;
(iii) The continuously compounded risk-free rate for pounds is 8%;
A 9-month European put option allows selling £1 at the rate of
$1.50/£. A 9-month dollar denominated call option with the same
strike costs $0.0223.
Determine the premium of the 9-month dollar denominated put
option.

Currency options
Example
Solution:
C (x0 , K , T ) − P (x0 , K , T ) = x0 e −rf T − Ke −rd T
= 1, 4e −0.08(0.75) − 1.5e −0.05(0.75)
= 1.3185 − 1.4447 = −0.1263
P(1.4, 1.5, 0.75) = 0.0223 + 0.1263 = $0.1486

Currency options
A call to purchase foreign currency with domestic one is

equivalent to a put to sell domestic one for foreign (the units are
different)
Example
The spot exchange rate for dollars into euros is $1.05/AC1. A 6-month
dollar denominated call option to buy one euro at strike price
$1.1/AC1 costs $0.04.
Determine the premium of the corresponding euro denominated put
option to sell one dollar for euros at the corresponding strike price.

Currency options
Example
Solution:
The call option allowing to buy A C1 with $1.1 is equivalent to put
options which allow to sell $1.1 for A
C1, or to sell $1 for
A
C 1.1 = A
1
C0.909.
We need to sell $1.1, correspond to 1.1 units of put option which
allow to sell $1 for A
C0.909 (called euro denominated put option).
The premium of such a put in dollars is $ 0.04
1.1
, and in euros is

1 0.04
A
C =AC0.0346
1.05 1.1

Currency options
In general, consider a call option, with the spot rate x0 units of

domestic currency and the strike price K units of domestic
currency.
The call premium is Cd (x0 , K , T ) units of domestic currency,
allowing to buy 1 unit of foreign currency for K units of
domestic currency;
The equivalent put option: allow to sell K units of domestic
currency for 1 unit of foreign currency;
We need K put, each allows to sell 1 unit of domestic currency
for 1/K unit of foreign currency, with total premium in
domestic currency of:

1 1
KPd , , T = Cd (x0 , K , T )
x0 K

Comparing Options

Comparing Options
How option prices change when there are changes in option

characteristics: exercise style, strike price, and time to expiration.
Some issues for stock options:
How prices of otherwise identical American and European
options compare.
How option prices change as the time to expiration changes.
How option prices change as the strike price changes.
Assumption: No arbitrage opportunity!

Bounds for Option Prices

An option must be worth at least 0: no negative payoff is

possible,
C (S, K , T ), P(S, K , T ) > 0
European Versus American Options: An American option

can be exercised at any time, whereas a European option can
only be exercised at expiry =⇒ the American option must be
worth at least as much as a European option with the same
strike price and expiry,
CA (S, K , T ) ≥ CE (S, K , T )
PA (S, K , T ) ≥ PE (S, K , T )

A call option cannot be worth more than the underlying stock:

buying stock will have stock, buying option allows to buy the
stock for the strike price.
S ≥ CA (S, K , T ) ≥ CE (S, K , T )
A European call option cannot be worth more than the prepaid

forward price of the stock:
P
F0,T (S) ≥ CE (S, K , T )

A put option cannot be worth more than the strike price;
K ≥ PA (S, K , T ) ≥ PE (S, K , T )
A European put option cannot be worth more than Ke −rt
Ke −rT ≥ PE (S, K , T )

A European option is worth at least as much as implied by

put-call parity assuming the other option is worth 0
P
(S) − Ke −rT

CA (S, K , T ) ≥ max 0, F0,T
PA (S, K , T ) ≥ max 0, Ke −rT − F0,T
P

(S)

For call options:
P
(S) − Ke −rT

S ≥ CA (S, K , T ) ≥ CE (S, K , T ) ≥ max 0, F0,T
For European call options:
F P (S) ≥ CE (S, K , T ) ≥ max 0, F0,T

P
(S) − Ke −rT

For put options:
K ≥ PA (S, K , T ) ≥ PE (S, K , T ) ≥ max 0, Ke −rT − F0,T

P

(S)
For European put options:
Ke −rT ≥ PE (S, K , T ) ≥ max 0, Ke −rT − F0,T

P

(S)

Example
You are given:
(i) The price of a stock is 70.
(ii) The stock pays continuous dividends at the annual rate of 0.08.
(iii) The continuously compounded risk-free interest rate is 0.04.
(iv) A 1-year American put option on the stock has a strike price of
69.
Determine the lowest possible price for this put option.

Example
Solution:
PA (S, K , T ) ≥ max 0, Ke −rT − F0,T
P

(S)
≥ max 0, 69e −0.04 − 70e −0.08 = 1.6763

So the American put option must have the price of at least 1.6763.

Early exercise of American options

Calls on a non dividend paying stock: Consider an American call

option at time t when the stock price is St > K ,
If exercise the option: pay K , receive the stock, and sell it, get
profit of St − K and interest on St − K for the period T − t;
If do not exercise the option: sell the stock short, get profit of
St − ST from the shorted stock, + max (0, ST − K ) from
exercise of the option at maturity, + interest on St for the
period T − t.
If ST ≥ K : St − ST + ST − K + Int(St ) = St − K + Int(St )
If ST < K :
St − ST + Int(St ) > St − K + Int(St )
The interest this way is greater than through early exercise.

Calls on a non dividend paying stock: American-style call option

on a non dividend paying stock should never been exercised prior to
expiration.
Proof: Using Put-Call Parity, at time t, an option expiring at time T
satisfies
CE (St , K , T − t) = PE (St , K , T − t) + St − Ke −r (T −t)
= PE (St , K , T − t) + (St − K ) + K 1 − e −r (T −t)

> St − K
CA (St , K , T − t) ≥ CE (St , K , T − t) > St − K
Selling the option will get you a higher profit than exercising it early.

Calls on dividend paying stock: If a stock pays dividends, it

may be rational to exercise an option early.
CE (St , K , T − t) = PE (St , K , T − t) + (St − K )

− PVt,T (Div ) + K 1 − e −r (T −t)

Early exercise will not be rational if
PE (St , K , T − t) + K 1 − e −r (T −t) − PVt,T (Div ) > 0


Example
An American call option has a strike price of 50. The risk free rate is
5%. There are 2 months left to expiry. The present value of
dividends over the 2 month period is D.
Determine the lowest value of D such that exercising the option early
could be rational.
Solution:
D > K 1 − e −r (T −t) = 50 1 − e −(0.05)(1/6) = 0.4149


If early exercise is rational, exercise should be right before a
dividend is paid.
Example
An American call option on a stock has a strike price of 85 and
expires in 5 months. You are given:
(i) The risk free rate is 4%.
(ii) A dividend of 1.50 is payable at the end of today, and another
dividend of 1.50 is payable in 3 months.
(iii) The current price of the stock is 100.
(iv) A European put option with a strike price of 85 which expires in
5 months costs 0.82.
Could it be rational to exercise the option immediately, before the
dividend is paid?

Example
Solution: The value of the put option is 0.82. The value of the
interest on the strike price is:
85 1 − e −(0.04)(5/12) = 1.4049

The total loss by exercising now is 0.82 + 1.4049 = 2.2249.

The present value of the dividends is:
1.5 1 + e −(0.04)(3/12) = 2.9851

Since the PV of dividends is greater than the losses from early

exercise, it may be rational to exercise the option early.

Put options: It may be rational to exercise an American put
option on a non dividend paying stock early (Get the cash
earlier, and earn interest on the strike price);
By Put Call parity,
PE (St , K , T − t) = CE (St , K , T − t) + Ke −r (T −t)

− St + PV (Divs)
= CE (St , K , T − t) + (K − St )
+ PV (Divs ) − K 1 − e −r (T −t)

No exercise condition, P > K − St , implies
CE (St , K , T − t) + PV (Divs ) − K 1 − e −r (T −t) > 0


In summary, for stocks without dividends:

An American call option is worth the same as a European call
option;
An American put option may be worth more than a European
put option.
Time to expiry
Time to expiry
An American option with expiry T and strike price K must cost

at least as much as one with expiry t and strike price K , with
T > t;
PA (S, K , T ) ≥ PA (S, K , t) ; CA (S, K , T ) ≥ CA (S, K , t)
A European call option on a non dividend paying stock with

expiry T and strike price K must cost at least as much as one
with expiry t and strike price K .
CE (S, K , T ) ≥ CE (S, K , t)
Time to expiry
A European option on a non dividend paying stock with expiry

T and strike price Ke r (T −t) must cost at least as much as one
with expiry t and strike price K ,
PE S, Ke r (T −t) , T ≥ PE (S, K , t) ;

CE S, Ke r (T −t) , T ≥ CE (S, K , t)

Time to expiry
Arbitrage for 2 calls: Suppose that

CE S, Ke r (T −t) , T < CE (S, K , t) =⇒ Buy CE S, Ke r (T −t) , T +

Sell CE (S, K , t), get initial profit.

At t, if St ≤ K : CE (S, K , t) is worthless. You keep the profit
you already made, make additional profit if ST > Ke r (T −t) ;
At t, if St > K : CE (S, K , t) will be exercised. Borrow the stock,
deliver it and collect the strike price K . Invest K at the risk-free
rate to have Ke r (T −t) at time T .
If ST ≤ Ke r (T −t) , the accumulated cash will beat least enough
to buy back the stock, and get additional profit.
If ST > Ke r (T −t) , by exercising CE S, Ke r (T −t) , T to buy the
stock for Ke r (T −t) , have just enough cash to close all
transactions at no gain or loss.
Time to expiry
Example
A non dividend paying stock’s current price is 40. You are given:
(i) The continuously compounded risk-free interest rate is 5%.
(ii) A European 6-month call option on the stock with strike price
45.00 costs 0.60.
(iii) A European 12-month call option on the stock with strike price
46.14 costs 0.55.
(iv) You create a position which takes advantage of the arbitrage
between these two options by buying or selling exactly one call option
of each type.
Calculate your profit at the end of 12 months if the stock price is
50.00 after 6 months and 47.00 after 12 months.
Time to expiry
Example
Solution: Sell a 6-months call and buy a 12-months call for a gain of
0.05.
After 6 months, the call you sold is exercised. You receive 45.00 and
borrow the stock to deliver it.
6 months later, your 45 is worth 45e 0.05(0.5) = 46.14. You exercise
the 12-months call, pay 46.14, get stock back, return it to the lender.
Your profit is:
0.05e 0.05 + 45e 0.05(0.5) − 46.14 = 0.052
Time to expiry
Example
The cash flows:
Sale/payoff Purchase of Purchase/sale Net
Time 6-month call 12-month call of stock CF
0 months 0.60 -0.55 − 0.05
6 months -5.00 − 50.00 45.00
12 months − 0.86 -47.00 -46.14
Different strike prices
Different strike prices
Three inequalities for both European and American options.

Arbitrages can be created if these relationships don’t hold.
1 Create a position that results in maximal initial gain, and which
cannot possibly lose as much as the initial gain in the future.
2 Create a position that has minimal initial gain, but which has
the possibility of future gain.
Different strike prices - Direction
For a call option, the higher the strike price, the lower the
premium. For a put option, the higher the strike price, the
higher the premium.
Algebraically, for K2 > K1 :
C (S, K2 , T ) ≤ C (S, K1 , T )
P (S, K2 , T ) ≥ P (S, K1 , T )
With derivatives:
∂C (S, K , T ) ∂P(S, K , T )
≤ 0; ≥0
∂K ∂K
Arbitrage: Sell the overpriced option + Buy the underpriced

one.
Arbitrage that maximizes the initial gain: Suppose K2 > K1 and

C (S, K2 , T ) > C (S, K1 , T ),
=⇒ Sell one K2 -strike call + Buy one K1 -strike call. The immediate
gain is C (S, K2 , T ) − C (S, K1 , T ), and nothing to pay at the end.
1 ST ≤ K1 : Neither option pays;
2 K1 < ST ≤ K2 : The bought option pays ST − K1 , and the sold
option doesn’t pay;
3 ST > K2 The bought option pays ST − K1 and the sold option
pays ST − K2 . The net profit is K2 − K1 .
Arbitrage that minimizes the initial cost: Suppose K2 > K1 and

C (S, K2 , T ) > C (S, K1 , T ),
=⇒ Sell one K2 -strike call + Buy c = CC (S,K
(S,K2 ,T )
1 ,T )
K1 -strike call. The
net cost is 0 and c > 1.
1 ST ≤ K1 : Neither option pays;
2 K1 < ST ≤ K2 : The bought option pays c (ST − K1 ) , and the
sold option doesn’t pay;
3 ST > K2 The bought option pays c (ST − K1 ) and the sold
option pays ST − K2 . The net profit is
(K2 − K1 ) + (c − 1) (ST − K1 ) > 0
Example
Two 6-month European put options on a stock are available with the
following strike prices and premiums:
Strike Price Premium

35 5
45 4
You are also given:

(i) The current stock price is 47;
(ii) The continuously compounded risk-free rate is 0.05.
You take advantage of arbitrage by selling a 35-strike put and buying
45-strike puts so that the net cost 0. After 6 months, the stock price is 32.
Calculate your total profit after 6 months, including interest.
Example
Solution: Sell one 35-strike put + Buy 45 = 1.25 45-strike put. The
net cost is 5 − 1.25(4) = 0
After 6 months, the stock price is 32, the 45-strike put pays
1.25(45 − 32) = 16.25, and the 35-strike put pays 35 − 32 = 3. Net
profit is 16.25 − 3 = 13.25.
Different strike prices - Slope
The premium for a call option decreases more slowly than the
strike price increases. The premium for a put option increases
more slowly than the strike price increases.
Algebraically, for K2 > K1 :
C (S, K1 , T ) − C (S, K2 , T ) ≤ K2 − K1
P (S, K2 , T ) − P (S, K1 , T ) ≤ K2 − K1
With derivatives:
∂C (S, K , T ) ∂P(S, K , T )
≥ −1; ≤1
∂K ∂K
Arbitrage that maximizes the initial gain: Suppose K2 > K1 and

C (S, K2 , T ) < C (S, K1 , T ) − (K2 − K1 ),
=⇒ Sell one K1 -strike call + Buy one K2 -strike call.
The immediate gain is C (S, K1 , T ) − C (S, K2 , T ) > K2 − K1 .
If none of the options are exercised you have a gain. Suppose the
option you sold is exercised at time t ≤ T . Then there are two
possibilities:
1 K1 < St ≤ K2 : Pay St − K1 < K2 − K1 =⇒ Net gain;
2 St > K2 : Exercise the bought option, pay St − K1 and receive
St − K2 on the bought option, for a net payment of K2 − K1
=⇒ Net gain.
Example
Two 1-year American call options on the same stock are priced as
follows:
Strike Price Premium
40 10
45 4
The continuously compounded risk-free interest rate is 0.08. You
take advantage of arbitrage by buying one 45-strike call and selling c
40-strike calls, where c is the lowest possible value that results in no
possibility of loss when interest is ignored.
After one year, the stock price is 46.
Determine your profit including interest.
Example
Solution: The initial gain is 10c − 4.
The payoff can be computed as: (S1 − 45)+ − c(S1 − 40)+
S1 ≤ 40: No payoff;
40 < S1 < 45, S1 = 40 + k, 0 < k < 5: Payoff = −kc;
S1 = 45: Payoff = −5c;
S1 > 45, S1 = 45 + m, m > 0: Payoff = m(1 − c) − 5c > −5c
The worst case is S1 = 45 when you pay 5c at expiry. We want to
select c so that there is no possibility of loss:
4
(10c − 4) − 5c = 0 =⇒ c =
5
Example
The initial gain is 10 45 − 4 = 4;

If S1 = 46, the gain at expiry will be:

4
(46 − 45) − (46 − 40) = −3.8
5
With interest, the net gain is:
4e 0.08 − 3.8 = 0.5331
Arbitrage that minimizes the loss: Suppose K2 > K1 and

C (S, K2 , T ) < C (S, K1 , T ) − (K2 − K1 ),
=⇒ Sell c K1 -strike call + Buy one K2 -strike call.
The worst case is when St = K2 , K1 option is exercised.
The initial gain is cC (S, K1 , T ) − C (S, K2 , T ) and the payment at
time t is c(K2 − K1 ).
Solving for c to make the sum 0:
cC (S, K1 , T ) − C (S, K2 , T ) − c (K2 − K1 ) = 0
C (S, K2 , T )
c=
C (S, K1 , T ) − (K2 − K1 )
Different strike prices - Convexity
Option premiums are convex with respect to the strike price.

The rate of decrease in call premiums as a function of K
decreases. The rate of increase in put premiums as a function of
K increases. Algebraically, for K3 > K2 > K1 :
C (S, K3 , T ) − C (S, K2 , T ) C (S, K2 , T ) − C (S, K1 , T )

≥
K3 − K2 K2 − K1
P (S, K3 , T ) − P (S, K2 , T ) P (S, K2 , T ) − P (S, K1 , T )
≥
K3 − K2 K2 − K1
An equivalent way of expressing convexity: the price of the

K2 -strike option is less than the linearly interpolated prices of
the other two options.
K3 − K2 K2 − K1
C (S, K2 , T ) ≤ C (S, K1 , T ) + C (S, K3 , T )
K3 − K1 K3 − K1
K3 − K2 K2 − K1
P (S, K2 , T ) ≤ P (S, K1 , T ) + P (S, K3 , T )
K3 − K1 K3 − K1
With derivatives,
∂ 2 C (S, K , T ) ∂ 2 P(S, K , T )
≥ 0; ≥0
∂K 2 ∂K 2
Example
For options with the same style (European or American) and expiry
date, you are given.
(i) 40-strike put options on a stock have price 1.
(ii) 70-strike put options on a stock have price 10.
Determine, based on convexity of option prices, the highest possible
price for a 60-strike put option.
Solution: By convexity,
(60 − 40)P(70) + (70 − 60)P(40)

P(60) ≤ =7
70 − 40
Arbitrage that maximizes the initial gain: Suppose that

K3 > K2 > K1 and
K3 − K2 K2 − K1
C (S, K2 , T ) > C (S, K1 , T ) + C (S, K3 , T )
K3 − K1 K3 − K1
Sell the K2 -strike call;

Buy KK33 −K2
−K1
K1 -strike calls;
K2 −K1
Buy K3 −K1
K3 -strike calls. The initial gain ¿ 0.
Arbitrage that maximizes the initial gain:
St < K2 : K2 -strike call is not exercised, nothing to pay.
K2 < St < K3 : Pay St − K2 and receive
(K3 − K2 )
(St − K1 )
(K3 − K1 )
Let St = K3 − x with x > 0 and we get
K3 − K2 K2 − K1
(St − K1 ) − (St − K2 ) = (x) > 0
K3 − K1 K3 − K1
St = K3 : the worst case, net payment = 0;
St > K3 : Pay St − K2 and receive
K3 − K2 K2 − K1
(St − K1 ) + (St − K3 ) = St − K2 ,
K3 − K1 K3 − K1
net payment = 0.
Arbitrage that minimizes the initial gain:

Sell one K2 -strike call;
Buy vu p K1 −strike calls;

Buy vu q K3 −strike calls. where

K3 − K2 K2 − K1
p= ; q= ;
K3 − K1 K3 − K1
u = C (S, K2 , T ) ; v = pC (S, K1 , T ) + qC (S, K3 , T )
No initial gain.
The portfolio pays at least u/v > 1 times as much as you will pay on
the K2 -strike call.
Example
For three 6-month American call options on a stock:
(i) One with strike price 45 sells for 6.30.
(ii) One with strike price 44 sells for 7.00.
(iii) One with strike price 40 sells for 9.50.
The option with strike price 44 is overpriced based on the convexity
property of option premiums. You therefore sell it.
Determine the maximum and the minimum amount of the other two
options you should buy to guarantee a profit.
Example
Solution: Let x be the number of 40-strike calls and y the number of
45-strike calls.
No initial investment:
9.50x + 6.30y ≤ 7.00
To assure no loss, we will exercise our options when the 44-strike one
is exercised.
If S > 45: For each unit increase in stock price above 45, we must
pay an additional 1 on the option we sold. So we must make sure
that the options we buy also pay an additional 1 for each increase in
the stock price above 45. That means x + y ≥ 1.
Example
If 44 < S ≤ 45: Only the 40-strike option pays off. We must make
sure that the amount it pays is more than the amount we need to
pay. The worst possible case is when the stock price is 45. The profit
we made initially is
7 − 9.5x − 6.3y
The amount we need to pay if the stock price is 45 is 1 − 5x. So we
must have
7 − 9.5x − 6.3y ≥ 1 − 5x
4.5x + 6.3y ≤ 6
Example
So we have three conditions:
9.5x + 6.3y ≤ 7
4.5x + 6.3y ≤ 6
x +y ≥1
Calculate the intersections of the three lines,

1 7 25 5
≤x ≤ ; ≤y ≤
6 32 32 6

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The Models for Analysing & Evaluating the

Van Quy NGUYEN

Actuary program - NEU

February 21, 2024

Van Quy NGUYEN IFM course February 21, 2024 1 / 131

Van Quy NGUYEN IFM course February 21, 2024 2 / 131

Van Quy NGUYEN IFM course February 21, 2024 3 / 131

Van Quy NGUYEN IFM course February 21, 2024 4 / 131

Van Quy NGUYEN IFM course February 21, 2024 5 / 131

Van Quy NGUYEN IFM course February 21, 2024 6 / 131

Profit of a long Call is the

Van Quy NGUYEN IFM course February 21, 2024 7 / 131

Exercise styles: governs the time at which exercise can occur.

Van Quy NGUYEN IFM course February 21, 2024 8 / 131

The Moneyness of an Option: describes whether the option

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Van Quy NGUYEN IFM course February 21, 2024 10 / 131

Van Quy NGUYEN IFM course February 21, 2024 11 / 131

Van Quy NGUYEN IFM course February 21, 2024 12 / 131

Van Quy NGUYEN IFM course February 21, 2024 13 / 131

There are many exercise styles: American, European, and

Van Quy NGUYEN IFM course February 21, 2024 14 / 131

Van Quy NGUYEN IFM course February 21, 2024 15 / 131

max (0, K − ST ) − FV (Premium) = 1000 − S − 74.20(1.02)

The profit for being short is:

−max (0, K − ST ) + FV (Premium) = −1000 + S + 74.20(1.02)

Equating these, we get:

2S = 2000 − 2(74.20)(1.02) −→ S = 924.32

Van Quy NGUYEN IFM course February 21, 2024 16 / 131

Van Quy NGUYEN IFM course February 21, 2024 17 / 131

Options Strategies: Combine options and other assets, for hedging,

Van Quy NGUYEN IFM course February 21, 2024 18 / 131

Van Quy NGUYEN IFM course February 21, 2024 19 / 131

Strategies involving buying/selling an option and the underlying

Van Quy NGUYEN IFM course February 21, 2024 20 / 131

Insurance strategies - Long put, long stock:

Van Quy NGUYEN IFM course February 21, 2024 21 / 131

Insurance strategies - Long put, long stock:

Van Quy NGUYEN IFM course February 21, 2024 22 / 131

Insurance strategies - Long call, short stock:

Van Quy NGUYEN IFM course February 21, 2024 23 / 131

(50 − 3.69)(1.04)0.025 − 60 = 46.77 − 60 < 0, ST > 60

Profit > 0 when ST < 46.77.

Van Quy NGUYEN IFM course February 21, 2024 24 / 131

Covered written call - Short call, long stock:

Van Quy NGUYEN IFM course February 21, 2024 25 / 131

Covered written put - Short put, short stock:

Van Quy NGUYEN IFM course February 21, 2024 26 / 131

Van Quy NGUYEN IFM course February 21, 2024 27 / 131

Van Quy NGUYEN IFM course February 21, 2024 28 / 131

If K = F0,T : synthetic forward. The initial payment must be 0:

Equivalent strategies: Long call + short stock = Long put +

S0 e (r −δ)T = 1300e 0.05−0.02 = 1339.59

The price of the off-market forward is

e −rT (1339.59 − 1310) = e −0.05 (29.59) = 28.15

Van Quy NGUYEN IFM course February 21, 2024 30 / 131

Van Quy NGUYEN IFM course February 21, 2024 31 / 131

Option strategies involving two options:

Van Quy NGUYEN IFM course February 21, 2024 32 / 131

Van Quy NGUYEN IFM course February 21, 2024 33 / 131

The payoff of Bull spreads with put:

Van Quy NGUYEN IFM course February 21, 2024 34 / 131

Van Quy NGUYEN IFM course February 21, 2024 35 / 131